Specialized ETFs: The new “structured products” for inexperienced retail investors

So is style investing a good idea? Should you invest in a new specialized ETF that focuses on today’s hot sector or theme? The answer is unambiguous – No!

After the 2008 global financial crisis, structured financial products such as mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs) received significant blame for what had occurred. Briefly, these products consisted of pools of mortgages repackaged for different types of investors with different levels of risk appetite. Margot Robbie explains them (provocatively) in The Big Short:

Investors eagerly bought these opaque products, mistakenly believing that they were not as risky as their underlying holdings because of diversification, but when housing prices fell across the board, sparking a wave of defaults, the value of these “safe” structured products also plunged.  

So what does any of this have to do with ETFs?

Exchange-traded funds are structured financial products for retail investors. When they were first introduced in the 1990s, their premise was quite similar to that of traditional mutual funds: Provide retail investors with access to a well-diversified stock portfolio but with certain advantages such as the ability to trade intraday and better tax efficiency. As demand soared and the number of ETFs grew exponentially, the market for broadly-diversified funds became saturated. After all, how many nearly-identical S&P 500 or MSCI World funds do we really need? Fund providers responded by creating specialized ETFs focusing on market segments, and the segments grew more and more narrow to meet investor demand for differentiated products: First regions of the world (Asia Pacific) and then individual countries (China), first economic sectors (Technology) and then sub-industries (Semiconductors), and finally intersections of these subgroups (such as Chinese Technology). As with CMOs, the “baloney” kept getting re-processed and cut more and more thinly.

Once the baloney was cut so thin that you could barely see it, ETF providers came up with a new way of repackaging stocks by using “themes”. Thematic ETFs take advantage of investor demand for “hot” groupings of stocks that have been recently in the news and/or have had high returns. Some examples of thematic ETFs include funds based around innovation, blockchains, cannabis, artificial intelligence, and video games. Specialized ETFs have received a lot of investor dollars and media attention, especially with the recent growth of do-it-yourself retail investing sparked by the coronavirus pandemic. The ARK Innovation ETF, a thematic fund that is actively managed by Cathie Wood, grew since March 2020 from $2 billion in assets to $20 billion, and is a darling of the financial media.

Andrei Shleifer and Nicholas Barberis, two of the world’s preeminent behavioral economists, wrote about the tendency of investors to move money from cold into hot stock categories and its implications for financial markets, naming it Style Investing in a 2003 paper. This tendency is due to recency bias, where investors project recent past returns of an asset or portfolio into the future, and a fear of missing out on high returns attained by others, an investments version of “keeping up with the Joneses.” A 2005 study in the Journal of Finance by Michael Cooper, Huseyin Gulen, and P. Raghavendra Rau found that when a mutual fund changes its name to include a popular category or style, it grows its assets under management by 28% in the following year relative to its peers, whether or not the fund’s stock portfolio actually changes.

So is style investing a good idea? Should you invest in a new specialized ETF that focuses on today’s hot sector or theme? The answer is unambiguous – No!

The logic is simple. In an efficient market, everything is priced correctly and you will earn the appropriate return for the amount of risk that you are exposed to, no matter what you choose to invest in. In reality, due to frictions such as short-sales constraints and other limits to arbitrage, financial asset prices tend to suffer from momentum and reversals, booms and busts, bubbles and crashes. Increasing buzz around a specialized ETF is a sign that the stocks in the fund have just gone up in price; as more investors rush in to “chase” this past performance, those stocks become more and more overpriced and therefore more and more likely to go down in price in the near future. It turns into a game of hot potato and you don’t want to be one holding it when the music stops.

Two recent studies confirm this intuition. In a recent blog post at The Evidence-Based Investor entitled “Thematic Funds: Good Stories, Poor Investments,” Amy Arnott of Morningstar shows that the average thematic ETF has a lower risk-adjusted return (as measured by the Sharpe Ratio) than investing in the entire market. This makes sense since thematic funds are less diversified than the market, exposing their investors to higher risk without a commensurate higher return. She concludes: “The generally poor investor experience for people buying into thematic funds underscores a boring but wise lesson: Investing isn’t supposed to be exciting.”

A more comprehensive analysis is conducted by Itzhak Ben-David, Francesco Franzoni, Byungwook Kim, and Rabih Moussawi in an impressive 2021 working paper entitled “Competition for Attention in the ETF Space.” They argue that fund sponsors launch specialized ETFs to take advantage of hype surrounding a specific grouping of stocks. When the hype moves on to something else, as it invariably does, investors also jump off the train and the fund’s returns turn sharply negative. The graph below (taken directly from their paper) compares the average risk-adjusted performance in the months after the launch date for broad-based ETFs versus specialized ETFs, and clearly shows how the latter group significantly underperforms the former.

As the thumbnail for this post shows, there is a difference between speculating and investing. For retail investors, there is no need to waste time and effort on nearly all of the more than 2,000 exchange-traded funds that are available today. While the power to quickly invest in a portfolio of Brazilian stocks or gold mining stocks or virtual reality stocks, or whatever the next fad might be, sounds cool, these structured products, just like those that were so popular before the 2008 financial crisis, are likely to lead to unhappy endings for investors that think they found a shortcut to building wealth.