An introduction to thematic ETFs

This article on thematic ETFs is by The Lone Exchanger from Team Monevator. Come back every Monday for another fresh perspective.

Opening up his browser and heading to the ‘Funds’ page of his online broker, The Lone Exchanger felt like trying something new.

Navigating away from the relative safety of his All-World Tracker, he discovered a fresh and potentially exciting world…

Setting the stage

We know the drill by now for long-term financial independence. Budget effectively and put aside as much as you can in tax-efficient savings vehicles. Make a global index tracker fund the core of your strategy.

But where is the fun in that? In dutifully popping a portion of your hard-earned wedge into a slow and steady grower?

Surely the game played by these City types isn’t that complicated?

Well, flicking through the Monevator archives reminds us that over a ten-year period, more than 70% of professional fund managers failed to beat the market.

What chance do you or I have of doing better?

Not much.

But human nature is curious. Despite all the evidence that index funds are best for most – and that successful stockpicking is fiendishly difficult – there remains a temptation to try to beat the market to juice returns.

And as ever the financial world has stepped up to scratch that itch.

Theme-me-up, Scotty

While they’ve been around for well over a decade, ‘thematic’ ETFs have become much more popular in recent years.

The idea is that investors can easily put money into a fund which aims to track an index comprised of a subset of companies who share commonality around a certain theme.

As the name suggests, thematic ETFs offer investors the opportunity to actively invest in that specific field, or theme, without needing to buy lots of individual stocks themselves.

That makes thematic ETFs both similar to, and different from, so-called sector ETFs, which focus on a traditional industry sector, such as Banking, Retail, or Consumer Staples.

Companies held within thematic ETFs often track across different traditional sectors. For example, an ETF focusing on Robotics may contain one company focused on Artificial Intelligence (IT sector), another which manufactures industrial robots (Industrial sector), and one which provides automated surgical equipment (Healthcare sector).

Variations on a theme

There are at least a hundred such thematic ETFs now trading on European exchanges – and many more in the US.

Themes include ‘Ageing Populations’, ‘eSports & Gaming’, and ‘The Future of Food’. They are often focused on future perceived trends or fields.

In recent years, these thematic funds have become especially popular with younger investors who may have a higher risk tolerance – or a higher misunderstanding of risk.

The lowering (or elimination) of share dealing fees and the introduction of fractional share trading has also made it easier to allocate money towards such funds – and to trade in and out of them at will.

The following graph from Defiance ETFs shows the huge flow of funds into thematic ETFs since the start of 2020, compared to other ETF categories such as Financials and Energy:

Source: Defiance ETFs

Storming or performing?

Performance of thematic funds, as with any asset or sub-asset class, is difficult to gauge.

Picking different start dates can change the theoretical returns. And as most investors adjust their holdings over time – ‘dollar-cost averaging’ in at best or selling their winners at worst – the performance over fixed dates can be misleading.

The Accumulator was underwhelmed when he reviewed several popular thematic ETFs in his ten-year review in late 2019.

A deeper delve into thematic ETFs can also be found at The Evidence-Based Investor. Its conclusion was that thematic funds have put up market-beating returns on a 3-5 year timeframe. But they’ve done worse over ten years.

In addition, thematic ETFs were more volatile. That can impact returns over the longer term.

We also need to touch upon costs.

Many large passive ETFs that track broad stock indices have very low costs. Annual charges can be below 0.1%.

In contrast, thematic ETF providers may charge 0.4% or more. This sort of fee drag will dig into your returns over time.

Higher costs may be justified if the ETF is invested in tricky international stocks, or in small cap companies with limited liquidity. But often these ETFs buy large liquid companies listed on major exchanges.

In that case the higher fees charged will go straight into the pockets of the ETF’s management company and the associated index providers.

Risk or reward?

Many of the popular thematic ETFs are focused on the future, with funds often heavily exposed to growth-orientated technology companies.

In a world of relatively slow growth rates and low interest rates, these shares have done well recently due to their strong revenue growth figures and that ultra-low interest rate environment, which boosts the value of their future cash flows.

However if global interest rates start rising, it’s likely that there will be a hit to the valuations of such companies.

Furthermore, we need to be mindful of concentration risk.

If you purchase a broader ETF such as one tracking the S&P 500 in the USA, you have exposure to a mixture of sectors. This will include Financials, Energy, Retail, and Construction, as well as technology. If a particular sector struggles, others may pick up the slack.

In contrast, it’s likely most individual companies in a specific Thematic ETF will move in relative lockstep as there is little diversification. We saw that at the start of this year, when the iShares Clean Energy ETF plunged by around 30% in a couple of months as the sector fell out of favour.

Another consideration is that some companies included within a thematic ETF may have relatively small market capitalisations. This means they could end up being owned in large part by such ETFs.

Should investors’ preferences change and the ETFs get dumped, the funds in turn could be unloading shares in relatively illiquid companies. That could exacerbate share price movements to the downside, increasing volatility.

Holding on

It’s therefore important to look under the hood of a thematic ETF. At the least you should establish the number of individual holdings, and scan to see if anything interesting pops out.

You can do this by pasting the ETF name into a search engine and going to the provider’s website. There should be information on returns, any dividend yields, and exposures to regions and currencies.

As an example of what you might find, until recently the aforementioned iShares Clean Energy ETF only held around 30 companies. Compare that to a world tracker, which could hold more than 3,000. Clearly each individual company will have a far larger impact in the concentrated portfolio.

Furthermore, individual weightings matter. Do the companies held by the ETF have a fairly equal weighting? Or do just a handful make up a large proportion of the fund? In the latter case performance could again be driven by just a few giant positions.

Some holdings within an ETF may only be tangentially related to the theme in question, at least in your view. The index provider will determine how strict or loose its criteria is. Candidate holdings may only need a 25% revenue exposure to the theme to be eligible, for instance.

Consider too the overlap with any existing investments you may own.

Many specialist funds contain giants like Apple, Google, and Amazon – which you probably already hold in your passive global tracker. You’ll be paying a higher cost to hold more of them within a thematic ETF, and increasing your reliance on their performance, too.

High? Low? Silver?

Individual investors are unlikely to beat the market over a long time horizon if they deviate away from passive index trackers – and that includes making forays into thematic ETFs.

With such ETFs, costs – a key determinant of returns – are higher, returns more volatile, and some themes may be subject to boom and bust swings that gyrate with the economic cycle or investor sentiment.

Thematic ETFs do offer the more adventurous investor a glimpse of a more exotic investing world. But caution and due diligence are vital.

See more articles from The Lone Exchanger in their archive.

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