The flow‐performance puzzle: Insights from passive and active ETFs

Abstract This study examines the relationship between fund flows and subsequent performance, testing the smart money and price pressure hypotheses within the context of passive and active exchange‐traded funds (ETFs). By differentiating between managerial skill and non‐fundamental demand shocks, we uncover a significant positive flow‐performance relationship, challenging traditional attributions solely to investor skill in identifying superior fund management. We further develop a measure of flow shocks to individual stocks by aggregating daily changes in ETF ownership of 5600 stocks. An event study on ETF constituents further disentangles the effects of price pressure from smart money. Through robust analyses, including Fama–French industry portfolios and propensity score matching, our findings suggest a nuanced interaction between investor behaviour and market dynamics, contributing to the discourse on fund flows' impact on performance. This research highlights the complexity of the flow‐performance relationship and its implications for fund management and investment strategies, offering new insights into the mechanisms driving fund performance in the ETF landscape.