Over the past decade, exchange-traded funds (ETFs) have transformed the investment industry with total net assets skyrocketing to $6.73 trillion by February 2023. As a passive investment product, ETFs track a particular index and aim to replicate its performance. To maintain low tracking error, ETFs rebalance portfolios following underlying index reconstitutions. With the rise in popularity of nontraditional ETFs, such as rules-based ETFs, characterized by frequent portfolio rebalancing, the volume of rebalancing trades has increased exponentially.
ETFs owe their disruptive power to their unique structure, which offers investors cost-effective and highly liquid alternatives to mutual funds (MFs). However, the embedded transparency of ETFs and the predictability of their rebalancing trades creates an opportunity for arbitrage traders to front-run rebalancing events, potentially incurring significant hidden costs for ETFs and their investors. By predicting the rebalancing trades of ETFs, hedge funds and other arbitrage traders may front-run and buy the stocks that will be included in an ETF portfolio and (short) sell stocks that will be excluded from it. Such actions by arbitrageurs may drive up the prices of stocks that ETFs need to buy prior to rebalancing dates, making rebalancing more expensive for ETF investors. Conversely, if hedge funds anticipate sales by ETFs, they may drive prices down, causing ETFs to sell at a loss. The importance of understanding the interaction between ETF rebalancing and arbitrage trading was highlighted in March 2020 when major index providers, such as S&P Dow Jones, canceled their scheduled rebalancing events due to the COVID-19 pandemic and unstable market. This decision hit hedge funds that positioned themselves to anticipate the trades of these indices with large losses.
ETF trades break down into two parts: (1) trades in response to inflows and outflows and (2) rebalancing-driven trades due to either stock inclusion in (exclusion from) the underlying index or weight changes in case of equal-weighted ETFs. While prior work explored the impact of ETF flows and documented the nonfundamental demand shock imposed by ETF flows on underlying securities (Brown, Davies, and Ringgenberg, 2021), we conduct an empirical study to examine the role of arbitrage traders in ETF rebalancing events and their impacts on stock returns and capital markets.
ETF rebalancing trades and stock returns
It is commonly assumed that due to the passive nature of ETFs, they directly translate flows into trading. Therefore, flows are considered one of the main drivers of price pressure on underlying securities. However, ETFs also trade to follow any changes to the underlying indices, such as changes in index constituents or their weights. Therefore, it is important to consider the effect of ETF rebalancing activities on underlying securities. We hand-collect monthly holdings data on US domestic equity ETFs from Morningstar for the sample period from 2005 to 2020. First, we show that ETF rebalancing trades exhibit a positive relation with contemporaneous returns and a negative relation with future returns of the underlying stocks, which is incremental to well-documented flow-induced trades. The estimated negative relation is short-lived and only remains significant over a one-month horizon, which indicates that the effects may reflect the temporary price pressure of ETF rebalancing trades. We find that the impact of ETF rebalancing trades on stock returns is stronger among small stocks.
We further investigate the impact of ETF rebalancing trades across different types of ETFs: broad-market ETFs, rules-based ETFs, and sector ETFs. The growth of ETFs can partially be attributed to the growth in popularity of rules-based ETFs that are considered less passive as their portfolios tend to follow a specific rules-based index or factor strategy (e.g., momentum). To keep their portfolios consistent with the underlying rule or strategy, rules-based ETFs rebalance their portfolios more frequently compared to the broad-market ETFs that track broad-market indices (e.g., S&P 500 and Russell 1000); hence, their rebalancing activity may have a significant impact on underlying securities. Indeed, our analysis shows that the negative relation between ETF rebalancing and future returns is more pronounced for rules-based ETFs but remains statistically significant for broad-market ETFs.
On the basis of the findings above, we explore a strategy that bets against ETF rebalancing trades: buying stocks with the lowest ETF rebalancing trades and short selling stocks with the highest ETF rebalancing trades. This strategy yields significant monthly returns of 0.38% over the sample period of 2005–2020, and the spread is even larger after 2010 with a monthly return of 0.47%.
Impact of hedge funds front-running trades
Arbitrageurs, specifically hedge funds, may utilize front-running strategies in advance of ETF rebalancing events to capitalize on potential price fluctuations. This practice may further exacerbate the price impacts of ETF rebalancing on stock returns and destabilize prices prior to the scheduled rebalancing date. As a consequence, ETFs may face higher execution costs and be compelled to “buy high and sell low.”
We document that hedge funds gradually increase (decrease) their positions in stocks to be included in (excluded from) the ETF portfolio. Our comprehensive analyses suggest that professional arbitrageurs make profit at the expense of ordinary ETF investors around ETF rebalancing events. Stocks that are subject to arbitrage trading by hedge funds significantly outperform stocks that are not front-run by hedge funds by 0.86% per month before the ETF rebalancing event, and the outperformance remains significant (0.75% per month) during the ETF rebalancing month. This implies that hedge funds’ arbitrage trades move stock prices up before ETFs’ rebalancing date, which forces the “buy high and sell low” scenario upon ETFs. Consequently, ordinary ETF investors may suffer from intervention of hedge funds into ETFs’ rebalancing events.
Unique nature of ETF rebalancing and its importance
It is well established that strategic traders profit from front-running flows of distressed traders and sell stocks ahead of fire sales, which results in price overshooting. We highlight that due to the transparency of ETFs, hedge funds have the ability to accurately predict most ETF trades, which allows them not only to trade in anticipation of flows, but also front-run their rebalancing trades, even in the case of rules-based ETFs. Therefore, the unique setting ETFs provide for hedge funds’ front-running trades can destabilize the prices of underlying securities to a greater extent.
The closest alternative to ETFs is index mutual funds (IMFs), both of which closely follow an underlying index and rebalance their portfolios accordingly and hence may also be subject to hedge funds front-running. Indeed, we find that stocks in the rebalancing portfolios of both ETFs and IMFs experience higher hedge fund front-running activity. However, unlike ETFs, IMFs have the managerial discretion to postpone portfolio rebalancing to avoid delegation costs. Due to the flexibility of IMFs to decide when to rebalance, the negative impact on future stock returns might not be as significant as for ETFs. We find that stocks rebalanced by ETFs alone and front-run by hedge funds significantly underperform stocks with IMFs rebalancing by 1.05% in the month following reconstitution events. These findings reveal the unique nature of ETF rebalancing trades and their potential to significantly impact underlying securities.
Overall, our study provides important insights into the impact of ETF rebalancing on stock returns and highlights the need for investors to carefully consider the implications of ETF rebalancing when making investment decisions.
George Jiaguo Wang is Associate Professor of Finance at Lancaster University Management School.
Chelsea Yaqiong Yao is Associate Professor of Accounting and Finance at Lancaster University Management School and Visiting Research Professor at New York University’s Stern School of Business.
Adina Yelekenova is a Ph.D. student at Lancaster University Management School.
This post was adapted from their paper, “ETF Rebalancing, Hedge Fund Trades, and Capital Market,” available on SSRN.