Themed ETFs look poised to further shake-up the investment world

Some believe that themed ETFs offer an engaging way for established investment platforms to compete with new digital players, while others are concerned that they merely encourage dubious investments

A wide array of thematic exchange-traded funds are growing in popularity, with the Global X Robotics & Artificial Intelligence ETF being launched in September 2016
A wide array of thematic exchange-traded funds are growing in popularity, with the Global X Robotics & Artificial Intelligence ETF being launched in September 2016 

For some people, investing will always be seen as pretty boring. Even the prospect of earning huge riches may not be enough to convince these individuals that studying share prices is worth their time. They might reconsider, however, if they were investing in businesses that were a little more stimulating than the norm. Real estate, while a sensible choice, may not get the heart racing, but perhaps robotics, cryptocurrencies or medtech are interesting enough to convince individuals to part with their cash.

Being interested in a subject is not the same as being knowledgeable in it, and investment always comes with risk

Of course, being interested in a subject is not the same as being knowledgeable in it, and investment always comes with risk. For every cutting-edge start-up that goes on to achieve business success, there are countless others that simply know how to talk a good game. Investors must be careful not to let their passion for a particular business sector cloud their judgment. This is particularly true now that thematic exchange-traded funds (ETFs) are
growing in popularity.

Essentially, ETFs are bought and sold just like regular stocks and, as such, can be traded at any time of the day through stock exchanges. However, they are pooled investment vehicles: they contain an underlying collection of different stocks, bond and other securities. They can focus on a broad variety of things, from commodities to forex and everything in between.

Unsurprisingly, the commodities that underpin thematic ETFs revolve around a shared topic or theme. Traded ETFs can now be focused on disruptive technologies, environmentally friendly firms, religion – pretty much anything that a potential investor can think of. Still, just because a shiny new ETF has been launched based on an interesting theme doesn’t mean it is necessarily worth backing, particularly given some of the thematic ETFs being made available.

Standing out
While the world of investment remains impenetrable for many, the market has undergone a substantial opening-up in recent years. The rise of digital investment platforms has allowed casual investors to check their portfolios and make trades using their smartphones – having a personal fund manager is no longer a necessity. Many of these new, digital-only investment platforms require little in the way of fees, cutting margins to the bare bones.


The year in which the first ETF was created


of thematic ETFs launched in Europe before 2012 have closed

As a result, investment managers are under pressure to continually create new products that will enable them to stand out in an increasingly crowded marketplace. ETFs are a case in point: the first ETF was not created until 1990, but it quickly became a mainstay of the investment scene. In fact, the rapid growth of ETFs meant that they too have become a crowded sector for investment platforms.

“ETFs offer two advantages to investors,” Daniel Wolfe, CEO of Tradingene, told World Finance. “First and foremost, they carry much lower loads (fees) for investors, making them an efficient way to get exposure to a diversified portfolio of assets. [Second], especially for those ETFs linked to popular indices, they generally outperform the majority of actively managed funds.”

Globally, there are now more than 2,000 ETFs for investors to choose from, so financial advisors need to be more persuasive than ever to ensure investors choose their funds over someone else’s. Pitching thematic ETFs to potential clients is one way of standing out, particularly if the theme is an eye-catching one. Drones, space travel and deep-sea exploration represent just a handful of the ETFs that are causing investors to take notice.

As well as allowing investors to engage with disruptive technologies, themed ETFs also let them tap into a narrative that may have personal significance for them. This also means they can bet broadly regarding a particular market – say, that health stocks will go up – without having to conduct detailed research about the leading industry players.

“ETF providers have moved into the space of active fund managers, through offering non-market cap products,” said Oliver Smith, Portfolio Manager at IG Smart Portfolios. “Themed ETFs are perhaps the most obvious; playing into our desires to invest in more interesting stories, some of which may have a structural growth element.”

The problem is, these stories do not always have a happy ending, When investment is driven by an emotional reaction – as may be the case with an investor getting a little carried away at the prospect of space travel – due diligence can quickly get pushed to one side.

It takes all sorts
Initially, there may not appear to be much difference between a thematic ETF and a regular one. After all, they are both made up of a collection of underlying assets and, in both cases, these assets are chosen because they are connected in some way. An ETF focusing on precious metals, for example, makes perfect sense from an investment point of view. The differing fortunes of, say, palladium, gold and silver provide enough diversification to hedge against volatility, but enough similarity to ensure that investors aren’t spread too thinly.

These ETFs, focused on related commodities or currencies, are not really what investors are referring to when they talk about thematic ETFs. Instead, a more concerning trend has developed recently where ETFs are being created with themes that appear to be based on little more than a gimmick.

An example of the thematic ETF trend being taken to its logical endpoint came in June 2017 when Dani Burger, a reporter at Bloomberg, looked into the possibility of creating an ETF for cat lovers. Choosing the stocks that went into her ETF was simple enough: any with the word ‘cat’ in them made the cut. Thanks to a few highly volatile penny stocks, the ETF actually promised huge returns (in percentage terms, at least), but had no economic basis.

Burger’s cat ETF may be an extreme example, but many other themed ETFs have dubious economic grounding too. Fund managers have created thematic ETFs centred on Millennials, conservative Christians and firms tackling obesity. By selecting assets based on how closely they match a particular theme rather than their future growth prospects, fund managers and investors are playing a risky game.

James Lindley, Managing Partner at Castell Wealth Management, told World Finance: “Unlike other investment approaches such as strategic beta strategies, the best of which are tested across sprawling historical data sets, thematic investing is entirely focused on trends that have yet to fully play out. If you look at the most popular themed ETFs – technology and environmental, as good examples – their popularity often appears to be correlated to news topics and ‘flavour of the week’ investments. This can also be seen in the growing popularity of social-themed ETFs, such as gender equality.”

It is important not to tar all thematic ETFs with the same brush, however: some are doing well for reasons other than luck. Environmentally themed ETFs, for example, have gained popularity because many governments are making efforts to decarbonise their economies – it is easy to see that this is a long-term trend, rather than a fad. Such a distinction is not always so easy to make, however. When ETFs targeting the ‘next big thing’ are created, perhaps fund managers are merely hoping that investors buy into the hype.

Choose wisely
If investors are to avoid being disappointed, they’ll need to carefully assess thematic ETFs before parting with their cash. Investors can calculate an ETF’s worth based on a multitude of factors, including the value of its net assets, the fund’s outstanding shares and the amount of excess cash in the fund. Assessing how long the ETF is likely to exist for is another good way of distinguishing the gimmicks from the real deal.

When ETFs targeting the ‘next big thing’ are created, perhaps fund managers are merely hoping that investors buy into the hype

“It is hard to spot what could constitute a gimmick, and investors should ask themselves whether they think the ETF will still be there in 15 years’ time,” Lindley told World Finance. “It is also worth considering themed mortality rates amongst ETFs. To put this into context, 80 percent of all thematic ETFs launched in Europe prior to 2012 have now closed.”

If ETFs do not attract enough interest to cover their costs, they will quickly be shut down – but equally, an ETF that is receiving a lot of hype may not represent a worthwhile investment either. Thematic ETFs often try to ride the coattails of the next big technological or social development, but if this centres on a theme that has already been widely publicised – say, artificial intelligence – then investors probably aren’t getting in early enough to maximise their returns. If something is creating enough buzz to be part of a themed ETF, then it’s possible that investors will be paying a high price to get involved.

“The main thing to be aware of – in any product launch – is that to get from concept to launch, a new issue will need a favourable performance tailwind,” Smith said. “It’s very rare to launch a new product where the underlying investment has performed poorly and looks cheap. Themed ETFs cover some quite niche parts of the market, and it would be unwise to commit too much of your portfolio to any one idea unless you are certain in your analysis.”

Ultimately, it is up to the individual investor to determine whether a thematic ETF represents a good investment. Sticking to funds with more than $50m in assets under management ensures they are less likely to fold any time soon, but equally this may mean the ETF is not quite as cutting-edge as investors would like. As with any other investment, carrying out due diligence will help when weighing up the risks and rewards of thematic ETFs.

Keep it simple
Despite the hype, returns on themed ETFs performed worse than stocks on the S&P 500 last year. Beating the market is difficult, regardless of whether investments concern a space travel ETF or a single real estate firm. At the end of December 2018, when US stock markets suffered their worst December since 1931, share prices of themed ETFs fell alongside stock market giants such as the S&P 500 (see Fig 1), demonstrating that these ETFs are just as susceptible to market volatility as any other fund.

Part of the problem lies in fund managers working backwards: instead of noticing a consistent theme among a number of different stocks with good growth potential, too many managers are choosing a theme first and then looking for the stocks to fit it. Not only does this increase the likelihood of choosing dud assets, but it can also prove misleading.

Some of the more exciting thematic ETFs are actually made up of rather more prosaic underlying stocks. The SPDR Kensho Final Frontier ETF that launched back in October, for example, has only dedicated approximately 50 percent of its assets to aerospace or defence firms. Electronics, energy, semiconductors and telecoms assets make up the rest of its holdings. These may all have some connection to space travel, but they don’t exactly conjure up images of an intergalactic future. “Themes are often misleading,” Wolfe noted. “Investors need to carefully examine the holdings in an ETF before entering. They should also try to understand how much of the underlying business is related to the theme.”

Still, investment platforms may feel as though they have little choice but to continue coming up with ever-more outlandish thematic ETFs in order to grab attention in a crowded marketplace. Assets held by low-cost and online investment platforms grew by 25 percent in 2017, partly due to their embrace of thematic ETFs. More established financial organisations are now beginning to take notice. In August last year, Goldman Sachs filed a proposal to launch five thematic ETFs of its own.

An easy criticism made against investing is that it is too detached from the companies being invested in – as long as they are making money, it doesn’t really matter what field they are in or what their business practices are. From this point of view, thematic ETFs are a good thing, bringing a more personal element into the world of investment and creating a closer emotional attachment between investor and investment. As long as backers don’t get caught up in the excitement of a newly launched ETF, a personal interest in a particular theme may actually turn out to be an advantage – whether it relates to space travel, religious ethics or cats.