Are thematic ETFs the 'junk food' of investing?

Academic study says that thematic ETFs may face significant underperformance compared to broad-based alternatives

Are thematic ETFs the 'junk food' of investing?
Steve Randall

Investing in exchange-traded funds (ETFs) tied to burgeoning sectors such as cryptos, cannabis, or work-from-home may bring disappointment.

That’s according to a group of academics who have researched performance of thematic funds compared to more diversified options.

They found that ETFs based on ‘hot-topic’ assets typically produced returns 30% below that of more diversified funds in the five years since they launched.

“When people chase these popular investment themes, they are going to be disappointed,” said Itzhak Ben-David, co-author of the study and professor of finance at The Ohio State University’s Fisher College of Business. “These hot-topic funds are based mostly on hype and tend to lose value relative to the general market almost as soon as they are launched.”

Ben-David and his co-authors published their findings online in the Journal of Financial Studies.

They used US data from the Center for Research in Security Prices to consider the performance of ETFs that traded on the US markets between 1993 and 2019.

They analysed performance of 1,086 ETFs including 613 that were broad-based.

Broad-based ETFs had earnings over the study period that were relatively flat, the analysis showed. But specialized ETFs lost about 6% of value per year, with underperformance persisting at least five years after launch.

“It is not that the ETFs cause the losses. It is just that they are almost always launched when the hype for that particular area is at its peak and is already starting to decline,” Ben-David said.

Don’t believe the hype

The researchers concluded that the hype on social media and traditional media channels that surrounds themes such as the metaverse or electric vehicles, means that some investors pile money into funds without really understanding the stocks in the funds’ portfolios.

By the time they have invested, it’s too late to make any real returns, the authors said.

Ben-David cited work-from-home ETFs which became available many months after the stocks for this sector had peaked during the early days of the pandemic.

Junk food investing?

The study’s authors also concluded that fees are typically higher for thematic ETFs, and that despite accounting for just 20% of the market, they generate of third of the industry’s revenue from fees.

“The firms that market these specialized ETFs are supposedly giving the people what they want. But that’s not a good idea when investors are not sophisticated and don’t know how to think about investing,” Ben-David said. “It is a lot like junk food. It may be what some people want, but it is not necessarily good for them.”