Thematic ETFs, "a financial innovation gone awry"

Catering to the future expectations of investors is inherent to the world of finance which, as such, plays an import role in fostering economic growth through it's ability to innovate. However, financial innovations are not always flawless. A recent study co-authored by USI finance professor Francesco Franzoni reveals the significant performance inefficiencies of the increasingly popular ‘thematic’ exchange traded funds (ETFs). The findings of Prof. Franzoni and his colleagues has been featured in the Wall Street Journal and the Financial Times. 

The democratisation of many processes in the economy and society is one of many novelties of the digital age, impacting a range of domains such as communication and media, science, and financial markets. Compared to three decades ago, in fact, dealing with sophisticated financial products and services is widespread and investing in financial markets is not far from becoming a household chore. Exchange-traded funds (ETFs, low-cost investment vehicles that passively replicate the performance of an index and can be traded continuously in the stock market) embody the current trend of democratisation of the investment process. Just as easily as they can trade a single stock, investors using ETFs can trade large baskets of any asset class, like stocks, bonds, and commodities – but also niche investment themes, such as legalising cannabis, vegan products, work from home, and COVID-19 vaccines. 

"In our analysis of around 1,000 U.S. equity ETFs from 1993 through 2020, we found that specialised ETFs lagged behind the broad market’s return by an average of 5.4 percentage points a year on a risk-adjusted basis over the first five years of their lives", says Prof. Franzoni. "These so-called ‘thematic’ EFTs tend to hold attention-grabbing and overvalued stocks and underperform significantly, failing therefore to create value for investors".

Increasing interest in investing according to good environmental, social and governance (ESG) principles is one of the main drivers for thematic ETFs, to which investor are attracted as a catalyst that could drive change. However, one of the problems with thematic ETFs is that by the time many investment ideas become fashionable they have reached their market peak. As Prof. Franzoni explains, "in our research we come to the conclusion that the implications of the 'democratization of investment' that ETFs bring about are mixed. On the one hand, investors can now access financial markets at low cost, but on the other hand, the marketing strategies of specialised ETFs attract unsophisticated investors to underperforming investment propositions. In a way, this is financial innovation gone awry". 

Itzhak Ben-David and Byungwook Kim of Ohio State University, Francesco Franzoni of USI Università della Svizzera italiana, and Rabih Moussawi of Villanova University are the authors of the research paper Competition for Attention in the ETF Space, available online at
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3765063 

Further reading (media coverage): 

• The Story Behind The Market’s Hottest Funds, Wall Street Journal, January 15, 2021
• Day-Trader Frenzy for Trendy Stocks Is Defying Decades of Losses, Bloomberg, January 21, 2021
• Thematic ETFs can deliver significant losses, academics find, Financial Times, January 26, 2021
• New ETFs, Forced to Chase Trends, Shorten Their Own Lives, Wall Street Journal, February 5, 2021