From marijuana to the metaverse: specialised ETFs underperform

Exchange-traded funds (ETFs) are low-cost investment vehicles that passively replicate the performance of an index and can be traded continuously in the stock market. Over the past three decades they have allowed investors to expand their investment opportunities and an increasing number of people to investing in the financial markets at relatively lower fees.

After the success of the first wave ETFs tracking market indices such as S&P500 index, competition in the ETF industry has become increasingly fierce and fees declined. In their recent research prof. Franzoni and his coauthors show that, to continue maximizing their revenues, ETFs providers came up with new types of products that charged higher fees and tracked smaller segments of the market. The new products are designed in such a way to steadily cater investor’s attention and focus on ‘hot’ topics, which investors are excited about. These investors are more likely less sensitive to the price they pay for the product as they are readier to bet on their preferred theme. Examples of thematic ETFs range from Covid-19 vaccines, to telemedicine, smart working, from marijuana to the metaverse and bitcoin.

The authors find that, on average, these new equity ETFs are poor investments on a risk-adjusted basis, as they have underperformed by about 30 per cent with respect to broad-based ETFs in the first five years since their inception. The gross underperformance is largely driven by the underperformance of the stocks these specialized ETFs choose to hold. As prof. Franzoni explains, “the stocks in the baskets of specialised ETFs start from relatively high valuations. In particular, new ETFs hold firms that, before the fund launch, had unusually high past returns (outperforming benchmarks by 5 per cent a year, on average) and received very favorable media coverage.” 

“Investors should therefore beware - says prof. Franzoni – when considering investing in the new ETFs because they risk losing along three dimensions: they sacrifice portfolio diversification, they are likely to invest in overvalued assets and they pay higher fees. Our research shows that recent episodes of protracted and deep drawdowns for specialised ETFs are a widespread phenomenon”.

The full article on the Financial Times is available here: https://www.ft.com/content/48fd0fd2-f12c-43ac-93f4-a25074fcb35f?shareType=nongift

The academic research the article refers to is available here: https://academic.oup.com/rfs/advance-article-abstract/doi/10.1093/rfs/hhac048/6655702

An interview with prof. Francesco Franzoni on this topic can be found in Corriere del Ticino of February 18, 2023: https://www.cdt.ch/news/economia/etf-tematici-piu-rischiosi-meno-redditizi-e-sopravvalutati-308638