The short selling feature of active ETFs enhances market efficiency by removing poorly performing managers and deterring low quality ones from entering, according to new academic research.

In a recent paper titled ETFs as a disciplinary device, authors including a Bank of International Settlements (BIS) economist and two Hong Kong University of Science and Technology researchers, found active ETF flows are five times more sensitive to performance than mutual funds since investors can establish short positions – ultimately producing outflows from the fund.

Meanwhile, only existing holders can create outflows from mutual funds.

The report found short sellers also tend to be good at identifying underperforming managers, with high levels of short selling a statistically significant predictor of negative alpha.

Active ETF managers therefore experience much tougher penalties for poor performance and are more likely to be forced out of the industry.

The paper also found that second-rate mutual fund managers were unlikely to launch an active ETF in the first place since short sellers can bet against their performance - exposing them to unwanted career risk.

“The best-performing managers manage both types of funds as they know their good quality and are probably less afraid of being forced out if they convert to an active ETF,” explained the authors.

With underperforming managers forced out and poor-quality ones reluctant to enter, the active ETF industry theoretically boasts a superior pool of managers compared to active mutual funds.

This could help explain why active ETF managers outperformed their active mutual fund peers over the 2016-2024 study period.