Specialized ETFs Remain Popular, despite Losing along Three Dimensions
20 Years of SFI—A Look behind the Scenes of World-Class Finance Research
As part of SFI's 20th anniversary celebrations, we are showcasing a selection of finance research conducted by SFI faculty members. Today, SFI ranks among the top 10 finance institutes worldwide. Each edition of our showcase features one SFI professor, presenting their research area, key insights, and the practical impact of their work.
At their core, these blog posts reflect what lies at the heart of SFI: fostering world-class research, advancing knowledge, and bridging research and practice—all contributing to the long term prosperity of Switzerland's financial marketplace and the country as a whole. SFI, growing knowledge capital for the last 20 years and in the years to come.
This edition features SFI Professor Francesco Franzoni from the Università della Svizzera italiana and his research on specialized ETFs.
SFI Professor Franzoni has long studied the pros and cons of active versus passive management, including within the ETF marketplace. He and his coauthors published an influential academic paper on ETFs in the Journal of Finance in 2018, showing that stocks owned by ETFs exhibit significantly higher intraday and daily volatility. This is because investors use ETFs to trade at a higher frequency than that at which they would trade the underlying securities.
"Our early research showed that the trading volume of ETFs was not always motivated by the fundamental information of the underlying securities, but by the pure liquidity or speculative need of the investors. We also realized that not all ETFs are created in the spirit of passive, diversified investing for the long haul. So we wanted to explore if this explosion of specialized ETFs was beneficial for investors."
Not Diversified, Not Cheap, and Not High Performing (yet Ubiquitous)
Despite the reputation of ETFs as cheap and passive products, the most recent research by SFI Professor Franzoni and coauthors found that specialized ETFs are neither. Specialized ETFs meet only minimum diversification requirements because they focus on a sector or theme, betraying the spirit of diversification originally behind these products. They come with higher fees than ETFs that track an index. And they perform poorly, losing an average of 30 percent in the five years after launch. Their research found that this underperformance is due to the fact that at launch, the theme or sector is already very trendy, and that the underlying securities tend to be overvalued.
This research by SFI Professor Franzoni and coauthors has been widely cited in the academic literature and has also been covered by many financial news outlets. Despite this, these specialized ETFs continue to be very popular among investors. The financial industry continues to answer this high demand for thematic ETFs in areas such as sustainable energy, artificial intelligence, and quantum computing.
The next question for SFI Professor Franzoni and coauthors will be to explore the competition between firms launching specialized products and those launching more broad-based products. The observation is that the big players launch broadly diversified products that are very cheap, compelling new entrants to develop more specialized products. The authors want to explore how this competition creates perverse incentives to create more and more eccentric products, and what the welfare implications are for investors.
More Information
- Competition for Attention in the ETF Space, The Review of Financial Studies (with I. Ben-David, B. Kim, and R. Moussawi)
- Do ETFs Increase Volatility?, The Journal of Finance, (with I. Ben-David and R. Moussawi)
SFI Prof. Francesco Franzoni (USI)
Francesco Franzoni is Professor of Finance at the Università della Svizzera italiana, a research fellow at the Center for Economic Policy Research, and holds an SFI Senior Chair. His research has been published in the top finance journals and featured in the international press. He deepens the study of the pros and cons of active versus passive asset management.
"I try to make my research relevant for the financial industry. Thanks to SFI, I am continuously in touch with the industry through events, SFI Master Classes, knowledge exchange seminars, and conferences, where I can meet practitioners and discuss where the industry is going."