Thematic ETFs: what investors need to know

We explain the risks and rewards of using ETFs that invest in world-changing trends.  

Thematic investing is not exactly new. Since the earliest days of investing, there has always been a sense that the fortunes of certain types of stocks were driven by big structural political or economic changes.

While some investors have tried to focus on the fundamentals of a particular company, many investors have tried to identify big changes and pick the companies set to benefit. In the 20th century, many funds were created with a “thematic” approach, focusing on the supposed potential of technology.

More recently, thematic investing has evolved with the proliferation of thematic ETFs, tracking all sorts of themes.

What is thematic investing?

The best way to view thematic investing is as an attempt to pre-empt the big future trends of the world and then invest in the sort of companies that will, in theory, benefit from this.

As mentioned above, this is not exactly new, but investors now have a systematic way to do this with thematic ETFs. A thematic ETF tracks an index of companies expected to benefit from the same trend. Rather than rely on the stock-picking ability of a fund manager, the investor gains rules-based passive exposure.

There are numerous themes, but the main ones include cloud computing, robotics and automation, adoption of electric cars, clean energy and the ageing of societies in the West.

Is it the same as sector-based investing?

Another popular way to invest has been to invest in sectors. The growth of indices with sector classifications and ETFs tracking these sub-indices has made it easier than ever for investors to buy into certain sectors they expect to do well.

The lines between sector-based investing and thematic can seem blurred. Is investing in a healthcare ETF investing in the healthcare sector or is it an attempt to benefit from the “theme” of increased healthcare spending as populations age?

The answer is not always clear. However, it is important to note that thematic investing is not sector constrained. A sector-based ETF may be one way to play a certain theme, but a thematic ETF will take a different approach. Instead of simply buying an index of a bunch of companies in a sector, a thematic ETF will track an index specifically designed and weighted to capture the upside of a theme.

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So, for example, an electric car ETF may have a heavy weighting towards big-name electric car manufacturers or traditional car manufacturers with big investments in electric technology. However, it could also have some weightings towards other companies that may benefit from the broad theme of electric cars. This could include companies involved in the extraction and sale of lithium, a key part for batteries. It could also be weighted towards infrastructure companies expected to help with things such as the rolling out of car charging points.

Which theme?

However, while all that sounds appealing in theory, it can be harder to put it into practice. For instance, knowing which theme is going to outperform in the future is no simple task.

Even if you correctly identify a trend, how can you be sure that its future growth is not already priced in? If you have identified that cyber security is a particular theme that should benefit from the working-from-home transition, why has no one else? Chances are, if there is an ETF providing that theme, many people will already have hopeful expectations about this theme.

The danger, therefore, is spotting a theme too late in the day and buying when valuations are at high levels – resulting in the likelihood of returns being lower in the future. 

How to capture the theme?

Once you’ve decided on the theme you want to allocate money to, how can you be sure of the best way to access it?

There is no agreement on how best to construct an index that provides exposure to electric cars or online gaming. There are several index providers with their own rather different methodologies. As a result, the stocks and weightings in a thematic index can vary quite a bit. Therefore, so too can the performance.

Pure-play versus liquidity

When an index tracking a theme is constructed, companies are usually screened using some sort of revenue requirement. For example, the rules of a space thematic index may require companies to derive a defined percentage of their revenue from the “theme”. Companies are also sometimes weighted in the index based on how much of their revenue is associated with the theme.

Companies with higher revenue exposure are seen as being more of a “pure play” on the theme. As a result, an index or ETF with a higher revenue requirement will be seen as a being more of a “pure play” on the theme. This, presumably, is what investors want.

This, however, potentially creates liquidity issues. Many of the companies with the highest revenue exposure are often likely to be small. As a result, they are often thinly traded. This can add to costs when the ETF needs to rebalance. 

If the ETF grows large, the high weighting of these “pure play” companies can mean they see large inflows. As a result, a large thematic ETF can end up owning a large percentage of one of these pure-play shares. Some fear that if the ETF sees large outflows, it will struggle to sell these less liquid pureplay holdings.

As a result, some ETFs adopt loser requirements for inclusion. There is no right or wrong answer here. Instead, when it comes to thematic ETFs there is always a trade-off between purity and liquidity.

Is it a fad?

There is also the risk that the “theme” has fallen victim to becoming a “bubble” or a “fad”. Themes are stories about the future. This makes them compelling and appealing to investors. It makes them much more marketable.

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As William Quinn and John Turner note in their book Boom and Bust: a Global History of Financial Bubbles, “marketability” is a key component of any bubble. And marketability here refers to two things. First, the compelling story about the future (or theme). Second, the proliferation of easily investable thematic ETFs.

This isn’t to say there is a bubble in any particular theme or that thematic ETFs are even specifically to blame for any future bubble. Active managers were perfectly capable of fuelling the dotcom theme in the late 1990s. But it is worth keeping in mind that compelling investment stories, which themes often are, and the democratisation of access, which ETFs provide, have previously been part of the recipe for bubbles.

Investors should consider the possibility that a theme could be a short-lived fad. Excitement in a new technology or theme can often be very temporary. The investing public’s attention may be captured only to quickly disappear. Think of the short but sharp uptick in public interest in blockchain and cryptocurrency in 2017 -  it helped bitcoin hit new highs before prices started to fall and the public lost interest.

There is unlikely to be such an extreme scenario in thematic ETFs, but the sometimes-fickle nature of public interest is worth considering. 

What’s the cost?

Finally, thematic ETFs are sometimes more expensive than the more traditional ETFs. An ETF tracking the FTSE 100 can charge as little as 0.07% per year, while thematic ETFs usually charge somewhere north of half a percentage point. 

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.