What's up with all these niche ETFs?

ESG, uranium, cannabis, inverse, leveraged – where they came from and what to watch out for

Andrew Willis 13 June, 2019 | 6:56AM

 

BMW

ETFs have helped give Canadian investors more convenience, cost-efficiency and choice than ever. There’s over 850 of them now, all vying for a spot in your portfolio, and they’re getting more targeted, complex and different than ever before. Some recent launches include ESG-focused, uranium, inverse, leveraged… the list goes on.

But why? It’s hard to imagine masses of investors waking up one morning, thinking ‘you know, I’d really love to invest in palladium, I wish there was an ETF for that’. A solid business case must be established before each fund company makes a significant investment into a getting a product off the ground, including a thorough evaluation of demand.

As an investor, it’s important to recognize the motives and marketing surrounding these products – and how these investment vehicles move once they’ve hit the markets. And if you consider investing in them, you should understand the environment around their expected return.

Products, products everywhere…

Product launches these days into three categories of demand, says Dan Hallett, Vice President and Principal at HighView Financial Group. “Those that respond to investor needs, those that respond to investor wants, and those that are intended to create demand. Very few fall into the first category.”

Investor wants – not necessarily needs – are a driving force behind new launches today. Hallett has seen the industry respond with trendy products focused on smaller slices of financial markets.

The likes of cannabis ETFs – first spearheaded by Horizons in Canada with the Horizons Marijuana Life Sciences Index ETF (HMMJ), followed by the Purpose Marijuana Opportunities Fund (MJJ) – and crypto ETFs such as the Coincapital STOXX B.R.A.I.N. index ETF (THNK), are some that Hallett puts in category two.

Investors have more control and want more of a say around how their money moves. And providers are happy to meet their demands.

“An investor who feels strongly about the direction of a certain industry relative to the broader market might be better suited to a more focused product. Clearly there’s a growing number of investors who are looking for alternatives to conventional (market) index investments,” says Kelly Gares, Investment Advisor at BlueShore Financial.

Providers are also happy to further broaden investor horizons as investable data becomes more accessible, trading becomes more tangible and individual investors develop an appetite to become more tactical.

This is where the third category that Hallett identifies, products intended to create demand, come into play.

Where’s the value?

Gares likes giving investors the ability to pick and choose the specific sector or industry that they invest in, and Hallett agrees, in theory.

“One could argue that more choice is good; allowing investors to isolate the kind of exposures that they want,” says Hallett, “and some people feel an element of excitement when they can more easily take these focused bets on popular investment themes or sectors – and do so in a way that doesn’t require them to have a view on any one stock (not to mention actually putting a value on any of the businesses).”

But excitement isn’t a quantifiable return, and the time saved of not having to research every stock in a portfolio isn’t something that necessarily leads to returns. “These are superficial – not real – benefits. I’m in my 25th year as an advisor and analyst; and I’ve never seen people benefit from these products,” says Hallett.

Gares cautions that there are structural portfolio pitfalls to control if investors opt for the choice of an industry-focused approach. “Significant sector concentration has the potential to be more volatile than the broader market and if the sector in question underperforms then the portfolio as a whole will suffer more as a result.” By taking on products with leverage, Gares notes you’re potentially magnifying losses.

There is nothing inherently wrong with these products. They’re tools. Regulated, transparent devices with their plans disclosed in their prospectuses. But Hallett notes that the biggest risk with these products is never disclosed.

The biggest risk is…you!

“The biggest risk is the risk that will never be disclosed – and that’s the behavioural risk,” says Hallett.

Investors aren’t always rational. They tend to buy when the hype is at its highest, Hallett says. It’s similar to what we’ve found at Morningstar as well, with investors picking up and paying more for securities with ‘popular’ characteristics that have little to do with risk and return, in turn becoming ‘willing losers’, Paul Kaplan, director of research at Morningstar Canada found.

This inherent behavioural risk is compounded by the timing of advertising around new products. “The industry plays another key role in advertising these products only after they sport high double-digit or triple digit returns,” says Hallett, “That increased promotion lures investors into such products at almost exactly the worst time – i.e. after a run of unsustainably high performance.”

“Once investors have jumped headfirst into such investments, returns are bound to come down to Earth,” notes Hallett. After encountering significant losses, “people then feel bad about the investment and decide to bail before they lose even more money.” At best, they might stick around and be made whole.

Ideally, investors would get in before the advertisements or when the returns are in the red.

At the same time, it would be difficult to convince a fund provider to promote these products when they’re down. It doesn’t make much business sense.

“If investment products were judged by investor outcomes – not just published returns – the vast majority would be terminated and similar new products would never be launched,” says Hallett.

So what can you do?

“What’s needed to succeed with such investments is for people to resist every one of their natural urges – which something like 95-99% of investors are unable to do,” says Hallett. Fund providers aren’t about to hand out free tickets to yoga classes, so it’s up to the investor to stay calm and focused on their long-term plans.

What makes the problem particularly puzzling is that it’s not a matter of investor intelligence, notes Hallett. “It’s an issue of temperament and discipline.”

Looking for alignment between the objectives of the fund and the objectives of your portfolio can provide cues, confirmations, signs of potential incompatibilities, and reminders that can help investors stay disciplined.

Like we say, the key to successful investing is simple, but not necessarily easy.

 

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Coincapital STOXX B.R.AI.N. ETF18.86 CAD0.59
Horizons Marijuana Life Sciences ETF16.67 CAD-1.71
Purpose Marijuana Opportunities ETF26.05 CAD-1.31

About Author

Andrew Willis

Andrew Willis  Andrew Willis is a content editor for Morningstar.ca.