Thematic exchange traded fund strategies have been a great way to access specific segments of the market and capture new trends, but may also pose unique risks.
According to academic research on U.S.-listed ETFs traded between 1993 through 2019, thematic ETFs on average underperformed the stock market on a risk-adjusted basis by about 4 percentage points per year for at least five years after their launch, the Financial Times reports.
“On the one hand, investors can now access financial markets at low cost, which can be welfare-improving because it allows broader risk sharing. On the other hand, the marketing strategies of specialized ETFs attract unsophisticated investors to underperforming investment propositions,” Itzhak Ben-David, Francesco Franzoni, Rabih Moussawi, and Byungwook Kim said in their paper, Competition for Attention in the ETF Space.
The authors argued that the rapid growth in the ETF industry has also intensified competition among issuers to a point that they are “competing for investors’ attention by emphasizing either the low price or the product’s unique features.”
While the unique features of thematic ETFs can pay off, such as those that have tracked clean energy or biotechnology over the past year, the academic research suggested that the higher fees they charge do not justify fund performance.
“The returns are calculated net of fees, but the difference in performance far outweighs the difference in fees,” Franzoni said, highlighting that while some thematics outperformed the average findings, others performed much worse.
One reason behind this underperformance may be associated with the problem that many of these thematic plays are launched at the peak of their respective markets. The risk is further exacerbated once a fund is delayed months beyond the height of exuberance for the specific sector.
“There’s an element of trading on old news,” Ben-David warned.
“There’s the potential for outsized success but also the potential for outsized distress,” Elisabeth Kashner, director of ETF research and analytics at FactSet, a data provider, told the Financial Times, adding that it was very hard for any investor to get the timing right.
This article originally appeared on ETFTrends.com.