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Cannabis ETFs have had a compelling story, but performance has been dismal. In turn, Evolve Marijuana ETF and Evolve U.S. Marijuana ETF were delisted earlier this year.

Chris Young/The Canadian Press

Direxion Work From Home ETF (WFH-A) is a play on remote work. Global X Telemedicine & Digital Health ETF (EDOC-Q) focuses on telehealth. And ETFMG Treatments, Testing and Advancements ETF (GERM-A) holds vaccine producers.

Welcome to the world of thematic exchange-traded funds (ETFs), in which recent offerings are aiming to ride a COVID-19 tailwind. Although hot trends may be enticing, investors need to tread carefully before buying niche ETFs to avoid overexposure to stocks they may already own – or wind up in money-losing funds.

The benefit of thematic ETFs is that they can give exposure to names not represented in broad market indexes and also reduce risk from owning a basket of stocks instead of making “a bet on a single company,” says Daniel Straus, vice-president of ETFs and financial products research at National Bank Financial Inc.

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E-sports (electronic sports) and e-gaming is an emerging theme, but companies are often small and not in index ETFs, he says. If the theme resonates with investors, Evolve E-Gaming ETF (HERO-T) and Roundhill BITKRAFT Esports & Digital Entertainment ETF (NERD-A), are funds that could supplement a portfolio.

But investors need also to be mindful when choosing a thematic ETF because the stocks held within it could already be inside index ETFs that they hold, so they could become overconcentrated in certain names, Mr. Straus says.

Thematic ETFs are not part of National Bank’s model ETF portfolios because they tend to be expensive, while the best model for most investors’ portfolios is to own broad market index ETFs, he says. Specifically, thematic ETFs can charge a fee in the 0.40-to-0.60-per-cent range while passive index funds can cost close to zero.

Given that it’s common for thematic ETFs to be terminated if assets under management (AUM) and returns don’t gain traction, they shouldn’t be more than a low-single digit part of an ETF portfolio, or be considered “play money,” Mr. Straus suggests.

For example, a batch of ETFs with exposure to blockchain – a distributed ledger technology pioneered by cryptocurrencies – were listed in 2018. “But the theme was so nebulously defined that many portfolios were basically fintech plays,” he says.

Blockchain Technologies ETF (HBLK-T) holds pure blockchain plays as well as names such as Visa Inc. (V-N), Mastercard Inc. (MA-N), Overstock.com Inc. (OSTK-Q) and Microsoft Corp. (MSFT-Q), all of which are found in broad indexes. It’s questionable as to whether the blockchain theme is driving returns, he says.

Coincapital STOXX Blockchain Patents Innovation ETF and FBC Digital Ledger Technology Adopters ETF delisted in less than a year. And Horizons Blockchain Technology & Hardware ETF morphed into Horizons Big Data & Hardware ETF (HBGD-T) as “blockchain may to be too narrow a theme,” Mr. Straus adds.

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Technology-oriented thematic ETFs tend to be longer-term plays while themes such as infrastructure and airline travel are shorter term, he says. The fortunes of infrastructure stocks often depends on government spending.

Timing can affect an ETF’s popularity. Guggenheim Airline ETF and Direxion Airline Shares ETF delisted years ago, but U.S. Global Jets ETF (JETS-A) has seen AUM surge in recent months to more than US$1-billion despite negative turns. That’s because some investors see it as economic recovery play, Mr. Straus says.

Ben Johnson, director of global ETF research at Chicago-based Morningstar Research Services LLC, says that investors should approach thematic ETFs with healthy skepticism because their track record is generally poor. “These products are designed much more with saleability in mind than investment merit.”

In Mr. Johnson’s survey of thematic mutual funds and ETFs launched globally before 2010, only 45 per cent of them survived until 2020 – and just one in four outperformed the MSCI World Index over that 10-year span, he says.

With thematic ETFs, investors are making a trifecta bet, Mr. Johnson says. “They’re betting that they are getting the theme right, the stocks right and valuations right. Your odds are slim when making these bets …albeit, they may pay off handsomely.”

ETFMG Prime Cyber Security ETF (HACK-A), formerly PureFunds ISE Cyber Security ETF, gathered AUM quickly shortly after listing in 2014 because of a cyberattack on Sony Pictures Entertainment Inc. and other data breaches at the time. However, the ETF posted a loss in 2015 and has lagged the Morningstar U.S. technology index on annualized basis for five years to July 31.

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“Often, these products are brought to market when valuations for the underlying stocks are fairly rich,” Mr. Johnson says.

AUM in thematic ETFs, a bull-market phenomenon, tripled to US$195-billion worldwide in 2019 from US$75-billion in 2017, he says, adding that robotics and automation were among the most popular themes. U.S.-listed Robo Global Robotics & Automation ETF (ROBO-A), though, lost money in the two calendar years after launching in 2013 and in 2018.

Cannabis ETFs have had a compelling story, but a lot of future growth proved to be priced into the stocks, he says. “Performance has been dismal.” In Canada, Evolve Marijuana ETF and Evolve U.S. Marijuana ETF delisted earlier this year.

Still, some niche ETFs have done “phenomenally well,” Mr. Johnson says. ARK Innovation ETF (ARKK-A), which focuses on disruptive innovation, has returned an annualized 32 per cent for five years to July 31. It had an early successful investment in bitcoin and benefited from a big holding in electric car maker Tesla Inc. (TSLA-Q), Mr. Johnson says.

Todd Rosenbluth, senior director of ETF and mutual fund research at New York-based CFRA Research, says thematic ETFs can make sense for investors seeking growth, but it depends on the ETF’s focus and investors’ time horizon and other investments.

He likes the newly launched Direxion Work From Home ETF over the medium term because he expects more employees will be working from home. And the ETF invests in four sub-themes, including remote communications, cybersecurity, project and document management and cloud technologies.

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But some investors might see this ETF as a tactical play for the second half of this year, he says. “If there is a vaccine … and people start returning to work as normal, demand [for work-at-home products and services] may not be as strong.”

Some themes, such as cloud-computing, online video gaming and genomics, will likely play out for many years, although “they won’t always perform well, and there are going to be cycles,” Mr. Rosenbluth warns.

Investors who believe that cloud computing can play out over the next five years might hold a fund like Global X Cloud Computing ETF (CLOU-Q) for the longer term, he says.

Still, there’s a caveat, he says: If a cloud computing ETF is an investor’s only exposure to technology, then it could mean missing out on other areas in this sector, such as semiconductors, that could outperform.

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