Should You Buy a Thematic ETF?

Thematic and niche ETF offerings are built on a good story, but will their plots continue developing to ensure an enduring and successful investment tale?

Emma Rapaport 7 August, 2019 | 11:15AM
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Thematic or flavour-of-the-moment ETFs have soared in popularity and their appeal is easy to understand. You can get an exchange-traded fund to tap into the robotics revolution, another for getting exposure to rapid urbanisation and even one designed to find businesses benefiting from millennials. 

Unlike traditional ETFs, which are low-cost and focus on a broad market, thematic ETFs seek to capitalise on emerging – and, their promoters hope, lucrative – trends. Think environmental change, demographic shifts, or technological advances. They are often unconstrained by traditional sector and size groupings.

Product providers now offer exposure to eye-catching and sometimes controversial strategies such as obesity, organics, and marijuana ETFs (aptly called YOLO, the 21st century spin on “you only live once”). But a good story doesn't always make a good investment. 

A Good Story

Thematic ETFs appeal to investors because they are relatively easy to understand, particularly when you consider the amount of jargon in financial products, says Morningstar research analyst Hortense Bioy.

"Investing themes tend to tap into powerful narratives that are often well-known to investors, such as aging populations or the shift to a digital economy, making them easy to relate to," she says.

Morningstar senior behavioural scientist Sarah Newcomb endorses this theory, saying stories – be it the rise of electric vehicles or the burgeoning legalisation of cannabis – exert strong pull on investor emotions. 

She explains: "Stories are really powerful to us because they're easy to remember. They're small and easy for our minds to understand. A story is a self-contained thing that has meaning in our lives. Our brains love self-contained things that have meaning."

She also says stories can exert influence by stirring our emotions and generating excitement around a product or trend: "Generally, in a story, we're able to make an emotional connection to what's happening. Emotions solidify memories and add salience to an experience. So, if something is emotionally charged, we're more likely to remember it and place higher importance on it."

Thematic ETFs may be relatively new on the scene, but Morningstar manager research analyst Daniel Sotiroff says their use of compelling stories about the changes investors see taking place around them is a strategy that has been used to lure investors for centuries.

Sotiroff cites the South Sea Company, a British joint-stock company founded in 1711, which used a well-spun narrative about its ability to exploit its exclusive right to hold silver and other exotic commodities in South America to entice new investment.

Investors piled in, but the company's ability to capitalise on these rights faced big hurdles, and its underlying businesses and ultimately proved unstainable.

"Narratives like those used by the directors relied on simplicity, plausibility, and dramatic emotional connection to exert a powerful pull on the public, causing them to make decisions based on emotion and reaction rather than logic and reflection," says Sotiroff. "Plausibility is part of what makes a well-crafted narrative compelling and credible, even if the circumstances aren't factually true."

Thematic ETFs, Sotiroff says, are modern-day investment strategies that rely on simple, catchy stories to attract investors.

Easy Access is Attractive

But it's not just inherent cognitive biases that have allowed this industry to flourish. Other forces such as cost and ease of access are also at work, says Morningstar director of passive funds research Ben Johnson.

"The ETF industry has levelled the playing field for retail investors by bringing down costs and expanding access to managed investment trusts," he says.

These same factors have simultaneously lowered barriers to entry for asset managers, allowing new players to enter the industry at far lower costs relative to launching an actively managed unlisted funds.

Johnson adds: "Given the relatively low hurdles facing prospective entrants and the large potential rewards, it's no surprise that there has been a gold rush in the ETF space."

Fad or Theme?

Once you get past the story, however, the crucial part is whether thematic ETFs share the basic traits that one associates with great investments. Bioy says thematic ETFs rightly have to fend off accusations of being "gimmicky" or of tapping into fashions that will soon swing out of favour as interests shift to the next big thing.

"We only need to glance at the rogue wave of launches and subsequent closures of interest-themed funds in the late 1990s and early 2000s to validate this concern," she says. "Ask yourself: will the thematic ETF that I buy today still exist in 10 years?"

And the ETF graveyard is already pretty full. Almost 80% of thematic ETFs that launched in Europe before 2012 have closed; investment experts worry about inevitable consolidation in a market that may have the depth to absorb all the offerings.

"Even if you have a great investment idea, if a product doesn't have broad appeal, it may not be around for your investment thesis to play out," Morningstar Australia associate director, manager research, Alex Prineas says.

"What we see is a fund focused on a niche part of the market is launched at the peak of the theme's cycle and investors rush in, tossing valuations aside. We potentially get weaker performance after that when investors lose interest – that's when we start to see investors exit and products close."

Place Your Bets

Sotiroff says investors in thematics are essentially making three bets:

  • That their chosen theme will grow as expected
  • That the companies held in the fund are positioned to profit from the growth of that theme; and
  • That profit growth will translate into attractive stock returns

Beyond the story and investment strategy, it also pays to consider basic traits such as cost and diversification. These types of funds charge considerably higher fees than their broad market counterparts and are less diversified.

The idiosyncratic nature of thematic ETFs means that evaluating their performance can be tricky, says Bioy. The funds often also have little or no performance history, and the theme, by its nature, is yet to play out, making it difficult to evaluate the robustness of the strategy.

"And even after the fact, they are quite difficult to assess in terms of performance, because often they have no direct peers with which to evaluate, or appropriate benchmarks," she adds.

Prineas recommends comparing technology funds, for example, against a global equity manager who's overweight the tech sector.

Avoiding Overlap

Thematics have grown in popularity because of their efficiency in giving investors access to a cause they’re keen on, particularly if the theme is concentrated in offshore markets.

For those unable to resist, Prineas suggests thematic funds – because of their concentration – are best used as “satellites”, rather than a core portfolio holding.

Thematic ETFs typically invest in a much smaller basket of companies than the MSCI Index – and often in smaller companies. And, while most thematic ETFs are global in scope their geographical footprints can be strikingly different from broad global benchmarks like MSCI World.

"Most investors will be best served by sticking to a long-term investment strategy that focuses on the core building blocks of a portfolio,” says Prineas. “If they're going to use satellite holdings to complement that, we recommend carefully considering whether a product suits their investment strategy and risk profile."

It’s also crucial to avoid doubling up on a sector. Those considering thematic ETFs may already be getting exposure to a particular theme through a broad-market, diversified ETF – for example, an investment in the Nasdaq that is already weighted heavily towards the tech sector.

Bioy says a robust strategy should be loose enough to adapt as the specifics of the chosen theme evolve. On the other hand, it shouldn't be so loose that it is too similar to a vanilla broad market strategy.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Rapaport  is editorial manager for Morningstar Australia.

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