Working Paper: CEPR ID: DP15762
Authors: Itzhak Bendavid; Francesco Franzoni; Byungwook Kim; Rabih Moussawi
Abstract: Exchange-traded funds (ETFs) are the most prominent financial innovation of the last three decades. Early ETFs offered broad-based portfolios at low cost. As competition became more intense, issuers started offering specialized ETFs that track niche portfolios and charge high fees. Specialized ETFs hold stocks with salient characteristics---high past performance, media exposure, and sentiment---that are appealing to retail and sentiment-driven investors. After their launch, these products perform poorly as the hype around them vanishes, delivering negative risk-adjusted returns. Overall, financial innovation in the ETF space follows two paths: broad-based products that cater to cost-conscious investors and expensive specialized ETFs that compete for the attention of unsophisticated investors.
Keywords: ETFs; Financial Innovation; Competition for Attention
JEL Codes: G12; G14; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| specialized ETFs attract unsophisticated investors (G23) | negative risk-adjusted returns after launch (G12) |
| high past performance and media attention (L82) | specialized ETFs attract unsophisticated investors (G23) |
| investor flows to specialized ETFs are less sensitive to fees (G19) | investors are chasing returns rather than considering costs (G11) |
| negative performance of specialized ETFs (G19) | overvaluation of the stocks they hold (G32) |
| high market-to-book ratios and media sentiment prior to launch (G24) | negative performance of specialized ETFs (G19) |
| specialized ETFs cater to investors with extrapolative expectations (G41) | misalignment between perceived and actual performance (D29) |
| investor behavior (G41) | negative performance of specialized ETFs (G19) |