Playing future trends with niche ETFs

Covid-19 only appears to have accelerated the shift from old trends to new. When it comes to retail, for example, traditional names appear to be losing ground to e-commerce even more quickly than before. An accelerated adoption of digital services has worked out nicely for the tech sector, while healthcare names have also received a boost for the time being.

It is important to note that some gains could ultimately prove short-lived: critics might argue, for example, that Zoom Video Communications (US:ZM) has already notched up its biggest wins and is unlikely to maintain its recent momentum indefinitely. Buying a basket of stocks that fit within the same theme or subsector could be a more diversified source of exposure to such trends.

The case for niche ETFs

The exchange traded fund (ETF) sector is now rife with niche products that look to capitalise on a popular trend, but most of these are notably absent from our latest Top 50 ETFs list for good reason. We would argue that getting exposure to core markets and asset classes as the building blocks of a diversified portfolio is most important, and the list reflects that. Niche products can then be added if investors have a specialist interest or wish to take more of a risk in the hope of boosting their returns.

As Peter Sleep, senior investment manager at 7IM, puts it: “Investors should get the basics right…before they head off and get involved in niche areas they might not be well equipped to deal with.”

For those who do wish to focus on a specialism, there are many names that might stand out. Our 2020 Top 50 ETFs list already includes iShares Automation & Robotics UCITS ETF (RBTX), iShares Ageing Population UCITS ETF (AGES), iShares Global Clean Energy UCITS ETF (INRG) and iShares Digitalisation UCITS ETF (DGIT), but the table highlights a handful of other options. Most of these were previously highlighted by members of the panel who assisted with the construction of this year's top 50 list.

Where possible we have opted for sterling, UK-listed share classes, although alternatives are available on some ETFs. The assets under management given for the ETFs tend to be in dollars. This non-exhaustive list is split into three very broad categories: technology, health/demographics and infrastructure/environment.

It should be noted that there may well be overlap between the categories used and the products in them. Also do exercise caution before going ahead with specialist products: there are good reasons to either steer clear of them entirely or at least tread carefully, as outlined in the “Reasons to stick to the basics” section of this article.

Specialist picks

With many aspects of life taking an increasingly digital quality, pockets of the tech sector could be in for big wins. A handful of potential picks are highlighted in the table.

Sector-based plays appear to make sense: L&G Cyber Security UCITS ETF (ISPY) and Rize Cybersecurity & Data Privacy UCITS ETF (CYBP) both capitalise on an environment where companies must spend more to avoid data breaches and IT failures. WisdomTree Cloud Computing UCITS ETF (KLWD) tracks an index focused on companies that make most of their revenue from “business-oriented software products via a cloud delivery or cloud economic model”, with prospects for revenue growth, including Zoom.

The criteria, index composition and level of specialism should be among the factors that inform your choices. For example, the Rize ETF may have a broader remit than L&G Cyber Security, even if they share holdings such as Cloudflare (US:NET). Sam Dickens, a portfolio manager for IG and panelist for this year’s Top 50 ETFs list, has previously singled out the Rize offering because it has lower exposure to large-cap stocks in the cybersecurity industry and is relatively low cost at 0.45 per cent.

ETFs such as these will understandably give investors heavy exposure to the US: the region made up nearly three-quarters of the Rize ETF’s assets at the end of July, more than 80 per cent of assets for the L&G ETF and more than 90 per cent of assets in the WisdomTree product. This highlights a key risk with tech ETFs: you are likely to double up on exposure you may already have in US funds and stocks, whether via markets such as the S&P 500 or the more tech-oriented Nasdaq 100.

Plays on tech elsewhere might appeal. Mr Dickens has previously highlighted EMQQ Emerging Markets Internet and Ecommerce UCITS ETF (EMQP) because it captures two megatrends that could shape the global economy in the next decade. “Favourable demographics and a growing middle class will boost online consumption in some of the most exciting industries, from online retail to social media and e-payments to e-sports,” he says. That said, portfolio duplication concerns also apply here: the ETF’s biggest holdings at the end of July were Tencent (HK:700) and Alibaba (US:BABA), names that are extremely prominent in both passive and active Asia and emerging market funds.

Thematic plays are not all about tech, but its current dominance and popularity means that assessing some of the options makes sense.

Knowing what you're buying

A selling point for ETFs is they tend to have a good level of transparency: all providers should at least produce fact sheets that detail major holdings and broad exposures, while iShares among others tends to detail the full holdings for its offerings online. This can be useful for understanding what you are holding, because thematic ETFs can come with important nuances.

iShares Ageing Population UCITS ETF, for example, focuses on companies that specifically provide products or services to people aged 60 or older, but a look at its sector weightings shows a good spread of sectors beyond just healthcare. At the time of writing, the fund had 45 per cent of its assets in health names, with nearly 40 per cent in financials and 8.3 per cent in consumer discretionary stocks. Its biggest financials holding at this point was in New China Life Insurance. Other funds might be harder to assess without picking through all of their holdings. iShares Healthcare Innovation UCITS ETF (DRDR), for example, does not provide a breakdown of the subsectors it invests in, although details of its geographical weightings and a full holdings list are available.

A few general points apply when considering specialist names. Larger ETFs are generally better because scale can translate into good liquidity, and niche ETFs will in many cases look small compared with their mainstream counterparts. Costs are also important. These can come down if an ETF builds up decent scale, but niche products will tend to be costlier than a generic equity ETF.

Lynn Hutchinson, a senior collectives analyst at Charles Stanley with a focus on passives, argues that limited size is less of an issue for new products, but adds: “Small size matters more when products have been launched for some time and are not gathering assets, meaning trading spreads can sometimes be wide”. ETFs that have existed for some time without picking up a decent level of assets might even run the risk of closure, with those that have less than £50m potentially looking vulnerable.

It also pays off to ask whether an ETF can adapt to changing developments. For example, some products, such as Defiance Next Gen Connectivity ETF (US:FIVG), focus on the rollout of 5G, but Ms Hutchinson questions what will happen to such offerings when the next upgrade arrives. “Will it change its benchmark to include those [upgrades] or will it remain just focused on 5G?” she asks.

Reasons to stick to the basics

Trends such as the rise of digital services or medical advances appear fairly entrenched for now, but there is good reason to be wary of niche funds. Mr Sleep, who previously highlighted Lyxor World Water UCITS ETF (WATL) listed in the table, but only as “the best of a bad bunch”, believes skepticism is warranted on several fronts.

The biggest risk remains that you back a potential trend via an ETF and it simply fails to play out. Mr Sleep notes the emergence of many commodities ETFs a decade ago that have since disappeared, with various others, such as a nuclear energy ETF, failing to play out. Damningly, he also cites the case of VanEck Vectors Rare Earth/Strategic Metals ETF (US:REMX). As the chart shows, it was launched at a time of surging prices for rare earth metals and appears to have “just caught the top”.

Even if a trend does play out, the execution of an investment strategy can also be problematic. For one thing, Mr Sleep warns that an ETF’s holdings can sometimes only be tangentially related to its investment theme, citing medical cannabis ETFs that hold stocks in fertiliser companies. He adds that specialist ETFs run the risk of coming to a trend too late, and therefore buying in when prices are high.

“By the time an ETF provider has tested the popularity of a theme, put together an index of stocks, winners and losers, gets regulatory approval to sell the ETF and lists it on the stock market, I think there is a good chance that the buyer of the ETF will be the last buyer of that and get the worst price,” he says.

More generally, niche ETFs can be volatile because of their narrow focus, and they lack diversification even if they might be preferable to individual stock picks. Mr Sleep adds that ETF structures can sometimes put prominence on smaller and potentially less liquid stocks: products that weight their holdings equally focus heavily on smaller names, while UCITS concentration rules can partly limit how much an ETF can put behind its winners. However, it should be noted that passives are less restricted by these rules than active funds.