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Investors are often told that the golden rule of investing is diversification. Sometimes, though, it pays to make a targeted bet. That has been the driving force behind thematic exchange-traded funds: These niche funds grew three times as fast as the rest of the ETF industry in the second quarter.

Thematic ETFs typically focus on long-term, societal trends, such as disruptive technologies, climate change, or shifting consumer behaviors. Some of the most popular themes include cloud computing, robotics, and electric vehicles, as well as the gig economy, e-commerce, and clean energy.

These are hot topics, for sure. And theyre hot stocks: Year to date, 89 out of the 129 thematic ETFs on the market beat the S&P 500 index, returning 17% on average; 47 of them even outran the best-performing sector, technology. Thanks to both strong inflows and market-beating performance, thematic ETFs saw their assets increase 65% in the second quarter, more than three times the broader ETF industrys 19% growth, according to data from Global X, which offers 20 thematic ETFs. Five years ago, there were just 40 thematic ETFs with $5 billion in assets. Today, theres $41 billion in these ETFs.

The Covid-19 pandemic, meanwhile, has disrupted how people live and how companies are runpossibly forever. More than ever, investors have become aware that the future might look very different from today, says Matthew Bartolini, State Streets head of SPDR Americas research, and they are interested in the companies that could be the biggest beneficiaries. This acceleration is likely to remain very sticky beyond Covid-19, says Jay Jacob, head of research and strategy for Global X.

For a theme to be investible, there must also be a large enough addressable market, and sufficient companies with products and services to address that market. Some industries, while promising, are still too nascent. TrueMark Investments, a new ETF firm founded just a year ago, closely monitors venture capital and private equity to identify emerging public companies for its $12 million TrueShares Technology, AI & Deep Learning ETF (ticker: LRNZ).

Note: Data as of July 30, 2020; *annualized; **the fund has fee waivers in place capping expenses at 0.55% until at least February 1, 2021; N/A means the funds are launched less than three years ago.

Sources: Global X, Morningstar

Despite thematic ETFs impressive returns, investors should proceed with caution. Most of these ETFs are quite small; More than half of the 129 funds have less than $100 million in assets, though a dozen have crossed the $1 billion mark. Most are also fairly new; just 16 funds have a 10-year track record, mostly in clean energy and natural resources; 75 havent been open for three years. Theyre also a bit more complicated to build, since theyre either actively managed or track a customized indexand that means they can be more costly. The average expense ratio for this group is 1.05%, while the broader ETF industry charges just 0.67%.

Two of the largest thematic ETFs, the $6.1 billion ARK Innovation (ARKK) and $4.7 billion First Trust Cloud Computing (SKYY), have returned 61% and 29%, respectively, year to date, beating the $32 billion Technology Select Sector SPDR (XLK)s 18% return. The $1.6 billion ARK Genomic Revolution (ARKG) is the largest thematic ETF focused on health-care innovation; it has returned 63% year to date, ahead of the $24 billion Health Care Select Sector SPDR (XLV)s 5% return.

Thematic ETFs dont perform like their sectors ETFs because they are actually quite different. Most thematic ETFs have very little overlap with traditional sector funds. They usually have fewer stocks, and tend to own more small and international stockssometimes across multiple sectors. The 39 holdings in ARK Innovation, for instance, have an average market cap of $8.4 billion, whereas the technology SPDR, with 72 stocks, has an average market cap of $339 billion. The ARK fund also has 13% in international stocks, and the SPDR, virtually zero. Only two of the ARK funds holdings Xilinx (XLNX) and Autodesk (ADSK)also belong to the SPDR tech ETF, and due to their smaller size, they account for only 1% of the SPDR tech. Similarly, only three out of the 39 stocks that the ARK Genomic Revolution holds are also in the health-care SPDR, making up just 4% of the latters portfolio.

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Because thematic ETFs are so specific, even those with similar names can turn out to have little in common. The same theme can be interpreted differently, and various methodsfrom fundamental to quantitativeare used to select and weigh stocks.

Investors who still want some diversification might be better served with equal-weighted funds, especially those with a higher number of holdings. The $2.4 billion iShares Exponential Technologies (XT) and the $1 billion SPDR Kensho New Economies Composite (KOMP), for instance, have about 200 and 400 holdings, respectively, and both are largely equal-weighted, with minor modifications. This is really about delivering thematic beta, says Jeff Spiegel, head of iShares megatrend and international ETFs at BlackRock, Its not about having a view that one particular company will be the winner of the theme. Its much more about getting exposure to a range of firms.

Many thematic ETFs are more concentrated, however. These can be more pure plays, but only as a supplement to an otherwise well-diversified portfolio. Ark Financials and Global Xs ETFs, for instance, have fewer holdings, often less than 50, and the weighting depends on either active managers conviction or how well the stocks have been performing. Thematic investing, if done right, should be more concentrated, says Global Xs Jacob, You own the companies that are best positioned to benefit from the materialization of a trend.

Write to Evie Liu at evie.liu@barrons.com

Read more:

Thematic ETFs Invest In the Hottest Trends. How Not To Get Burned. - Barron's