Hedge Fund Investment in ETFs

This paper investigates the causes and consequences of hedge fund investments in exchange-traded funds (ETFs) using U.S. data from 1998 to 2020. The findings show that transient and quasi-indexer hedge funds are significantly more likely to invest in ETFs. Moreover, hedge fund firms with a greater share of assets under management in Macro, Relative Value, and Fund of Funds strategies tend to invest more in ETFs, whereas those focused on Equity Hedge and Event-Driven strategies are less inclined to do so. ETF investments are generally associated with lower hedge fund returns, consistent with the presence of agency costs. The data also indicate that abnormal capital flows do not meaningfully affect ETF investments, which is inconsistent with the notion that ETFs are used as a tool for managing such flows. Furthermore, ETF usage is negatively correlated with the absolute value of the unobserved return component, suggesting that hedge funds primarily employ ETFs as passive investment vehicles rather than for short-selling, leverage, or derivative-based strategies.