Whatever the niche, there is probably a fund for it.
There are already exchange-traded funds that aim to profit from cannabis, the gig economy and adult obesity. One short-lived fund focused on trade and tariff fights. Another, the Cow exchange-traded note, bets on livestock.
These niche E.T.F.s are proliferating as fund managers try to stand out after a long bull market.
But whether investors really need these narrowly sliced funds is another question.
While broad- index mutual funds and E.T.F.s provide simple, low-cost ways of tracking the entire market, these so-called thematic E.T.F.s are relatively complex, costly and risky.
“This is a sector product, and the performance tends to be more volatile than a broad-market index product, and these funds tend to be on the more expensive side,” says Linda Zhang, chief executive of Purview Investments, an advisory firm that focuses on E.T.F.s. “For the individual investor, ask yourself: ‘Is this a marketing scheme or truly an investment?’”
The premise behind narrowly focused funds is that they’ve identified an opportunity to exploit unrecognized growth.
“Our strategy is to look at the big transformational trends, the amorphous things, that could be amazingly important, but you’ve got to go find where the pots of money are with this stuff,” says Simeon Hyman, Global investment Strategist from ProShares, which has issued several such funds.
The ProShares Pet Care E.T.F., for example, invests in an index of companies involved with health care for pets, including pharmaceutical companies, specialty retailers and distributors. That includes Covetrus, the Pets at Home Group and Freshpet.
“We saw the pile of money,” Mr. Hyman says. “Sixty-eight percent of households have pets, and that’s more households than have children.”
One large thematic fund is FlexShares Morningstar Global Upstream Natural Resources Index Fund, which tracks an index of companies working in energy, agriculture, precious or industrial metals, timber or water. Top holdings include Exxon Mobil, Tyson Foods and Archer Daniels Midland. Established in 2011, the fund had $5.5 billion under management at the end of December, and returned nearly 16 percent for the year.
Overall, about 150 thematic E.T.F.s posted total net inflows of $3.4 billion in 2019 and managed $40.6 billion in total assets.
Several funds have themes and stock tickers that seem intended to grab attention:
iPath Series B Bloomberg Livestock Subindex Total Return E.T.N. (COW). The fund invests in just some of the stocks in the Bloomberg Livestock Subindex Total Return Index. It concentrates on futures contracts of live cattle and lean hogs (it’s not just about cows).
The Obesity E.T.F. (SLIM): It includes biotechnology, pharmaceutical, health care and medical device companies positioned to help the obese, along with companies offering weight loss programs or food supplements or large apparel. Top holdings include Novo Nordisk, DaVita and Herbalife Nutrition.
The Innovation Alpha Trade War E.T.F. (TWAR): This fund demonstrates the pitfalls of chasing hot trends. It started trading in June and stopped on Dec. 16. In its brief life, it made its debut at $25.71 a share, rose to $28.88 and was liquidated at $28.60. Designed by MCAM International of Charlottesville, Va., it tracked 120 companies with strong intellectual property protection and ties to “government patronage.” Its managers expected these attributes to lead to profits during trade wars. But Ignites Research says that brokers and financial advisers viewed it as too narrowly focused to succeed.
The problem is that new funds “have to find ways to stand out,” said John Swolfs, chief executive of Inside E.T.F.s, a conference on exchange-traded funds. These days, a plain vanilla S&P 500 index fund won’t do the trick.
But narrowly focused funds face built-in challenges, said Elisabeth Kashner, vice president and director of E.T.F. Research for FactSet Research Systems. “If the fund managers want exposure to big players in the industry, they have to buy companies that have many different business lines,” and that will dilute the focus of a very narrow fund.
An example is blockchain funds that consist mostly of semiconductor stocks. “While it’s true that the semis are big players in that space, blockchain might be just 2 percent or 4 percent of their business,” she said.
Another problem is that the business trend underlying an E.T.F. may not last long. A relatively undiscovered niche might present a good opportunity, but growth could be realized in a short period. That leaves investors with a timing challenge to exit the fund near the growth peak, which can be difficult to spot.
“The investment behind these funds is that this is an economic exposure that’s underappreciated and set to grow,” Ms. Kashner said. “Even if the whole thing works, there’s a point where it matures, and you want to be out of it. And if it doesn’t work, you’ve sacrificed the benefits of diversity.”
Experts say thematic E.T.F.s shouldn’t replace core holdings — such as a broad S&P 500 E.T.F. — for prudent investors and, at most, might constitute 5 percent of a risk-taker’s portfolio. These funds might be best suited as small holdings for hands-on traders looking for the thrill of playing the market and willing to take losses when their bets go bad.
“Some of these funds are just chasing shiny objects,” Ms. Kashner adds. “And sometimes you catch the shiny object. I’m not saying it never happens. It’s just a very tough bet to get right.”