Innovation and Informed Trading: Evidence from Industry ETFs

We hypothesize that industry exchange traded funds (ETFs) encourage informed trading on underlying firms through facilitating the hedge of industry-specific risks. We find that the industry ETF membership increases hedge funds’ abnormal holdings before earnings announcements and reduces the market reaction to the firm’s earnings surprise, especially the positive surprise. In addition, we show that short interest on industry ETFs positively predicts returns on these ETFs and the percentage of positive earnings announcements of underlying firms. Our results suggest that financial innovations such as industry ETFs can be beneficial for informational efficiency if they help investors to hedge risks.