Think Themes Are Narrow Minded?

August 28, 2018

[This article appears in our September 2018 issue of ETF Report.]

The first time I got asked the question, “are there too many ETFs?” was about 20 years ago, when I was an active mutual fund manager. It’s easy, therefore, to look at the 2,000+ funds currently on the market and think, “these can’t possibly all exist, can they?” Well, the short answer is, yes they can. And in fact, I’d argue that the proliferation of narrower slices of the market can actually be a very good thing for investors as well as the market.

Let’s think about it from the investor’s perspective first. If I’m interested in being overweight “tech,” I have a few options. I can either select individual stocks, or I can buy a fund. Any fund I choose is going to have someone’s opinion baked into the construction, whether it’s active or passive.

The biggest fund in the space, the Technology Select Sector SPDR Fund (XLK), has just 76 stocks in it, with Apple, Microsoft, Facebook and Google making up nearly 45% of the portfolio. The second-in-line competitor, the Vanguard Information Technology ETF (VGT), still wades in deep on Apple and Microsoft, but spreads across 358 stocks, and its third-largest holding is Visa.

And then there are the “thematic” ETFs in the tech space. Want to go all in on internet and media? The actively managed AdvisorShares New Tech and Media ETF (FNG) concentrates on just 21 names, and you won’t find Apple or Microsoft anywhere in the top 10. Instead you get Amazon, Baidu and Dropbox.

No Template

Is one of these the “right” way to play tech? Of course not. But each fund serves different kinds of investors, with a different investment thesis. All of the usual caveats apply, of course—whether FNG at an eye-watering 0.85% expense ratio is the most efficient way to get this exposure is up to you. For some, not having to monitor the space and reconstitute holdings through single stocks is worth the price.

Of course, there’s a limit to how narrow one can go. The granddaddy of all thematic ETFs is the old “HOLDRS” series from Merrill Lynch. An odd duck by modern standards, HOLDRS held fixed and heavily concentrated port-folios in very narrow sectors: oil services, regional banks, biotech.

By construction, each HOLDR was essentially unmanaged—their index was defined in the prospectus, and only altered for corporate actions. This led to the bizarre situation of the B2B internet HOLDR owning just two securities at the time it closed, clearly no longer an efficient exposure vehicle.

Two stocks is probably too small for an ETF. But 20? If both the convenience and the intellectual property of selecting those 20 stocks is valuable, why not? Let the market decide.

The second reason these narrow slices of the market matter is because they play a role in price discovery. One of the biggest (specious) criticisms of ETFs (by active managers in particular) is that if everyone owned one giant index fund, there’d be no price setting.

But narrow funds are the counterpoint. Investors don’t just all own one giant index fund—they own thousands of funds. With the billions of dollars in daily ETF inflows and outflows, you have a very large amount of price discovery. And of course, single-stock traders and active managers fill in the gaps by trading the shares of the individual companies, all day, every day, responding to news and opinion.

While some long-term investors might just buy a global total market fund and leave it, most investors want to express opinions, and they’ll continue to do that by trading stocks—or maybe just by buying into a thematic ETF. Either way, it’s good for the market.


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