ETFs and index funds
Exchange traded funds, or ETFs as they are commonly called, are often a great way to track a collection of securities such as stocks. These can often track an underlying index of some type – like how the Vanguard FTSE Europe ETF (VGK) tracks the FTSE Developed Europe Index. These are ways for investors to gain low-cost and easy access to often 100s or more individual stocks and diversify their investments. The broadest ETFs and index funds can offer access to the entire market making up 5,000 or more stocks like VTI + VXUS or VT – follow this link to learn more. However, there is a market segment of ETFs that seek to offer access to different types of investing – these can be things like sector based ETFs like CQQQ which tracks Chinese tech stocks or mining ETFs for Africa like AFK. Ultimately, these types of specialized ETFs seek to offer an alternative investment philosophy which involve taking on sector specific risk in hopes of higher returns. This paper I’m summarizing today looks at the “Competition for Attention in the ETF Space” and how its results are applicable to average investors.
Competition for Attention – testable hypothesis
The paper, Competition for Attention in the ETF Space, looks at the difference between two types of ETFs – broad market index funds and specialized index funds – and compares the two types. Further, they are testing one hypothesis within the paper, that is highly specialized ETFs must offer something to the market, in the traditional view of markets, these ETFs would offer a way to hedge portfolios. However, the alternative theory is the ‘competition for attention’ theory. This would imply that ETFs are designed to “attract consumers’ attention to a feature other than their price.” Another implication of the competition for attention theory is that providers will launch ETFs at high sentiment times – implying that demand is already high. This would predict that newly launched specialized ETFs focus on attention grabbing themes, and likewise would be overvalued, thus producing negative risk adjusted performance.
The final question they seek to answer is why investors are interested in these specialized ETFs? They focused on two ideas – hedging and responding to demand from unsophisticated investors and end up under preforming. And from that they find that the evidence supports that investors aren’t hedging but they are being attracted to high sentiment ETFs which are overvalued and thus under preform.
Data, statistics, and other interesting findings
The authors collected ETFs that were traded on the US market between 1993 and 2019. They focused solely on ETFs that trade on the US stock market. They decided on that because it allows them to more closely benchmark ETF portfolios to broad based US stock indexes. They excluded anything that was a non-equity, foreign equity, inverse, or leveraged ETF. As a result, the authors found 1,080 distinct US equity ETFs.
From economic theories of competing for attention there are two main ways in which producers can attract consumers to their products, make a product with meaningfully different attributes or compete along price. In the context of financial innovation these translate into product attributes that appeal to some investors like the expected return of a portfolio or investing in the betterment of human kind. Along the lines of price, it looks like highly specialized ETFs tend to compete less on price, and more on product differentiation. For example, the authors use this chart to demonstrate their findings:
Figure 1 shows how the level of differentiation and fees correlate. While, the trend is generally down across the board, it’s of note that that sector, smart beta, and thematic ETFs are all much more costly to investors than broad market index funds are.
As mentioned earlier the authors divided the sample of ETFs into two portions – broad market index funds and specialized ETFs. The board market ETFs are classified as Broad index funds and smart beta categories (from figure 1). While the specialized ETFs are any ETFs related to a sector or a theme (like space exploration). I suppose they could have also classified them as low-cost ETFs are broad market ETFs. While, high-cost ETFs are specialized ETFs. An interesting fact, and one implied by the above graphic is the following:
“As of December 2019, specialized ETFs manage only 18% of the assets under management but generate about 36% of the industry’s fee revenues. We show that in the market for broad-based products, ETFs hold large portfolios and compete on price by offering similar portfolios at a low cost. In the specialized segment, ETFs hold undiversified and differentiated portfolios and charge higher fees”
In their effort to look through the ETF space they produced a number of graphics that can help us understand the ETF space:
For example, we see here that there are typically more specialized ETFs created every year than broad market ETFs and similarly there are typically more closures of such funds. However, they tend to have similar levels of revenue despite a smaller amount of assets under management.
And here with Table 1, we see that on average specialized ETFs hold significantly smaller portfolios than broad based ETFs do – the median broad-based holds 247 stocks, while the specialized ETFs hold 53. Further, broad-based charge lower fees than – those findings support the idea that providers compete on product differentiation and not on cost.
Further, in support of another one of the author’s findings, is that due to the nature of specialized ETFs attracting unsophisticated investors the ETFs capital flows will also respond greater to returns than broad based ETFs will.
And this is exactly what Figure 5 shows.
The Performance of Specialized ETFs:
In order to test the performance of specialized ETFs they formed a monthly portfolio that held all the available ETFs in the market – they separated these into both broad based and specialized products. They found that in general, the specialized ETFs do not create value for their investors by outperforming. The results are presented below.
In Panel A we see that the measurement of “Alpha” and under each measurement in parathesis is the associated T-stat for the above Alpha. We see that for the entire time period, Specialized ETFs produced an Alpha (or a strategy’s ability to beat the market) which was largely significant to the 95% confidence level for the capital asset pricing Model, Fama-French three-factor model, and the Fama-French four-factor model. However, it was not significant, but still produced a negative alpha for the remaining models. Overall, this indicates that the underperformance of specialized ETFs exists independently of the fees that they charge. The fees only add on more negative drag to the overall performance of the funds.
So why do investors invest in these?
Well, the authors first explore the theory that investors demand these due to hedging. However, they found insufficient evidence to support this as evidenced by our prior figure 5 featuring capital inflows and outflows which show that performance dramatically impacts capital flows.
So next they explore the theory that it’s driven by investor and media sentiment and what they find is compelling.
“The results in Panel (a) of Figure 9 show that the number of users holding the stocks that will be included in future specialized ETFs increase and peak right before the launch. Around the launch time, the number of users starts declining. We observe no similar pattern for broad-based ETFs. These results reiterate the point made in Section 6.1, that specialized ETFs are launched in segments of the market that sentiment-driven investors are excited about; further, these investors seem to be arriving after the excitement has peaked.”
“Prior research shows that investors in ETFs chase past performance (Dannhauser and Pon-tiff, 2019). Here, we find that this tendency is far stronger in specialized ETFs than in broad-based ETFs (see Figure 5 shown earlier). This empirical pattern is consistent with positive feedback trading (De Long et al., 1990) and further suggests that investors in specialized ETFs are less sophisticated than those in broad-based ETFs. While this behavior could make sense in actively managed funds—because investors in such funds can learn about the ability of managers from their past performance (a la Berk and Green, 2004)—it is likely inconsistent with rationality when it comes to passive investment vehicles, such as ETFs. Indeed, Ben-David, Franzoni, and Moussawi (2018) and Brown, Davies, and Ringgenberg(2020) find that high flows into ETFs are followed by negative returns.
The narrative that emerges from the results in this section is that specialized ETFs cater to sentiment-driven retail investors with trendy investment themes. These portfolios include attention-grabbing stocks that are overvalued at the time of launch. In the years following the launch, the value of specialized ETFs declines drastically.”
The conclusion of the study is that while broad based ETFs clearly achieve their goals of giving investors access to diversification at low costs, they found no evidence of whether specialized ETFs provide value, in either forms of insurance or exposure to successful investment ideas. Their results indicate that specialized ETFs fail to create value for investors. Further, they found no evidence that the negative performance corresponds to the price investors are willing to pay evidence by capital out flows during periods of under performance. Instead, what it suggests is that specialized investment products are lunched at the peak of excitement and around an investment theme. And that investing in those newly launched products are, on average, a bad investment strategy.
The democratization of investment that ETFs bring about are mixed. Investors have access to low-cost diversification which is “welfare-improving because it allows broader risk sharing.” But, the marketing of specialized funds attracts unsophisticated investors to under performing investment strategies. “It is possible that, absent specialized ETFs, these investors would still invest their money inefficiently. However, specialized ETFs could encourage greater participation due to their marketing efforts. Investors on the extensive margin may be worse off due to holding specialized ETFs”
Overall, you’re better off following the investing advice this website offers by investing in broad market index funds. While if you must use specialized ETFs in order to get your interest in investing, do so. But keep them to a small portion of your overall portfolio and use broad market index funds for the vast majority of your investment purchases – as those produce Alphas which are roughly zero – meaning they produce market returns. If you aren’t investing in the markets yet try using m1 finance (you’ll get an extra $10 dollars with the referral link) it’s a great platform for long term investing. And finally, if you’re looking for further ways to enhance returns check out our high risk and ultra-high risk newsletter.
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