COLUMBUS, Ohio — People often say the rich don’t have to work because they have their money work for them. If you’ve been looking to put some of your money to work for you, researchers from Ohio State University have a suggestion: avoid specialized Exchange Traded Funds (ETFs) focusing on “trendy” industries such as cannabis, work-from-home companies, and cybersecurity.
Study authors say these popular ETFs usually attract tons of inexperienced investors looking to make a quick profit. In most instances however, they end up resulting in near immediate losses.
“As soon as people buy them, these securities underperform as the hype around them vanishes,” says study co-author Itzhak Ben-David, professor of finance at OSU’s Fisher College of Business, in a university release. “They appeal to people who are not sophisticated about investing. They may have an extra $500 and decide to try to make what they think is easy money in the stock market.”
What exactly are ETFs?
ETFs were first conceived in the 1990s and are set up similarly to mutual funds. Intended to allow interested parties to diversify their investments, ETFs hold multiple stocks in their portfolios. The original set of ETFs created a few decades ago were designed to essentially copy index funds; investing in large portfolios such as the entire S&P 500.
However, as the years have progressed and ETFs have risen in popularity, some companies have started introducing “specialized” ETFs that focus solely on specific industries or themes dubbed as the “next big thing.”
“These specialized ETFs are often promoted as the ‘next big thing’ to investors who are wowed by the past performance of the individual stocks and neglect the risks arising from under-diversified portfolios,” explains study co-author Byungwook Kim, a graduate student in finance at Ohio State.
Researchers examined U.S. market ETF trading data from 1993 to 2019, provided by the Center for Research in Security Price. In all, that dataset accounted for 1,086 ETFs, with 613 of those being “broad-based,” or not specialized. That left 473 specialized ETFs.
“The securities that are included in the portfolios of specialized ETFs are ‘hot’ stocks,” comments co-author Francesco Franzoni, professor of finance at USI Lugano and senior chair at the Swiss Finance Institute. “We found that these stocks received more media exposure, and more positive exposure, than other stocks in the time leading up to the ETF launch.”
COVID and social justice of the stock exchange?
Examples of recent specialized ETFs include those launched in 2019 focusing on marijuana, video games, and cybersecurity. In 2020, new ETFs focused entirely on the COVID-19 vaccine, working from home, and even the Black Lives Matter movement.
The research team’s analysis reveals that broad and specialized ETFs usually perform very differently from one another. Broad ETFs saw their profits remain “relatively flat,” while specialized ETFs actually saw their value decline by four percent on average annually. This trend among specialized ETFs continued for at least five years after initial launch.
“Specialized ETFs, on average, have generated disappointing performance for their investors,” says co-author Rabih Moussawi, assistant professor of finance at Villanova University. “Specialized ETFs are launched near the peak of the value of their underlying stocks and start underperforming right after launch.”
Researchers also looked into the types of investors who usually choose specialized or broad ETFs. Experienced investors with the luxury of a financial advisor almost always avoid specialized ETFs and opt for broader options. The study finds that roughly 43 percent of the market capitalization among broad-based ETFs in their first year are owned by institutional investors. In comparison, seasoned investors only account for one percent of specialized ETFs’ market capitalization in their first year.
“If you purchase a specialized ETF, you are likely to lose money because their underlying stocks are overvalued,” Prof. Ben-David concludes.
This study was presented at the American Economic Association 2021 annual meeting.