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ETF Focus: Are thematic ETFs gimmicks or smart strategic plays?

April 18, 2017
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It has become something of a joke on Wall Street: if the industry exists, there is an ETF for it.

Fund issuers have been looking for ways to tap into the white-hot market for exchange-traded funds, one of the fastest-growing vehicles in the financial industry, but with major asset classes and regions already dominated by multibillion-dollar funds from major asset managers, new players are hoping to make a name for themselves by engineering niche ETFs.

As a result, the market has been flooded by new “thematic” ETFs, which track a narrow sliver of the equity market, focusing on a specific subsector of a broader industry. In the past year alone, funds dedicated to wearable technology












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 medical marijuanaHMMJ, +4.85%










 health and fitness












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the Internet of Things












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and mobile payments












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among many others, have all been released.

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“The issue isn’t that there is no place for these types of funds, but that the themes are often redundant with larger, cheaper funds, or that they don’t offer pure exposure to the theme they’re supposed to.”


Kevin Quigg, chief strategist at ACSI Funds

The category is small, with most products struggling to amass much in assets or daily trading volume (Morningstar says it doesn’t track thematic funds as a category). Still, it has come under fire, with critics charging that the funds misrepresent the exposure they claim to offer, or that they serve little use to the average investor.

“The problem investors have isn’t that there aren’t enough products, it’s that the products aren’t good. You don’t create 40 solutions by launching 40 funds; you just create new questions about how or if they should be used,” said Kevin Quigg, chief strategist at ACSI Funds. “The issue isn’t that there is no place for these types of funds, but that the themes are often redundant with larger, cheaper funds, or that they don’t offer pure exposure to the theme they’re supposed to.”

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The “SHE” ETF allows everyday people to invest in companies with strong female leadership. It is based on recent data that suggests companies with a high representation of women in the executive ranks outperform their male-dominated peers.

A major complaint about thematic funds is that the industries they track are too small or ill-defined to have many public companies that work directly—and exclusively—within the “theme.” The PureFunds Drone Economy Strategy ETF












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for example, holds a number of companies that aren’t, strictly speaking, drone companies.

The fund’s top 10 holdings include Boeing Co.












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Jabil Circuit Inc.












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and Honeywell International Inc.












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While those companies do have products related to drones, the business segments makes up a fraction of their overall revenue. As a result, the companies likely won’t move on drone-related news or trends, meaning the fund won’t either, given their weight within it.

In addition, the Drone ETF charges an expense ratio of 0.75%, more than twice the 0.35% fee of the SPDR S&P Aerospace & Defense ETF












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which has many of the same top holdings, making it difficult for investors to outperform. (The fund is up 5.3% over the past 12 months, compared with the 25% rise of the SPDR fund.)

“We knew out of the gate that there aren’t a ton of pure-play drone technology companies. Right now you’re getting diversified aerospace companies [with the Drone ETF], because how else would you capture companies doing various things in the drone industry?” said Andrew Chanin, chief executive officer of PureFunds, which operates the fund. He added that the fund was “built towards being a pure play” offering, and that as more drone-specific companies went public, they would become components.

“We knew out of the gate that there aren’t a ton of pure-play drone technology companies. Right now you’re getting diversified aerospace companies [with the Drone ETF], because how else would you capture companies doing various things in the drone industry?”


Andrew Chanin, chief executive officer of PureFunds

PureFunds also operates what could be the greatest success of the thematic category, the PureFunds ISE Cyber Security ETF












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which tracks cybersecurity related software companies. The fund, which coincidentally launched in the immediate aftermath of the hack of Sony, garnered massive attention and inflows, and has seen spikes in trading whenever a data breach is reported. Currently, it has nearly $1 billion in assets. Comparatively, many thematic funds struggle to reach $10 million.

Read:Here’s why the ETF graveyard is getting crowded

“Good thematic ETFs provide different exposure. Bad ones just slap on a buzzword and call it something different.”


-Chanin

What distinguishes the fund from the drone ETF, for example, is that there are dozens of companies dedicated exclusively to cyber security, with each offering different products and services within the industry. That means the fund is a pure play, but a diversified one, and one that can be reasonably expected to perform differently than the broader technology space. The Cyber Security fund is up 23% over the past 12 months, compared with the 19% gain of the Technology Select Sector SPDR












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—a level of outperformance that may justify its higher fee (0.75% to 0.14%).

“A niche, if it is distinct enough, will have different drivers and correlations than the overall sector, and a thematic fund can give you exposure to that niche while reducing single-company risk,” Chanin said. “Good thematic ETFs provide different exposure. Bad ones just slap on a buzzword and call it something different.”

The performance of thematic funds overall depends on the components they hold and the broader economic environment. But some themes have posted dramatic results, making a strong case for looking for growth areas within sectors.

The Amplify Online Retail ETF












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for example, tracks companies that derive 70% of their revenue from online purchases. It is up more than 10% thus far this year. The SPDR S&P Retail ETF












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which has a heavy weighting toward brick-and-mortar stores, a category that has been struggling, is down 4.9% over the same period (see chart below):

Source: FactSet data

“There needs to be a reason for the specialization—cyber security doesn’t have the same story as technology, and the outlook for online retail is much different than the one for brick and mortar,” said Christian Magoon, chief executive officer of Amplify ETFs. “A successful fund needs to have limited overlap with a broad index, it needs to reduce company-specific risk, and it needs to bring a certain characteristic that is additive to your portfolio, like higher growth or less volatility.”

“I actually think the fund is interesting, and worth looking into. However, I think ETFs generally need to solve a specific problem for investors, in terms of the exposure they can provide or the strategy they can be a part of.”


Matthew Hougan, chief executive officer for Inside ETFs

The problem is, few funds can meet that criteria, particularly within major parts of the economy like retail. The alcohol-themed Spirited Funds/ETFMG Whiskey & Spirits ETF












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 has been cited as a fund that, while boasting strong year-to-date performance, is more of a novelty than a strategy.

“I actually think the fund is interesting, and worth looking into. However, I think ETFs generally need to solve a specific problem for investors, in terms of the exposure they can provide or the strategy they can be a part of,” said Matthew Hougan, chief executive officer for Inside ETFs. “I just don’t know what problem a fund like this solves.”


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