Academic Research Insight: Abusing ETFs

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Academic Research Insight: Abusing ETFs

By |2017-08-21T11:08:06+00:00August 21st, 2017|Basilico and Johnsen, Academic Research Insight|
  • Title: ABUSING ETFs
  • Publication: REVIEW OF FINANCE, VOL.21, 2017 (version here)

What are the research questions?

By studying the trading data (provided by a German brokerage house) of a large (6,949) group of individual self-directed investors over the period from 2005-2010, the authors attempt at answering:(1)

  1. Do ETFs provide performance benefits to individual investor portfolios?
  2. If not, what are the reasons?
  3. Does investors’ heterogeneity (specifically, overconfident investors and/or financially unsophisticated ones) impact the results?

What are the Academic Insights?

The authors look at both raw returns as well as risk adjusted returns (with up to 5 factors in the model). Additionally, they divide the sample into ETFs users (1,080, those who traded an ETF at least one time) and non-ETF users (5,869). Answering the questions above, they find:

  1. NO – ETFs do not improve portfolio performance of ETF users rather, compared to the non-ETFs part of the portfolio, total performance decreases by -1.16% on average (however, investors using ETFs use all products sub-optimally-not just ETFs- see Tables IV and V in the paper)
  2. POOR “TIMING” and “SELECTION” abilities. By using counterfactual portfolio analysis, the authors turn off “timing” and “security selection” behaviors. They find that, out of the -1.16% drop in performance, 0.77% comes from poor timing abilities (and cannot be related to additional trading costs). Similarly, when they compared the results of the total average portfolio with a portfolio invested in a market portfolio buy & hold strategy (proxy for security selection), they find that the majority of underperformance comes from security selection behavior
  3. NO – The authors find that there is no distinct investor group that significantly benefits from ETF use or that experiences significant increase in diversification. Differently, they also find that no group will lose by investing in the right market ETF.

The analysis includes transaction costs.

Why does it matter?

Investing is difficult, especially timing the entry and exit points as well as the selection of the right instruments. Investors under this analysis emerge as buying and selling ETFs at the “wrong” time or trading the “wrong” ETFs. In the words of the authors: “Ironically, the growth in the number of ETFs that track single industries or countries seems to encourage this damaging behavior.” The suggestion from the authors for “Do it yourself” investors is to stick to a Buy&Hold strategy in a low-cost diversified market instrument.

The Most Important Chart from the Paper:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

  • The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).
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References   [ + ]

1.out of the 8000 investors in the original sample,96% refused an offer of free financial advice and continued trading as before
Elisabetta Basilico, PhD, CFA
Dr. Elisabetta Basilico is a seasoned investment professional with an expertise in "turning academic insights into investment strategies." Research is her life's work and by combing her scientific grounding in quantitative investment management with a pragmatic approach to business challenges, she’s helped several institutional investors achieve stable returns from their global wealth portfolios. Her expertise spans from asset allocation to active quantitative investment strategies. Holder of the Charter Financial Analyst since 2007 and a PhD from the University of St. Gallen in Switzerland, she has experience in teaching and research at various international universities and co-author of articles published in peer-reviewed journals. She and co-author Tommi Johnsen are currently writing a book on research-backed investment ideas. You can find additional information at Academic Insights on Investing.
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