Why AI Powered ETFs Can Surpass Thematic ETFs
The U.S. Exchange Traded Fund (ETF) industry has become a behemoth in the stock market in recent years, surpassing a record high of $5.5 trillion dollars in assets under management in 2020.
Part of its proliferation is due to a growing popularity in thematic investing — more specifically, with thematic ETFs, which account for 1.9% of the total ETF market share. They allow investors to ride a trend that essentially carries an entire sector. Trends like clean energy, cybersecurity, and cloud computing have spiked interests and proven to be successful ETF products.
With increasing adoption of new technologies and trends, some may agree the possibilities for thematic ETFs are endless. However, research shows that consumers should think twice before buying another trend focused ETF.
Source: Global X ETFs by Mirae Asset & Palandrani, P. (2021, January). Thematic ETF Report: Q4 2020. https://www.globalxetfs.com/thematic-etf-report-q4-2020/
What are Thematic ETFs?
To start, thematic ETFs focus on macro-level trends and identify areas of growth in disruptive and evolving industries. According to the Thematic ETF Report Q4 2020 by the Global X ETFs’ research team, there were a total of 148 thematic ETFs with $104.1B in assets under management in Q4 2020. This is up 78% from Q3 2020, according to the research team.
Disruptive technologies may include Fintech, Digital Content, Big Data, Robotics, and Mobility — many of which have underlying themes like Electric Vehicles, Blockchain, Cybersecurity, and AI. Other evolving industries include consumer trends like Cannabis or Sports Betting and environmental issues like Clean & Renewable Energy and CleanTech.
Good Intent, Not Really
Back in 2017, when Global X ETFs came out with a report called Beyond Baby Boomers Survey: The Invisible Assets of Tomorrow, nearly 83% of millennials considered integrating thematic investing into their portfolio strategy. And when asked why, 40% claimed because of the way themes reflect their personal values. How thematic ETFs have become popularized then is largely due to the gamut from investing alongside values that deeply matter to millennial investors.
Source: Global X ETFs by Mirae Asset & Jacobs, J. (2017, May). Beyond Baby Boomers, The Investable Assets of Tomorrow. https://www.globalxetfs.com/2017-beyond-baby-boomers-survey-the-investable-assets-of-tomorrow/
At the core of each thematic ETF is a compelling story. This marketable aspect has been the main driver for attracting retail investors. In their research paper Competition for Attention in the ETF Space published in the Swiss Finance Institute on January 29th, 2021, authors Itzhak Ben-David, Francesco Franzoni, Rabih Moussawi, and Byungwook Kim share their perspectives on the earlier notion that millennials choose specialized investment products that align with their personal values. But what started out as “good intent” may not translate well to “good investments.” Here’s why.
Academics who published the paper Competition for Attention in the ETF Space find that specialized ETFs attract more retail investors than institutional investors; institutional investors, whom in theory, have more knowledge of market conditions than the so-called “Robinhood investors.” This disproportionate interest could be an issue when investors end up buying funds for the wrong reasons.
Source: Ben-David, Itzhak and Franzoni, Francesco A. and Kim, Byungwook and Moussawi, Rabih, Competition for Attention in the ETF Space (January 14, 2021). Fisher College of Business Working Paper №2021–03–001, Charles A. Dice Center Working Paper №2021–01, Swiss Finance Institute Research Paper №21–03, Available at SSRN: https://ssrn.com/abstract=3765063
Passing Fad or Promising Future?
Competition in the ETF space is becoming more crowded each year. According to the research paper, financial innovation in the ETF industry follows two distinct paths: one for cost-conscious investors and the other for unsophisticated investors. They go on to share that once the hype or trend dies down, most thematic ETFs end up underperforming the market and delivering negative risk-adjusted returns. Hence, institutional investors prefer broad-based ETFs. While some may still feel that thematic ETFs are good investments due to their highly concentrated exposure of stocks, durability may be a low bar. For example, more than half of all thematic ETFs launched globally prior to 2015 have closed down, according to the research Competition for Attention in the ETF Space. As such, many retail investors should be well aware that some trends are just passing fads.
The Problem with Thematic ETFs
The potential issue with thematic ETFs comes down to risk. The current landscape of specialized ETFs, particularly thematic ETFs, have attracted greater media exposure than broad-based ETFs and thus may have driven the price up with irrational expectations. For example, browse through any financial news online and you’ll quickly find that Cathie Wood has been grabbing headlines with her ARK ETFs. With that being said, most thematic ETFs are narrowly focused and not diversified enough and the greatest pain point might be that they depend heavily on certain sectors to drive growth.
Looking at the exponential growth of ARK investments, you’ll find the company owns significant amounts of the outstanding stock of some companies it invests in. This could limit its ability to trade stocks freely and carry risk of relying on a single sector. As of 02/17/21, ARK Innovation ETF (NYSE: ARKK) holds almost 9% in Tesla stocks so far. If tech sector suddenly drops in price, ARK funds will most likely get drastically impacted. This is just one example. Other thematic ETFs cover stocks related to COVID-19 vaccines, work from home trend, and even Black Lives Matter movement. Once the hype around those stocks die down, there is potential risk of their price dropping significantly.
On the other hand, broad-based ETFs are likely more favored by institutional investors. Broad-based ETFs are funds that track broad market indices. They are considered more beneficial in that they reduce transaction costs and provide higher diversification. While specialized ETFs may attract unsophisticated investors who chase performances and disregard fundamentals, broad-based index-tracking ETFs often offer low-risk and low-cost exposure to greater market segments.
The Impact of AI in Actively Managed ETFs
Some may argue then that thematic ETFs, while risky, do offer higher returns than broad-based ETFs, at least in the short-term. This is true in many cases, where some investors just want to ride the momentum until the trend is over.
But what if there’s an alternative way to “ride the wave,” except not for the short-term? In a broad-based ETF category, there is such a thing called AI powered ETFs. AI powered ETFs are managed directly by AI technology. In other words, no humans manage the fund.
Qraft AI ETFs, which consist of four listed AI powered ETFs on the New York Stock Exchange, built a proprietary AI technology that automatically finds alpha factors to potentially bring excess returns.
Let me unpack what this means.
Unlike thematic ETFs, which rely on the latest “hot” stocks, Qraft AI ETFs strategically seek to find factors, or market anomalies, in the investment universe attempting to create excess return formulas to be applied to the fund. Qraft’s core research technology, called Factor Factory, leverages AutoML technology to produce at least 10 factors per day without any human intervention. These factors are then applied to the large cap holdings in the fund and AI automatically rebalances the weightings of the stocks each month to favor potential outperformance against the benchmark index.
Interestingly enough, Qraft AI-Enhanced U.S. Large Cap Momentum ETF (NYSE: AMOM) has held Tesla as its biggest position for three consecutive months since November 2020. However, Qraft’s AI system automatically reduced Tesla shares to zero beginning of September when the stock plummeted by 13.9% and didn’t buy back until November when the stock became bullish again. This may very well be just mere coincidence. However, this could also be indicative of the potential predictive power of AI’s solution for building high performing ETFs.
For information purposes only. Not meant to represent the Fund. Past performance does not guarantee future results. For AMOM top ten holdings, click https://qraftaietf.com/amom.
Key Takeaway
With all investments in the stock market, there will always be a risk factor involved. In the advent of thematic ETFs, investors are exposed to trendy themes with the possibility of holding attention seeking and overvalued stocks that may potentially underperform the market in the long run. As a viable alternative to specialized ETFs, investors can add AI ETFs that are broad-based ETFs that provide diversification at low cost with the added benefit of AI integrating alpha factors in search of excess return strategies.
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1. Macro level trends — A macro trend is a pervasive and persistent shift in the direction of some phenomenon on a global level. Examples of current macro trends include urbanization, automation, and changing demographics.
2. Specialized ETFs — Specialized ETFs are classified as ETFs that invest in a specific sector or in sectors that are tied by a theme.
3. Risk-adjusted returns — A risk-adjusted return is a calculation of the profit or potential profit from an investment that takes into account the degree of risk that must be accepted in order to achieve it.
4. Broad-based ETFs — Broad-based ETFs are all ETFs that track broad market indices.
5. Alpha — Alpha is a measure of the active return on an investment, the performance of that investment compared with a suitable market index.
6. Factor Factory — Qraft’s core AI technology that automatically finds factors that could bring excess returns. Factor Factory is able to produce at least 10 factors per day without any human intervention.
7. AutoML — Short for Automated Machine Learning, AutoML is the automation of the machine learning process to make machine learning jobs simpler, easier, and faster.
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Investing involves risk including possible loss of principal. Diversification does not ensure profits or prevent losses.
Artificial intelligence selection models are reliant upon data and information supplied by third parties that are utilized by such models. To the extent the models do not perform as designed or as intended, the strategy may not be successfully implemented. If the model or data are incorrect or incomplete, any decisions made in reliance thereon may lead to the inclusion or exclusion of securities that would have been excluded or included had the model or data been correct and complete. Service providers may experience disruptions that arise from human error, processing and communications error, counterparty or third-party errors, technology or systems failures, any of which may have an adverse impact.
Investors should consider the investment objectives, risks, charges, and expenses carefully before investing. For a prospectus or summary prospectus with this and other information about the Qraft ETFs, please call (855) 973–7880 or visit our website at www.qraftaietf.com. Read the prospectus or summary prospectus carefully before investing.
Distributed by Foreside Fund Services, LLC
Investing involves risk, including loss of principal. The Funds are subject to numerous risks including but not limited to: Equity Risk, Sector Risk, Large Cap Risk, Management Risk, and Trading Risk. The Funds rely heavily on a proprietary artificial intelligence selection model as well as data and information supplied by third parties that are utilized by such model. To the extent the model does not perform as designed or as intended, the Fund’s strategy may not be successfully implemented, and the Funds may lose value. Additionally, the funds are non-diversified, which means that they may invest more of their assets in the securities of a single issuer or a smaller number of issuers than if they were a diversified fund. As a result, each Fund may be more exposed to the risks associated with and developments affecting an individual issuer or a smaller number of issuers than a fund that invests more widely. A new or smaller fund’s performance may not represent how the fund is expected to or may perform in the long term if and when it becomes larger and has fully implemented its investment strategies. Read the prospectus for additional details regarding risks.
