2022 saw the highest number of new exchange-traded funds launched in the past 10 years, Morningstar analysis has revealed, with a strong skew towards environmental, social and governance (ESG) themes, and disruptive technologies.

Thematic ETFs allow investors to get exposure to everything from video games to cloud computing and even food security.

But do these niche thematics have a place in an investment portfolio?

We spoke with two Morningstar analysts for insights into the growing thematic ETF trend.

The appeal of thematic ETFs

Thematic investors focus on a predicted or long-term trend or theme—such as the transition to green energy or the uptake of a new disruptive technology—and then select investments that are likely to benefit from that trend.

But it also means the merits of individual companies aren't often considered in the selection process.

EFTs can be an attractive option for thematic-seeking investors as they allow access to a pre-made basket of investments, rather than individually selecting investments by hand. 

Last year, with wider market woes pushing many ETF investors to the sidelines, or towards traditionally defensive bond-based funds, Morningstar senior research analyst Kongkon Gogoi says flows to ESG and thematic ETFs were beginning to stand out.

“You can see some money flowing into thematics and shifting from broad-based ESG exposure to specific ESG exposure,” he says.

“This trend is still in the nascent stage, I think, but you can see the prominence of these ideas in what was launched in 2022,” he said.

New launches show ETF ‘shift’

Analysis by Morningstar shows 41 new ETFs were launched in 2022, and many of the new strategies zeroed in on growing demand for specific thematic trends or exposures.

Gogoi says flows were notable in commodity and currency ETFs, a trend propelled by new offerings hitting the market.

“Generally, managers are trying to capture a particular trend, which is leading to the launch of these super specialized ETFs which can give exposure to a specific theme or a specific asset class—like a currency or a commodity—which both did really well last year.”

Source: Morningstar Direct

A Morningstar analysis that grouped Australian ETFs revealed those under the “Commodities & Precious Metals” category posted an 8.3% one-year return across 2022 and funds further exposed to both commodities and currency under the “Miscellaneous” grouping tallied an 11.5% one-year return.

Thematic ETFs entice ESG investors

ESG themes were also notably present among the new offerings, with 14 of the 41 new ETFs launched in 2022 geared towards one or more environmental, social or governance themes.

“What was interesting was seeing these thematics becoming more prominent in 2022,” Gogoi said.

“ESG was a big buzzword a few years ago […] but now these new ETFs are letting investors pick and choose what aspects of ESG they want to invest in and a lot of them are drawing good amounts of flows,” he added.

Morningstar currently lists 26 Australian ETFs under a particular thematic with the majority (18) falling under falling under the “technology” banner.

Tech ETFs available in Australia include BetaShares Cloud Computing ETF, Global X Battery Tech & Lithium ETF, and BetaShares Global Robotics & Artificial Intelligence ETF.

Also common are ETFs with a focus on the 'energy transition', which account for four of the listed thematic ETFs: BetaShares Energy Transition Metals ETF, Global X Hydrogen ETF, BetaShares Climate Change Innovation ETF, and the VanEck Global Clean Energy ETF.

Many of these newer niche-exposure offerings add to the existing 40+ Australian ETFs classed as ‘sustainable’ by Morningstar.

Morningstar ESG analyst Erica Hall sees demand continuing to grow in the thematic ESG ETF space.

“The reason that we're seeing more ESG ETFs is because we're seeing more ESG or sustainable investing options coming to market due to client demand,” she says.

The shift towards thematic ESGs has also brought with it a shift in fund management styles too, according to Hall.

“Typically, in the past ETFs were synonymous with passive investing, but now they're also actively managed products as well,” she says.

And the data supports this, of the 44 sustainable ETFs available in Australia, 19 of them are actively managed. That equates to around 43%, compared to around 30% of funds being actively managed industry wide.

“I think the rise of the individual is a real thing and having investments that match an individual’s values and desires is a growing area,” Hall says.

According to Hall, the appeal of ETF products over other established ESG investments comes down to a few factors.  

“What's really appealing about ETFs are the typically lower costs, and they're easy to trade so you don't have to fill out all the paperwork and forms that you have to undertake to invest into a fund structure,” she says.

In the wake of growing ‘greenwashing’ concerns among in traditional ESG mutual funds, the more transparent nature of ETF structures may also be appealing to environmentally driven investors.

Disclosure laws in Australia do not require mutual funds to publicly disclose their full holdings. While many fund managers choose to entirely or partially disclose to the public, the regulations can leave investors in the dark as their true exposure.

As a result ability to verify the underlying assets in an thematic ETF package sets them apart from the more opaque mutual funds offering similar themes, but according to Hall that transparency usually comes with a trade-off in investing style.

“While they [ETFs] are more transparent they are, not always, but generally more rules-based in their approach but the trend in the ESG space is more towards the active investment approach,” she says.

Pitfalls and upsides

As with all highly specific investment choices, Morningstar warns the lack of diversification thematic ETFs present creates investing risks.

“It's certainly not as diversified as a core holding or something with a broad-market exposure. They tend to be a lot more concentrated but you are getting professional management,” Hall says.

However, while thematic ETFs present an exposure risk compared to a traditional index fund, Gogoi points out that they may also present a more diverse option compared to some.

“The risk is relative to which point of view you're looking at. If you're an investor interested in Tesla’s disruptive technology, when you hold a Tesla stock you're taking an idiosyncratic risk on one specific stock.”

“But if you are very positive about the specific theme of disruptive technology, you may like to hold a thematic ETF with 40 other stocks. Then you are diversifying your risk,” he says. 

Gogoi also notes the proliferation of ESG ETFs has brought with it the risks associated with “fad” investment trends, and both he and Hall agreed that for any investor considering a thematic strategy, patience is the key.

“Investors need to look to be patient and realize that these are very long-term, concentrated and niche trends that you're getting exposure to that may not behave with the wider market,” she says.  

Gogoi adds that investors should be wary that the theme they are investing in has the underlying long-term credentials beyond a short-term investing trend.

“Our view is that careful due diligence before investing remains as critical as ever. Many strategies focus on specific themes that often only capture the fleeting interest of investors- and markets.”

“At Morningstar, we see that 'investment merit' is of crucial importance,” Gogoi adds.