One of the primary benefits of the exchange-traded fund (ETF) space at this stage is that investors have an incredible degree of flexibility. Looking for a fund that targets mid-size manufacturers of health care products? It's likely that you'll find at least one ETF catered to your tastes.
As the ETF space has blossomed into a $5 trillion industry in the U.S. alone, the number of funds on offer has exploded as well. This means there are many funds that offer an increasing specificity and focus. So-called thematic ETFs aim to isolate a target niche of the market and can be narrow or relatively broad in scope. But how does an investor go about determining whether or not to explore the thematic ETF space? Below, we'll examine some of the benefits and risks of thematic ETFs that any investor should consider before setting aside assets for investment.
One of the major concerns when it comes to thematic ETFs is volatility. In a recent report for ETF.com, Roger Nusbaum of Your Source Financial and Seeking Alpha uses the iShares U.S. Medical Devices ETF (IHI) as an example. Given that IHI focuses on a narrow segment of the health care industry—companies that produce medical devices—Nusbaum expects that IHI will be more volatile than a broader spectrum of sector stocks. He indicates that "when things are going well in markets...IHI will [likely] outperform the broader sector fund." On the other hand, IHI may also underperform when the market is troubled.
This gets to the root of one of the issues of thematic ETFs. If health care stocks represent something like 12% to 13% of the S&P 500, and if IHI can be expected to have higher volatility than the sector in general, Nusbaum suggests not having too much exposure to the thematic ETF.
At work here is the assumption that the narrower one focuses in on a particular subset of sector stocks, the more volatile that fund is likely to be. As Nusbaum points out, "a broad sector is going to be less volatile, the vast majority of the time, than some sort of narrower industry group or theme fund." One can see the theme fund as a midway point between a broader basket of sector stocks and an individual name, which is likely to be most volatile of all.
While volatility is a concern, it's something that can be mitigated by careful allocation. On the other hand, thematic ETFs can also offer incredible benefits. As Nusbaum acknowledges, the growth of the thematic ETF space is so exceptional that essentially no theme is "too far out there." This gives investors a wonderful flexibility; if you're interested in a specific subset of the video game market, for instance, there are plenty of ETF options for you. There is a question, of course, as to whether it's best for an investor to view thematic ETFs as a means of expressing a personal conviction or as a way of utilizing their own expertise. This could lead to complicated conversations with an advisor, who may push investors toward a more global approach when it comes to selecting themes.
Nusbaum encourages investors to look to sector weightings in the S&P 500 as a guideline for thematic ETF investing. He suggests rarely if ever exceeding the sector weight in the index in an ETF allocation.
Investing in thematic ETFs carries higher risks and, potentially, more lucrative rewards than the broader ETF space. Investors should be aware of the pitfalls to participating in these niche ETFs, but at the same time, if done carefully, thematic ETF investment can provide excellent returns.