A rush of thematic Exchange Traded Funds (ETFs) is giving investors new tools to gain exposure to hot global trends, and it makes sense when investing in emerging themes to take a diversified approach through a fund and look globally. Why bet on a few local stocks when you can own dozens in one trade, knowing there are always many more losers than winners in megatrend investing?
However, the global ETF industry has a habit of launching thematic ETFs that cash in on hot trends but can disappoint. It’s too soon to know if tech ETFs will deliver. The ETFS Robo Global Robotics and Automation ETF (ROBO), which includes robotics, automation and artificial intelligence (AI) stocks, has had a solid start. The BetaShares Global Cybersecurity ETF (HACK) has starred, with a 45% return over 12 months, and the ETFS Morningstar Global Technology ETF (TECH) has a 39% return over one year to September.
We do know tech ETFs are being issued after an incredible bull run in tech stocks, and that hype about robotics, AI, electric vehicles, cybersecurity and Asian tech stocks is rampant.
We also know that more tech ETFs are about to be issued. BetaShares has announced plans to launch an Asia Technology Tigers ETF (ASIA) and Global Blockchain Innovators ETF (BLOK), pending regulatory approval, and this week launched a Global Robotics and Artificial Intelligence ETF (RBTZ) that invests in global companies involved in the production or use of robotics or automation products and services.
I suspect there will be strong interest in these, and other thematic ETFs, in the next 12 months. Investors need to be on their guard with thematic ETFs. Quality ETFs from quality issuers can solve problems for SMSFs that want to take bets on emerging global trends via ETFs. But ETF issuers can construct an index over seemingly anything these days, if there is a market.
As extra care is needed to avoid being burned, here is my 10-point guide to assessing technology and other thematic ETFs.
- Look under the bonnet
As with any ETF, the starting point is understanding the index on which it is based and how that index is constructed. The BetaShares Nasdaq 100 ETF (NDQ), for example, might look like a play on the world’s biggest tech stocks. But only 59% of the index is in the information technology sector.
Always understand what the ETF owns and form a view of whether or not you would be comfortable investing directly in such companies.
- Company risk
The ETFS Battery Tech and Lithium ETF (ACDC) invests in emerging lithium miners, large battery producers and car manufacturers, and technology companies. Some companies in the ETF should be considered speculative, meaning ACDC has a higher risk profile.
That’s not necessarily bad. The electric-vehicle megatrend is, by its nature, speculative. The key is to know what you are buying, whether that suits your risk profile and not rely blindly on diversification to save you if the trend loses market favour.
- Portfolio concentration
Investors might think an ETF provides exposure to many dozens or hundreds of stocks in a single trade. The ACDC ETF is based on 28 stocks and the BetaShares HACK ETF has 33 stocks. This is low by ETF standards, and partly a result of index issuers having to narrow the number of stocks to ensure significant liquidity in the ETF portfolio.
That’s still more diversified than investing directly in a handful of electric-vehicle or cybersecurity stocks. But a few disappointments in a portfolio of 28 or 33 stocks can crunch the overall return. Risks are higher in concentrated ETFs.
Investors in technology ETFs must be satisfied the underlying securities are sufficiently liquid. A tech ETF that invests in small- or micro-cap stocks could face problems if markets tumble and liquidity dries up, making it harder to price the ETF to its net asset value.
Prospective investors should also check whether thematic ETFs have a few well-known market makers that provide on-market liquidity as required. Nobody knows for sure how trillions of dollars worth of ETFs worldwide will perform on liquidity in a market meltdown.
- ETF style
Understand the style of the technology ETF you invest in. The BetaShares Nasdaq 100 ETF, for example, is market-capitalisation weighted and replicates its underlying index.
In contrast, the ETFS Morningstar Global Technology ETF (TECH) uses an equally weighted index – each stock, regardless of size, has the same index weight. The index includes tech stocks that Morningstar believes have a competitive advantage (moat) and are attractively priced.
TECH and other “smart-beta” ETFs have potential for higher returns because they have varying degrees of active management, but they also carry higher risk than traditional ETFs.
- Index governance
Governance of an underlying ETF index rarely gets enough attention. Larger providers, such as Standard & Poor’s, usually have big teams monitoring their indices and strict rules for inclusion in, or exclusion from, an index. They also have deep expertise in index construction, methodology and governance.
ETF issuers worldwide, particularly smaller ones, are starting to favour lesser-known index providers that charge lower fees. That makes sense in straightforward market-weighted indices or large-cap equities, but in customised indices it pays to assess the index provider.
ETF issuers often promote an ETF’s hypothetical return based on backtesting of its index. For example, the new ACDC ETF for batteries and electric vehicles is benchmarked against the Solactive Battery Value-Chain Index, created by German index provider Solactive. The ETF says that index has delivered an annual return of 15% a year over five years.
Beware backtesting results. There’s nothing wrong with understanding or promoting an index’s historical returns, but ETF providers, and most financial-product issuers for that matter, tend to choose a timeframe that presents their product in the best light.
Also, three or five years of backtesting will not show how a sector (and thus the thematic ETF) has performed through a cycle, in good and bad years.
Fee comparisons are critical when selecting ETFs over traditional market-weighted indices, such as the S&P/ASX 200. Investors need a slightly different approach when assessing fees on technology or other thematic ETFs that have different styles.
Smart-beta ETFs that offer limited active management will charge higher fees than traditional ETFs, as will those that are investing in a custom-made index. The ETFS ACDC ETF, for example, charges 69 basis points; the iShares S&P 500 ETF (IVV) over US stocks charges 4 basis points.
All ETF investors should be fee conscious, but paying slightly higher fees can be worth it if the ETF issuer, index provider and the actual ETF have a good record.
- Currency risk
Many thematic ETFs on the ASX are unhedged for currency risks, so investors must form a view on the Australian dollar’s direction against the US dollar, as well as the underlying security.
A rising Australian dollar, relative to the US dollar, can crunch overall returns. The good news: the Australian dollar is likelier to head gradually lower in the next 12 months as US interest rates rise, and ours, stay on hold, and as commodity prices ease.
Still, it pays to understand currency risks and have a view before investing in unhedged ETFs.
- Form a view on value
Don’t use the tired excuse of investing “for the long term”. The price you pay for an asset has a huge bearing on future returns. Nobody expects investors to analyse 40 stocks in an ETF, but they can look at aggregate Price Earnings (PE) information on an index that ETF issuers often provide (for a rough guide) or do further research on sector valuations.
I am concerned about US technology stock valuations after the incredible bull run in the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google (Alphabet)). But cybersecurity, robotics, electric vehicles and other niches within technology still look interesting for long-term portfolio investors who understand the risks of these sectors.
- Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor All prices and analysis at September 19, 2018.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.