Bloomberg recently launched a new ETF-focused TV show, ETF IQ, which includes a segment called “There’s an ETF for that”. In the latest episode, the show spotlighted a rare earth metals ETF. The prior week, a video game ETF was highlighted. The title of this segment is perfect because if you can think of a particular theme to invest in, there is a very high likelihood an ETF exists which allows you to do so. Whether rare earth metals or video games, robotics or cybersecurity, thematic ETFs have proliferated. Just today, an ETF launched that lets you bet on the decline of malls. Interestingly, the two ETFs I am most frequently asked about these days are bitcoin ETFs and marijuana ETFs. Both are in the works, though perhaps I’m running with the wrong crowd!
One of the wonderful aspects of ETFs is they have democratized investing. The average investor now has access to strategies and assets they could not have dreamed of owning even a few years ago. The innovation occurring in ETFs is staggering, though it does raise a legitimate question. Do you really need access to the whiskey industry through the Spirited Funds Whiskey ETF (WSKY) or to invest in companies fighting the world’s obesity epidemic through The Obesity ETF (SLIM)? Should you actually hold these in a retirement account???
I believe the best approach to investing is simply owning a globally diversified, low cost portfolio. Depending upon your situation, a well-balanced mix of U.S. stocks, developed international stocks, emerging market stocks, bonds, and maybe even a little gold will do the trick. Set the correct allocations based on your circumstances, rebalance consistently, and periodically monitor to ensure you are on track. However, there is another, perhaps even more critical, element to investing success: YOUR BEHAVIOR. The greatest portfolio in the world only works if you can actually stick with it. That’s where thematic ETFs come into play.
Nearly every investor I have ever met has at least some semblance of a gambler inside of them. The thought of achieving outsized investment returns or “hitting a home run” has crossed the mind of every investor since the dawn of time. It’s this gambler, the devil on your shoulder, that can derail even the most well-intentioned portfolio. The gambler causes you to buy at the top, day trade penny stocks, or go all-in on a high-flying tech company. Gambling is predicated on human emotion and irrationality. Even though every gambler knows the odds are stacked against them, the thrill and prospect of hitting it big causes them to toss math and probabilities out the window. That’s a significant problem when applied to your investment portfolio.
Another quality I have found in nearly every investor is they typically have some sort of unique knowledge or passion in a certain area or areas. I have spoken with aircraft engineers, social media developers, cybersecurity experts, bitcoin enthusiasts – all of whom could offer a highly convincing investment thesis in a particular segment of the market. Many have extremely strong beliefs or conviction in how the future may play out in a given area or for a certain company. Because of that, there is often a desire to express that conviction through specific investments. This can also be detrimental to your portfolio. The fact is, regardless of how well you know an area, there is always someone who knows more. There are countless Harvard MBAs on Wall Street who eat, sleep, and breathe your conviction 24/7.
The value of thematic ETFs is, if used properly, they can allow you to scratch your gambling itch, while also pursuing your particular investment passion – all while keeping your portfolio on track. If 95% of your money is properly invested in a well-diversified, low cost portfolio, allocating 5% towards an area where you have a high level of interest and with potentially greater upside potential can be beneficial. If your investment thesis turns out correct, your portfolio benefits. If incorrect, you avoid causing significant damage. Behaviorally, this “play” money can help keep your real money on track. Now, you could also scratch your itch with individual stocks. However, this exposes you to company specific risk. You may properly recognize a burgeoning industry, but the specific company you bet on could turn out as the loser in a winning sector of the market. This risk is usually magnified in innovative market segments that are just beginning to mushroom. ETFs diversify away this idiosyncratic risk, allowing you to own a basket of companies within your theme and removing the risk of completely blowing yourself up.
Another way to think about this is like dieting. Having a “cheat” day can help you stick with a healthy, long-term diet. In a conversation I had last year with Martin Small, Head of U.S. iShares, he compared the proliferation of niche ETFs to flavors of ice cream, saying “I used to think that there were too many flavors of ice cream, and then I tried black raspberry chocolate chip, and it kind of made my mind explode.” His point was that there are some fascinating ETFs now available to investors. Innovation has resulted in new flavors of ETFs. But just like with ice cream, you don’t want to overdo it. A diet consisting entirely of black raspberry chocolate chip ice cream clearly won’t end well. You need to eat fruits, vegetables, whole grains, lean meats – pretty boring. But occasionally having a bowl of ice cream can help you stick to that diet. And, if you happen to be one of the few people that doesn’t have a gambler inside or you don’t like ice cream, great – keep 100% in your well-diversified portfolio.
If you are interested in thematic ETFs, there are several important factors to consider:
> Never invest in an ETF you do not understand. Period. End of story. If you can’t explain the ETF to a 10-year old, stay away from it.
> There is no question some new ETF launches simply look to capitalize on short-term trends or fads. Instead, look for ETFs representing areas of the market experiencing fundamental shifts. You want exposure to long-term, sustainable trends. A fidget spinner ETF is probably not a good bet, though my daughters would argue otherwise!
> Be prepared to stick it out. If you are hoping to capitalize on a longer-term, secular trend, it may take a while to manifest itself. You will likely experience significant ups and downs. If you have the conviction to invest in a theme, have the wherewithal to see it through.
> Make sure your ETF offers pure exposure to whatever trend or theme you’re seeking to capitalize on. Sometimes, there simply aren’t enough companies offering pure exposure to a niche area, resulting in thematic ETFs holding companies that offer indirect exposure to the particular segment of the market – it’s just not a pure play. Other times, a thematic ETF may be too broad, with holdings overlapping positions you already own. Look for ETFs with high active share, holdings that are distinct from the broader market. ETF construction is key. If you attempt to roll the dice with a thematic ETF, if you end up being correct, you want to be properly rewarded.
Famed American economist Paul Samuelson once said, “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” I would argue investing doesn’t have to be quite that boring – you can still have some excitement by using thematic ETFs.