Smart Beta, “Smarter” Flow

Cao, Hsu, Xiao, and Zhan examine the impact of smart beta equity exchange-traded funds (ETFs) on how investors evaluate active mutual fund performance. They find that when smart beta ETFs are actively traded, mutual fund flows become “smarter”, with a higher sensitivity to alphas from multi-factor models. The dominance of the CAPM alpha weakens and even disappears. Their findings highlight the importance of financial innovation in shaping investor behavior and are not explained by alternatives such as investor learning because the results are driven by sophisticated investors.

You can find the working full paper here.