Stockholm (Ekonamik) – Exchange-traded funds (ETFs) allow investors to get low-cost exposure to a diversified pool of assets, protecting against the idiosyncratic risks of single securities going south. ETFs are designed to provide better diversification at a lower cost than active managers, which explains the steady flows of money rushing into ETFs.
According to the Investment Company Institute’s (ICI) Fact Book for 2019, ETFs attracted US$311 billion in capital from investors in 2018, after drawing a record inflow of US$471 billion in 2017. The number of ETFs increased to 2,057 at the end of last year from 743 available in 2008. Despite the increasing demand for passive investing, total net assets in ETFs accounted for only 16% of net assets managed by investment companies at the end of last year. As Gregory Venizelos, Ombretta Signori, and Allessandro Tentori wrote in AXA Asset Management’s commentary last year that “the rise of ETFs has been a key component in the overall growth of passive investments. However, passive funds still represent only a fraction of total global assets under management.”
Ever-Expanding Range of ETFs: The Rise of Thematic Investing
According to Daniel Wolfe, CEO of Tradingene, ETFs offer two advantages to investors. “First and foremost, they carry much lower loads (fees) for investors, making them an efficient way to get exposure to a diversified portfolio of assets.” Second, “especially for those ETFs linked to popular indices, they generally outperform the majority of actively managed funds.” Whereas the original idea behind ETFs was to enable investors to get exposure to a diversified portfolio of assets such as the S&P 500 Index, new ETFs entering the market appear to be designed to help investors diversify away from these portfolios. The proliferation of thematic ETFs is a case in point.
“ETF providers have moved into the space of active fund managers, through offering non-market cap products,” Oliver Smith, Portfolio Manager at IG Smart Portfolios, tells World Finance. “Themed ETFs are perhaps the most obvious; playing into our desires to invest in more interesting stories, some of which may have a structural growth element.” James Lindley, a Managing Partner at Castell Wealth Management, corroborates Smith’s last comment. “Unlike other investment approaches such as strategic beta strategies, the best of which are tested across sprawling historical data sets, thematic investing is entirely focused on trends that have yet to fully play out.”
Some industry professionals see some benefits stemming from the rise of thematic investing in the ETF space. Although “thematic ETFs are somewhat hard to define” given that “there are so many different flavors” according to Michael Arone, Managing Director of State Street Global Advisors, “if we take a step back, I think thematic ETFs can play an important role in portfolios.” As Arone explained, thematic ETFs can be used to “complement an existing sector allocation, getting a bit more specific about an investment.” Similarly, these ETFs can be used “for diversification relative to more traditional stock and bond investments, or to manage risk.”
Chris Mellor, Head of ETFs at Invesco, said in August last year that “ETFs can let you focus your investments in a much more specific way, whether that’s singling out a sector or focusing on a particular theme that you find interesting. It can be a good way to get the exposure you want at a very reasonable price.”
Beware of Misleading Thematic ETFs
Indeed, a big theme in the world of ETFs has been the rise of thematic investing, with many thematic ETFs focusing on Millennials, robotics, artificial intelligence and ESG/sustainability among others. Therefore, industry professionals encourage investors to assess these thematic ETFs carefully before investing. “It is hard to spot what could constitute a gimmick, and investors should ask themselves whether they think the ETF will still be there in 15 years’ time,” Lindley tells World Finance. “It is also worth considering themed mortality rates amongst ETFs. To put this into context, 80% of all thematic ETFs launched in Europe prior to 2012 have now closed.”
Peter Sleep, fund manager at Seven Investment Management, reckons that “mainstream passive investments, such as a FTSE tracker, are great as they allow you invest relatively small amounts in a widely diversified portfolio of stocks.” Sleep, however, voices his concerns about the narrow themes of many ETFs. “I am less enthused about thematic ETFs as they are very narrow and almost by definition, not very well diversified, so can be quite risky,” adding that “thematic ETFs tend to be faddish.”
Lindley agrees, arguing that “if you look at the most popular themed ETFs – technology and environmental, as good examples – their popularity often appears to be correlated to news topics and ‘flavour of the week’ investments. This can also be seen in the growing popularity of social-themed ETFs, such as gender equality.” Daniel Wolfe also argues that “themes are often misleading” and encourages investors to “examine the holdings in an ETF before entering. They should also try to understand how much of the underlying business is related to the theme.”
To illustrate how misleading themes can be, one can consider the SPDR Kensho Final Frontier ETF, designed to capture companies that drive innovation behind the exploration of the final frontiers – areas of outer space and the deep sea. Around 65% of its assets are allocated to aerospace or defense firms, whereas electronics, industrial machinery, IT consulting and other sectors make up the rest of its holdings. The ETF’s exposure to companies driving innovation in the exploration of outer space may not be as high as investors presume.
Horizon Kinetics puts forward a more interesting example of a single company being wrapped up under many, very distinct ETFs. Given its presence in so many ETFs, oil and gas company ExxonMobil (NYSE: XOM) can simultaneously be viewed as a growth stock, a value stock, a quality stock or a yield stock.
Before parting with their cash, investors should conduct a careful analysis of which stocks an ETF bundles up.
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