Thematic ETFs (are Terrible Investments)
Investment Themes and Excitement
This section discusses how certain investment themes capture the attention of investors and highlights the potential risks associated with investing in exciting industries.
Investment Themes and Excitement
- Some investment themes, such as crypto and blockchain, marijuana psychedelics, cloud computing, electric vehicles, clean energy, robotics, and artificial intelligence, have recently attracted investors' interest. These themes are often associated with disruptive trends or innovations that can potentially generate excess returns.
- Throughout history, there have been other exciting investment themes that captured investors' imaginations. Examples include electronics in the '60s, the NIFTY 50 in the '70s, biotech in the '80s, and internet stocks in the '90s.
- Thematic indexes offer access to technologically enabled industries referred to as the Fourth Industrial Revolution. However, thematic investing can be risky.
The Pitfalls of Exciting Investments
This section explores why being excited about an investment may not necessarily make it a good investment. It discusses how collective excitement can drive up stock prices and highlights past examples like marijuana stocks.
Excitement and Stock Prices
- The collective excitement of investors tends to drive up stock prices. New technologies or industries often generate significant excitement among investors.
- Hyped-up investment crazes can lead to inflated stock prices. For example, marijuana stocks were once highly anticipated but eventually experienced a decline.
- The challenge with exciting industries is that many businesses emerge to meet potential demand in a big market.
Earnings Growth vs Market Potential
This section emphasizes that while a big market may seem promising for profit opportunities related to an investment theme, what matters to investors is the growth in earnings per share. It discusses the potential dilution of investment themes due to the issuance of new shares.
Earnings Growth and Investment Themes
- The excitement about a big market stems from profit opportunities for businesses, but investors should focus on growth in earnings per share.
- If many shares are issued by companies pursuing an investment theme, it can lead to dilution and underperformance in the market.
- A 2003 paper titled "Earning Growth: The Two Percent Dilution" highlights this concept.
Market Prices and Overconfidence
This section explores how big markets can drive up prices for companies pursuing a hot investment theme. It discusses the dynamics of high prices followed by a drop when reality sets in.
Market Prices and Competition
- Big markets often create high prices for companies despite limited opportunity for investment returns.
- As investors learn more about the market and competition increases, stock prices tend to fall dramatically.
- A 2020 article titled "The Big Market Delusion: Valuation and Investment Implications" explains this dynamic.
Overconfidence Effect on Asset Prices
This section delves into the overconfidence effect on asset prices. It discusses factors such as overpricing, uncertainty, winner-take-all perception, and empirical examples from e-commerce, online advertising, and cannabis stocks.
Overconfidence Effect on Prices
- Overconfidence exhibited by entrepreneurs and investors can lead to overpricing in a market.
- Factors influencing overpricing include overconfidence level, potential market size, uncertainty about future profitability, and winner-take-all perception.
- Empirical examples from various industries demonstrate how intense competition can result in extremely high stock prices followed by significant drops.
Naive Investors and Asset Pricing
This section highlights the impact of overconfidence on asset prices, particularly for naive investors with limited knowledge about asset pricing. It discusses how experts may exaggerate the value of new technologies, leading to over-optimism among naive investors.
Impact on Naive Investors
- Naive investors with limited knowledge about asset pricing are vulnerable to over-optimism generated by experts exaggerating the value of new technologies.
- Financial product providers take advantage of this over-optimism.
- A 2013 lecture emphasizes how experts tend to signal their familiarity with new technologies, contributing to overconfidence among naive investors.
Specialized ETFs and Investment Themes
This section discusses specialized ETFs (Exchange-Traded Funds) that focus on trendy investment themes. It explores how these ETFs are often launched after the peak of excitement and returns related to popular investment themes.
Specialized ETFs and Timing
- Specialized ETFs concentrated on trendy themes are typically launched after the peak of excitement and returns related to popular investment themes.
- These specialized ETFs do not create value for investors on average.
- A 2021 paper titled "Competition for Attention in the ETF Space" provides insights into this phenomenon.
The transcript is already in English, so there is no need to respond in a different language.
New Section
This section discusses the creation of specialized ETFs based on popular themes with high past returns. However, these funds tend to hold securities with low expected returns. The securities in the indexes increase in relative price leading up to the ETF launches but decline after launch.
Creation of Thematic ETFs
- Thematic ETFs are created based on popular themes with recent high past returns.
- These funds tend to hold securities with low expected returns.
- Securities in the indexes increase in relative price before the ETF launches but decline after launch.
Investor Expectations
- Investors in thematic ETFs have optimistic beliefs and expect high long-term growth.
- Analyst forecasts are used as a proxy for investor expectations.
- Portfolios of specialized stocks display significantly higher long-term growth forecasts before the ETF launch, but experience downward revisions after launch.
Risk Factors and Returns
- Thematic indexes have lots of idiosyncratic risks that can be diversified away.
- They are tilted towards small-cap stocks with high prices, weak profitability, and aggressive investment.
- Empirically, this combination of risk factors delivers the worst risk-adjusted returns compared to other factor-based portfolios.
Reasons for Investing in Thematic Indexes
- Some investors may not believe in factor models for expected returns and prefer holding small-cap growth stocks.
- Thematic indexes may still deliver positive unexplained returns or alpha despite their poor expected return profiles.
- Investors may be attracted to lottery-like payoffs or behave irrationally by chasing past returns.
New Section
This section explores the question of what risk factors thematic ETFs offer exposure to. It discusses how thematic indexes tend to have non-diversifiable risks and are tilted towards small-cap stocks with weak profitability. The possibility of investors not believing in asset pricing models is also considered.
Risk Factors in Thematic ETFs
- Thematic indexes have lots of idiosyncratic risks that cannot be diversified away.
- They are tilted towards small-cap stocks with high prices, weak profitability, and aggressive investment.
- This combination of risk factors delivers the worst risk-adjusted returns compared to other factor-based portfolios.
Investor Beliefs and Asset Pricing Models
- Some investors may not believe in asset pricing models and prefer holding small-cap growth stocks.
- Investors may choose thematic indexes based on their high conviction in a given theme, regardless of expected returns.
New Section
This section discusses the possibility that thematic indexes offer non-financial benefits to investors. It mentions the sense of community and emotional satisfaction that investors may derive from owning stocks in thematic indexes.
Non-Financial Benefits of Thematic Indexes
- Owning stocks in thematic indexes can provide non-financial benefits such as a sense of belonging or feeling good about the investment.
- Investors may choose thematic indexes based on emotional reasons or thrill-seeking rather than purely financial benefits.
New Section
This section highlights the contrast between quantitative investors who follow factor-based investing strategies and invest in stocks with low prices, robust profitability, and conservative investment, versus thematic index investors who focus on specific themes regardless of expected returns.
Contrasting Quantitative Investing and Thematic Index Investing
- Quantitative investors follow factor-based investing strategies with theoretically sound and empirically persistent positive expected returns.
- Thematic index investors focus on specific themes regardless of expected returns.
- Quantitative investing emphasizes low-cost systematic approaches, while thematic index investing may involve higher concentration and potentially irrational behavior.
New Section
This section discusses the behavior gap that investors face and highlights the impact of timing on their cash flows.
Investor Behavior Gap
- The behavior gap refers to the difference between the return of funds and the return of investors in those funds, which is influenced by the timing of their cash flows.
- Sector funds, and potentially thematic funds as well, have significant behavior gaps.
- Cathie Wood's flagship ARKK fund is an example of a sector fund with a large behavior gap.
- Despite ARKK Innovation delivering a compound return of 41.3% over five years, the average ARKK investor earned only 9.9%.
New Section
This section focuses on the higher fees associated with thematic ETFs compared to broad market ETFs.
Higher Fees for Thematic ETFs
- Fund companies have a strong incentive to create and market products that cater to attention-grabbing investment themes.
- Thematic ETFs generally have higher fees compared to broad market ETFs.
- Examples include Cathie Wood's ARKK Innovation ETF with a fee of 0.75% and Horizons Marijuana Life Sciences Index ETF with a management fee of 0.75% and an expense ratio including other costs of 0.85%.
New Section
This section emphasizes that jumping on thematic bandwagons is not a recommended approach for investing money.
Avoiding Thematic Bandwagons
- While it may be good business for ETF providers to ride these trends, it is not advisable for investors in terms of long-term returns.
- Investing in thematic bandwagons is one of the worst approaches to investing money, both in the short run and especially in the long run.
The transcript is already in English, so there is no need to specify the language for each section.