The Wrong Way To Look At Thematic ETFs

Some ETF stuff.

Eric Balchunas Tweeted about the AI Powered ETF (AIEQ) which seems topical with all the hype around chatGPT in the last few weeks. Here's what he said;

 

There very well could be some set of circumstances and sequences where AIEQ would outperform but with the turnover that Eric mentioned, one thing that is certain is the strategy underlying the fund does not get the benefit of the stock market's ergodicity. 

If you buy some sort of broad based index fund and leave it alone for a decade or two you're bound to see a chart that moves pretty steadily from the lower left to the upper right. Various declines along the way of course but still much higher over a long period. 

This is an important point of understanding for developing an investment strategy. You can make a full time job out of frenetic trading, but if you do what are the odds you outperform holding an index fund and doing nothing? Someone has a $1 million account, they put it into an S&P 500 index fund the first day of 2021 and sell it on the last day of 2021. Yahoo Finance says the index was up 28% so this person is up $280,000. 

The person who trades frenetically in that same period, how much might they outperform by? Maybe not at all right, they could easily lag in any given time period but let's give them the benefit of the doubt and say they did outperform by placing many trades every day, riveted to their screen all day. How much then, above the $280,000 would they need to make trading this way for it to have been time well spent? 

Let's say this outperformer beat the S&P 500 by 5 percentage points. In that scenario they worked their tail off, tethered to computer for $50,000. How much do you make? If it is more than $50,000 then you'd be taking a pay cut. It's not that no one should try to do this, go for it if you're inclined but the tradeoff I am outlining is worth understanding. 

Next item, the FT is not a fan of thematic ETFs. I am but I will use the term narrow based to replace thematic. To the FT's point, yes if some sort of hot segment has been working for a few months and then a narrow based ETF gets launched, buying the new fund probably is a bad idea, you'd probably be late to the party. 

I've been using narrower funds like sectors, industries and themes for a very long time. If you go narrower than broad based indexes (sectors, industries and themes), how do you choose which ones you're interested in and then how do you choose what to invest in to capture that narrow part of the market? Would you consider an individual stock? I imagine looking at a couple of stocks would be part of the process. If, after putting in time to learn about some theme and deciding you want in, you probably want to own whatever you think is the best way to capture that sector, industry or theme. Maybe the best way is an individual stock but maybe not. If there are ETFs or other funds, would you explore those? If there's no ETF or fund then obviously you'd just consider individual stocks. 

A narrow based ETF is simply then is just one way to access the sector, industry and theme you're interested. It is not something to be looked at in aggregate with other narrow based sectors, industries and themes. If the timing is bad for a new industry fund, then chances are the timing is bad for the individual stocks in that industry and that make up that fund.