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New frontiers: Esoteric ETFs – egregious or genius?

From companies capitalising on cannabis decriminalisation to the streaming of Quincy Jones’s music, you can almost guarantee there is an ETF available to enable you to invest in it. This pair were launched in the past two years, alongside another that tracks companies making money from … selling ETFs. 

Yet despite the vast range of these increasingly esoteric ETFs, or funds based on a specific theme, they have so far failed to entice institutional investors. A recent report from DWS’s Xtrackers, in association with Create-Research, found pension funds and other institutional investors had very little inclination to engage with these sorts of products. Their quirkiness, though attractive for retail investors who appreciate more of a story to their financial commitments, does not fit with the overall strategy of most long-term investors’ portfolios, the research found. 

But ignoring some of the more gimmicky ideas, are these large investors missing out on potential alpha opportunities? In May, the ETF that tracks ETF providers reported its first-year performance had been more than 35%.

For Kenneth Lamont, a passive fund analyst at Morningstar who is about to publish a detailed report into these thematic ETFs, the reticence from institutional investors has been understandable. 

“These funds tend to not have a long track record,” says Lamont. “The theme the fund is investing in has yet to play out, so you often cannot look at past performance to assess the quality of an idea.”

Thematic ETFs launched in the past year have included one shorting large retail names in North America, as many struggle with the advent of ecommerce, and another that invests in international brands with recognisable logos to capitalise on increasing globalisation, partly via social media. 

Both these themes ring true, but institutional investors, as fiduciaries, need more than just a gut reaction before allocating capital. Due to the newness of the phenomenon, there is no way to back test it. “You can research the fund provider and look at how it accesses the theme,” said Lamont, “but it is hard to assess how the theme will perform in future.”

Unconstrained

Additionally, due to both the originality and idiosyncrasy of these themes, there is no way to benchmark how they are performing – a must for the majority of institutional investors.

These funds are often entirely unconstrained, which causes another stumbling block.

“Even factors, size, style and the value of the fund change over time,” says Lamont, pointing to an unpredictability that is not favoured by institutional investors with strict risk budgets, investment principles and guidelines. 

Their cost – usually significantly higher than more traditional ETFs – and relative transiency – 84% of thematic ETFs launched before 2012 have closed, according to Lamont – also strikes them off pension funds’ list. 

However, there are a couple of compelling reasons why large investors might want to take another look at these types of vehicles – and some providers have begun to trying to help them. 

Legal & General Investment Management bought relative minnow Canvas in 2017 to help build out its ETF platform in Europe. The former Canvas chief executive, Howie Li, now heads up the £1trn fund manager’s whole ETF unit. 

Li has brought his entrepreneurial style to LGIM and has created a set of ETFs that have a thematic basis rather than track a traditional index.

“As an investor, you have to understand what is changing daily lives,” says Li. “At LGIM, we consider the impact of technology, energy transition to cleaner forms and demographics, such as the ageing population and growing middle class in developing economies.”

Unlike investing in a range of large technology disrupters, such as Amazon, Google and Facebook, one of the ETFs LGIM has launched examines the critical use of tech in a variety of business models, and along the supply chain in various industries. 

Another considers the dramatic increase in the need for cyber security, with a further fund looking at logistics after the explosion of ecommerce.

“It’s about structural change,” says Li. “These themes will play out regardless of what happens in the economy. They are not connected to economic cycles.”

For Lamont, this is one of the strengths of thematic investments. “They are very pleasing as they disregard the traditional sectoral and geographical breakdowns that are usually found in the industry,” he says. 

For Li, all investors considering this type of allocation must think about what they believe is happening in the long term, rather than jump on the bandwagon of a short-term fad. 

A recently opened, and then closed, whisky ETF would probably have not passed this test. 

“You have to understand the drivers,” says Li. “Are business models being disrupted? Are we seeing a change to accepted structures?”

With this in mind, and investors anticipating another market downturn or at least correction, it is possible that more providers could begin producing similarly thematically driven ETFs. 

Antoine Lesne, head of SPDR ETF investment strategy at State Street Global Advisors, said providers loved coming up with new ideas – the key for them was working with investors to create something they wanted, too.

The company launched a gender diversity ETF, with the ticker SHE, to coincide with the placing of the Fearless Girl statue opposite Wall Street’s Charging Bull in 2017.

It was an unusual move for SSGA, but the drivers were specifically grounded in long-term, global change, says Lesne. LGIM launched its GIRL fund – not yet available as an ETF – to follow the same theme a year later.

Creating these types of products are more complicated than traditional ETFs, according to Lense. Using an index constructed by a provider itself is not accepted in some jurisdictions, while back-testing and gathering enough analysis, before even trying to protect all the intellectual property and still being first to market, can be too onerous for giant companies with plenty of existing products to sell.

iShares, the world’s largest provider, has just nine thematic ETFs available to UK investors, four of them boasting just a one-year track record. 

No smoke without fire

The other ETFs mentioned – cannabis industry, ETF providers and retail giants falling – are all run by relatively small companies.

“There is room in the market for newcomers,” says Lesne at SSGA, pointing to the range of ideas that his firm, as one of the largest ETF providers, do not consider directly. 

“A lot of the established players do not really know how to get into creating these funds,” said Lamont. “And if they do it, it has to be in a logical way. These funds can be interpreted in the media as being gimmicky and they would prefer to not be associated with that.”

Some of the biggest international ETF providers declined to participate in this article. 

However, as the largest fund managers in the world are fighting for a piece of the ETF action, they may have to change tack.

“The ETF business is saturated with core offerings,” says Lamont. “Thematic funds are the new battleground. The 16% of esoteric ETFs launched before 2012 that are still trading today are based on themes that are still relevant. The key is getting the timing right.”

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