Should You Consider Nontraditional ETFs?

Today there's an ETF for almost every corner of the market—from broad-based, bread-and-butter indexes like the S&P 500^® and the Russell 1000^® to the truly niche, like trendy weight-loss drugs and the Korean entertainment industry.

"While that's great from a choice perspective, many newfangled and niche funds don't necessarily have the same low costs and full transparency investors have come to expect from ETFs," says Michael Iachini, CFA, CFP^®, managing director and head of manager research at the Schwab Center for Financial Research. "That's why it's increasingly important to look under the hood."

Here are three important developments in the ETF space and what investors should know when considering such nontraditional ETFs for their portfolios.

For most of their history, ETFs didn't lend themselves to active management. "Until recently, launching a new ETF required a time-consuming and costly process of obtaining specific approvals and exemptions from regulators," says Emily Doak, CFA, director of ETF and index fund research at the Schwab Center for Financial Research. "Additionally, most ETFs had to disclose their portfolio holdings daily, making it difficult for active managers to protect their strategies from copycats."

But in 2019 the Securities and Exchange Commission (SEC) approved two new rules that fundamentally changed the ETF industry:

• The first removed many of the expensive regulatory hurdles that made it difficult to launch a new ETF, allowing fund providers to introduce new strategies more quickly.
• The second permitted fund managers to shield their methodologies or buy-and-sell decisions for up to a full calendar quarter, giving rise to what is commonly referred to as active semitransparent ETFs.

"These changes opened the floodgates," says Emily, who notes that active ETF assets reached $550 billion as of December 2023—a 55% increase in just one year and a 383% increase since the rule was passed.

Active ETFs have become so popular that more than 80 active mutual funds have converted to ETFs to lower their costs and attract investors—and more conversions are likely on the way. (Such conversions tend to happen seamlessly, generally without tax consequences, for a fund's investors.) "And the really surprising thing is that many fund managers are opting for the fully transparent, rather than the semitransparent, structure," Michael says.

Despite their appeal, active ETFs do have some drawbacks—notably the potential for larger bid-ask spreads, which can drag on performance. "Limited transparency can increase uncertainty for market makers, leading to wider spreads," Michael says.

And, of course, active ETFs tend to have higher fees than traditional ETFs, which can further erode returns. "As with any actively managed product, you'll need to ensure the active ETF you're paying for is providing enough value to justify the added cost," Michael says.

One of the more high-profile ETF types made headlines in January 2024, when the SEC approved 11 bitcoin ETFs that track the movements of the cryptocurrency in the spot market—without the need for a digital wallet or having to transact on sometimes opaque crypto exchanges.

That said, the price of a bitcoin ETF can reflect the volatility of its underlying asset. In fact, the flagship cryptocurrency has traded below $10,000, soared above $60,000, dropped back under $20,000, then again topped $60,000—and that's just in the past five years.¹ "While a bitcoin ETF provides more liquidity and a somewhat regulated infrastructure, the underlying investment remains extremely speculative," Michael says.

Investors who nevertheless believe cryptocurrency or the blockchain technology that underpins it are worth investing in could also consider other crypto-related ETF strategies, including:

• Crypto equity ETFs, which primarily hold stocks of companies directly engaged in the crypto business, including cryptocurrency banks, exchanges, and miners. (For more, see "Thematic ETFs.")
• Blockchain equity ETFs, which primarily hold the stocks of firms involved with blockchain technology and may include large multinationals like Amazon, Microsoft, and Walmart.
• Bitcoin and/or ether futures ETFs, which offer a more regulated way to speculate on bitcoin's or ether's price moves. (Bitcoin and ether are currently the only cryptocurrencies for which futures are available.) Note that the leverage created by futures contracts can amplify both the gains and the losses of an already volatile investment. These ETFs must also pay to roll from one futures contract to the next, which can further erode profits or add to losses.

"Despite cryptocurrencies' allure and the many ways to invest in them, they are extremely volatile and haven't been around long enough to prove themselves as worthy long-term investments," Michael says. "If you do decide to speculate in cryptocurrencies, be sure to keep those investments far away from your retirement portfolio."

"For a lot of investors, portfolio returns alone are no longer enough; they want their investments to reflect their interests, values, and views of the future," Michael says. Thematic investing helps investors identify companies from across industries that have a part to play in a perceived long-term investing trend.

Indeed, a global survey by Trackinsight found that 40% of respondents anticipate increasing their allocation to thematic investments over the next few years.² "And ETFs can offer an easy, affordable way to access a theme in a single investment," Michael says.

Because there's no shortage of thematic ETFs available in the market today, the challenge may lie in choosing among the available options. Here are three factors to consider:

• Cost: According to ETF.com, the average expense ratio for a thematic ETF is 0.61%³—not far from the 0.57% average for ETFs overall. Be that as it may, some thematic ETFs charge upwards of 1%, which can severely erode returns over time. "All else being equal, opting for a lower-fee fund almost invariably improves long-term returns," Michael says.
• Exposure: Some ETFs are a "pure-play" investment—meaning they invest only in companies directly involved in the theme—while others invest in companies that may benefit from the theme but aren't necessarily core to its mission. For example, some clean energy ETFs invest only in renewable energy companies, while others invest in companies that have clean energy ambitions but may still derive the lion's share of their profits from oil and gas. (Recent changes to regulations require funds to invest at least 80% of their assets in accordance with the investment focus the fund's name suggests.)
• Thematic objective: How does the ETF define the theme, and how does it select its underlying investments? Often you can find the relevant details in the fund's prospectus; however, if an ETF tracks an index, you might need to look at the index's methodology to understand how investments are selected and weighted.

While thematic ETFs can help align your investments with your interests, by definition they invest only in a slice of the market and are therefore often far less diversified than more broad-based ETFs. "Themes can also take some time to gain traction, if it happens at all," Michael says, "which is why they're often more appropriate for long-term investors with the ability to overlook short-term swings."

"The ETF has truly been a transformational tool for regular investors," Emily says. "But the rapidly evolving nature of ETFs means investors will need to keep up with the latest varieties." When it comes to some of the more speculative ETFs available today, such as cryptocurrency ETFs, it's best to invest only what you can afford to lose—and to keep those investments separate from your long-term holdings.