ETFs as a disciplinary device
(April 2025, revised May 2025)
Summary
Focus
We investigate the role of actively managed exchange-traded funds (AETFs) as a disciplinary mechanism in the asset management industry, which distinguishes AETFs from traditional mutual funds and passive ETFs. We explore how the unique short-selling feature of AETFs enables investors to penalise underperforming fund managers, thereby enhancing market efficiency. We also examine the implications of AETFs for fund flows, managerial turnover, investment strategies and the price informativeness of underlying stocks.
Contribution
We highlight the short-selling feature of AETFs as a market-based disciplinary tool, a previously unexplored aspect in the literature on asset management. While previous studies have focused on the tax efficiency, liquidity and transparency of ETFs, we extend the understanding of AETFs by demonstrating their role in improving the efficiency of the fund management industry. Our paper also complements existing research on short-selling and market efficiency by showing how short-selling can discipline active fund managers, thereby bridging gaps in the literature on active ETFs and their impact on managerial performance and market dynamics.
Findings
We find that AETFs exhibit over five times greater flow-performance sensitivity than mutual funds, making them more effective at penalising underperforming managers. Investors actively short-sell AETF shares when poor-performing managers join, leading to higher outflows and increasing the likelihood that these managers will exit the industry. This process enhances the overall quality of fund management by retaining high-performing managers. Additionally, AETFs are associated with improved price informativeness of their underlying stocks, and AETFs exhibit a higher propensity for risk taking, favouring momentum and stocks with higher idiosyncratic risk.
Abstract
We document a unique feature of active exchange-traded funds (AETFs): they serve as a disciplinary tool for investors to remove underperforming managers. Unlike mutual fund shares, AETF shares can be shorted, allowing any investor to take a position against underperforming AETF managers. We show that AETFs exhibit over five times greater flow-performance sensitivity than mutual funds, indicating that AETF managers face harsher penalties for poor performance. Investors actively short-sell shares of AETFs managed by underperforming managers, ultimately driving their departure. AETFs' unique short-selling mechanism reduces frictions in active fund management, enabling more efficient allocation of capital to high-performing managers.
JEL classification: G10, G11, G12, G20, G23
Keywords: ETF, mutual funds, performance, flow, active fund management
