From marijuana legalization to the rise of work-from-home opportunities, if there is a market trend or theme, there will be a specialized ETF for it.

Financial innovation has thrived since the cost of launching new specialized ETFs is low and competition among fund issuers is fierce. Over the last three decades, many new ETFs have been introduced. The variety of recent specialized ETFs appears to be limited only by investors’ imaginations.

But, in the ETF industry, does financial innovation provide value for investors? A study co-authored with Itzhak Ben-David, Byungwook Kim, and Rabih Moussawi for the Review of Financial Studies argues otherwise. Findings suggest that, on average, new equity ETFs are poor risk-adjusted investments.

The study leads to specialized stock ETFs that target specific industries and themes.

Thematic ETFs

Industry and thematic ETFs have underperformed broad-based benchmarks by roughly 30% in the first five years of their debut over the last two decades.

Only roughly 3 percentage points are related to their costs, while the remaining 27 percentage points are due to the underperformance of the basic assets.

To draw investors’ attention, ETF providers have ridden the newest trends, transforming a passive product into an active gamble on the topic du jour.

Following the success of the initial wave of ETFs tracking broad-based benchmarks like the S&P 500 index, competition increased and fees decreased.

To combat this trend, issuers developed new types of products that demanded greater fees and tracked fewer sectors of the market. Smart beta ETFs, which are designed to reflect investment strategy rather than market capitalization, were introduced.

ETFs based on industry and themed variations followed. Single-stock ETFs are only the most recent step in the species evolution.

and they keep on going…

Newly released ETFs focus on popular topics that investors are interested in. New ETFs held portfolios relating to Covid-19 vaccinations, telemedicine, and gaming/sports betting in 2020.

Bitcoin, electric cars, and the metaverse were among the hopes of investors in 2021.

Naturally, ETF issuers create new products with one goal in mind: to maximize income.

Revenues increase when the fee rate and the number of assets invested increase.

With thousands of ETFs currently on the market, new ETFs must be distinct and appealing to investors.

And if the ETF’s concept excites investors enough to gamble on their favorite theme, they will be less sensitive to the price they pay for the instrument.

As a result, the sector is resuming its bet on specialized ETFs, despite the forced reorganization imposed by dropping markets.

Despite managing only 18% of the assets in equity-focused ETFs in the US, these products are true blockbusters, collecting approximately 35% of the revenues due to higher fees.

Seeking High Returns

According to academic research, investors seek out assets that have recently achieved high returns.

ETF issuers develop products that track “hot” industries and themes, maybe in response to these findings. As a result, the companies in specialized ETF baskets begin with somewhat high valuations. New ETFs, in particular, invest in companies that have unusually strong past returns (outperforming benchmarks by 5% per year on average) and had favorable media coverage before the fund’s introduction.

The high fees charged by specialized ETFs contribute to their poor performance – roughly 0.60 percentage points.

However, fees are not the primary cause of the overall underperformance.

This is simply due to the assets that specialized ETFs choose to hold. They are overpriced at debut and underperform in subsequent years.

Caution Needed

Finally, investors should exercise caution when considering investing in specialized ETFs. They risk losing in three ways: they forego portfolio diversity, are more likely to invest in overpriced assets, and pay higher fees.

According to our analysis, recent instances of prolonged and significant drawdowns for specialized ETFs are a common occurrence.

ETFs were heavily criticized by Jack Bogle, the inventor of the index fund industry and a proponent of passive investment. In his opinion, ETFs are the greatest marketing innovation of the twenty-first century, but they do not serve investors properly.

In the case of specialized ETFs, our research supports this viewpoint.

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