Should Investors Beware of Trendy ETFs?

It's no secret to investors of all kinds that exchange-traded funds (ETFs) have become wildly popular in recent years. ETFs are among the very most popular investment vehicles largely because they offer investors strong returns for a very low relative fee. Furthermore, they are easy to buy and structured in such a way as to remove a great deal of the detailed work of managing assets so that investors do not need to worry about these things.

While it's perhaps unsurprising that ETFs are some of the most popular vehicles, this fact should encourage caution among eager investors. With more interest on the part of everyday investors comes a larger pool of ETFs, and with an increasingly crowded field, it's natural that some funds will rise above others with regard to popularity. As a result, investors new to the space and overwhelmed by the magnitude of the ETF sphere might be tempted to focus on the trendiest names. A recent report by Forbes, however, suggests that there may be danger in this approach. (See also: A Look at the Growth of the ETF Industry.)

One of the risks of a trendy ETF is that it is likely to draw in investors who are new to the ETF world. Because they are unfamiliar with ETFs, these investors may not recognize some of the inherent risks and other considerations necessary in order to invest wisely in this space. ETFs track an index that already exist, trading like a stock to provide ease of access to a basket of separate names for their investors. They are opposed to mutual funds, which tend to be more open ended; ETFs are more likely to be focused on investment themes or particular sectors. An ETF may be a good option, say, for an investor looking to invest broadly in the video game industry or in legalized cannabis.

However, what ETFs do not provide as a general rule is broad exposure. The ease with which an investor can shop for a trendy ETF may be deceptive, according to the Forbes report; former Royal Bank of Canada portfolio analyst Janelle Nelson suggests that it is the liquidity of the underlying securities that is more important. "Sometimes one underlying stock comprises 30% or 40% of an ETF. It might make more sense to buy the stock outright," she explains. (For more, see: The Rise of the Socially Responsible ETF.)

The drive toward specialization and thematic structure in the ETF space has fostered the creation of both legitimate and less legitimate funds. Following the trends may prevent investors from taking the time to fully investigate their investments. Nelson suggests buying only "quality ETFs with a strong sponsor." After all, an ETF that is easy to buy into but difficult to sell at a crucial time may make all the difference for an investor. (See also: Top 3 ETFs for Investing in Water.)

The report suggests that, when focusing on small ETFs that are new entrants into the industry, investors should look for funds with at least $50 million of assets under management (AUM); smaller ETFs are more likely to fold unless they have the support of a major sponsor. This is not a passing concern, as small ETFs regularly do shut down over an insufficient level of assets to cover costs.

Along with the general concern about trendy ETFs comes a cautionary note from Forbes about timing. "If the ETF has already been created, you're generally not at the beginning of the curve," Nelson warns, adding that "you're often at the middle of the curve." She goes on to describe the relationship between sponsors and investors: "ETF sponsors have to anticipate enough demand for it to [attract] investors and provide returns ... if an ETF is built on a hot theme, that theme is usually already widely publicized."

In other words, investors piling on to a trendy ETF may have already missed out on the greatest opportunities to capitalize on that ETF's success. (For additional reading, check out: The Biggest ETF Risks.)