Stay away from trendy ETFs: Research shows they almost always end up losing money

‘It is a lot like junk food. It may be what some people want, but it is not necessarily good for them.’

Want to make some money in the stock market? If so, stay away from investing in “trends” because you’re already too late to get in on the fad! Researchers from The Ohio State University say people who invest in trendy exchange traded funds (ETFs) almost always end up losing their money.

Overall, study authors say “specialized” ETFs lose about 30 percent of their value over a five-year period after their launch.

“When people chase these popular investment themes, they are going to be disappointed,” says study co-author Itzhak Ben-David, a professor of finance at Ohio State’s Fisher College of Business, in a university release.

“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.”

What are specialized ETFs?

First developed in the mid-1990s, these popular funds are on the stock market and are set up just like mutual funds. They hold a variety of stocks in their portfolio. However, specialized ETFs generally invest people’s money in trendy topics like remote work, the “metaverse,” legalized cannabis, Bitcoin, or even social causes like Black Lives Matter.

By the end of 2021, investors poured over $6 trillion into more than 3,200 ETFs. Originally, ETFs invested in large, diversified portfolios, such as the entire S&P 500, according to Ben-David. Now, many of them focus on these more specific themes which typically receive a lot of positive attention from the media.

“These specialized ETFs are all about areas hyped in social media and other platforms as the ‘next big thing.’ But by the time these ETFs are launched into the market and available to investors, it is already too late to make money,” Ben-David explains.

“Specialized ETFs are basically boiled down to a soundbite: ‘You should invest in electric vehicles,’ for example. That’s it. Most of the investors in this don’t know anything about the stocks in the ETF’s portfolio, the fees, the price to earnings ratio. They just want to be part of the trend.”

You’re too late to cash in

The Ohio State team used Center for Research in Security Prices data on ETFs traded in the U.S. market between 1993 and 2019 during this study. They focused on 1,086 ETFs, including 613 broad-based funds with a wide variety of stocks. The other 473 were specialized ETFs that focused on certain industries or a variety of industries that all have the same “theme.”

Results show the broad-based ETFs had relatively flat earnings throughout the study. On the other hand, specialized ETFs lost roughly six percent of their value each year after their launch — a trend that continued for at least five years.

“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 says.

The study author specifically noted the trend of working from home as a faulty ETF to invest in now. He explains that the time to invest in work-from-home ETFs was in March 2020, when countries first started issuing stay-at-home orders during the pandemic. When these ETFs appeared on the scene a year later, however, the stocks connected to remote work already peaked.

The media talks people into making bad investments

The study found investors often put their cash in areas that both traditional and social media hype up. Media sentiment — a measure of positive coverage of these themed stocks — typically peaked at the same time the specialized ETF launched.

The positive media coverage then declined as the financial press examining the future prospects of this topic became negative. Simply put, once financial experts start saying these themes can’t make money anymore, the positive media coverage mysteriously dries up.

Specialized ETFs are also very expensive

Researchers found that large institutional investors who have professional managers, including mutual funds, pension funds, banks, and endowments, avoid specialized ETFs. Meanwhile, brokerages which cater to individual investors are more likely to see its clients invest in specialized ETFs.

The team notes that specialized ETFs also charge higher fees in comparison to broad-based ETFs. Ben-David contends that investors in trendy topics generally don’t care about the fees because they just want to be part of the fad.

Interestingly, although specialized ETFs only make up about a fifth of the ETF market, they generate one-third of the industry’s revenue from their high 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 concludes. “It is a lot like junk food. It may be what some people want, but it is not necessarily good for them.”

The study is published in the journal Review of Financial Studies.

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