When first introduced over 40 years ago, passive mutual funds were designed to provide a low-cost way to mimic the returns of market indices like the S&P 500. Exchange Traded Funds (ETFs) improved on this concept by allowing investors to buy and sell their holdings throughout the day. Thematic ETFs are the latest iteration of a passive approach. The category is relatively small today, representing just 1.4% of the U.S. ETF industry’s $4.5 trillion in assets, but is growing quickly (see chart below).
In the increasingly complex world of investing, the appeal of these products is not hard to fathom. With clever ticker symbols like SKYY (cloud computing), BOTZ (robotics), CIBR (cybersecurity) and TAN (solar), Thematic ETFs allow investors to make a concentrated bet on any number of promising new technological or societal trends. Investing in a “basket” of companies too helps investors avoid the risk of having to identify ultimate winners and losers.
But as is always the case with investment products, it pays to “look under the hood” before buying. Here are some of the drawbacks to investing in these popular vehicles.
Survivorship: Market themes come and go. Internet ETFs dominated back in 2001 while cloud computing ETFs were all the rage last year. Morningstar reports that as of June 30, 2020, there were 141 Thematic funds trading in the U.S.. Of these, however, only 45% had accumulated more than $50 million in assets. Funds that fail to attract sufficient assets are often closed by their asset manager. In a study, Morningstar found that 45% did not last five years and less than 15% endured for 15 years or longer.
Performance: Thematic ETFs have, on average, outperformed the broad market over the past 1,3, and 5-year periods of time. This is not surprising considering that most of the funds issued over the past few years have targeted market leading growth stocks. But the chart above sheds some light on these results. First, Thematic ETFs have underperformed on an absolute basis over longer time periods. Second, the short-term outperformance was insufficient to compensate for the additional risk (i.e., volatility) they impart. The underperformance has much to do with the fact that by the time a trend has been identified and an ETF created, the prices of related stocks have already soared.
Unintended Exposure: The problem with many emerging trends is that they are, well, emerging. This means many of the related businesses are either small, unprofitable entities or divisions of larger companies. To put funds to work, asset managers can get creative in how they define “exposure.” Portfolio overlap can also cause a problem. Microsoft and Apple, leading components of both the S&P 500 and most technology funds, are top holdings in the Autonomous & Electric Vehicle ETF (DRIV) even though both companies make little money from these areas today.
Costs: On average the costs for Thematic ETFs are higher (1.05%) than the costs associated with broader ETFs (0.67%). Higher costs directly reduce investor returns.
Thematic ETFs can provide a diversified way of participating in a new emerging part of the economy. But to succeed in this small corner of the investment market you need to pick both the winning theme and the right product to participate in that theme. Investors need to also be careful not to overpay by chasing the latest “hot” theme. Finally, most Thematic ETFs display a high risk/return profile. This suggests that at best they should play a supporting role in any portfolio.