Smart beta, “smarter” flows

We document that when smart beta ETFs are more actively traded, mutual fund flow sensitivity to multi-factor alphas increases significantly. This evidence is consistent with a friction hypothesis that active smart beta ETF trading reduces the costs of investing in non-market risk factors (e.g., SMB and HML). Consequently, when this friction is diminished, investors reward mutual fund managers more for multi-factor alphas. We show that the results are driven by sophisticated investors, ruling out behavioral explanations. The results are concentrated among mutual funds with high exposures to non-market risk factors. We further find that the gap between CAPM alpha and multi-factor alphas in explaining flows reduces when smart beta ETFs are actively traded.