[This article appears in our December 2018 issue of ETF Report.]
With so many exchange-traded funds launched in 2018, it takes a lot to stand out in a crowded field, but several ETFs debuting this year did.
Many were technology-focused, some took new concepts on risk management, and others took a narrower focus on environment, social and governance investing.
Themes Key In 2018
Todd Rosenbluth, senior director of ETF research for CFRA, says thematic ETFs seemed to dominate this year.
“The various benefits of ETFs, primarily diversification, make ETFs well-suited for firms that see a potential trend for the long term and [can] create products—and have fast follower products—tied to that investment theme,” he said.
James Hickey, chief investment strategist at HD Vest, is a big fan of thematic ETFs, and sees them as the future.
“It gives the advisor an ability to invest in themes they believe in, which is how you really create alpha without having to do a deep dive into research of XYZ company,” he said. “You just bet on the basket. I think that’s huge.”
Brett Manning, senior market analyst at Briefing.com, says when looking back at many of the thematic ETFs released this year, they have one overarching theme in common.
“To me, it’s basically capitalizing on the due-diligence laziness of the average investor. They want to be involved in something,” he explained. “They just buy that ticker and then they’ve got that thematic exposure.”
In early 2018, six blockchain ETFs arrived in a flurry of launches: the Reality Shares Nasdaq NexGen Economy ETF (BLCN), Reality Shares Nasdaq NexGen Economy China ETF (BCNA), Amplify Transformational Data Sharing ETF (BLOK), REX BKCM ETF (BKC), Innovation Shares NextGen Protocol ETF (KOIN) and First Trust Indxx Innovative Transaction & Process ETF (LEGR). (See Figure 1.)
These ETFs launched on the heels of cryptocurrency fever, when bitcoin and others rose to stratospheric highs, only to see the cryptocurrencies crash later.
Kian Salehizadeh, senior analyst at Reality Shares, says its two blockchain ETFs have struggled a bit with reduced interest in cryptocurrencies because of bitcoin’s price drop, along with a misunderstanding of the concept.
“There tends to be some confusion between blockchain as the underlying technology and blockchain as cryptocurrencies,” he said. “So that’s just something we have to continue to work to get past, especially in the advisor community.”
Considering that blockchain is playing a role in companies like Walmart using it to make their operations more efficient, Salehizadeh doesn’t see it going away: “We’re still bullish on it.”
Manning believes at some point there’s going to be a big payoff for some of the early established blockchain funds that gathered credibility while few people are paying attention.
Artificial intelligence was a big theme this year in ETFs—whether it was funds selecting companies involved in robotics and artificial intelligence, like the iShares Robotics and Artificial Intelligence ETF (IRBO), or funds that are using artificial intelligence and machine learning to improve selection, like the Rogers AI Global Macro ETF (BIKR), launched by commodity guru Jim Rogers midyear (see Figure 2). In 2017, only three ETFs followed the artificial intelligence theme; in in the first 10 months of 2018, 10 more AI ETFs debuted, not including the suite of seven "Evolved" ETFs from iShares, actively managed sector funds driven by machine learning.
Rosenbluth says the success of the early AI funds like ROBO and BOTZ likely sparked the advent of this year’s AI funds.
Reality Shares’ Salehizadeh, whose firm’s Reality Shares Fundstrat DQM Long ETF (DQML) launched in early November, says its fund is a passive, multifactor fund that uses machine learning to tweak the algorithm slightly per sector during rebalancing to keep the human element out.
“The system is trying to outsmart smart beta,” he said. “[Machine learning] is really trying to become the next frontier of multifactor investing,”
Rosenbluth agrees that funds using machine learning to rebalance indexes is sort of like smart beta 2.0: “It’s taking smart beta to the ultimate next level.”
Whereas smart beta is based on academic research exploiting historical inefficiencies in the market, the stronger computing power now available via AI could spot those trends faster than ever before, he says.
Tech, a sector and theme closely linked to AI, has been in a multiyear bull market, but how well tech funds do now that the sector seems to be in retreat remains to be seen. One of two new narrowly focused technology funds from Defiance ETFs, the Defiance Quantum ETF (QTUM), which tracks an adjusted equal-weighted index of companies involved in the research and development of quantum computers, debuted just as the sector saw one of its biggest downdrafts this year.
Paul Dellaquila, global head of ETFs for Defiance, says valuations in the tech sector are high, especially for some of the big names like Microsoft and Apple, but it’s one of the reasons Defiance equal-weighted both QTUM and its new augmented/virtual reality Defiance Future Tech ETF (AUGR), so large names don’t drive the ETFs’ performance.
While tech may be ripe for a pullback, it’s not going away. “Technology is a sector in the S&P,” Dellaquila said, “but it’s really impacting every sector or company.”
The 10-year equity bull market has some investors nervous about a correction, and a suite of risk management ETFs from Innovator ETFs may help financial advisors limit their downside. Defined-outcome products, like structured notes, exist elsewhere in the financial industry, but Matt Kaufman, principal and senior director at Milliman Financial Risk Management, subadvisor for Innovator’s suite of six defined-outcome ETFs (see Figure 3), says these ETFs are an industry first.
The defined-outcome ETFs are options-spread plays on the S&P 500, providing a price return. The funds have a downside buffer of 9-30% and an upside cap of 10-15%. They rebalance annually to reset the buffers.
Kaufman says with the one-year rebuild cycles and the defined outcome, some users look at the ETFs as bond alternatives for people uneasy holding fixed income in this investing environment.
Moreover, Innovator is launching three funds for each quarter, and the products will provide slightly different levels of upside potential, meaning investors can use the products from the quarters they think offer the most favorable results given market conditions.
ESG funds are popular with investors who want to put their money where their beliefs are, but many of them are broad-based and not necessarily created by people specifically involved with a particular cause.
The three funds from Impact Shares—the NAACP Minority Empowerment (NACP), supporting the promotion of racial equality; the YWCA Women’s Empowerment ETF (WOMN), which includes firms that rank highly on gender diversity; and the Sustainable Development Goals Global Equity ETF (SDGA), based on the U.N.’s goals—take a different tack.
Ethan Powell, founder and president of Impact Shares, says what makes these ETFs different is that Impact Shares built, operates and distributes the funds not just as ETFs, “but really as a tool for leading social advocacy groups to really be the ambassadors for these important social causes within the private sector,” rather than the financial sector determining what’s important.
Similarly, UBS’ InsightShares has partnered respectively with the Human Rights Campaign and Victory Media on its own cause-based ESG ETFs, the InsightShares LGBT Employment Equality ETF (PRID) and the InsightShares Patriotic Employers ETF (HONR). (See Figure 4.)
Powell says the groups allied with Impact Shares pick their screens—WOMN, for instance, has 19 screens—and those screens may evolve and change over time, based on the organization’s goals and expectations relative to the private sector.
“Now, the investor themselves can easily engage with credible organizations to align their capital with, and also feel confident they’re going to get an equity market rate of return,” he said.
But ESG ETFs are a crowded field, and some broader-based funds are struggling to gather assets. “I don’t know that a narrower focus will be more successful,” Rosenbluth noted.