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Investing basics: How to select a thematic ETF

Ben Johnson, CFA  |  04 Jun 2021Text size  Decrease  Increase  |  
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Thematic funds have been one of the big winners to emerge from the global pandemic, with many posting eye-catching returns over the period.

The global market for these funds, which attempt to harness secular growth themes ranging from artificial intelligence to cannabis, has expanded rapidly in size and breadth. Since we published the first instalment of this paper in early 2020, the supply of these niche and often gimmicky funds from asset managers has increased, as has the demand for clarity and guidance from investors.

Here are our best practices for choosing from this expansive universe.

A Trifecta Bet

Before getting into specifics with respect to best practices for thematic fund due diligence, selection, and implementation, a bit of framing is in order.

Investors in thematic funds are making a trifecta bet (a term from the racetrack). Specifically, they are implicitly betting that they are:

  1. Picking a winning theme.
  2. Selecting a fund that is well-placed to harness that theme.
  3. Making their wager when valuations show that the market hasn't already priced in the theme's potential. The odds of winning these bets are low, but the payouts can be meaningful.

The long-term performance figures for thematic funds are not flattering. They suggest that investors' odds of selecting a fund that will survive and outperform over the long run are slim.

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For those intrepid investors looking to choose a thematic fund from the menu, the following section summarizes our thoughts regarding best practices when analysing, selecting, and allocating to these funds.

Thematic ETFs listed on the ASX

Thematic ETFs Australia

Source: Morningstar. 'Thematic' as defined by the provider. Fund return data to 30 April 2021.

Analysing the Theme

The first port of call when evaluating a thematic fund is the theme itself. First and foremost, a robust theme should be logical. Is the narrative convincing? Is there a coherent and compelling growth story behind the strategy? Is there data to back it up?

A robust strategy should be loose enough to adapt as the specifics of the chosen theme inevitably evolve through time. As timely as they may seem now, some themes will age poorly. Investors must ask themselves: Will that work-from-home ETFs till be relevant in three years' time? On the other hand, it shouldn’t be so loose that it dilutes any potential gains or becomes too similar to often-cheaper, more-vanilla existing sector or broad equity strategies. How different is an innovative healthcare ETF from a vanilla GICS healthcare strategy? Over what time frame is the theme expected to play out? How will you know when to exit? Having pre-set exit criteria based on robust metrics such as valuation ratios will help protect against poor investment decisions. These should be monitored regularly.

It is also important to understand the key risk and return drivers embedded in the theme. For example, when investing in a cannabis fund, it would be important to look beyond the growth projections and to fully understand the regulatory risks associated with that theme.

Once isolated, it should be determined whether the risk and return drivers of the fund in question are either complementary or redundant when framed within an investor's portfolio.

Implementation

A strong narrative should not distract us from looking more closely at how well a fund tracks its theme.

While at face value the theme in question may be intuitive and appear to have durable investment merit, it might not be possible to capitalise on it via publicly traded stocks. This is because there are often few firms that represent pure plays on any given theme. Even when there are pure-play companies, there is no guarantee that they stand positioned to profit directly from a given theme. And even if they are, their growth might already be priced into their shares.

Also, there tend to be several different approaches to harnessing any given theme. Funds tracking a similar theme can end up being very different from one another. This creates an additional due diligence and ongoing monitoring burden for investors.

Thematic Index Selection Criteria

Most passive thematic strategies use one or more of the below approaches to select stocks.

Revenue

The majority of thematic ETFs select stocks based on the revenues that companies derive from a defined set of activities. For example, an alternative energy fund may select constituents based on the percentage of revenues tied to solar, wind, or wave power.

This approach is logical, and the data are readily available.

A potential downside of a strictly revenue-based approach is that it is primarily backward-looking. This can leave investors gazing in the rear-view mirror, which may be particularly problematic in rapidly developing areas such as technology.

Committee

In some cases, a committee of experts meets regularly to decide which stocks align with the desired theme, usually supplementing quantitative inputs like revenue sources with a more qualitative assessment. The committee can offer a "soft touch" approach, which allows the strategy to adapt to meet changes in the investment landscape. On the other hand, it means the strategy is reliant on the judgment of the committee and is therefore opaque. The committee is often lent credibility by being overseen by specialist organizations (like a trade association) or well-known experts in their fields.

Other

Some modern index/data providers use cutting-edge technology to scrape data from more obscure sources such as academic papers and patent submissions. The advantage of this approach, particularly in the fast-moving world of technology, is that it is forward-looking (patents signal intention).There are also claims that this approach can help generate an informational edge. A downside is the black-box nature of these strategies.

Thematic Index Weighting Criteria

After selecting stocks, an index must choose how to weight them. Given the narrow nature of most thematic funds’ selection universes, a standard market-cap-weighting approach will often result in large weightings in a small handful of stocks. To correct for this, most indexes have single stock, sector, or geographic weighting caps and/or floors. Another popular solution to this single-stock concentration problem is to equally weight constituents. Both approaches balance the influence of larger companies and result in a small-cap bias.

Some funds implement more complex tiered or graded weighting approaches that prioritise firms that offer greater exposure to the underlying theme. For example, a specialised robotics company like U.S.-based iRobot IRBT would be given a higher weighting than a huge conglomerate like Siemens SIEGY, for which robotics forms a smaller part of overall operations.

Liquidity

In their search of companies with the highest exposure to emerging themes and those with the highest growth potential, thematic funds often invest in the smaller, less liquid stocks.

Micro-cap stocks can offer large upside potential, but a lack of liquidity means trading in and out at short notice can be costly.

The surge in popularity of thematic funds—and thematic ETFs, which tend to have narrow exposures and (when passively managed) are compelled to buy and sell in line with index rules—has raised questions surrounding stocks' liquidity. The stratospheric growth of the ARK Financial range of actively managed ETFs has seen the firm build huge stakes in smaller companies. In the case of 3D printing firm Stratasys, the ARK Innovation ETF alone holds 22 per cent of the stock's available free float.

When evaluating the liquidity of a thematic fund, investors should look directly at fund holdings (and the index methodology). Metrics like market capitalisation of the stocks and average daily traded volume can be used to estimate how difficult it would be to sell holdings at short notice. A fund with large exposure to small-and micro-cap stocks is worth further scrutiny.

Understanding Thematic Funds' Biases

As always, it is crucial that investors understand what they own, but this is particularly true when picking thematic funds, which come in a variety of flavours. Below, we examine these funds’ holdings and make some observations.

Size

At the time of writing, over 75% of thematic funds globally had a smaller size profile than the Morningstar Global Markets Index, a proxy for global equities. This is important because smaller stocks tend to have elevated risk profiles relative to their larger brethren.

Style

By their nature, thematic funds are trying to profit from areas of anticipated growth. It should therefore come as no surprise that more than 45% of these funds globally have a growth bias. This number rises to over 80% for technology-themed funds. Only 15% of all thematic funds had a value tilt at the time of writing.

Sectors and Geography

One hallmark of thematic investing is a disregard for traditional sectors or geographies. Depending on the themes tracked, investment footprints can be strikingly different from broad global benchmarks like the Morningstar Global Markets Index.

Fees

It is hard to overstate the importance of compounded fees on long-term fund performance. Indeed, fees have been shown to be the most reliable indicator of future fund performance. Thematic funds tend to be more expensive than their nonthematic counterparts. These higher fees should be scrutinized closely. Are they justified?

Assessing Performance

The odds of picking a thematic fund that outperforms a low-cost global equity index fund over long-time horizons are stacked firmly against the investor in all regions. Globally, just 58% of all thematic funds launched prior to 2011 were still trading by the end of first-quarter 2021. Of these, only 39% managed to beat the Morningstar Global Markets Index. That said, those that do win can win big.

Some extra risk is to be expected given the speculative nature and the narrow remit of many thematic strategies, but it also means they miss out on the risk-damping diversification benefits of broader equity holdings.

Fitting Thematic Funds Into Your Portfolio

Because of thei rnarrow exposure and higher risk profile, thematic funds are best used to complement rather than replace existing core holdings. Narrower exposures might be considered as single-stock substitutes for those investors looking to express a view on a particular theme but lacking the time, tools, and inclination to conduct due diligence on individual companies. The best themes are expected to play out over many years. This means that they are most suitably deployed over longer investment horizons.

Return Booster or Risk Reducer?

Most thematic funds will be used with the hope of boosting returns over the investment period, but some can be specifically used to reduce portfolio risk. For example, alternative energy funds can be substituted for core energy holdings to reduce carbon risk. They fit especially well with "ex-energy" exposures. Even if we set aside the claims of prospective outperformance from asset managers, if a thematic fund has drivers of risk and return that are distinct from other portfolio holdings, adding it around the margins of a core portfolio might yield diversification benefits. Ultimately, the risk and return drivers should be well-understood before any attempt is made to blend them into a broader portfolio. Equally, portfolio overlap and potential style drift should be monitored carefully through time.

is director of global exchange-traded fund research for Morningstar.

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