A passive revolution with blemishes

With the spread of index funds, thematic ETFs are also gaining popularity. But investors lose three times here.

Investors seem to rely less and less on the skills of active investment fund managers and are increasingly investing in index-related products such as exchange-traded funds (ETF), which has led to exponential growth in this segment: From almost zero in the early 1990s, investors worldwide are now invested in ETFs with over $9 trillion, of which $6.4 trillion are in the USA.

For example in Switzerland, ETFs manage around CHF 187 billion, which corresponds to about 13% of the total fund market. It is therefore not surprising that experts speak of a "passive revolution" in the light of this enormous growth. However, blemishes can be seen in the otherwise flawless success story of ETF.

Diversification does not exist

A development in the passive investment world is the fact that new ETFs are constantly being launched on different trend topics. In 2019, for example, the ETF industry focused on investments related to cannabis, cybersecurity or video games. A year later, the "Black Lives Matter" movement, Covid vaccines or topics related to home office were taken up. And in 2021, Bitcoin or any other cryptos, impact investing and the metaverse were discussed.

What many investors do not realise - or too late - is the fact that these thematic approaches, which are based on marketing narratives, invest in significantly fewer companies compared to established equity indices, such as the S&P 500. This inevitably falls by the wayside a balanced diversification of the portfolio.

Against this background, Francesco Franzoni from the USI Lugano together with Itzhak Ben-David and Byungwook Kim, both from Ohio State University, as well as Rabih Moussawi from Villanova University examined the performance of thematic ETFs and compared its performance with broad, regular ETFs that reflect well-diversified indices. They have also tried to find out why the financial industry is constantly putting up ETFs that are chasing popular investment topics.

Usually disappointing returns

In their study, they focused on the US market for ETFs in the years 2000 to 2019 and found that thematic ETFs usually generate disappointing returns. In the first five years, the said passive investment products achieve an average return that is about 30% lower than that of ETFs, which are significantly more widely supported. The reason for the weaker performance is explained by the fact that the securities underlying the corresponding ETF are usually already overvalued at the time of their launch.

Simply put, investments are often made in so-called "hot stocks" in a thematic context. These are securities of companies that, unlike their less trend-oriented competitors, have already received a high media attention. Of course, with decreasing media interest, the valuation of these companies decreases, and the ETF that maps these stocks subsequently delivers disappointing investment performance.

Higher fees, weaker performance

The hunt for "hot" and overvalued investment topics seems to be the result of a targeted marketing strategy by ETF providers due to the highly competitive environment. Over time, the profit margins achieved by the financial industry have become thinner. By constantly introducing new ETFs aimed at popular investment topics, sellers attract investors' attention and at the same time are able to enforce higher fees.

As has also been shown, the annual cost of thematic ETFs is on average a whopping 30% higher than its broader counterparts. Last but not least, it is characteristically, the less experienced investors of all people who are receptive to thematic ETFs, while institutional investors such as investment funds, pension funds, banks and foundations usually favour the broader ETF. Incidentally, this is also confirmed by the data of an established online discount broker in the USA, which is highly in the favour of private investors.

In summary, investors must be advised to exercise restraint when investing in thematic ETFs.

As the study shows that they are disappointed in three ways:

• They refrain from balanced diversification in the portfolio,

• they have to expect disappointing investment performance

• only pay even higher fees for it

Not really a good deal.

post scriptum

This post is based on a news article written by Francesco Franzoni from the USI Lugano and his research work together with his colleagues.