It has always been known that ETFs serve as a hedging tool, but a recent research presentation explores this issue more precisely and shows that many short interest spikes are driven by hedging and not an industry view. See "Innovation and Informed Trading: Evidence from Industry ETFs" by Shiyang Huang, Maureen O’Hara, and Zhuo Zhong Darden Mayo Center Virtual Seminar April 2020.
Assume a hedge fund finds an attractive stock to purchase. Instead of buying outright, selling against another stock, or hedging against the market portfolio, the best alternative may be to sell short an industry ETF. The industry basket hedge is easy to execute and is a useful tool since there are not industry index futures available. Hence, the short interest in an industry ETF may not tell us anything the absolute or relation performance of the industry group. A spike in ETF shorts is often just a signal of hedging in order to purchase a stock that is likely to a have a positive earnings surprise.
The researchers explore these hedging details through looking at specific times when there are combinations of stock picking and industry ETF shorting. First, they look at abnormal long-short hedge fund holdings prior to earnings announcements. The long-short trade of buying the stock and selling the industry index before a positive earnings announcement shows how hedge funds use the ETF as a hedging tool and use their stock specific skill at making earnings bets.
This is a subtle test of the value of ETF hedging, but it displays the power of ETFs as a multi-faceted tool for investors to both display an industry view and employ an inexpensive hedging tool. Industry ETFs help to make markets more efficient.
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