Thematic ETFs need careful evaluation…

Kenneth Lamont, Morningstar

…says Kenneth Lamont (pictured), Senior Analyst, Passive Strategies, Manager Research, Morningstar.

Smart city infrastructure, travel technology and intelligent machines are just some of the attention-grabbing themes tracked by ETFs launched globally already this year. These new entrants join more established thematic ETFs such as robotics and water strategies.

Global assets in these ETFs have skyrocketed to USD38.3 billion over the past three years, more than quintupling in size, albeit from a low base. 

Despite their rise in popularity there remain questions about how to evaluate and integrate these products into an existing portfolio.

What are thematic ETFs?

Thematic ETFs can be defined as those that select holdings based on their exposure to one or more investment themes. These themes may pertain to macroeconomic or structural trends which transcend the traditional business cycle. Examples include demographic shifts or technological advances. 

Passing fad or enduring theme?

Thematic ETFs rightly have to fend off accusations of being ‘gimmicky’ and tapping into fashions that will soon swing out of favour as investor interests shift to the ‘next big thing’. This is valid a concern, especially looking at the high mortality rate of thematic ETFs. More than half of all thematic ETFs launched globally prior to 2015 have since closed shuttered.

A trifecta bet

In the parlance of the racetrack investors in thematic funds are making a trifecta bet. Specifically, they are implicitly betting that they are:

1. Picking a winning theme.
2. Selecting a fund that is well-placed to harness that theme and survives to reap the benefits.
3. Making their wager when valuations show that the market hasn't already priced in the theme's potential. 

The odds of winning these bets are low, but the payouts can be meaningful.
The long-term performance figures for thematic funds are not flattering. They suggest that investors' odds of selecting a fund that will survive and outperform over the long run are slim.

Fitting thematic ETFs into your portfolio

Because of their narrow exposure and higher risk profile, thematic funds are best used to complement rather than replace existing core holdings. Some, like Global X Thematic Growth ETF, might be considered as part of a core allocation, as they are broadly diversified and retain some of the characteristics of a broad global benchmark. More-narrow exposures might also be considered as single-stock substitutes for those investors looking to express a view on a theme but who lack the time, tools, and inclination to conduct due diligence on individual companies.

Durable themes are expected to play out over many years. This means that they are best deployed over longer investment horizons.

Return booster or risk reducer?

Most thematic funds will be used with the hope of boosting returns over the investment period, but some can be specifically used to reduce portfolio risk. For example, alternative energy funds can be substituted for core energy holdings to reduce carbon risk.

Even if we set aside the claims of prospective outperformance from asset managers, if a thematic fund has drivers of risk and return that are distinct from other portfolio holdings, adding them around the margins of a core portfolio might yield diversification benefits.

Understanding biases

One hallmark of thematic ETFs is their lack of traditional sector, geographic and size constraints. For example, the most popular battery ETF globally, the Global X Lithium & Battery Tech ETF invests in companies as diverse as US-based Tesla Inc and Sociedad Quimica Y Minera De Chile SA, the World’s largest producer of lithium based in Chile.

This diversity results in several biases which should be understood before investing.

Size

At the time of writing, nine out of 10 thematic ETFs globally had a smaller size profile than the MSCI World Index, a proxy for global large and mid-caps. This is important because smaller stocks tend to have elevated risk profiles relative to their larger brethren. 

Sectors and geography

Depending on the themes tracked, investment footprints can be strikingly different from broad global benchmarks like the MSCI World Index. 

Some ETFs offer diversified global exposure across all traditional market sectors, whereas other narrower offerings like the recently launched Franklin Genomic Advancements ETF select stocks largely within the confines of a single GICs sector (in this case healthcare) or geographical market.

Style

By their nature, thematic ETFs are trying to profit from areas of anticipated growth. It should therefore come as no surprise that more than two thirds of these funds have an explicit growth bias. 

It is important to remember that as themes are constantly evolving, biases need to be monitored through time accordingly.
 

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