How to bet on the next big thing

Sector-based ETFs can give you diversification without diluting your focus.

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The robot revolution. Clean energy. Global agriculture.
 
All are themes that from time to time capture investors’ imaginations – and send them scurrying off to look for companies who stand to profit mightily from the Next Big Thing.
 
Indeed, the biographies of famous money managers are stuffed with examples of prescient investments in new-fangled sciences or products that paid off beyond their imagining over the decades.
 
Think of Philip Fisher’s investment in the up-and-coming Motorola in 1955, for example.
 
Or Warren Buffett seeing earlier than most the power of global consumer brands in the modern world, and taking huge stakes in Coca-Cola and American Express as a result.
 
Then there are the traders who scooped up battered technology stocks after the dotcom bust because their belief in the internet never wavered, and others who are now buying oil companies before the next big reversal in the cycle.
 
Putting your money behind such big ideas is certainly not the only way to invest – but it’s popular, and it can make fortunes.

Boom or kaboom?

However, there’s one obvious flaw with seeing where the world is going and buying a company to try to benefit from the transition.
 
What if your company is a dud?
 
Think of former internet legends Yahoo and AOL, which were both acquired at a fraction of their peak valuations after the internet went in a different way and left them behind.
 
Or imagine you decided to buy into the Peak Oil theory in 2010 – and chose to do so by investing in BP (LSE: BP).
 
You’d then have seen your money crater even as the price of oil did indeed head above $120, because BP’s Deepwater Horizon oil spill caused it to lose tens of billions of dollars in clean-up costs and fines, while other energy firms prospered.
 
Of course, companies failing to live up to their promise – or doubling down on disaster, whether through accident or incompetence – are always a risk for stock pickers.

Buy a FTSE All-Share index fund, say, and your money is spread across several hundred firms.
 
Invest in but a dozen of your favourite shares, and however careful you are, there’s the possibility that one or more of the investments will go south for its own reasons, souring your overall returns.
 
That’s bad enough if you’re trying to beat the market by investing in only the best (or best-priced) opportunities out there.
 
But it’s even more infuriating if instead you’re trying to bet on a big idea or a theme – such as the aforementioned robotics boom – and the big idea does turn out to be the next big thing, only for your particular company to go haywire.

The theme team

Well, there’s a way around this conundrum that’s little discussed among private investors, but which is increasingly popular with fund managers and the like.
 
And that is to use specialised ETFs to put your money behind on a particular area of the market – or investment theme – without having to take on massive individual company risk.
 
These so-called sector ETFs have proliferated in recent years.
 
And while they’re not without some disadvantages, I would argue that they are a lower-risk way to wager on a particular narrative coming true, compared to buying into a company as a one-shot proxy with all the risks that entails.

Water, water, everywhere but…

For example, let’s say you believe the provision of clean water is going to be one of humanity’s greatest challenges.
 
In its latest Global Risks Report, the World Economic Forum identified what it calls the “water crisis” as one of the biggest issues likely to be faced by businesses and populations for decades to come.
 
The old-fashioned way to put your money to work in this theme would be to select a company making products or investments that stand to benefit.
 
You might invest in the utility Severn Trent (LSE: SVT) or the niche manufacturer Halma (LSE: HLMA).
 
But these are hardly ideal vehicles to play the water story.
 
Severn Trent is overwhelmingly UK-focused, and our wet and rainy climate hardly tops the table for water shortage concerns.
 
And while Halma does make many useful widgets used in water treatment and transportation the world over, the impact of these sales to its bottom line will be swamped by everything else this well-diversified business does, too.
 
Also, you might ideally want to invest in an emerging market water-problem solver – but then you’re exposed to additional kinds of risks and headaches that go with that territory.
 
The stage is set for a sector-based ETF!
 
Instead of picking or one two companies, you could invest in the iShares Global Water ETF (LSE: IH20).
 
This ETF holds a massively diversified range of industrial firms and utilities across the globe, including the shares I’ve mentioned above but also various US, Swiss and French giants.
 
It also offers some direct exposure to critical regions for water provision and usage, such as Brazil and China.
 
If the business of water does turn out to be as valuable over the next few decades as oil was over the past 50 years, then this ETF looks well placed to prosper.

The theme team

There are myriad other thematic ETFs available, from more mundane ways to put money to work in broad sectors such as industrials or technology, to increasingly exotic specialist fare.
 
To give you just a few tasters:
 
iShares Global Infrastructure (LSE: INFR) – offers exposure to a basket of over 100 international utilities and other infrastructure companies.
 
iShares Global Timber & Forestry (LSE: WOOD) – get a stake in timber processors and forestry plantations.
 
ETFS Global Robotics and Automation (LSE: ROBG) – make sure you’re one of the winners from the rise of the robots!
 
Again, there are dozens of other exotic sector ETFs available, and more are being dreamt up all the time.

Do your research

Now I’d caution that sector-based investing – especially via the more niche ETFs – is something that you should research just as much as if you were buying into a company.
 
You’ll want to look under the hood to make sure the ETF actually invests in the sort of companies you believe it does, for starters.
 
Names can be misleading.

Look out, too, for just a handful of companies dominating the portfolio, which increases risk.
 
Note that some sector ETFs are synthetic ETFs – which means they don’t actually own shares in companies itself, but rather have an arrangement with an investment bank to deliver the return of the thematic index being followed.
 
Some people believe such synthetic ETFs are riskier than traditional tracker funds.
 
Finally, the annual expenses charged by sector ETFs are typically higher than the ultra-low costs we’re used to with many index-tracking products. This is particularly true with smaller funds, which are also vulnerable to being closed down due to lack of demand.
 
Still, even pricey ETFs are vastly cheaper than paying a clever hedge fund manager to bet on the robot revolution on your behalf.
 
So what are you waiting for – except for your next big idea?

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Owain owns shares in BP and Halma. The Motley Fool has recommended shares in BP.

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