Extant research provides evidence for financial innovation’s contribution to market efficiency by documenting that hedge funds which bet on positive earnings surprises manage their sector risk by shorting industry exchange-traded funds (ETFs). The authors add to this literature by considering a hypothetical hedge fund that can anticipate positive earnings news. They construct return series for a naked strategy that only takes long stock positions and a hedged strategy that also holds short positions in industry ETFs around earnings announcements with positive content. The main result is that hedging with industry ETFs improves fund performance based on various reward-to-risk ratios. This finding holds in various equity subsamples and both strategies tend to perform better among riskier stocks.
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