Exchange-traded funds became the next big thing in portfolio management a couple of decades ago by being cheaper and easier to trade than mutual funds.

These days, some managers are offering E.T.F.s as tools for specialization at the expense of diversification, carving up the stock market into ever thinner slices for investors eager to find other next big things.

E.T.F.s have evolved from covering only broad indexes, such as the S&P 500, to sectors like energy and health care, industries like homebuilding and gold mining, and lately to subsets of industries — niches within niches — often in ultracool areas like robotics, cybersecurity and video gaming that capture investors’ imaginations and then their money.

While investment advisers occasionally use thematic funds when managing assets for their clients, they typically encourage small investors to avoid the practice, no matter how enticing it might be to try to find the next Amazon, Netflix or Google before it becomes a technological colossus.

“We would prefer that someone build a portfolio around more diversified funds,” said Jason Browne, chief investment strategist of the FundX Investment Group, a firm that manages fund portfolios for high-net-worth individuals. He warned: “If you’re an average investor, you will probably look back and think this is something you were sold and not something thoughtfully invested in that’s aligned with your long-term goals.”

Like Mr. Browne, Christopher Cordaro, chief investment officer of RegentAtlantic, a Morristown, N.J., financial-planning firm, said he sees more fund marketing than fund management at work with narrowly focused E.T.F.s.

“It sort of reminds me of ‘The Graduate,’ when the guy takes Benjamin aside and says, ‘I’ve got one word: plastics,’” Mr. Cordaro said. Providers of these funds “are looking for things that sound good to people, then they give them an itch they’ll want to scratch.”

Sam Masucci, chief executive of the ETF Managers Group, which manages about $3 billion across 12 thematic portfolios, said funds dedicated to such narrow market segments are especially dependent on investor demand and are introduced in areas experiencing a surge in popularity.

His company’s thematic funds are a mix of actively managed and passively managed portfolios. In addition to cybersecurity and gaming funds, they cover some highly focused, even obscure, industries, including mobile payments and drone technology. And for anyone worried that all that cutting-edge technology will make human beings too efficient and productive, the company also offers the Alternative Harvest fund, which invests in companies involved in marijuana production.

Anyone interested in these areas, despite admonitions like Mr. Browne’s, has several alternatives to choose from.

A recent report on thematic E.T.F.s by Todd Rosenbluth, director of E.T.F. and mutual fund research at CFRA Research, highlighted two gaming funds — VanEck Vectors Video Gaming and eSports, and ETFMG Video Game Tech — and two that invest in cybersecurity: ETFMG Prime Cyber Security and First Trust Nasdaq Cybersecurity.

The report also mentioned four that cover the burgeoning field of robotics: ROBO Global Robotics and Automation Index, Global X Robotics and Artificial Intelligence, First Trust Nasdaq Artificial Intelligence and Robotics, and iShares Robotics and Artificial Intelligence.

The performance of many of them last year illustrates the perils of owning an idea that would seem to have a lot of promise but so far has not delivered on it. The S&P 500 fell 6.2 percent last year, and the Nasdaq Composite Index, a benchmark for technology stocks, lost 3.9 percent. The ETFMG gaming fund lagged both indexes badly, losing 18.8 percent, while the VanEck gaming fund was down 12.6 percent just since its introduction in mid-October.

The cybersecurity funds did much better. ETFMG Prime Security rose 6.5 percent in 2018, and the First Trust fund eked out a 1.3 percent gain.

As for the robotics portfolios, their returns have been awful. None of the four came close to matching the Nasdaq index. Losses last year ranged between 14 percent and 29 percent.

Because interest in these areas tends to come and go, Mr. Browne uses thematic E.T.F.s to carry out short-term asset allocation decisions. Haim Israel, head of thematic investing at Bank of America Merrill Lynch, by contrast, views several technologies covered by the E.T.F.s as long-term opportunities.

The business and investment prospects associated with themes like Big Data, artificial intelligence, privacy and cyberthreats, the report said, will be helped by a “techceleration” resulting from the introduction of so-called 5G technology featuring much faster data transmission rates. The rollout of 5G “will bring about the fastest transformation in human history,” Mr. Israel predicted. The reduced time it will take to transmit data will help the spread of all sorts of technologies, like gaming or self-driving cars, he said.

Mr. Israel’s analysis and outlook are plausible — for the world as it is today and for various technologies as they have developed so far. As for five years from now, who knows? Change, often radical and unforeseeable, is a hallmark of the sector, making most forecasts speculative at best. That is one of the main complaints that investment advisers have with thematic E.T.F.s.

“We’ve been around long enough to see a lot of the ‘next big thing,’ said Leon LaBrecque, chief executive of LJPR Financial Advisors in Troy, Mich. “Remember Blockbuster or Boston Chicken? Anyone remember the first search engine? New tech becomes old tech.”

For investors interested in taking a shot with thematic E.T.F.s, advisers suggest using risk capital, and then only small amounts of it.

Mr. Masucci views thematic E.T.F.s as superior alternatives to buying individual stocks. These E.T.F.s “are a tax efficient, liquid, transparent way to give that exposure without relying on advisers’ ability to pick stocks,” he said.

But Mr. Cordaro pointed to a conundrum that anyone contemplating investing in thematic E.T.F.s faces: “Because they can be riskier, you wouldn’t want them to be too much of your portfolio,” no more than 5 percent, he said. “The paradox is that’s not going to move the needle that much. You’re not going to make much money on it.”

If you still want to try to move the needle, he advises doing it with funds that emphasize smaller, younger businesses that are pure plays in a particular niche and that don’t fill their portfolios with established companies that only dabble in fledgling technology.

Mr. Rosenbluth noted in his report, for instance, that the VanEck and ETFMG gaming funds both hold the gaming stocks Activision and Electronic Arts, but only the ETFMG fund owns the larger, more diversified tech stocks Apple and Microsoft. By contrast, the ETFMG cybersecurity portfolio is more skewed toward smaller software companies than First Trust Nasdaq Cybersecurity, while the latter holds more in big defense companies like Raytheon than the ETFMG fund does.

As for the robotics funds, the two with portfolios published on third-party sites like Morningstar’s, ROBO Global Robotics and Global X Robotics, each own big companies like Nvidia and Intuitive Surgical, and smaller ones like Helix Energy Solutions.

In the end, the most effective way to invest in the next big thing may be to avoid trying to do it through thematic E.T.F.s at all.

“Why even go for that ride is the question,” Mr. Browne said. When you own a diversified fund, “whatever drives the economy is going to be in your portfolio. It doesn’t rely on your or my predictions of what that’s going to be.”

Mr. LaBrecque recommended a similarly broad, simple approach.

“We can buy the S&P 500 and get the new FANGs,” a reference to Facebook, Amazon, Netflix and Google, “and the next acronym of choice,” he said. “And we can get the companies that make all the stuff people buy on Amazon, and the cars people drive to the store to buy the food to eat while they watch Netflix. And when the next thing comes along, we can own that, as well.”

Source: Read Full Article