Why You Should Steer Clear of Specialty ETFs
Iffy long-term returns and big fees on themed ETFs
Exchange traded funds (ETFs) are giving old-school mutual funds a run for their money. At the end of 2020, U.S. investors had nearly $5.5 trillion riding on ETFs, compared to less than $1 trillion a decade earlier.
That’s mostly a great trend, as the majority of ETFs are broadly focused, low-cost index funds. In fact, the rising popularity of ETFs over the past decade has played a central role in helping push down the cost of indexing for individual investors.
But new research raises a yellow flag for ETF investors. Narrowly-focused ETFs that invest in companies in a single industry or an investing theme (cannabis, private equity) are typically a bad deal for investors — and an important profit center for the firms that offer them. (Those two facts are definitely related.)
Specialty ETFs’ high fees
In a working paper that analyzed nearly 1,100 U.S. stock ETFs between 1993 and 2019, researchers found that the cost to own a specialty ETF is higher than the cost to own a broad-based ETF that tracks a major index such as the S&P 500 or the Russell 2000. The median cost of a broad-based ETF in their analysis was 0.35%, compared to 0.58% median annual expense ratio for a specialized ETF. That seemingly small difference can add up to tens of thousands of dollars over a long investment horizon.
The researchers assert that the higher costs of the specialized funds are important revenue sources for ETF firms. Investors focus intently on fees for popular, broad ETFs like the SPDR S&P 500 ETF, the largest ETF tied to that index has an annual expense ratio of 0.09%. But investors don’t sweat the annual expense ratio as much when investing in specialized ETFs, where they are more interested in the niche play the specialized ETF offers.
The researchers found that at the end of 2019, specialized ETFs accounted for 18% of ETF assets, but generated about 36% of ETF fee revenue.
Not especially high returns
Of course, paying more can pay off if you get higher returns. But the researchers find that specialty ETFs underperform – in market-speak, they earn a negative risk-adjusted performance of around 3% a year after fees. That underperformance is worse for newer ETFs, at 5% a year in the first five years. By comparison, broad-based ETF risk-adjusted performance is basically zero, meaning you’re getting paid for the risk you’re taking, minus the smaller annual expense fee.
Sector funds vs. theme funds
Among specialty funds there are some differences worth noting. An ETF (or mutual fund) that owns stocks from a single market sector is considered a specialty fund. While the core of your portfolio should be broad-based index mutual funds or ETFs, a sector fund can be a rational way to give your portfolio a slight tilt to a part of the economy you think is undervalued, or poised for strong growth (ideally both).
For example, the Vanguard Health Care ETF (VHT) gained more than 300% for the 10 years through Feb. 8, 2021, compared to a 200% gain for the Vanguard Total Stock Market Index ETF (VTI). And with an annual expense ratio of 0.10%, the Vanguard Health Care ETF is as cheap as many broader based ETFs.
It’s the theme-based specialty ETFs that require careful consideration. Often they are marketers’ attempt to cash in on some newsy investing angle, or play to individual investors’ desire to play along with institutional investors.
The most expensive ETF in the ETF.com website is the VanEck Vectors BDC Income ETF (BIZD) which is focused on publicly traded firms that are players in private equity. The ETF’s 10.24% annual expense ratio (not a typo) is seemingly hard to justify as a reasonable cost to entry to this part of the investing world. Over the past five years, the ETF is up a total of 7.22%, a stretch during which the Vanguard Total Stock Market Index more than doubled.
The largest marijuana ETF, ETFMG Alternative Harvest (MJ) looks amazing if your lens is set to 2021 — the ETF has doubled in less than two months. Zoom out a bit, and the story is much different: The ETF has lost more than 2% over the past three years, a period when the Vanguard Total Stock Market ETF gained 53%.
Of course, themes can hit the mark. The pandemic has been a boon to the ProShares Long Online/Short Stores ETF (CLIX). The ETF is up more than 85% over the past year, compared to a 22% gain for the broad market Vanguard ETF. It will be interesting if the outperformance continues once we’re all vaccinated and freer to shop at brick-and-mortar stores.
A common market gauge of the riskiness of an investment is its price-earnings ratio. The higher the ratio, the more expectations are already baked into the stock’s price. If things don’t go as well as expected, stocks (and ETFs/funds) with higher P/Es tend to fall harder. The average price-earnings ratio for the online versus brick and mortar retail ETF is now nearly 36, compared to less than 22 for the S&P 500.