Response of ETF flows and long-run returns to investor sentiment

ETFs combine features of open-end and closed-end funds. In this paper, we investigate how the unique characteristics affect ETFs’ response to investor sentiment. We employ a novel identification strategy to distinguish between the response of liquidity traders, short-term arbitrageurs and long-term arbitrageurs. We find that liquidity traders respond positively to sentiment, which results in a subsequent cumulative 12-month return of −8%. Long-term arbitrageurs who go long the ETF, and short the underlying asset benefit from this return reversal. Finally, short-term arbitrageurs respond negatively to the Baker and Wurgler (2006) sentiment measure. Their actions are profitable in the long-run as ETFs that experience fewer redemptions from short-term arbitrageurs experience weaker returns reversals.