Thematic ETFs are hot, until they're not

Unlike your garden variety low-cost, broad market ETFs, thematic ETFs seek to capitalise on emerging – and, their promoters hope, lucrative – trends. Think environmental change, demographic shifts, or technological advances.

They are often unconstrained by traditional sector and size groupings.

The US market has embraced thematic ETFs to a dizzying degree. There are now over 2,000 exchange-traded products in the US alone. But distinguishing a “theme” from a “sector” is somewhat blurry.

I recently joked with a colleague that there should be an ETF offering exposure to the products Kim Kardashian spruiks on her Instagram. Whether that’s in the works, I’m not sure, but I did learn the next day that there is an ETF named after legendary music producer Quincy Jones. (It invests in music-streaming companies, in case you’re wondering).

Product providers now offer exposure to eye-catching and sometimes controversial strategies such as obesity, organics, and marijuana ETFs (aptly called YOLO, the 21st century spin on “you only live once”).

And Canada has certainly had its fair share of niche offerings. 

Tell a good story and they will invest

Thematic ETFs appeal to investors because they are relatively easy to understand, particularly when you consider the amount of jargon in financial products, say Morningstar research analysts Lamont and Hortense Bioy.

"Investing themes tend to tap into powerful narratives that are often well-known to investors, such as aging populations or the shift to a digital economy, making them easy to relate to," they say.

Morningstar senior behavioural scientist Sarah Newcomb endorses this theory, saying stories – be it the rise of electric vehicles or the burgeoning legalisation of cannabis – exert strong pull on investor emotions.

"Stories are really powerful to us because they're easy to remember. They're small and easy for our minds to understand. A story is a self-contained thing that has meaning in our lives. Our brains love self-contained things that have meaning."

She also says stories can exert influence by stirring our emotions and generating excitement around a product or trend.

"Generally, in a story, we're able to make an emotional connection to what's happening. Emotions solidify memories and add salience to an experience. So, if something is emotionally charged, we're more likely to remember it and place higher importance on it."

Thematic ETFs may be relatively new on the scene, but Morningstar manager research analyst Daniel Sotiroff says their use of compelling stories about the changes investors see taking place around them is a strategy that has been used to lure investors for centuries.

Sotiroff cites the South Sea Company, a British joint-stock company founded in 1711, which used a well-spun narrative about its ability to exploit its exclusive right to hold, silver and other exotic commodities in South America to entice new investment.

Investors piled in, but the company's ability to capitalise on these rights faced big hurdles, and its underlying businesses and ultimately proved unstainable.

"Narratives like those used by the directors relied on simplicity, plausibility, and dramatic emotional connection to exert a powerful pull on the public, causing them to make decisions based on emotion and reaction rather than logic and reflection."

"Plausibility is part of what makes a well-crafted narrative compelling and credible, even if the circumstances aren't factually true."

Thematic ETFs, Sotiroff says, are modern-day investment strategies that rely on simple, catchy stories to attract investors.

Low cost, ease of access

But it's not just inherent cognitive biases that have allowed this industry to flourish. Other forces such as cost and ease of access are also at work, says Morningstar director of passive funds research Ben Johnson.

"The ETF industry has levelled the playing field for retail investors by bringing down costs and expanding access to managed investment trusts," Johnson says.

"These same factors have simultaneously lowered barriers to entry for asset managers, allowing new players to enter the industry at far lower costs relative to launching an actively managed unlisted funds.

"Given the relatively low hurdles facing prospective entrants and the large potential rewards, it's no surprise that there has been a gold rush in the ETF space."

Passing fad or enduring theme?

Once we get past the story, do thematic ETFs share the basic traits that one associates with great investments?

Lamont and Bioy say thematic ETFs rightly have to fend off accusations of being "gimmicky" or of tapping into fashions that will soon swing out of favour as interests shift to the next big thing.

"We only need to glance at the rogue wave of launches and subsequent closures of interest-themed funds in the late 1990s and early 2000s to validate this concern," they say.

"Ask yourself: will the thematic ETF I buy today still exist in 10 years?"

And the ETF graveyard is already pretty full. Almost 80 per cent of thematic ETFs launched in Europe before 2012 have closed. And Canadian investment experts worry about inevitable consolidation in a market that may have the depth to absorb all the offerings. 

"Even if you have a great investment idea, if a product doesn't have broad appeal, it may not be around for your investment thesis to play out," Morningstar Australia associate director, manager research, Alex Prineas says.

"What we see is a fund focused on a niche part of the market is launched at the peak of the theme's cycle and investors rush in, tossing valuations aside. We potentially get weaker performance after that when investors lose interest – that's when we start to see investors exit and products close."

Inside the mind of a thematic ETF investor

Sotiroff says investors in thematics are essentially making three bets:

• That their chosen theme will grow as expected
• That the companies held in the fund are positioned to profit from the growth of that theme; and
• That profit growth will translate into attractive stock returns

Beyond the story and investment strategy, it also pays to consider basic traits such as cost and diversification. These types of funds charge considerably higher fees than their broad market counterparts and are less diversified.

The idiosyncratic nature of thematic ETFs means that evaluating their performance can be tricky, say Lamont and Bioy. The funds often also have little or no performance history, and the theme, by its nature, is yet to play out, making it difficult to evaluate the robustness of the strategy.

"And even after the fact, they are quite difficult to assess in terms of performance, because often they have no direct peers with which to evaluate, or appropriate benchmarks," they say.

Prineas recommends comparing technology funds, for example, against a global equity manager who's overweight the tech sector.

Avoiding overlap on a theme

Thematics have grown in popularity because of their efficiency in giving investors access to a cause they’re keen on, particularly if the theme is concentrated in offshore markets.

For those unable to resist, Prineas suggests thematic funds – because of their concentration – are best used as “satellites”, rather than a core portfolio holding.

Thematic ETFs typically invest in a much smaller basket of companies than the MSCI Index – and often in smaller companies. And, while most thematic ETFs are global in scope their geographical footprints can be strikingly different from broad global benchmarks like MSCI World.

"Most investors will be best served by sticking to a long-term investment strategy that focuses on the core building blocks of a portfolio,” says Prineas.

“If they're going to use satellite holdings to complement that, we recommend carefully considering whether a product suits their investment strategy and risk profile."

It’s also crucial to avoid doubling up on a sector. Those considering thematic ETFs may already be getting exposure to a particular theme through a broad-market, diversified ETF – e.g. an investment in the NASDAQ which is already weighted heavily towards the tech sector.

Lamont and Bioy say a robust strategy should be loose enough to adapt as the specifics of the chosen theme evolve. On the other hand, it shouldn't be so loose that it is too similar to a vanilla broad market strategy.