The onward march of exchange-traded funds (ETFs) is nothing short of astonishing.
Since the first low-cost passive index tracker was launched in 1993, they have conquered the investment world.
In 2003, investors could choose from only 276 ETFs, which act like investment funds but are bought and sold in real time much in the same way as shares.
Last year, that hit a staggering 8,754 funds managing $10 trillion worth of global assets.
In the US, ETFs manage 12.6 per cent of equities, according to BlackRock, which offers funds through its iShares brand.
ETFs have revolutionised the fund management industry by giving private investors access to professional level techniques, at minimal cost.
The cheapest charge as little as 0.03 per cent a year, with no upfront costs.
This means investors keep a lot more of their gains compared to the days when active fund managers could get away with charging upfront fees of 5 per cent, then another 1.75 per cent a year.
Most private investors use ETFs to track the fortunes of thousands of stocks on broad-based indexes such as the S&P 500, FTSE 100, Europe or an emerging markets index.
Yet there is also an expanding range of speciality, or “thematic”, ETFs, which offer private investors access to some weird and wonderful markets and financial instruments.
Unfortunately, this is where the problems start.
Studies have repeatedly shown that thematic ETFs have delivered a disappointing performance, especially those that focus on narrow industries and themes.
Over the past two decades, they have underperformed broad-based benchmarks by about 30 per cent in the first five years after launch, according to a new paper in the Review of Financial Studies.
One reason is that fees on thematic ETFs are higher, typically about 0.60 per cent a year.
But the biggest issue is stock underperformance, according to the study’s co-author Francesco Franzoni, a professor of finance at the University of Lugano and senior chairman at the Swiss Finance Institute.
With the big indexes saturated with ETFs, new funds tend to focus on the “flavour-of-the-month topics that investors are excited about” at the time, he wrote in The Financial Times.
In 2020, these included Covid-19 vaccines, telemedicine and sports betting, moving onto Bitcoin, electric cars and the metaverse in 2021.
It is not hard to see where the problems lie, says Laith Khalaf, head of investment analysis at AJ Bell.
“There is nothing wrong with speciality ETFs in principle, but all too often they pander to the latest investment fashion to cash in on a sudden wave of demand. The obvious danger is that you end up jumping on to a hot trend just as it is starting to cool,” he says.
Higher charges also eat into any returns you make.
“I’d especially urge caution with ETFs that use derivatives to achieve exposure, as these are often complex and their charges are not immediately obvious but stack up over time,” Mr Khalaf warns.
Some thematic ETFs took a real beating last year.
Global Online Retail UCITS ETF from HANetf fell by 72.2 per cent in 2022, while WisdomTree Cloud Computing UCITS ETF fell 54.3 per cent.
The iShares Automation & Robotics UCITS ETF crashed 34.2 per cent, Rize Sustainable Future of Food UCITS ETF fell 18.1 per cent and the iShares Ageing Population UCITS ETF fell 13.9 per cent.
As the cryptocurrency winter struck after the FTX Sam Bankman-Fried scandal, the VanEck Crypto and Blockchain Innovators UCITS ETF, launched in April 2021, crashed 68.31 per cent.
Clearly, it is unfair picking out a few funds at random, especially after a year when almost every investment was under pressure.
VanEck Crypto and Blockchain Innovators UCITS ETF has bounced back strongly on Bitcoin's rebound, jumping 63.53 per cent in January.
Yet Mr Franzoni’s figures suggest wider underperformance.
What is Bitcoin and how did it start?
Vijay Valecha, chief investment officer at Century Financial, says some speciality ETFs delivered healthy returns last year, but they are few and far between.
“Winners include ETFs that allow investors to short currencies like the euro and Japanese [yen] against the US dollar, such as Proshares Ultrashort Yen and Proshares Ultrashort Euro, and funds offering a play on stock market volatility, such as the Proshares Short VIX ST Future,” Mr Valecha says.
Equity ETFs investing in clean power, natural resources and infrastructure also did well, driven by the energy shock and climate change legislation.
“For example, the US Climate Bill helped SPDR S&P Kensgo Clean Power ETF deliver a one-year return of 19.51 per cent,” he says.
Despite these "isolated successes”, Mr Valecha says most speciality ETFs struggled.
“This is not surprising as they typically focus on emerging sectors and growth stocks, which all suffered as investor sentiment collapsed in 2022.”
Growth stocks may continue to struggle while inflation and interest rates remain high, which drives up borrowing costs while discounting the value of future earnings.
They may rebound when rates fall, but we are not there yet, Mr Valecha says.
“Many thematic ETFs also suffer due to their lack of diversification, making them vulnerable to sector-specific problems. Amplify Transformational Data Sharing ETF and ARK Next Generation Internet ETF both fell more than 40 per cent last year.”
Mr Valecha says they may still have a place in your portfolio, but only after you have bought a basket of broader-based ETFs to reduce your risk.
Jason Hollands, managing director of investment fund platform Bestinvest, says comparing the average performance of a diverse bunch of specialist ETFs to those tracking broad market indexes can be misleading.
“It’s like comparing a basket of exotic fruits with an apple.”
He says niche ETFs are primarily aimed at professional investors seeking a particular investment position, often for a short period, as part of a wider portfolio.
“They are not designed as a long-term buy-and-hold strategy.”
Mr Hollands agrees that most private investors should approach thematic ETFs with caution.
“It may sound more impressive to discuss your recent investments in clean power or specialist robotics, but a portfolio too heavily exposed to narrow strategies carries considerable risk.”
Have we reached peak ETF? Probably not. But there are some places investors don’t want to go.
