Most of us know about theme parks and theme restaurants, but are you familiar with theme-based investing? Indeed, many investors are just beginning to appreciate the potential of investing in themes.
The basic idea of thematic investing is to capitalize on corporate, economic, demographic, social trends or other themes that manifest themselves. As these themes become more noticed and popular, capital flows toward companies involved in these emerging businesses and investors can profit.
Unlike industry-sector exchange-traded funds (ETFs), which are usually a narrowly sliced portion of a broader stock index, thematic ETFs are typically based on stand-alone indexes with no family tree. The ETFs discussed in this article will cover emerging investment themes like alternative energy, fighting disease, corporate actions, vice and socially responsible investing.
Alternative EnergyA popular investing theme right now is alternative or clean energy. In addition to concern for Mother Earth's conservation, this particular trend has been driven by the accelerating cost of traditional energy sources. In early 2008, crude oil futures broke through the $100 per barrel barrier. Also, the rising cost of other energy sources like gasoline, heating oil and natural gas has been pinching consumers.
Several ETFs offer exposure to the alternative energy theme.
The PowerShares WilderHill Clean Energy ETF (PBW) and the PowerShares WilderHill Progressive Energy ETF (PUW) are two such funds. PBW focuses on zero-carbon technologies like solar and wind power whereas PUW is focused on companies that reduce the pollution and carbon from current dominant energy sources such as coal, oil and natural gas. Both ETFs are concentrated in a handful of companies involved in the emerging clean-energy movement. PBW gained 59.8 percent and PUW increased by 15.7 percent in 2007.
Clean water is another element of the alternative-energy movement. ETFs that follow this investment strategy are the First Trust ISE Water Index Fund (FIW), Claymore S&P Global Water Index ETF (CGW), and the PowerShares Global Water Portfolio Fund (PIO). While many of these funds track the same clean-water theme, they differ in the way they select and weight stocks. (See Figure 1.)
"There is a growing realization that the basic necessities for life -- food, water and energy -- are becoming increasingly dear, so having some exposure makes sense. But people must realize that these funds are speculative and therefore must use them sparingly," said Michael Krause, president of AltaVista Independent Research.
Krause observes that valuations of stocks inside some theme ETFs are even more elevated than most technology stocks. He notes, "The companies in PBW have never earned a profit in aggregate, adding to the speculative nature."
Another developing segment is nuclear energy. Lack of nuclear support is due largely to a handful of highly publicized accidents, notably Three Mile Island in the U.S. and Chernobyl in the Ukraine. In fairness, thousands die each year in coal mining accidents and untold millions are affected by conventional power plants. Although nuclear plants are not a major source of air pollution and greenhouse gases, the construction cost is very high.
The Market Vectors Nuclear Power ETF (NLR) is the purest nuclear play. The holdings include most of the top companies involved in uranium mining, enrichment, storage and providing equipment for nuclear plant infrastructure and nuclear fuel transportation. As the supply of other energy sources dwindles, the future prospects of nuclear energy look that much brighter.
Corporate Decision Dynamics "Corporate actions are the decisions made by the board of directors that affect the structure of a company," explains Richard Ferri, CFA, author of "The ETF Book" (2007, John Wiley & Sons). New companies may decide it's time to raise capital through an initial public offering. Others may decide to merge or to invest money in their own company stock through a share buyback.
A number of ETFs offer the opportunity to invest in any one of these themes.
The First Trust IPOX-100 Index Fund (FPX) attempts to measure the average performance of the 100 top U.S. IPOs during their first 1,000 trading days. Stocks are modified value-weighted and given a 10 percent cap within the index. Components are reconstituted quarterly. Google, MasterCard, and NYSE Euronext are among recent top holdings in FPX. Since its inception, FPX increased by 15.23 percent through the end of last year.
Another example of an ETF that follows a corporate action theme is the PowerShares Buyback Achievers (PKW). The fund tracks the performance of U.S. companies that have repurchased at least 5 percent or more of their own outstanding shares for the trailing 12 months.
Following a similar objective, but with a slight variation, is the Claymore/Sabrient Insider ETF (NFO). The fund aims to represent a group of stocks that have favorable corporate insider buying trends or Wall Street analyst earnings estimate increases. Each company is ranked using a quantitative rules-based methodology that includes composite scoring of a handful of specially targeted factors. The fund is adjusted quarterly and all stocks are given a fixed or equal weighting in the portfolio.
The Claymore/Clear Spin-Off ETF (CSD) is designed to include companies that have recently been spun off from larger corporations. By being separate entities, it's believed these companies can maximize their profits by focusing on their core business. The fund's underlying index is comprised of 40 stocks in various market capitalizations and each holding is given a maximum weight of 5 percent. In 2007, CSD posted a gain of 7.8 percent.
Disease Management Innovation in the health care field is a trend followed closely not just by the media but by investors. In 2007 XShares Advisors launched the HealthShares, a family of 19 funds that follow specific areas of health care, life science and biotechnology.
"Each sub-sector, or therapeutic area (such as cancer or autoimmune diseases or patient-care services), lends itself to discrete quantitative analysis, and this is what we did with HealthShares ETFs," says Jeffrey Feldman, chairman, XShares Group.
Most of the HealthShares are composed of 22 to 25 large-, mid-, and small-cap stocks. This is a stark contrast to other health care funds like the iShares Dow Jones U.S. Health Care Sector Index Fund (IYH), which has around 146 holdings or the Vanguard Health Care ETF (VHT) with 278 stocks. Certain HealthShares ETFs may end up delivering better performance than more broadly diversified funds, but the cost is increased volatility.
The HealthShares Composite ETF (HHQ) is a slight departure for this ETF family because it's a broader representation of more narrowly focused health-related ETFs offered by the company. For example, instead of investing in the HealthShares Cancer (HHK), the HealthShares Dermatology and Wound Care (HRW), and the HealthShares Cardio Devices (HHE) funds, the HealthShares Composite ETF takes top representative companies from each sub-index. HHQ consists of the 80 largest companies by market capitalization selected from the top five companies in size from each of the 16 HealthShares sub-indexes. Stocks within HHQ are screened and assigned an equal weighting.
The HealthShares Diagnostics ETF (HHD), which gained 31.3 percent last year, was the largest HealthShares ETF with $52.5 million in assets. Collectively, the HealthShares lineup concluded 2007 with $119.5 million in total assets.
Socially Responsible InvestingSocially responsible indexes attempt to help investors confront the moral aspects of investing. They filter companies according to certain rules or socials screens. For example, adult-entertainment companies, alcoholic-beverage makers, tobacco producers, and weapons manufacturers are excluded from most social indexes. Other screens may reach into labor practices, human rights and the treatment of animals.
The iShares KLD Select Social ETF (KLD) chooses stocks from the Russell 1000 index by evaluating them for their social and environmental record. How are they doing when it comes to corporate governance, the environment, community relations, diversity, employee relations, human rights, and product safety? Each company in KLD's Select Social Index is scored on these factors and weighted accordingly. Stocks with high scores receive higher index weightings whereas those with lower scores receive less prominence.
The Claymore/KLD Sudan-Free Large-Cap Core fund (KSF) is the first socially responsible ETF to address a geographic region. The bloodshed and unfolding humanitarian crisis in Darfur has been reported worldwide.
KSF follows the KLD Large-Cap Sudan-Free Social Index, which selects stocks from the Russell 1000 with market caps greater than $1 billion. The index screens stocks for environmental, social and governance factors. KLD then removes all holdings with certain types of business involvement in Sudan. The fund's annual expense ratio is 50 basis points (0.50%).
Index providers have varying views of what constitutes a social index and those opinions are ever changing. Your client's view of what is socially acceptable or unacceptable may not necessarily agree with the investment strategy of a social ETF. More information on social indexes along with a list of filters used by investment companies can be obtained by visiting www.socialinvest.org.
Investing in ViceAt the opposite end of the spectrum of a socially responsible approach is investing in sin or vice. Instead of avoiding stocks because of the undesirable effect they may produce on society or the planet, vice investing embraces them.
The FocusShares ISE SINdex Fund (PUF) includes owners and operators of casinos and gaming facilities, producers of alcoholic beverages, manufacturers of cigarettes and other tobacco products. Each index component is equally weighted with a 25 percent cap and rebalanced quarterly.
Another fund with a similar theme is the Gaming ETF (BJK) from Van Eck Global. It follows the S-Network Global Gaming Index. The index weightings are 39 percent in casinos and resorts, 31 percent technology, 22 percent sports and race books, 5 percent horse racing, and 3 percent online gambling. The underlying index is comprised of 69 companies, which trade on 21 different exchanges from 18 countries (approximately 43 percent U.S., followed by about 15 percent Australia).
ConclusionAfter you've laid a diversified foundation of index ETFs that have broad asset class exposure, only then consider adding thematic funds to the mix. As they say in the construction business, "foundation first, second and third floor next."
Ron DeLegge is the San Diego-based editor of www.etfguide.com