The ProShares Online Retail ETF (ONLN) is an industry-focused exchange-traded fund that invests in companies involved in online retail. ONLN has been a massive winner in 2020, up 87% year to date, with companies benefiting from a surge of demand and sales given the dynamics surrounding the COVID-19 pandemic. Indeed, e-commerce had been gaining market share over traditional brick-and-mortar retail over the past decade supported by themes like the rise of mobile shopping and convenience with fast shipping. While we recognize the fund as a good option for investors to capture tactical exposure to a group of high-growth and momentum stocks, we take a more cautious view on the near-term outlook. The fund’s concentrated portfolio remains high risk and faces some headwinds over the next year including ongoing macro uncertainties.
The fund manager ProShares highlights several drivers supporting the growth of online retail. Fundamentally, the global leaders in the segment including Amazon.com Inc. (AMZN) and Alibaba Group Holding (BABA) are disrupters that have changed the retail landscape. With data suggesting under 60% of the word’s population is online, there is a long-term tailwind of growth, supporting a positive outlook for the industry.
According to the fund methodology, ONLN tracks the index by the same name which includes both U.S. and non-U.S. companies that are classified as an “online retailer” according to standard industry classifications. The other requirement is for a minimum market cap of at least $500 million, along with some other market liquidity thresholds. No company can exceed more than 24% of the total index weighting while the sum of companies individually weighing more than 4.5% is capped at 50% of the index. Finally, the total weight of non-U.S. companies is capped at 25%.
Based on current market capitalization and the fund’s modified approach, the result is that Amazon and Alibaba dominate the fund, each with a 23% and 13% weighting. Rounding out the top-5 holdings, Etsy Inc. (ETSY) and Chewy Inc. (CHWY) each have a 5% weighting while the current position in Grubhub Inc. (GRUB) is closer to 4.5%.
Overall, this is a concentrated portfolio of just 26 stocks but includes most of the well-recognized leaders in the category. Within the group, there is some diversification across different segments of retail like Chewy Inc. in pet products, Wayfair Inc. (W) focusing on home goods and furniture, while a smaller position in Farfetch Ltd. (FTCH) has exposure to apparel as an example.
As mentioned, this has been a banner year for online retail stocks benefiting from the combination of several unique dynamics. In late Q1, the coronavirus pandemic forced the temporary shutdown of traditional brick and mortar stores due to worldwide lockdown orders and social distancing regulations. Shoppers moved more of their purchases online which was also boosted by stimulus efforts including direct payments by the government and enhanced unemployment benefits in the United States. Most online retailers saw record sales in the first half of the year resulting in an improved earnings outlook.
The ONLN fund is up about 87% year to date, and more impressively, 135% from its low in March during the period of extreme market volatility. The largest positions in Amazon and Alibaba are each up by 73% and 45% each year to date driving the returns. Etsy up 222% in 2020 along with a 191% gain from Stamps.com Inc. (NASDAQ:STMP) highlights widespread strength across most smaller positions.
Excessive Concentration in Amazon.com
While it’s hard to argue against the returns of the fund this year, we have a few criticisms regarding the structure of the ONLN ETF that in our view limit its attractiveness as a long-term investment.
First, the exposure to Amazon.com Inc. at 23% is very high for an individual stock in any ETF. Regardless of the historical returns or the company’s near term outlook, the high concentration means that its performance will have an outsized impact on the fund. It’s completely possible that Amazon could underperform the market going forward over any particular time frame. If you want exposure to Amazon, consider investing directly in the company with a small position. Most brokerages allow trading of fractional shares so the high stock price above $3,000 is hardly a barrier for most investors.
We highlight that Amazon’s cloud-services business group “AWS” represented over 60% of the company’s operating income in the last quarter. This implies that a significant portion of the business is not even directly based on e-commerce. This goes to a broader point, that the inclusion methodology of the ONLN ETF features some subjectivity in terms of the stocks included or excluded.
Subjective Classification of “Online Retailers”
We would like to see some broader diversification including some smaller stocks and others that are technically not in the “online retail” industry. The problem is that there is often a gray area of classifications and some companies don’t necessarily fit into standard categories.
As an example, a case can be made that Carvana Co. (CVNA) and Vroom Inc. (VRM), leaders in the high-growth segment of online car dealerships at least embody the spirit of the fund. There are other automobile online e-commerce stocks not included in ONLN such as Copart Inc. (CPRT) and CarParts.com Inc. (PRTS) which could help spread out the risk of the fund.
Furthering our point, Jumia Technologies AG (JMIA) that has had its market cap above $500 million since June, and has been referred to as the “Amazon of Africa“, benefits from the same global trends is not yet included in ONLN. We also point to some examples of stocks that don’t quite reach the $500 million market cap threshold but are relevant to the category. We recently covered China-based global e-commerce player LightInTheBox Holding Co., Ltd. (LITB) in an article and think it deserves a place in the fund.
Lack of Hybrid Brick-and-Mortar/Online Players
Keep in mind several traditional brick-and-mortar retailers are making a targeted move by investing in their online infrastructure, directly challenging Amazon’s market share. For all intents and purposes, Walmart Inc. (WMT), and Target Corp. (TGT) are important online retailers but not included in the fund. We bring this up because of the strong growth in these companies’ e-commerce channels has been cited as a factor driving their stocks higher this year.
While a consistent fund holdings methodology is important, we believe ONLN could find room for more than just 26 current holdings. Investors should be aware that there are potentially more underlying trends in the online retail industry than just what the fund is attempting to track. The fund performs well for targeted exposure to the industry leaders and can represent a high-growth component in the context of a diversified portfolio, but is high-risk overall.
In the current market environment with ongoing volatility and uncertainty related to the macro outlook, the concern is that a weaker than expected economic recovery can pressure the growth outlook for retail which remains exposed to cyclical risks. In a scenario where the labor market remains weak and consumer spending pressured through 2021, online retail could underperform what are currently lofty expectations forcing a reset of estimates lower. The stocks in the ONLN portfolio could see declines in a risk-off environment.
To the upside, the fund could benefit from a renaissance of global growth expectations possibly driven by a faster than expected availability of a COVID-19 vaccine which would help normalize the economic environment and support consumer spending.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.