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The finding is particularly visible in leveraged ETFs where buyers are essentially ‘catching a falling knife’ by preventing stocks from getting to their fundamental value © Reuters

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Investors in exchange traded funds are a barometer of what not to buy, with excess returns to be made by shorting those with the biggest inflows and going long those with the largest outflows, research suggests.

The contrarian nature of ETF flows is particularly strong for leveraged funds, thanks to the prevalence of “dumb” retail money, the academic findings show.

“ETFs with large inflows predictably earn lower future returns than ETFs with large outflows,” said Shaun William Davies, one of the authors.

Moreover flows to and from leveraged ETFs, which provide magnified short-term exposure to an underlying market, such as the S&P 500, are “always contrarian”, he added.

“When markets are going down, we see a big rise in long leveraged [flows] and vice versa. [Buyers] are betting against a shock and preventing stocks from getting to their fundamental value. They are catching a falling knife.”

One paper, ETF Arbitrage, Non-Fundamental Demand, and Return Predictability, co-authored by Davies, found that a portfolio that is short high-flow ETFs and long low-flow ETFs earned an excess return of between 1.1 per cent and 2 per cent a month for US equity ETFs during the nine-year sample period.

A follow-up paper, Speculation Sentiment, written by Davies, found similarly large predictive power in flows to and from leveraged ETFs. Specifically, a one standard deviation increase in net flows — a commonly used statistical measurement — is associated with a 1.14 per cent to 1.67 per cent decline in broad market stock indices during the following month.

The findings were no surprise to some.

“It is an open secret within the financial industry that certain portions of the retail investor community make bankably poor investment decisions, ie they buy at the top of the market and sell at the bottom,” said Kenneth Lamont, senior fund analyst for passive strategies at Morningstar.

“The short-term, high octane returns promised by leveraged products makes them especially attractive to this subset.”

Vitali Kalesnik, director of research for Europe at Research Affiliates, a Californian investment house, agreed that leveraged ETFs “are associated with less sophisticated investors [as] more sophisticated traders have cheaper and more efficient ways” to gain similar exposures.

Overall, what the researchers are finding is “mean reversion”, Kalesnik said. “The dumb money flows in. If these large flows are unrelated to fundamentals then ultimately there is mean reversion.”

The authors believe their findings result from ETF flows representing “non-fundamental” demand, which they define as “beliefs that are uncorrelated with fundamental news” as well as “over and under-reaction to fundamental news”.

They argue this non-fundamental demand “distorts asset prices away from fundamental values”, leading to an inevitable correction at a later point.

Davies argued there was “nothing nefarious about ETFs themselves”, which he described as “one of the most incredible innovations in the financial space”.

Instead, the authors argue that ETFs provide a “really clean way to observe mispricing” because of the trading mechanism that whirrs away behind the scenes to keep them fairly priced, at least in normal market conditions.

If an ETF sees meaningful net inflows, the price of the ETF’s shares will rise above the value of its underlying holdings. At this point, arbitrageurs or “authorised participants” step in, buying a basket of securities and swapping these with the ETF’s provider for newly created ETF shares. The AP then sells these shares, locking in the price differential and bringing the price of the ETF and its underlying securities back into line.

This creation process runs in reverse at times of net outflows, with ETF shares being redeemed.

“Any time we see arbitrageurs or APs step in to create or redeem shares we know that either the share price or the underlying assets are experiencing excess demand,” Davies said.

He argued that this “must be down to something non-fundamental” since the ETF and the underlyings “have access to the same cash flows”.

The team’s data crunching suggests that ETF share creations tend to be an indicator of sub-market returns in the subsequent months, as the mispricing driven by non-fundamental demand corrects. Conversely, redemptions presage above-market returns.

“That suggests that ETF shares are relatively more sensitive to non-fundamental demand shocks than the underlying is,” Davies said.

The analysis did not find such a strong relationship for fixed income ETFs, suggesting that “a lot of the non-fundamental demand is in the bonds themselves: a lot of the price discovery is in the ETFs,” Davies added.

The relationship was, though, very strong for leveraged ETFs. Davies attributed this to these funds being traded primarily by retail investors (“dumb” money), while the derivatives that underlie leveraged ETFs are traded by professionals (“smart” money).

Davies believed a long/short strategy based on the findings could be viable, given that ETFs tend to be easy and cheap to short compared with individual stocks, especially smaller companies.

He said he was working with a hedge fund that is attempting  to construct a vehicle that would consistently beat the S&P 500 by a few basis points and is using Davies’s leveraged ETF metric as one of the signals as to when to go long or short the market.

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