Genomics, robotics and cybersecurity funds hardly sound like investments for the risk-averse.
But according to Tom Staudt, chief operating officer of ARK Invest in New York, these thematic ETFs can work well for cautious investors who are trying to achieve diversification and manage risk.
“We talk to advisors who are extremely conservative who say, ‘I would never own a single name in your portfolio. The trailing 12-month [price to earnings ratio] is high; the volatility is high. That’s not for me. But I own some of your funds,'” recounts Staudt, whose firm’s offerings in Canada include disruption and genomics ETFs offered through Emerge Canada Inc.
Those advisors use innovation-oriented ETFs as a hedge against their clients’ market-capitalization weighted index holdings, Staudt explains. Broad indexes tend to include firms ripe for disruption — “Big Pharma will be disrupted by genomics; retail will be disrupted by online; you’ll see electric disrupt the internal combustion engine,” he says — but it’s hard to know which ones they are in advance.
Staudt adds that market-cap indexes can exclude innovative companies: newer and smaller companies don’t make the index, even if their fundamental growth outlooks are better; large companies that spend aggressively in research and development end up reducing their market caps, even if their return on invested capital will be higher in future.
“That’s great for investors today,” he says, “but bad for your weight in a market-cap weighted index.”
Instead of making bets, investors are saying, “I want to have exposure to the companies that will likely be the disruptors,” Staudt says.
Raj Lala, president and CEO of Evolve Funds in Toronto, agrees that making bets isn’t wise. He becomes concerned when advisors purchase individual stocks in order to gain exposure to a wider theme, suggesting it’s unlikely that a single name will consistently be the best performer.
For example, performance variance of the poorest to the best name in his cybersecurity ETF last year was almost 200%.
“If you’re picking a stock to be a proxy for a subsector, how do you know you’re getting the stock near the top? Instead, use an ETF as a proxy for a single-stock position,” he says.
While thematic ETFs can provide diversification, they are more typically used as a growth position.
Staudt says clients looking for growth from thematics would ideally have time horizons of five years or longer so they can get paid to ride out any volatility.
He also likens owning innovation-oriented thematics over that period to “venture capital investing using public equity securities.”
For all their benefits, Staudt acknowledges that thematics have gotten a “black eye” lately, with some being accused of overcharging for beta. The L.A. Times reports that in 2019, “investors added the least new money to [thematic] funds since 2016.”
When performing due diligence, Lala recommends comparing a thematic fund’s holdings to a client’s existing portfolio.
“You really need to take a close look at what you’re getting, and what the overlap is with your [client’s] existing exposure,” Lala says.
For example, he says Evolve “would never create a FAANG ETF, because our view is you probably already have enough exposure to the Facebooks and Apples of the world through your traditional portfolio. And a lot of the growth in those companies has already been garnered.”
On the other hand, his firm’s cybersecurity ETF has 36 positions — only one of which overlaps with the companies in the NASDAQ or S&P 500. Lala also argues that firms emerging in a specific subsector “have a lot more potential for gains.”
Whether as diversifier or growth play, Lala says it’s rare that thematic ETFs will comprise a significant portion of a client’s portfolio, adding that 2% to 5% is more typical.
Nonetheless, he says there’s room to grow in the thematic space, pointing out that U.S. thematic ETF assets amount to about US$50 billion. As of June 2019, 13 U.S.-listed thematic ETFs held more than US$1 billion in assets and another nine held more than US$500 million, according to Bloomberg Intelligence.
Meanwhile, no Canadian-listed thematic ETF holds more than $500 million, with the fund category holding about $2.5 billion.
“We’re punching below our weight as it relates to adoption,” Lala says. “As we see younger investors inherit and want their investments to speak for them or take a stance on something, you’re going to see greater and greater adoption.”