Thematic ETFs: which still look a good bet for the next decade?

It has been a year to forget for most passive funds that back a certain trend or theme. David Prosser explains why, and considers the risks and rewards of investing in funds taking a punt on the future.

Anyone who have ever seen the Back to the Future films knows that imagining what innovation and social change might bring is hit and miss. The movies were on the money with predictions about digital cameras and biometrics, but the promise of an end to roads courtesy of flying cars proved less accurate.

Investors in thematic exchange-traded funds (ETFs) might want to heed the lesson. These ETFs aim to passively invest in companies expected to benefit from a trend regarded as long-term and transformational – anything from businesses helping the world transition to clean energy to the rise of robotics.

• Explore: ii Super 60 Investments |  Top Investment Funds | Free regular investing

Such trends or themes often sound exciting and alluring, offering exposure to the sure-fire winners of a changing world. However, the trouble is mapping that change and identifying those winners often turns out to be harder than expected.

Indeed, the performance of thematic ETFs in 2022 is a reminder that in investment, sure things don’t exist. After a strong run – boosted by surging demand during the pandemic – many of the leading thematic funds booked losses of 30%-plus during the first half of the year. Some high-profile funds did much worse: the VanEck Crypto & Blockchain Innovators ETF (LSE:DAPP) lost 74% in the first half.

Interest rate rises hurt thematic ETFs

As David Liddell, a director of IpsoFacto Investor, points out, not every thematic ETF tanked – those with exposure to energy and commodities held up, for example. “Still, in simple terms, the most popular themes tended to have high exposure to the US and to technology and internet stocks; when interest rates started to rise, the long duration cash flows of these stocks became much less valuable,” Liddell explains.

He adds: “Investors also began to realise that the one-off lift to e-commerce given by Covid did not mean such growth rates could be maintained for ever.”

• Bank issues recession warning after biggest interest rate rise since 1989
• Here’s how UK interest rates compare with others around the world
• Investors stunned as Federal Reserve issues threat in war on inflation

Liddell also points out that the war in Ukraine clearly heightened a risk-averse attitude among investors. In addition, any theme that took in exposure to China has also been hammered as increased regulatory intervention and fears over Taiwan took their toll.

Investors took fright. Prior to this year, at least €1 billion (£871 million) had flowed into European thematic ETFs during each quarter since 2019, in niches such as cloud computing and cybersecurity, green energy, healthcare, robotics and AI, video gaming, e-commerce, food and water, digital currency and blockchain, and the metaverse. Data from Morningstar shows that by contrast, thematic ETFs saw €200 million of outflows in the third quarter.

Are big investment themes a busted flush?

The sell-off does not necessarily mean key themes are now regarded as a busted flush. The world has not suddenly decided, for example, that blockchain is not after all a technology with exciting potential and multiple use cases. And it certainly isn’t rejecting themes such as climate change mitigation, demographic shifts and the rise of cloud computing.

Nevertheless, this year’s sell-offs have exposed some weaknesses of thematic ETFs. Many appear to be highly exposed to growth stocks – unfortunate during a period when value strategies are reasserting themselves – and the technology sector in particular. And while the long-term allure of the trend may be strong, the short-term hurdles in its way are often considerable; when markets shift into risk-averse mode, they tend to focus on problems rather than potential.

The other big issue is hype. By their nature, thematic ETFs invest in areas where people have suddenly got very excited, which drives overvaluation. Indeed, such funds are often launched specifically to back a theme that has just come to prominence.

One study published by academics earlier this year found that thematic ETFs, on average, tend to lose investors money – and that those losses tend to be especially magnified for investors who buy into funds shortly after launch.

Three factors drive disappointing returns above all, the study argued. Investment themes are invariably overvalued, thematic ETFs often feature high charges, and funds tend to be more concentrated, eschewing the risk mitigation properties of greater diversification.

Expect a bumpy ride

These are problems that worry many experts. Peter Sleep, a senior investment manager at Seven Investment Management, warns: “Thematic ETFs are usually based around popular narratives that are easy to understand, front of mind and have momentum; unfortunately, by the time these themes go through internal product committee, past the lawyers and regulators and get issued in the form an ETF, they are probably quite mature in stock market terms and have been well researched and thought about by active managers.

“It is therefore not unusual for thematic ETFs to come off the boil as they become too expensive and topple over. Since many themes are long-term themes for the future some of the companies involved might be loss making and more speculative and so these companies might be quite volatile.”

• TINA’s out, PATTY’s in. Latest fund manager jargon explained
• How to invest for difficult times

In other words, investors need to tread carefully, says Dzmitry Lipski, head of funds research at interactive investor. “More investors are embracing a broader range of themes, and the range of choices from fund managers is also growing fast, making it even more difficult to choose,” he cautions.

Lipski’s view is that thematic ETFs should be at the more speculative end of your portfolio and that it will pay to make several bets. “They work better as satellite holdings in a well-diversified portfolio,” he says. “And longer-term investors who are prepared to be patient and tolerate higher volatility would be better off having exposure to not just one but to a few themes in their portfolio.”

Not straightforward to assess performance

One potential issue to consider is the difficulty of holding managers to account. With other types of fund – based around geography, sector or market cap, say – finding a benchmark index is usually straightforward. This will give investors at least some idea of whether the manager is worth the fees it is charging.

Thematic funds, by contrast, can be much harder to find useful metrics for; still, at the very least, as Lipski points out: “If a thematic fund has been struggling to outperform even a conventional benchmark, investors should question whether it’s worth it.”

Equally, it is important to recognise the realities of thematic investment, argues Tom Bailey, head of ETF research and content at HANetf. In particular, if you believe in the long-term value of the theme, maybe short-term volatility will be a price you’re prepared to pay. “Thematic investing is about tapping into long-term structural trends, often technologically enabled, so it is no surprise that these ETFs have high growth and technology exposure,” Bailey argues.

He also points out that there are areas of the thematic ETF universe where this doesn’t apply. “Some thematic ETFs have held up better this year, despite their exposure to growth – notably those tapping into the clean energy theme,” Bailey says. “And not all thematic ETFs are heavily growth-stock orientated. At HANetf we also have thematic ETFs that can be included in what we call ‘medium-term cyclicality’.”

What the experts pick

We asked three experts to pick out the thematic ETFs they think are most interesting in the current market environment.

Interactive investor’s Lipski picked out iShares Global Clean Energy ETF (LSE:INRG), a member of interactive investor’s ACE 40 list of sustainable fund ideas. The ETF tracks the performance of the S&P Global Clean Energy Index of companies in global clean energy-related businesses from both developed and emerging markets, targeting up to 100 constituents.

Sleep picked out the L&G Global Health & Pharma Index Trust. For investors who want an ETF rather than a tracker fund, he named the iShares MSCI World Health Care Sector ETF.

Liddell notes that providing the US avoids a deep recession, then global financials still look promising as they should benefit from higher interest rates. Xtrackers MSCI World Financials ETF (LSE:XDWF) is one such ETF he likes.

For long-term investors, Liddell also likes the iShares Global Clean Energy ETF. “This is a broad theme that is not going away,” he points out.