This popular type of investment fund almost always loses money

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Investors hoping for big returns by putting their money into trending topics like the metaverse through work-from-home and exchange-traded funds (ETFs) will likely face gross underperformance, a new study shows.

Researchers found that ETFs based on these and similar hot topics earn about 30% lower average returns than more diversified funds five years after launch.

“When people follow these popular investment themes, they get frustrated,” said Itzhak Ben-David, a study co-author and professor of finance at Ohio State University’s Fisher College of Business.

“These hot-topic funds are often based on hype and lose value relative to the general market as soon as they launch.”

The study was recently published online in the journal Review of Financial Studies.

ETFs, which were first developed in the mid-1990s, are popular investment funds that trade in stock markets and are set up like mutual funds, holding a variety of stocks in their portfolio.

The popularity of ETFs is growing rapidly. By the end of 2021, more than $6.6 trillion was invested in more than 3,200 ETFs. The original ETFs were broad-based products that mimicked index funds, meaning they invested in large, diversified portfolios, such as the entire S&P 500, Ben-David said.

But recently, some companies have introduced what Ben-David and his colleagues call “specialty” ETFs, which invest in specific industries or themes — usually those that have recently received a lot of media attention, such as bitcoin, cannabis, and related firms. With the Black Lives Matter movement.

“These particular ETFs are about sectors that are promoted as the ‘next big thing’ on social media and other platforms. But by the time these ETFs are launched and available to investors, it’s too late to make money,” Ben-David said.

“Specific ETFs basically boil down to soundbites: ‘You should invest in electric vehicles,’ for example. That’s it. Most investors in it don’t know anything about the stocks in the ETF’s portfolio, the fees, the price. Earnings ratios. They just want to be part of the trend.”

For the study, researchers used Center for Research in Securities price data on ETFs traded in the U.S. market between 1993 and 2019.

They focused on 1,086 ETFs. Of those, 613 were broad-based, investing in a wide range of stocks.

The remaining 473 were specialty ETFs, investing in a particular industry or multiple industries bound by a theme.

Broad-based ETFs had returns that were relatively flat during the study period, the analysis showed. But specialty ETFs have lost about 6% of their value per year, with at least five years of underperformance following launch.

“It’s not that ETFs cause losses. It’s just that they almost always start when the hype for that particular sector is at its peak and has already started to decline,” Ben-David said.

Ben-David gives the example of working from home. The time to invest in that area would have been in March 2020 when stay-at-home orders for COVID-19 emerged, he said. But by the time specialized ETFs around that theme were launched a year later, stocks in that sector had already peaked.

Investors in specialty ETFs often put their money in traditional and social media-promoted sectors, he said.

The researchers found that media sentiment — a measure of positive media coverage of the individual stocks included in a particular ETF — typically occurred around the same time a particular ETF was launched.

Positive media coverage declined after launch as the financial press weighed down on the future prospects of stocks in the ETFs thematic sector.

The study found that the type of investors who bought into specific ETFs differed from those who invested in broad-based products.

For example, large institutional investors with professional managers such as mutual funds, pension funds, banks and endowments generally avoid specialized ETFs.

Data from online discount brokerage Robinhood, which caters to individual investors, showed that its clients are more likely to invest in specific than broad-based ETFs.

Specialty ETFs also charge higher fees than broad-based ETFs — perhaps because investors in these trending sectors don’t care much about fees and just want to be part of the fad, Ben-David said.

The results showed that while specialized ETFs make up about 20% of the ETF market, they generate about a third of the industry’s revenue from fees.

The study’s findings show the dark side of what he calls “the democratization of investment,” Ben-David said.

“The firms that market these particular ETFs are giving people what they want. But it’s not a good idea when investors are not sophisticated and don’t know how to think about investing,” he said.

“It’s a lot like junk food. It might be what some people want, but it’s not necessarily good for them.”

Co-authors of the study were Byungwook Kim, a graduate student in finance at Ohio State; Francesco Franzoni, professor of finance at USI Lugano and senior president of the Swiss Finance Institute; and Rabih Mousavi, associate professor of finance at Villanova University.

Want a hot stock tip? Avoid this type of investment fund

More information:
Itzhak Ben-David et al, Competing for Attention in the ETF Space, Review of Financial Studies (2022). DOI: 10.1093/rfs/hhac048

Provided by The Ohio State University

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