Another Reason Not To Chase Hot ETFs

Financial advisors should know better than to chase the latest hot investment, and a research report offers more evidence of why it’s a bad idea.

Equity-focused exchange-traded funds that saw big inflows as a percentage of assets under management over a short time period generally underperformed funds with average inflows, according to a research report titled “Shun ETFs With Largest Inflows” by Jun Zhu, co-portfolio manager for the Leuthold Core Investment Fund and a senior analyst at The Leuthold Group.

With more than 2,000 ETFs available, and many having multi-year histories, Zhu applied the backtesting methodology Leuthold commonly uses for stocks. Although ETFs debuted in the U.S. in 1993, they didn’t start attaining critical mass until about 2006 when the number of U.S.-listed ETFs first exceeded 200.

Zhu looked at fund flow data from April 2006 to April 2018 for all ETFs to assess the performance relationship, but the lion’s share of ETFs are equity (69 percent), followed by fixed income (16 percent), commodities (8 percent), alternatives and asset allocation (both 3 percent), and currency (2 percent).

She grouped ETFs into five quintiles using one-month, two-month, and three-month fund flows as a percentage of month-end assets under management, and calculated the equal-weighted returns of each basket. The first quintile saw the largest inflows, second quintile saw the second-largest inflows, etc. The last quintile saw the largest outflows.

The forward one-month return for ETFs with the highest one-month fund inflows underperformed ETFs in the other four quintiles. The highest inflow ETFs saw a negative 0.01 percent versus a range of positive 0.37 percent to 0.48 percent for the rest. Zhu says this pattern persisted in back tests based on two-month and three-month fund flow data.

She also looked at how the fund-flow effect and performance appeared over six-month, nine-month and 12-month periods, and this also showed funds with the biggest inflows underperformed over all return horizons. During the 12-month period, ETFs with the largest outflows slightly underperformed ETFs in the middle three quintiles—i.e., those with more average inflows.

Over the course of the 12-year study period, people who invested equally weighted in equity ETFs with the highest inflows saw an 8 percent loss. Meanwhile, an equal-weighted portfolio using the other four ETF baskets returned 72 percent during the same period.

While Zhu can’t say exactly why this happens, she has a hunch.

“We know equity investors, especially with retail investors, have the tendency to chase returns,” she says.

That herd behavior tends to swell the valuation of the underlying assets in the ETFs, but eventually that valuation will revert back to normal and the asset eventually underperforms.

The equity-ETFs pattern doesn’t replicate when looking at fixed-income ETFs, Zhu notes. With fixed-income ETFs, the pattern of high-inflow/fixed-income ETFs versus the other fixed-income quintiles was flat since 2009.

She suggested the general pessimism investors have had toward fixed-income, along with dumping fixed-income ETFs that didn’t perform well, may have something to do with the pattern.

“Fixed-income investors are more risk averse. They want to protect their principal or protect their investment. So instead of return chasing, when things are not going well they may overreact [and sell],” Zhu says.

Regarding ETFs that invest in commodities and currencies, Zhu says there aren’t enough ETFs to make a meaningful analysis. But data show commodity ETFs seem to follow the equity-ETF pattern, while currency ETFs show a reverse relationship. Over nine years (April 2009 through April 2018), the back test showed investing in currency ETFs with the highest fund inflows netted investors a 37 percent cumulative return during the period tested, versus a loss of 15 percent for those buying ETFs with the largest fund outflows.

Zhu says she’ll need to do further analysis to ascertain why equity ETFs with high inflows relative to AUM underperformed, but for now she says it’s another reminder to be thoughtful when investing.

“It’s just something that you want to keep in mind when you are trying to build your portfolio, to probably avoid certain ETFs which are really hot,” she says.

Debbie Carlson is a freelance writer for ETF Advisor magazine.