At a time when exchange-traded funds (ETFs) are seeing record investment flows, themed ETFs are progressing from the original investment proposition.
- The previous year saw an increase in the popularity of ETFs. While the broad-based ETFs remain the biggest sellers, themed ETFs grew in numbers.
- The most popular themed ETFs are environmental, social and governance (ESG), and formed 15 percent of the total raised in Q1 2021. Other notable themes include technology, bitcoin, hydrogen and cannabis.
- However, analysis has shown that themed ETFs underperform, while the narrow nature of the investment can create volatility.
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While exchange-traded funds (ETFs) are attracting new assets at a record rate, it’s a time when the universe is evolving. The biggest sellers globally, over the 12 months to the end of March 2021, remained large broad-based ETFs, the classic low-cost passive vehicles for investing. But specialised ‘thematic’ ETFs were also increasingly popular.
The 12 months saw a surge in ETF popularity. Net global ETF inflows reached just under $1trn ($965bn), according to data from Refinitiv Lipper. The busiest period was the first three months of 2021, when inflows reached $349bn, as investors bet that successful Coronavirus vaccination campaigns would improve the outlook for the global economy.
Yet ETFs with specialist themes stood out.
The most popular theme at the moment is environmental, social and governance (ESG) ETFs, which were the biggest sellers in the first quarter of 2021. They took a record $55bn, or more than 15 percent of the total raised.
Differentiating narratives by ETF managers
Specialist narratives are proving effective at marketing ETFs.
The original ETFs remain broad-based, low-cost funds that make investment more accessible for ordinary people. But as competition has grown, some ETF managers have differentiated themselves by concentrating on specific investments that have performed well in the past, attracting media attention and widespread investor interest.
Take technology ETFs. Just as tech stocks rallied in 2020, so too did investor appetite for tech ETFs. Notably, New York-based tech boutique ARK Investments saw huge demand for its actively-managed technology themed funds – attracting significantly larger inflows than some more established competitors.
Apart from tech and ESG ETFs, there are some investors specialising in even narrower themes, such as bitcoin, cannabis or hydrogen.
It’s important to note that specialist ETFs give sophisticated investors the opportunity to implement specific investment views. And in many cases they have outperformed. For instance, Invesco’s Solar ETF was 2020’s best-performing ETF, returning 231 percent in the year, and the ARK Genomic Revolution ETF delivered net returns of more than 180 percent.
Themed ETFs: not for the inexperienced
Even so, the move to thematic ETFs is prompting comment that intense competition in the ETF sector has blunted the focus on democratising investment, according to a paper that was published in March 2021.
“On the one hand, investors can now access financial markets at low cost, which can be welfare-improving because it allows broader risk sharing,” notes the paper, called Competition for Attention in the ETF Space. “On the other hand, the marketing strategies of specialised ETFs attract unsophisticated investors to underperforming investment propositions.”
The paper finds that specialist ETFs tend to deliver a negative alpha of about 3 percent a year, due to holding “attention-grabbing and over-valued stocks”. The underperformance is strongest immediately after an ETF’s launch and continues for five years.
Often the narrow thematic nature of an ETF means that it has relatively few underlying investments, accentuating its volatility. This can be true of themes such as silver, rare earths, cannabis, and nuclear and renewable energy.
Not only is the ETF less diversified, but it may hold a high percentage of a company’s equity, meaning that sudden ETF redemptions could lead to a sale of such a large proportion of the equity that the price is forced lower.
Illustrating the risk, a recent analysis by Barron’s, the respected U.S. financial magazine, showed that ARK owned more than 10 percent of the free float – shares that can be traded without restriction – in at least 26 companies, most of which were biotech or tech firms.
As ARK grows, it is becoming a major shareholder in many smaller companies. However, in another instance of an ETF getting too big and becoming a victim of its own success, the VanEck Junior Gold Miners ETF acted to ameliorate the difficulties it faced by buying five holdings that were not part of its underlying index, including the VanEck Vectors Gold Miners ETF, another product from the same issuer.
Evolving from ETFs’ roots
The move towards specialist ETFs mirrors a trend in the wider investment industry, especially regarding ESG funds. Whether ETFs or mutual funds, specialist funds not only capitalise on popular narratives, but also allow for higher fees at a time when expense ratios are under pressure.
What does this mean? It’s true that ETFs are evolving from their original purpose and are no longer solely vehicles for ordinary investors to gain low-cost exposure to investing. But themed ETFs have a place as vehicles for skilled investors making sophisticated bets as part of a wider portfolio.