ETFs keep growing, but watch out for the high-risk ‘fashionable’ ones

The exchange-traded fund (ETF) revolution is showing no signs of slowing down – having grown by 32% last year to reach more than $135 billion in funds under management.

Within that growth, however, there have been some emerging trends which may not be all good news for investors.

The main one is the arrival of a plethora of “fashionable” ETFs which differ quite markedly from the conventional ETF, which usually shadows a large index such as the ASX 200 or ASX 300 to benefit from diversification and ultra-low management fees.

Unlike their more conventional cousins, these fashionable ETFs zero in on a particular investment theme such as electric cars, crypto companies, robotics or cloud computing.

The first thing to note about these thematic or fashionable ETFs which have proliferated greatly over the past couple of years is that they are usually the opposite of the big, broad index funds – they usually invest in a small number of companies that are judged to be beneficiaries of the particular investment trend being monitored and if there is an index being followed, it is often highly specialised.

Narrow approach proves spectacular – for gains and losses

The results of this narrow investment approach can be spectacular – in both the positive and negative sense.

Just looking at the last financial year, thematic ETFs featured heavily in the best and worst results for the year.

Focussing on the positive, the best five ETFs were BetaShares Crude Oil Index (ASX: OOO), up 67.09%, BetaShares Global Energy Companies (ASX: FUEL), 29.63% higher, and ETFS Ultra Short Nasdaq 100 Hedge Fund (ASX: SNAS), up 29.45%, BetaShares Strong US Dollar Fund (ASX: YANK), increasing 19.59% and BetaShares US Equities Strong Bear Currency Hedged (ASX: BBUS), gaining 18.06%.

So far, so good with the strong rally in oil prices due to the Ukraine war and a crunch in the value of technology stocks and rise in the US dollar producing stellar returns.

On the negative side, the losses were even higher and would have caused significant pain for many investors.

The worst five ETFs were ETFS Ultra Long Nasdaq 100 Hedge Fund (ASX: LNAS), down 50.25%, ETFS S&P Biotech (ASX: CURE), 40.53% lower, BetaShares Global Robotics and Artificial Intelligence (ASX: RBTZ), falling 36.50%, BetaShares Cloud Computing (ASX: CLDD), down 35.95% and BetaShares Asia Technology Tigers (ASX: ASIA), 35.62% lower.

Obviously, these results are just a snapshot in time and were achieved at a time of extensive market upheaval but they starkly show the benefits and the risks of taking a fashionable approach.

Interestingly, none of the broad index ETFs featured in the winners or losers, with most of them nursing small losses, depending on the index they are tracking and whether they hedge against currency.

Fashionable ETFs are satellite investment, not core

What these results show to me is that for a portfolio investor, the fashionable ETFs might be a fun way to add some spice to the mix, but they should be a much smaller part of the overall portfolio, with the broad market tracking ETFs much better suited to being the core of your investments.

This sort of core and satellite approach was justified nicely by some analysis by Chris Brycki, a big fan of ETFs and the founder of Stockspot, which showed that just six of 244 global share funds, or 2.5%, were able to outperform their benchmark, after fees, in the five years to the end of April.

Passive wins easily for international funds

Using Stockspot’s preferred ETFs as proxies for market returns in the study, Brycki found that the iShares Global 100 ETF (ASX: IOO) swept the floor compared to the vast majority of active fund managers.

Simply by tracking the largest 100 listed companies around the world, this ETF would have turned $100,000 invested five years ago into $194,151, compared to $154,427 for someone who earned the average return for the 244 actively managed global funds in the study.

Active approach works better in Australia

Perhaps unsurprisingly, the active managers did better on their home turf in Australia, with 80 out of 311 funds, or 25.7%, outperforming the Australian share market over the five years, after fees.

While that might seem like a fair percentage beating the ETF proxy of the Vanguard Australian Shares Index ETF (ASX: VAS), the problem is in knowing which active managers are going to outperform in any particular year and for how long they will keep outperforming.

It may pay to go active for small companies

If there is an area where active managers shine it is in investing in smaller companies, probably because there are so many of them and there is such a high failure rate that an overall index will struggle to keep up with even the most rudimentary solvency analysis.

Even here, though, only 31 out of 85, or 36.5%, of the funds outperformed the Vanguard MSCI Australian Small Companies Index ETF (ASX: VSO).

Perhaps the lesson is that you should use ETFs as a core investment, but that active management could have its uses in areas such as investing in small companies.

Oh, and following fashion will only get you so far.