The popularity of thematic ETFs has exploded in recent years, with investors lured in by the prospect of getting in on the next big thing - such as artificial intelligence or the electric vehicle revolution.

But they haven’t always delivered, leaving investors to question where, if at all, a thematic fund belongs in a well-rounded portfolio.

A thematic ETF offers investors exposure to a trend by holding a basket of investments exposed to that given theme.

These trends can be broad, such as the move towards energy transition, or hyper-niche areas like e-sports or the Metaverse.

In Australia, Morningstar lists 27 ETF funds as thematic in nature. That’s just a fraction of the growing global thematic ETF market, with more than 300 registered in the US alone.

Australian Thematic ETFs:

While ‘thematics’ have rapidly captured the attention of retail investors, many analysts and financial advisors have been more hesitant, given the inherent risk such niche plays can present.

Morningstar analyst Kongkon Gogoi says ETF providers are continuing to drive product innovation toward these niche and narrow market segments which are often new, under-researched, or focused on just one specific theme.

“As such, investors may often get exposure via an obscure rules-based index from a little-known index provider […] Investors should be wary of the risk/return imbalance that such products exhibit,” he adds.

That risk/return imbalance remains significant.

Recent Morningstar analysis found that between 2006 and 2021, more than 80% of thematic funds launched worldwide ultimately closed their doors, and of the surviving funds, few were able to provide the kind of performance more traditional equity vehicles returned.

Despite this, the recent success of thematic exposures to transition metals like lithium and copper have continued to pull investors toward these kinds of funds.

That isn't to say investors shouldn't ever invest in a theme. We spoke with ETF providers and Morningstar analysts to discuss how best to approach incorporating a thematic into your portfolio.

Thematics more suited to ‘core and satellite’ portfolios

For investors considering a thematic exposure, one approach is to incorporate the fund into a wider 'core and satellite' style portfolio.

This style of portfolio begins with a core set of holdings, which are intended to deliver low-cost, diversified, and steady returns.

Examples of holdings in a core fund or funds could consist of broad-exposure equity holdings or passive investment vehicles that track broad-based and well-established indexes like the S&P/ASX 200 or S&P 500.

Typical core fund holdings may also contain a mix of low-volatility or foreign equities as well as bonds, non-thematic ETFs or other low-volatility funds, all intended to contribute to a well-rounded set of holdings aimed at performing steadily (rather than dramatically) over a longer time frame.

This core set of holdings will make up most of the core-satellite portfolio, in some cases between 80-90%. The exact proportion will depend on an individual investors risk tolerance and financial goals, but by its design, the core holding is intended to remain the majority stake in the portfolio.

Once a core portfolio has been developed, investors could consider bringing in satellite positions—this is where thematic ETFs could present an option.

Satellite positions are more niche or targeted exposures, which an investor hopes will append to the core holdings and, in theory, help bolster the underlying returns. Typically, in the past, satellite holdings were comprised of riskier assets, such as a basket of smaller-cap stocks or a more volatile, actively managed fund.

Senior investment strategist for ETF provider Betashares, Cameron Gleeson, says thematic ETFs are also well-suited to satellite holdings.

"When you think about a core portfolio, it's generally market-cap weighted and tends to be rooted in the current world or the old economy,” he says.

“Adding for example, an exposure to thematic growth gives you an opportunity to access something which isn't necessarily in that portfolio."

Blair Hannon, head of investment strategy at Global X, another thematic ETF provider, says this approach to thematic funds has become more common among financial advisors and institutional clients.

"Inherently, because of the targeted nature of a thematic, it's going to be a satellite holding.”

"We're seeing that from financial advisors too in terms of managed accounts. What was typically done in the past was to build a low-cost core and perhaps have an active manager on the side as a satellite.”

“Now, that’s where we’re seeing a lot of [thematic ETFs] fit in, at that 3-5% mark, and that may be one of three or four satellites that sit around the edges.”

By understanding their core and satellite exposures as separate elements of an overall portfolio, investors taking this approach are encouraged to avoid relying on thematics for meaningful, long-term returns. Instead, investors look to establish a less volatile core holding and build out from there.

"If you're at that stage where you're thinking I've accumulated a fair degree of capital, you can start to use sector bets or thematics, but keep them in the satellite though and be conscious how they contribute to overall risk," Gleeson says.

Whether an investor is considering a thematic satellite or core holding, however, Gogoi says careful due diligence before investing remains as critical as ever.

“At Morningstar, we see that 'investment merit' is of crucial importance. Our view is that investors should avoid fads and focus on long-term, well-diversified options at the lowest possible price. This, for us, remains a core principle of ETF investing,” he says.