ETF Investing Mistakes

If you studied the ETF market, you know that there are ETFs covering a large number of investment strategies and sectors. A number of the ETFs are very quirky or focus on what seem to be tiny niches. This paper from Research Affiliates points out that ETF providers generally launch new ETFs based on investments or strategies that have done well the last few years. After launch, those ETFs tend to deliver average returns. It’s another case of investors chasing recent past performance only to be disappointed by the future performance.

What’s hot may change abruptly, but investors’ penchant for what’s hot is steady, because it is sustained by ingrained psychological forces and habitual cognitive biases. Hong and Stein (1999) provided a theoretical foundation in demonstrating that trend chasers underreact to fundamentals at first, and then overreact as their numbers grow. Early trend chasers profit from the initial underreaction; late trend chasers lose money. Some investors are overconfident about their ability to pick stocks or time the market, and in evaluating their own performance, they give most weight to decisions that have proven successful (Daniel, Hirshleifer, and Subrahmanyam, 1998). Others, presumably less self-assured and more in need of social validation, simply follow the emotional crowd, buying the popular stocks and selling the ones that are out of favor (Howard, 2014). Thus, numerous factors contribute to investors’ enduring preference for winners.