ETFs are funds, not friends: Editor's Note

Thematic exchange-traded fund (ETF) issuers were out in force this week spruiking their wares. Sponsored Facebook posts, native content, quotes in news articles. Perhaps it's because I read and write about financial markets all day, but I bet if I'm seeing them, you are too.

Remember, issuers are selling a product. It's their job to tell you why it's a good buy, not illuminate its flaws. Would you ask a Ford dealer if the Ford Everest is the best SUV on the market? No, because you already know what they'd say. You'd seek independent advice, try out a range of products and make up your own mind.

Salespeople love a good story, and we all love to believe them. The story of the explosive growth of semiconductors. The story of aspirational middle-class growth across emerging markets. The story of how you can beat market-cap indexes in a few clicks. Thematic ETFs are the new stock picking for millennials. Don't worry about studying company fundamentals or messing around with global exchanges. Just pick a theme you believe in, something you can see with your own eyes.

Those stories are now being told through the all-important financial language of the 'ticker': HACK FOMO ERTH YOLO. Like a mnemonic, they're easy to remember, and if we go the way of the US, could lead to increased flows for the provider quick enough to snap up a great code. You have to admire the people at BetaShares who realised that a ticker could be selected simply by asking the ASX for it. It started with the sheer genius of ‘AAA'. Little wonder it attracted inflows by the billion, while many of its cash competitors have since shut shop.

Funds management is cutthroat. Thematics are a way for issuers to differentiate themselves and issue higher-margin products to offset the secular decline in ETF fees. Every provider has an ASX 200-tracking ETF, but not everyone has a lithium ETF or a cybersecurity ETF. Morningstar research shows Australian thematic ETFs charge between 57 basis points (0.57%) to 95 basis points (0.95%), substantially higher than their more-diversified peers and akin to active management fees. And in thematics, we've yet to see the 'fee war' issuers brought to ASX 200 ETFs a few years ago.

It's undeniable that performance for some of these thematic ETFs has been spectacular. These ETFs target niche segments, relying on a handful of stocks, and are likely to be on the top of the ETF ladder, but also the bottom. They take riskier bets in niche markets and are more exposed to cyclical risk and reward.

But don’t be blinded by exceptional past performance. When a new ETF is launched because it satisfies the latest trend or fad, ask yourself if that thematic has already substantially played out. Many of these products have less than two-years of performance history—hardly enough time to demonstrate consistent outperformance. Distinguishing whether the theme is really a transformational trend or simply the latest fad takes time. You are likely buying into a "hot" trend when valuations are stretched, not picking up a bargain.

The fortunes of any theme are at the mercy of government policy, advances in technology, interest rates, and shifts in investors’ own biases. Look at the way Asian tech has been hit by the Chinese Government crackdown. Great companies but how great when the Government does not want kids in front of screen 10 hours a day? While a theme may stay up for a while yet, it will fall, and no one will tell you before it happens.

At Morningstar, we're not party poopers. Investing isn't all about spreadsheets and risk models. It can also be, dare I say it, fun. It's fun to find the next "hot stock" or "theme". It's fun to unearth an undervalued stock before everyone else and watch your returns skyrocket. It's fun to tell your friends about your successes. But don’t bet your life savings on a bit of fun. Investing is about reaching financial goals or freedom (if you seek that). So, how much of your portfolio are you willing to bet on the next megatrend?

My advice, and the advice of our analysts, is to get your house in order first. Build your 'core' portfolio with diversified, broad-based funds. Then, if you're looking to take on narrower exposure, or increase your risk profile, thematics do have the potential to outperform, if chosen carefully, and complement a diversified portfolio. Thematic ETFs are products—wrappers around a portfolio of stocks. Look to the underlying holdings to understand what you're buying, its size, geographical and sector exposures and the risks involved. Determining an appropriate valuation is difficult in these scenarios, but nonetheless an indispensable part of investing.

We all want to believe investing is as easy as E-T-F, but there is no fool-proof way to generate market-beating returns.