Are Thematic ETFs for You?

Ruth Saldanha: Though the equity market saw some volatility at the start of the coronavirus pandemic last year, it has still rebounded strongly, leading investors to question where to look for growth in this year and beyond. While the sectors or areas of growth might be unclear right now, the vehicle that they have chosen to get there is not. Overwhelmingly, Canadian investors have chosen ETFs. Horizons ETFs' Mark Noble estimates that ETF surpassed $40 billion in sales for 2020, an all-time record. Where does he think the flows will go in 2021? He's here today to tell us.

Mark, thanks for being here today.

Mark Noble: Always a pleasure, Ruth.

Saldanha: To start with, you believe that a lot of ETF flows are not real. What does that mean and why do you think so?

Noble: Well, I think I want to couch this response a bit to say last year was a fantastic year for ETF flows. So, the $40 billion is real money in terms of that money went into ETF. One of the challenges we have in the ETF industry is determining how much money is, what we would call, organic flow, which is flow coming from other sectors outside of the asset managers. And so, what we've seen over the last few years is, we've seen the number of ETF providers skyrocket well into the 30s where pretty much every major asset manager in Canada now has an ETF business. Now, what that means is that a lot of times what they can be doing is seeding these ETFs with money that they already internally hold. Or it could be mutual funds buying the ETFs that they have on their platform. So, how much money is actually coming from net new Canadian investors that have chosen to take money out of one thing and put it into these ETFs, that gets a little bit tricky to quantify. I look at the inflow numbers on the ETFs and I would say we're still well above $30 billion last year. But potentially as much as $10 billion could have come from potentially double counting and flows from those asset managers.

Saldanha: Let's talk about your expectations going ahead now. You said before that you anticipate thematic ETFs to see increased interest. So, what themes are you watching for in 2021?

Noble: Thematic ETFs had a massive 2020. Our sister company in the United States, Global X, puts out a global thematic report and they showed that thematic ETF assets grew 78% in the fourth quarter, just the fourth quarter, three months, grew from about $60 billion to $105 billion. In Canada, we've seen not quite the same level of growth, because a lot of Canadian ETF investors can buy those U.S. ETFs. So, when you're looking at it from a Canadian perspective, I can buy a lot of these U.S. listed ETFs. But even in Canada we have about $5 billion now in thematic ETFs across 40 products. A lot of new launches in this space.

This is very similar to 2017-2018 where when you have a huge rally in the equity market, you start to see equity investors really starting to take on a lot more risk. And so, they start going after sectors that have delivered eyepopping returns. So, if you look at things like U.S. marijuana stocks, that's up 60%, over 100% in the last three months. Blockchain companies up over in 1000% in some of these companies. So, these absolutely astounding kind of generational returns really attract investors to these ETFs. Because one thing that they're looking for is sort of some more diversified and liquid exposure using these ETFs. I think that as long as the equity returns continue to be strong and we continue to have sort of this COVID-19 work from home movement where a lot of people are frankly investing a lot more, there's a lot of money coming into the investment complex, I think we're going to see a lot more investors chasing thematic ETFs and I think you're going to see the ETF industry respond in kind by launching a lot more of this product because they can charge higher fees to be quite frank. So, because of that you're going to see a lot more thematic ETFs coming to market and I think you will see more money chasing these hot thematic ideas.

Saldanha: Now, the two themes you mentioned were blockchain and marijuana. And when you say blockchain, most people automatically think bitcoin. And both of these sectors are quite risky. So, what kind of investor should consider these kinds of themes? And considering the risk factors and the fact that both these sectors have kind of increased significantly already, how much of an overall portfolio do you think should be in themes such as these?

Noble: Well, it's a really great question Ruth. And one of the issues I have sometimes with a lot of the commentary that comes out of the industry, people say to stay away from thematic ETFs, you should just have broad equity exposure. And I don't think that's – it's not an all or nothing proposition. Are thematic ETFs a higher risk/reward proposition than a broad equity ETF? So, let's take that blockchain example. If I buy blockchain equities, is that a higher risk/return proposition than buying the S&P 500? Absolutely, no question. But I don't think there's anything wrong with investors taking what we call a core and explore approach, which is that you build a portfolio with core asset classes that are designed to meet your long-term risk/return objectives. But if you have excess capital or excess risk, there's nothing wrong with having some of these other strategies in your portfolio taking up a smaller amount.

So, you ask what type of amount? Well, it's always impossible to determine that. You should work with a financial advisor to find a plan that works. But in general, just very generally, you're probably looking at maybe 5% to 15% of your portfolio can be this explorer bucket where you're taking on that risk. The key here is that when investors invest in these very high-risk, high-value asset classes, they need to know that there's the high likelihood that it could zero. So, the question you need to ask yourself before entering into these sectors is am I okay losing all of this allocation?

Saldanha: Now, we at Morningstar are certainly believers in highlighting the risks of thematic ETFs, some of which are the concentrated portfolios, their high fees that you already talked about, and also overall low survivorship rates. So, what are some ways in which investors could identify these risks and perhaps (guard those) when trying to pick a thematic ETF?

Noble: Well, first, I would just challenge that concept from Morningstar, which by the way, I think is very good. I mean, Morningstar is an excellent education portal. Obviously, we're here on Morningstar talking about it and you guys are leaders in taking this intellectual view of it. Let's take the devil's advocate or the other view of if I'm a thematic investor, what am I looking for?

Well, if you understand that you're willing to take on this risk, then how can we mitigate some of that risk? And the number one way that you can mitigate that risk is through diversification within that sector. So, the dispersion of the stocks in these thematic strategies, I mean, use marijuana for example, is massive. You have some stocks in the marijuana space last year, like Canopy Growth, for example, a large leader where it's up well over 100%. You have some of the U.S. MSOs like Curaleaf which could be accessed through the U.S. marijuana ETFs, that are up double digit, well over 100% or 200%. And then, you have some stocks that are mass negative that are on their way to bankruptcy. If you were to invest the same capital in those individual stocks and you picked the wrong stocks, you can go to zero. Whereas if you buy the ETF, you will get that sector exposure.

Is it more expensive to buy these ETFs? This is obviously the number one pushback. The answer is yes. And I would argue that to a certain degree these are more expensive. There is probably a little bit more margin built-in, but it comes with some real reasons why. Number one – managing a liquid portfolio in new sectors like emerging technologies or marijuana requires a lot more portfolio oversight, a lot more trading capacity, even if it's an index strategy for the ETF provider. There's a cost to that which is going to result in higher management fees. So, they are slightly more expensive, but that's because you're trying to get liquid exposure in sometimes less liquid equity spaces. And they provide some diversification versus a concentrated exposure.

Where I really do agree with the approach that Morningstar highlights thought is sometimes this stuff isn't really thematic or isn't really worth the cost. So, the one issue that you really need to look at is, is the ETF something that you could – is the performance something that you could replicate cheaper? So, for example, you'll see a lot of emerging or technology leader strategies. Really at the end of the day those are high beta correlation to the Nasdaq 100. So, a lot of these strategies you could generate almost all that performance by buying a Nasdaq 100 ETF, which you could probably get for – in Canada, you get that for 25 basis points. We have one at Horizons that's 25 basis points. You can get that exposure at very low costs. And Nasdaq sort of becoming the new beta. So, sometimes what you can see is a lot of these ETFs have this Nasdaq 100 as what we call a closet index strategy. That's something we want to look at. So, the one last piece there is, if you are buying a thematic ETF, make sure it really is a unique kind of sector that you're looking to get exposure for and not something that could be easily replicated using a broader, more low-cost product.

Saldanha: Finally, our research also finds that globally a lot of thematic ETFs tend to fail. Do you see that as being a problem in Canada? And how should an investor kind of pick a fund that's likely to survive?

Noble: That's a really hard question, and it's also a really valid point. Yeah, I expect there will be as many of these thematic ETFs that are launched, I would expect that you have ultimately a failure rate that's quite large, very large, much larger than the broader investment fund. And it's simply because the ETF providers are trying to find what I call the lightning in the bottle, trying to find that sector that's going to capture the imagination of both investment and growth and performance, and that is not easy to do. So, as you get more popular, you're going to get more – as thematics get more popular, you're going to see more thematic ETFs get launched which really slice and dice this exposure of these different sectors and a lot of them won't work. Again, the nice thing with ETFs is, ETFs themselves are structured as an open-ended investment trust. So, it's not like the investor invests in the thematic ETF and they are down any worse than if they bought the individual stocks. When those ETFs close, you will get the net asset value. Obviously, no one likes to see their ETF close. But it is a real risk.

I don't think this will impact Canada to the same degree simply because I think that the Canadian ETF industry recognizes that if we're going to launch a thematic ETF here in Canada, we needed to have a lot of scale for it to be worth the time for Canadian ETF investors to buy. Canadian ETF investors can get most of the themes they are looking for at a lower cost than what would be available in Canada by buying the U.S. theme. So, it's really got to be like mega themes like robotics, marijuana, I guess blockchain to a certain degree, where you have a Canadian product that has a hedge on it and it's more designed for Canadian investors. But I think generally speaking, when you're looking at the thematic space, you're looking at both the U.S. listings and the Canadian listings. And yes, I think eventually you'll see a large swath of those ETFs go under. But then on the opposite side, you'll see some of these ETFs really catch on and generate massive amounts of AUM. And so, you'll continue to see products launch in the hopes of capturing that next big theme.

Saldanha: Great. Thank you so much for being here today, Mark.

Noble: Always a pleasure. Thank you so much. A fun conversation.

Saldanha: For Morningstar, I'm Ruth Saldanha.