The best-performing exchange-traded fund (ETF) so far this year is a triple-leveraged gold miners product that goes by the ticker symbol “NUGT”. Aiming to deliver three times the returns of the Arca Gold Miners index in any given session, its 150 per cent increase this year is of little surprise: gold miners have rallied on the back of a rebound in the precious metal, which is up 20 per cent since the start of the year.
ETFs give retail investors cost-effective and flexible access to a huge variety of markets. Retail money accounts for half of all ETF assets, and there are now 6,780 products on 60 exchanges available to invest in. Aside from ETFs tracking well-known indices like the FTSE 100 or S&P 500, there are funds that take a more thematic approach, seeking to deliver returns by giving exposure to a particular theme – from biotech to coal, solar power to firms concerned with tackling social issues and human rights. While it is advisable to keep the bulk of your investments in core products or markets, James Butterfill, head of research & investment strategy at ETF Securities, says that a significant number of clients have quite a large part of their portfolio – up to 15 per cent – in thematic products. So how should you go about investing in big market trends?
In it for the long haul
Thematic investing rests on the idea that there are global trends that provide the potential for superior returns if you invest in assets that are exposed to them. Crucially, these macro trends are usually long term – and this is where ETFs can be useful for your portfolio.
The point about investing thematically is that a lot of the themes you may want to look at – ageing populations, robotics, climate change – require at least a one to three-year time horizon because they are about demographic change, says Butterfill. He gives the example of robotics. In Japan, there are 1,140 robots for every 10,000 employees. Elsewhere, that figure is 44. “Obviously it’s going to take some time for the demographic to change, and that’s why you have a long-term investment approach.” Chris Beauchamp, senior market analyst at IG, adds that “as an investor, you shouldn’t be trying to time these markets anyway. If you do, you run the risk of falling into the same trap as fund managers – chasing plays that lost you money when you could’ve stayed still and continued to enjoy the ride.”
Another key message for investors taking a thematic approach is to stay true to the theme you’re investing in, says Butterfill. You could, say, have Rolls Royce included in a robotics ETF – because it is involved in robotics – but it also does other things, so you need to look at how much exposure you’re actually getting to a certain trend. “If an ETF is market cap-based [it buys stakes in companies in an index based on their market cap] and not equal weighted [it buys an equal proportion of all companies in an index], you might buy a tech ETF and find that you simply own a lot of Apple, rather than a theme,” he adds.
Investing in an equal weighted ETF means that you will “diligently reflect a theme,” says Butterfill. This is particularly important if you’re looking at emerging themes and new technologies, because you want the potential growth of a particular company to impact the price of the ETF. “It’s very hard to know who’s going to be the winner – look at Google and Yahoo 15 years ago. Whereas more passive funds will often take big bets on one large company, equally weighted products reflect the belief that a particular theme will do well,” he adds.
The high level of liquidity ETFs offer also makes them conducive to active trading strategies. But if you’re taking a thematic approach, make sure to consider your risk appetite, says Butterfill. “Thematics are often in growth areas, so you’re probably more susceptible to volatility.”
That said, if you are taking a more active approach to trading ETFs, the structure of the product goes some way to protecting you from too much exposure. “The beauty of the ETF is that, by spreading your risk around, it takes some of that worry away. You might not see spectacular performance, but you won’t be carried out. That’s important for retail investors,” says Beauchamp
With the gold rally of previous weeks, ETFs have been helping investors to gain significant upside – but, as demonstrated by NUGT, via gold miners, rather than the precious metal itself. “Looking to gold miners is easier than hedging yourself on a metal that is subject to random movements,” Beauchamp explains.
And it’s a similar story for oil. Some firms might not survive or will be taken over, but ETFs remove the worry of being overly-exposed to the travails of a particular company. “The notion behind buying into the sector is that prices won’t stay at these levels forever. We saw $27 per barrel in January, now we’re up past $40. The thinking is that prices will, if you’re taking a longer-term view, go back up to $80,” Beauchamp says. As an investor, he explains, you can drip feed into a fund that backs that view without having to commit very much in one go – and do so reasonably cheaply.
Accessing the exotic
As ETFs are available in such a diverse number of market segments, they are often an ideal way for investors to play unusual sectors, says James McManus, ETF analyst at Nutmeg. “In unusual sectors, however, the number of assets available will be smaller – and this can increase the costs associated with trading them.” You also need to consider whether the underlying market lends itself to ETF replications – especially whether it is liquid enough to allow daily trading.
An example of a fairly new product which gives investors access to a burgeoning market is the ETFS ISE Cyber Security GO UCITS ETF, which goes by the apt ticket name of “ISPY” and tracks the ISE Cyber Security index. Designed to provide investors with exposure to firms actively involved in providing cyber security technology and services, the fund is physically replicated – meaning it holds the underlying stocks rather than a derivative. Butterfill points out that, despite being a niche area, “everyone needs cyber security, and that means it has a very broad revenue base, which will likely make it quite a stable sector in the long term.”
Too much sexiness
And thematic investors should be particularly careful with more unusual sectors. “ETFs can be used to access more niche areas of the equity markets. That said, we continue to believe niche sectors should only be utilised by investors in moderation, and as part of a diversified portfolio in order to balance the risk,” says McManus. And Beauchamp reminds investors that “as products, ETFs are not designed to be exciting – after all, ‘boring’ is no bad thing in financial markets.”
During periods of heightened volatility, investors should be careful not to fall into so-called value traps – where cheap stocks never improve. “It’s often a critique of smart beta programmes that focus on value rather than growth,” says Butterfill, who believes that gold miners are currently in a value trap. “We’re quite worried about the mining sector because earnings outlooks just don’t look great. The improvement in stock prices is not based on fundamentals, but is just a pure reflection of the gold price. As an investor, if you see something that’s super cheap, you have to stop and ask why it’s cheap.”