Why you should not invest in Thematic ETF

The challenge

The idea behind these investment theme ETF is that investors can participate in potential disruptive trends or innovation to gain excess returns.

Some investment theme are more excited than other crypto/blockchain, cloud computing, electric vehicle, metaverse, clean energy and many more. If you are excited in an investment, it probably not an good investment. The collective excitment of investors have the tendency to drive up stock prices.

Remember disruptive technology & innovation in 2020? Everybody thought they are going to be rich. The main challenges of an exciting industries are they are exciting. When there is a huge potential market, buisnesses will be form to meet the potential market demand.

The excitment of the big market stand an opportunity for buisnesses to profit. However, what matters to investors are growth in earnings per share. If new or existing companies issue lot shares to persue profit opportunity relate to investment theme, it is highly probable the theme is going to underperform the market, S&P500.

In "Earnings growth: The two percent dilution" state that earnings will always lag the GDP mainly due to the shares issue always exceed the shares buyback. Thus even there is huge potential of future earnings, the growth in earning per shares in these investment theme may not be attractive.

https://www.researchaffiliates.com/documents/FAJ-2003-Two-Percent-Dilution.pdf

The performance

In "Competition for attention in ETF space", state that specialized ETF, do not create value for investors on average. Delivering negative annual alpha of 6% on average in 5 years after inception.

Specialized ETF are launched in response to investors' demand driven by performance chasing behaviour. The author finds that specialized ETF, which typically concentrated portfolio with relatively high fees with trendy theme, are launched right after the excitment. Before fund inception, the securities used to create these ETF tend to have very positive performance. These make economical sense for the fund provider to cash in on investors.

The underperfomance of these specialized ETF are likely due to the overvaluation of the underlying securities at the time of launch. Couple with the pre-launch performance of underlying holdings and high media attention, the negative post launch returns suggests the issuance of these ETFs occurs near the peak of valuation of underlying securities.

The author suggests these specialized ETFs, tend to attract less sophisticated investors (as shown in the ownership of institution & robinhood users on the specialized ETF) who expectations formed by extrapolating positive past performance into the future.

The author also find the long term earnings growth forecast (LTG) from analysts are significantly higher for the specialized ETFs pre-launch. After launch the fund experience a downward growth expectation. The forecast error grew significant negative after launch.

These data prove the hypothesis that Thematic ETF providers launch product that investors hold positive belief. Thematic ETF which consists of high price stocks, strong media sentiment and optimistic analyst forecast tend to decline overtime after launched.

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3765063

Risk of thematic ETF

In "Betting against quant: examining the factor exposures of thematics indices". In this study, the author uses leading index providers S&P and MSCI thematic ETF as a sample. It is found that thematic indices have elavated systematic risk and idiosyncratic risk (high volatility and concentration risk). In addition, these fund tend to hold companies with high prices and weak profitability. This combination of risk factors give the worst risk-adjusted returns.

This study is alluding that quantitative investors are often investing in companies with low prices, robust profitability and conservative investment. Invest in this way can be done systematically with a low cost, theoretically sound and able to generate positive returns in excess of the market.

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3899750

Conclusions

Expected stock returns come from how much you paid for future profit, not from investing in the most hype innovative companies. Paying a low price for an OK company, is better in terms of expected returns, than paying a high price of the best company in the world.