ETFs provide key to investment themes

By John Beveridge - September 6, 2021

ETF exchange traded fund investment themes ASX ACDC ASIA CURE ESPO ETHI FANG HACK RBTZ ROBO TECH — A more concentrated ETF is going to offer less diversification and have higher volatility, but if it focuses on the right megatrend it could result in outsized returns.

In the early days of exchange traded funds (ETFs), the big sales pitch was all around a “core and satellite’’ approach.

The idea being that you could use an ETF to get your main “core” exposure to a particular market and were then free to buy and sell satellite exposure – usually through riskier individual stocks, managed funds or through more exotic investments like hedge funds or emerging markets.

That was a great sales pitch at a time when many investors held between 20 and 30 individual stocks on the ASX and really struggled to keep up with what was going on with them all.

Fast forward 20 years and the picture has changed dramatically, with ETFs now a central part of the Australian investment scene, accounting for almost $120 billion – much higher than the $50 billion in 2019.

Young investors have been particularly keen to get the instant diversification benefits of ETFs, which has played a large part in the booming use of these low cost, exchange traded instruments.

Now the core is covered, ETF’s do satellites as well

One of the biggest changes in recent years though is that a range of ETFs have been developed for the “satellite” investments.

Some of these can be ideal for set and forget brigade but also bring about the sort of investment themes and opportunities that would otherwise be difficult to replicate directly.

By definition, many of these opportunities will lie offshore, which is still a difficult administrative hunting ground for direct investments from Australia but can easily be tackled through an ETF.

Some of these would be well placed as a “core” investment – such as low-cost S&P 500, Europe, Japan, Nasdaq or US total market ETF’s – while others are much more nuanced and follow carefully constructed indices or themes.

Investment themes popular among younger investors

Unsurprisingly, many of these themes are popular among millennial investors and range from those that support clean energy to those that hone in on specific areas such as robotics, ethical investment, or cloud computing.

In a broad sense they follow disruptive industries and technologies or megatrends such as the electrification of mass transport or the development of artificial intelligence.

One of the cautions that should apply to these “satellite” ETFs is that they are by definition quite narrow and selective, so they often don’t give you access to a broad range of markets or companies.

Another consequence of that lack of diversification is that they are also more expensive to run and so come with higher fees than the very broad ETFs that cover a major index like the S&P 500.

That in itself is not a reason not to invest in these ETFs, but it is something to keep in mind when you are deciding what sort of asset allocation you might go for.

Obviously a more concentrated ETF is going to be more volatile and offer less diversification but if the investor is jumping on to the right megatrend at the right time, that could also lead to outsized returns over time.

An example of just some of these thematic ETFs that trade on the ASX include:

Need for a different approach

Investing in thematic or satellite ETFs is a bit different to buying those that represent a broad index.

You need to do some individual research to ensure that what you are buying is what you really want by checking out the actual companies the ETF holds.

There are so few companies in some of these sectors that one really large and over-valued one might really skew returns.

Fees can be higher

Another thing to check is the level of fees, which are likely to be higher than those on the broad ETFs.

Buying and selling thematic ETFs also requires a more nuanced approach.

Thematic ETFs are likely to be more lightly traded than the really large ETFs so it pays to be a bit cautious about how you go about buying them when you have finished your research.

Sometimes ETF trading can be a bit volatile around the opening of the market as buyers and sellers with advance orders do battle at the same time as the market makers (companies that try to smooth out trade) are just getting started so it is often a good idea to not place your buy order until the stock has already been trading for some time.

Also, it makes sense that these sort of investment trends will change over time so it probably pays not to have too much of a set and forget approach to the satellite part of your ETF portfolio.

You don’t want to be left holding a narrow, poorly traded and illiquid ETF long after the market has moved on to the latest “hot” sector, with fees often rising after investor outflows.

Adding spice and potential outsized returns

With these few cautions, many of these thematic or niche ETFs can be really useful to add some spice and perhaps outsized returns to your portfolio.

They can also encourage some education about new sectors that aren’t yet available on the ASX, may give access to long term growth trends and can offer a hedge against digital, climate and other forms of disruption and its impact on an overall portfolio.