HomeMetaverseFrom marijuana to the metaverse: specialized ETFs underperform

From marijuana to the metaverse: specialized ETFs underperform

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The writer is a professor of finance at the University of Lugano and a professor at the Swiss Finance Institute

From marijuana legalization to the work-from-home boom, if there is a trend or theme in the markets, there will be an exchange-traded fund for it.

With the cost of issuing new ETFs low and competition among fund issuers intense, financial innovation has flourished. Thousands of new ETFs have been launched in the last three decades. The range of recent specialized ETFs seemingly stretches as far as investors can imagine.

But does financial innovation in the ETF space create value for investors? A study to be published in the Review of Financial Studies that I co-authored with Itzhak Ben-David, Byungwook Kim, and Rabih Moussawi suggests otherwise. Our results show that, on average, new stock ETFs are poor investments on a risk-adjusted basis. The study points a finger at specialized stock ETFs that focus on specific industries and themes.

Over the past two decades, thematic and industry ETFs have underperformed broad-based benchmarks by about 30 percent in the first five years since their inception. Of these, only about 3 percentage points are due to its fees and 27 percentage points are due to underperforming core assets.

The need to attract investor attention has led ETF providers to follow the latest trends, turning a passive product into an active bet on the topic of the moment. After the success of the first wave of ETFs that track broad-based indices like the S&P 500 Index, competition has intensified and fees have come down. To counter this development, issuers devised new types of products that charged higher fees and tracked smaller segments of the market. Smart beta ETFs were introduced, which are built to reflect investment focus rather than direct market capitalization. Then came ETFs based on industries and thematic versions. Individual stock ETFs are just the latest step in the evolution of the species.

The newly launched ETFs focus on the themes of the month that investors are excited about. In 2020, the new ETFs held portfolios related to areas such as Covid-19 vaccines, telemedicine, and sports betting/gaming. In 2021, investor dreams included bitcoin, electric cars, and the metaverse.

Naturally, ETF issuers design new products with one consideration in mind: maximizing their income. Income is higher when the fee and the assets invested by investors are higher. With thousands of ETFs already on the market, new ETFs must be unique and capture investors’ attention.

And if the idea behind the ETF gives investors the thrill of betting on their preferred theme, they will be less sensitive to the price they pay for the product. For this reason, in the midst of the forced restructuring imposed by the fall of the markets, the industry is renewing its commitment to specialized ETFs.

Despite managing only 18 percent of US equity-focused ETF assets, these products are true blockbusters, raking in around 35 percent of revenue, due to higher fees that they charge

The academic literature has shown that investors chase assets that have recently experienced good returns. Possibly aware of these results, ETF issuers introduce products that track “hot” topics and industries. As a result, stocks in specialized ETF baskets start at relatively high valuations. In particular, the new ETFs have companies that, prior to the fund’s launch, had unusually high past returns (outperforming benchmarks by 5% per year, on average) and received very favorable media coverage. The high fees charged by specialized ETFs contribute to their underperformance, typically around 0.60 percentage points.

But commissions are not the main reason for low gross performance. That’s driven simply by the assets that specialized ETFs choose to hold. They are overrated at launch and underperform in subsequent years.

To conclude, investors should be careful when considering investing in specialized ETFs. They risk losing on three dimensions: they sacrifice portfolio diversification, are likely to invest in overvalued assets, and pay higher fees. Our research shows that recent episodes of long and deep drawdowns of specialized ETFs are a widespread phenomenon.

Jack Bogle, the founder of the index fund industry and advocate of passive investing, was highly critical of ETFs. His view was that ETFs are the greatest marketing innovation of the 21st century, but they don’t serve investors well. Our study supports this view, as far as specialized ETFs are concerned.

Click here to visit the ETF Hub

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