Thematic ETFs: accurate predictors of the future or false prophets?

Thematic ETFs are good at grabbing the imaginations of investors, but their speculative nature and individual idiosyncrasies need to be understood.

Artificial intelligence, orphan drugs and battery value-chains are just some of the attention-grabbing themes tracked by exchange traded funds launched this year. These join established themes such as robotics and water strategies. ETFs have become popular, but evaluating them and integrating them into an existing portfolio can be problematic.

Trend spotting

Thematic ETFs select listed companies based on their exposure to long-term environmental, technological or social trends. The key to thematic investing is identifying future trends before they are fully recognised by other investors and captured in current equity prices.

Thematic funds rightly have to fend off accusations of being gimmicky and tapping into fashions that will soon swing out of favour. This is a valid concern, especially looking at the high mortality rate among thematic ETFs: almost 80 per cent of thematic ETFs launched prior to 2012 have since closed. A sceptical approach will yield the best investment outcomes, and it pays to examine fund providers’ claims closely.

A robust strategy should be loose enough to adapt, as the specifics of a chosen theme inevitably evolve over time. (There would have been a big difference in outcomes between, hypothetically, investing in a digital music ETF rather than a rival MP3 player ETF back at the turn of the millennium.) On the other hand, it shouldn’t be so loose that it dilutes gains or is too similar to more ‘vanilla’ sector or broad equity strategies.

Thematic strategies are often unconstrained by traditional sector, geographic and size groupings. For example, the iShares Ageing Population ETF selects stocks globally based on their exposure to the ‘grey economy’. This means it invests in stocks as diverse as UK-based funeral services provider Dignity, Indian hospital specialist Fortis Healthcare and US-based travel and restaurant website TripAdvisor. This diversity results in biases that should be understood by investors before they buy ETFs.

Virtually all the thematic ETFs in Europe have a lower size profile than the MSCI World index, meaning that they invest in smaller companies. This is important, because while smaller-cap stocks are more volatile, they have historically produced higher returns than larger-cap stocks over the long term, making them worth sticking with even through periods of underperformance.

Although most thematic ETFs are global in scope, their geographical footprints can be strikingly different from broad global benchmarks such as the MSCI World index. The iShares Global Timber & Forestry ETF, for example, has a 13 per cent exposure to emerging markets.

It is also important to understand style exposures. Most thematic funds in Europe track a technological theme, and therefore invest in growth and momentum stocks.

Some ETFs offer diversified global exposure across all traditional market sectors, whereas narrower offerings such as the L&G Pharma Breakthrough ETF select stocks largely within the confines of a single global industry classification sector (in this case, healthcare). Remember that as themes constantly evolve, biases need to be monitored.

Thematic funds’ idiosyncrasies can make evaluating their performance tricky. Sizing up performance against a like-for-like ETF is encouraged.

A top 10 table of the 10 largest thematic ETFs

 

Complementary role

Due to their narrow exposure and higher risk profile, thematic ETFs are best used to complement rather than displace existing core holdings. But ETFs such as the Lyxor Global Gender Equality (DR) ETF may be used as part of a core allocation, as they use geographical and sector caps to retain some of the characteristics of a broad global benchmark.

Thematic ETFs track macro or structural trends that are expected to play out over many years, so they are best deployed over longer investment horizons. Most thematic ETFs will be used to produce returns, but some can be used to reduce portfolio risk. For example, alternative energy funds can be substituted for core energy holdings to reduce carbon risk.

If a thematic ETF has drivers of risk and return that are distinct from other portfolio holdings, adding it can boost diversification and overall portfolio performance. However, if the risk and return drivers are not distinct enough from cheaper existing ETFs, investors should question the purpose of tracking the theme altogether.

Kenneth Lamont is an analyst of manager research at Morningstar.

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