The Pros & Cons of Thematic ETFs

By Samuel Becker · May 31, 2023 · 4 minute read

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The Pros & Cons of Thematic ETFs

Thematic ETfs are a subset of funds that allow investors to make targeted bets on a specific trend. ETF providers have used them to cover a wide range of themes in recent years, allowing investors to use them to gain exposure to themes as wide-ranging as the gig economy, renewable energy, gender equality, and even pet care.

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, or exchange-traded funds, 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. Thematic ETFs, then, invest in securities that focus on a single theme, concept, or industry.

Over the years, interest in thematic ETFs has increased as more retail investors have entered the stock market and gravitated towards niche sectors that represent technological or societal shifts.

This flexibility is one of the benefits of ETFs, along with the ability to diversify at a low cost. Traditional ETFs tend to be inexpensive and track some of the broadest, well-known benchmarks in the world, like the S&P 500.

In contrast, thematic ETF tend to group stocks in a much more targeted way, grouping similar companies together, for example, to give investors exposure to a more narrow subset of the overall market.

Why Invest in Thematic ETFs?

Thematic ETFs allow an investor to gain exposure to emerging technologies, like cloud computing, electric vehicles, artificial intelligence, blockchain tech, or even robotics. It’s perhaps the wide range of options that makes thematic ETFs attractive to some investors.

But the basic vehicle of an ETF can also have some big advantages for investors. That is, ETFs have a built-in degree of diversification, which can help many investors get an out-of-the-box element of risk mitigation in their portfolios — though ETFs are far from a risk-free or safe investment. ETFs are also relatively easy to trade, and can be purchased or sold on the stock market similar to shares of a company.

With that in mind, there are still pros and cons to thematic ETFs for investors to consider.

Pros of Investing In 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 Investing In Thematic ETFs

However, there can be downsides of thematic ETFs too:

•   Thematic ETFs can be very narrow and small in assets. And many may be relatively new to the market, 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 experienced its 15 minutes of fame.

•   There’s evidence that thematic ETFs tend to underperform the broader market.

•   Costs for thematic ETFs may also be higher, so investors might pay higher fees.

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 current market movements, 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 for 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 its volatility.

The Takeaway

Thematic ETFs move away from the original tenets of index investing, which focused on providing very broad exposure to an asset class or sector. Instead, 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.

They do have risks, though. Trends can lose steam, for instance, and these funds also tend to be more expensive than traditional ETFs and have a history of underperforming the broader market. They can, however, make for an additional option for investors building a portfolio.

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