Focusing on long-term trends could provide some outperformance or diversification
By now it’s probably fair to say plain-vanilla ETFs have reached a saturation point; ETF providers that want to stand out have to show some innovation. For many, that has meant coming out with long-term thematic funds that can offer different exposures to the same broad theme.
“Because themes can be very broad, financial advisors can use them in different ways,” according to a recent article on ETF.com. “A popular way is to augment a sector view, or to diversify.”
Focusing on the tech sector, the article cited HACK, the largest cybersecurity ETF that has US$1.6 billion in AUM. Because it’s within a more specific niche, it can offer more concentrated exposure and potential outperformance compared to a broad-market tech ETF. Thematic ETFs could also be easier for clients to understand or identify with than broad-market funds.
Because competing tech ETFs can have the same theme but be based on different indexes, it’s important to examine a fund’s stock-picking methodology and investment process. According to Optimal Capital CEO Jay Batcha, it’s all right to have a mixture of unknown companies and household names; the goal for advisors is to “know what you’re getting and how much risk is in the portfolio.”
Some tech funds can also take a cross-sector approach, straddling niches like robotics and artificial intelligence. However, one can analyze a fund and decide that it has ramifications for a sector other than the one it’s promoted for.
“Robotics and artificial intelligence are making machines smarter and more capable, allowing robots to do very sophisticated things and tasks, and making production more accurate,” Global X CIO Jon Maier said as an example. “So from our perspective, robotics and AI are disrupting industrials.”
The concentrated exposure offered by thematic ETFs can be a double-edged sword; to Reality Shares CEO Eric Ervin, this means they should remain as satellite holdings that make up between 5% and 15% of a portfolio.
Instead of thinking that something is “the next big thing” they should allocate heavily to, Ervin said, people should decide that “it could be a big thing” that they want to have some exposure to. Concentrating on just two or three favourite themes, he added, would help investors avoid creating a Frankenstein index portfolio with higher fees.
According to Maier, many thematic ETFs focus on structural changes, so they should be long-haul investments with investment horizons of probably more than five years. But some thematic funds aren’t meant for a “Field of Dreams” narrative: fund managers build them, but investors don’t come, causing them to close in short order.
Even some thematic ETFs built on solid theses can lose money. Numerous renewable-energy ETFs have lost money over five- and 10-year track records, and many agricultural ETFs that are premised on the world’s growing need for food have lagged broader indexes.
“There can be bumps in the road between now and then,” said Todd Rosenbluth, senior director of ETF research for CFRA. “The crystal ball gets blurry.”