The story behind the hottest funds on the market

You are probably better off buying a story ETF than a story stock; the fund is at least somewhat diversified. But story ETFs carry their own risks.

These funds are often called thematic ETFs, and spread across industries and try to capitalize on ideas such as alternative energy, cloud computing or 3D printing. Others buy shares that could benefit if more people work from home, demand gender or racial diversity, or brag about money to their pets.

The assets in these funds have grown by an average of 45% annually over the past three years, says William Baun of Fuse Research Network in Needham, Mass.

In the fourth quarter of 2020 alone, thematic ETF assets soared 78% to $ 104 billion, according to Global X Management Co. LLC, which provides several such funds.

One reason is performance. Invesco WilderHill Clean Energy ETF gained 205% last year. ARK Genomic Revolution ETF returned 181%, and its four sibling funds each rose at least 100%.

The pandemic undermines the traditional belief that stocks in the same sector tend to move together, says Jay Jacobs, head of research and strategy at Global X. Norwegian Cruise Line Holdings Ltd. and Amazon.com. Inc.

are both consumer discretionary shares, but Norwegian shares fell by 56% in 2020 while Amazon rose by 76%. Meanwhile, ETFs that pursued the online shopping theme in several industries rose 74% and 123% last year.

With investors sitting at home, the trends succeeded in 2020. “People now understand themes like cloud computing and collaborative software in ways they may not have appreciated before,” says Scott Helfstein, head of thematic investing at ProShare Advisors LLC in Bethesda, MD. “Here they were suddenly. It was like, ‘Invest in what you know.’ ‘

Investors who follow themes that seem obvious should remember a few principles that should be even more obvious.

Investing in only one part of the market, instead of the whole market, lowers your diversification and increases your risk. Management fees can be at least ten times higher than with ETFs that follow the stock market as a whole. If a theme addresses you intuitively, it is likely to attract millions of other investors as well, making the underlying ownership of a fund more expensive.

A new study by several financial professors finds that such ETFs hold, on average, only about a quarter as many stocks as broad-funded funds. Looking at more than 1,000 ETFs of all kinds between 1993 and 2019, the researchers found that thematic funds adjusted the overall stock market by about 0.5 percentage points per month, better than risk.

They also found that these funds tend to launch months after a theme has warmed up – amid a great deal of media hype and stocks earning striking returns.

According to industry executives, it takes several months to launch an ETF. Between the time a compelling theme emerges and an ETF entering the market, the stocks that play out the trend can be dangerously overvalued. This means that fund managers are often ‘packaging dreams’, says Itzhak Ben-David, one of the authors of the study.

In other words, investors have a natural tendency to buy at exactly the wrong time, and these funds can make it even worse.

“This is a risk,” said Robert D. Nestor, president of Rafferty Asset Management LLC, which manages several thematic ETFs under the Direxion name. “It would be ridiculous to say otherwise.”

Peculiar rules of portfolio construction can also arise. In the US Vegan Climate ETF, the size of a single stock position is limited to 4.5%. Train Tesla Inc.,

the bulk of the fund rose to 7.9% of total assets.

The 4.5% limit is enforced twice a year when the fund rebalances every June and December, or adjusts the size of its shares.

In its semi-annual rebalancing, the Vegan Fund reduces any positions above 4.5%. It uses the proceeds of such sales to buy more of its other top interests, says Claire Smith, CEO of the fund’s adviser, Beyond Investing LLC.

It can eventually concentrate the fund into a handful of winners. The policy will be reviewed if it ultimately makes the fund too top-heavy, she says.

In general, entertainment ETFs are more enjoyable than ordinary old index funds that hold everything in the market, but also riskier.

In recent years, ‘people might get a tip from a taxi driver’, says Deborah Fuhr, founder of ETFGI, a fund research firm in London. “Now most people can have their own views on a theme.”

These ETFs are “the new version of equities for the new world,” she says.

Well, I have a tip for you. If you think you’ve spotted a theme that other investors have not yet fully appreciated, ask yourself why there is already a thematic fund for it.

Write to Jason Zweig at [email protected]