SINGAPORE (Dec 24): As the year-end approaches, heightened levels of volatility and intermittent market selloffs are becoming the norm. A 500-point move in the US Dow Jones Industrial Average in a single session is no longer unusual.
Unsurprisingly, some market watchers are placing some of the blame on the continued popularity of exchange-traded funds, and suggest that the catalyst for the next bear market could have its genesis in the behaviour of ETFs. Index investing, market watchers say, could cause the next financial crisis.
Since the global financial crisis in 2008, assets under management (AUM) for ETFs have grown from around US$800 million ($1.1 billion) to about US$6.32 trillion in mid-2018, according to data from Bloom berg. In its report titled “Ten Years after the Global Financial Crisis: A Changed World”, JPMorgan says: “The shift from active to passive assets, and specifically the decline of active value investors, reduces the ability of the market to prevent and recover from large drawdowns. The US$2 trillion rotation from active and value to passive and momentum strategies since the last crisis eliminated a large pool of assets that would be standing ready to buy cheap public securities and backstop a market disruption.”
The primary activities of ETFs involve creation and redemption of stocks to track the underlying index. Market tracking of this magnitude may end up leading the market, subsequently exacerbating the market movement, and lead to indiscriminate liquidating in the event of a downturn.
According to Bloomberg, trading in ETFs takes up a quarter of the daily volume in the US stock market, but that can leap to 40% on some days. Nevertheless, we need to dig deeper in understanding the actual impact that ETFs have on the market, by looking at the absolute value of the redemptions and creations of underlying stocks by ETFs.
Analysis done by Matthew Bartolini, head of SPDR US Research, found that there was US$11 billion worth of gross primary market transactions (US$5.5 billion of creates, US$6 billion of redeems) on Oct 10, 2018. The net negative flow of US$500 million from redemption is small compared with the total volume traded on Russell 3000 stocks — US$304 billion on the same day. Bartolini maintains that ETFs provide liquidity to investors looking for risk transferring, portfolio reallocation and market exposures. Case in point: Investors of the largest ETFs, such as ishares Core S&P500 ETF, tend to have a longer average holding period, evidenced by the low daily trading volume of 0.65%.
As the ETF industry matures over time, the diversity of product offering deepens as thematic investing comes to the fore. Defined by Fidelity Investment, thematic investing follows certain social, economic, corporate, demographic or other themes popular in society. To fund providers, it is an effective way to raise money quick. To investors, it provides an inexpensive and diversified means to a pool of companies of their preferred theme or investing angle.
In this article, we discuss the popular thematic ETFs and rank them by multi-year returns. More importantly, we illustrate some key considerations for investors to assess before investing in thematic ETFs.
Timing of the theme/trend
Investing in what is viewed as an emerging megatrend such as blockchain or marijuana could be a short-term phenomenon. The large initial inflows into these new funds are not necessarily supported by the belief of certainty or inevitability of their success or the fundamentals of the themes, but rather the need to gain exposure to these trendy themes. For example, Reality Shares Nasdaq NextGen Economy ETF (BLC) attracted US$119 million of inflows in the first month after its launch, but inflows in the following month dwindled to US$13 million.
Often, first-mover advantage exists. Thus, investors who are firm believers of a certain theme, should invest at the earliest possible opportunity. If investors are coming late into the thematic ETFs where the rally is already over, these latecomers may be too discouraged to hold on to their investments and wait for the next rally.
Jay Jacobs, director of research at Global X Fund, has identified two types of thematic ETFs investing: cyclical and structural. Cyclical themes occur at somewhat short- or medium-term intervals, typically based on changes in business cycle.
One example is iShares Global Timber & Forestry ETF. Paper and forestry products, real estate investment trusts (REITs, and containers and packaging are the top three industries of the fund. The ETF has rallied 75% from June 2016 to June 2018, owing to timber shortages, trade tension between the US and Canada, and a recovery in US housing prices. The price has been on a downward trend since June 2018, however, as demand-and-supply dynamics have rebalanced and there has been a slowdown in US housing activities. These cyclical trends can be mean-reverting, so that, over a long period of time, they tend to converge with some average level.
On the other hand, structural themes tend to be longer-term in nature, and are underpinned by powerful and disruptive forces. Examples are disruptive technolog ies, changing demographics and consumer behaviours. ETFs of these sorts should stand the test of time, when the demand of the underlying product eventuates.
According to our thematic ETF ranking, the top three ETFs are all associated with personal health and wellness: Global X Health & Wellness ETF, The Long Term Care ETF and The Obesity ETF. Despite the small asset size of US$14 million on average, these ETFs have exhibited commendable returns of 14.5% yearto-date during a time of market volatility.
Sponsor capability and proﬁle
The sponsors-cum-issuers of the ETFs are one of the highest priorities when considering an ETF. One should look at the background and experience of the sponsors. Industry leaders such as Fidelity, BlackRock, Vanguard and SPDR provide a certain level of assurance, with financial prudence. This is especially prevalent for funds with smaller AUM and unusual themes.
ETFs with a small AUM and small or unknown sponsors carry greater risk of closure, especially if they fail to gather sufficient assets to absorb management costs. In addition, investors should judge these sponsors on how clearly they articulate the investment objective of the ETFs. An ETF with blurry investment objectives and methodology, or with the wrong investing team despite a well-received theme, is bound to fail. One in four ETFs has failed, with more than 500 closures since the funds gained popularity over the past 10 years. The high mortality rate gives significance to the importance of sponsor’s strength.
High-in-demand themes such as blockchain technology have garnered widespread attention. Interest in blockchain investment was not limited to financial services but also the general public. Jumping on the bandwagon, more than seven ETFs related to blockchain technology were introduced this year alone.
A thematic ETF is something easily understood by the public. Since it is a fresh segment of the funds market, it provides a fresh entry point into this industry, where Vanguard, BlackRock and State Street Global Advisors own 70% of global ETF assets. This is where investors need to be cautious about the provider, not just the product. An ETF takes at least three years of track record to build its performance credibility. Investors are advised to at least look at or take reference from the other products offered by the same ETF provider to stay informed when investing.
Beware volatility and risk
Price volatility is an important consideration when investing in equities. Although thematic ETFs possess the diversification benefit by offering a pool of companies in an inexpensive way, the risk varies greatly with the underlying investing theme. Diversification benefit aside, thematic ETFs are still essentially the concentration of stocks in a single industry, moat or trend, which can be a double-edged sword.
For instance, healthcare ETFs are in demand because of the global ageing trend and generational changes in demographics. The healthcare sector accounted for 13% of the components of the Standard & Poor’s 500 index. But it is also a volatile sector. Based on standard deviation of stock prices, healthcare is the second most volatile sector in the S&P 500 after consumer discretionary. iShares Global Healthcare ETF and Invesco S&P Smallcap Healthcare ETF have exhibited one of the highest levels of volatility in 360 days, compared with other ETFs.
Nevertheless, these Healthcare ETFs are also the top performers in the thematic ETF universe, generating 19% in one-year returns on average as the sector outperformed the market in the latest quarterly results reporting season.