Thematic exchange-traded funds (ETFs) are a subset of stock funds that allow investors to make targeted bets on a specific trend. ETF providers have covered a wide range of themes with such ETFs in recent years, with everything from the gig economy, renewable energy, gender equality to even pet care getting featured.
ETFs are baskets of securities that give broad access to different stocks, bonds, or other assets. They’re useful tools for building investment portfolios because they allow investors to buy into a number of assets with a single investment. ETFs have become popular with both retail and institutional investors, accounting for almost $8 trillion in assets globally in 2021.
Interest in thematic ETFs has soared as more retail investors have entered the stock market and gravitated towards niche sectors that represent technological or societal shifts.
But some market observers warn that thematic ETFs tend to be too narrow in their focus and have a history of underperforming the broader market. Here’s a deeper dive into thematic ETFs and the pros and cons of including them in an investor’s portfolio.
What’s a Thematic ETF?
ETFs bundle many assets into one product, so when an investor purchases a share of an ETF, it gives them exposure to all the holdings in that fund. They’re similar to mutual funds, but ETFs are listed on an exchange so they can be bought or sold at any time of day.
This flexibility is one of the benefits of ETFs, along with the ability to diversify at a low cost. Traditional ETFs tend to be very cheap and track some of the broadest, well-known benchmarks in the world, like the S&P 500 or the MSCI Emerging Markets Index.
In contrast, thematic ETF tend to group stocks in a much more targeted way. Thematic ETFs have skyrocketed in popularity. Assets in thematic ETFs have more than quadrupled in the past five years, according to data from Bloomberg . Money in such ETFs totalled $17.9 billion in 2016. That figure steadily grew and reached in 2020 $81.9 billion, the data show.
Why Invest in Thematic ETFs?
The recent surge in interest in thematic ETFs has been attributed to retail investors, who are trading from home and have more time on their hands due to the Covid-19 pandemic. In fact, several thematic ETFs tied to the stay-at-home trend launched in 2020, including ones that focused on gaming and e-commerce.
Compelling narratives have been key to the recent popularity of thematic ETFs, as investors–particularly younger ones who have joined the surge in retail investing–seek out funds that reflect the societal trends around them.
For instance, thematic ETFs could allow an investor to gain exposure to emerging technologies, like cloud computing, electric vehicles, artificial intelligence, blockchain, or robotics. Catchy stock tickers and low fees have also helped.
Also, the demand for socially responsible investing and environmentally conscious decisions has fueled demand for thematic ETFs. As recently as 2019, some 95% of millennials were interested in sustainable investing, up 9 percentage points from 2017.
Environmental, Social and Governance (ESG) investing funds attracted $51.1 billion in new money in 2020–the fifth consecutive annual record, according to Morningstar data. For comparison, ESG funds drew $21 billion in 2019.
Pros of Thematic ETFs
There can be benefits to investing in thematic ETFs:
• Buying a thematic ETF can make it convenient to invest in a specific sector or trend an investor is interested in. For instance, instead of buying a number of companies in a niche space that appears to be growing, an investor can simply buy an ETF.
• Thematic ETFs can capture interesting societal or technological trends, giving investors quick access to a group of companies representing such changes.
Cons of Thematic ETFs
However, there can be downsides of thematic ETFs too:
• Thematic ETFs can be very narrow and small in assets. In July 2020, more than half of 129 funds had less than $100 million in assets. And most are new, meaning they don’t have much of a track record. This makes it more likely that they could close as well.
• Part of the reason many of these thematic ETFs end up performing poorly is because sometimes by the time the ETF hits the market, the theme has already played.
• An academic study has shown that thematic ETFs tend to underperform the broader market. They lagged on a risk-adjusted basis by about 4 percentage points a year for at least five years following their launch.
• However, business reports in 2018 suggested that investors who put money into thematic ETFs don’t get scared off by low returns as quickly as other investors. That’s because people who believe in a specific theme or are interested in that theme for ethical reasons appear more likely to keep investing in thematic ETFs even when they’re losing.
• On average, the costs for thematic ETFs are also slightly higher. The average expense ratio for the group is 1.05%, while the broader ETF industry charges 0.67%.
How to Choose a Thematic ETF
It can be very helpful to users to read the ETF prospectuses to make sure they understand the products they are putting money into. Investors can also do more research into the specific companies the ETF is invested in.
Timely themes, which might tap into a booming market, often start out strong but may drop off (and fast). Typically, the ETF that lands on the market first can have a big first-mover advantage—and end up being the go-to ETF in that theme.
Investors often consider the costs of the fund and what kinds of returns it’s had. Past performance is not necessarily a good predictor of future returns, but it may still provide a sense of the ETF’s volatility.
Thematic ETFs move away from the original tenets of index indexing, which focused on providing very broad exposure to an asset class or sector.
Thematic funds instead allow investors to wager on niche, trendy market sectors. They’ve been popular because they allow for very targeted wagers on technological or societal trends people see around them.
However, by the time the thematic ETF hits the market, the trend may have already played out. These funds also tend to be more expensive than traditional ETFs and have a history of underperforming the broader market.
How much risk an investor wants to take depends on factors including their financial goals and where they’re at in your career. As a person’s age and goals change, so often does their investment strategy.
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