Young & Invested: How to evaluate a thematic ETF for your portfolio
Not everything is as it appears.
Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.
This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.
Edition 35
I spend a lot of time on the internet.
Between doomscrolling Reddit and TikTok, my job also requires that I always keep a finger on the pulse of investor sentiment and financial markets.
Lately, I’ve seen a surge of content framed around questions like “How do I invest in AI?” or “Should I buy defence stocks?”, clear signs that thematic ETFs are back in the spotlight.
In previous edition of this column, I’ve made it clear that I don’t personally invest in thematic ETFs. But I can also recognise that my disdain won’t stop others from diving in – nor should it, necessarily.
Not every investor shares my pessimism, and some may still choose to allocate a portion of their portfolio to thematic strategies to reach their goals. So, for those hellbent on chasing a theme, I’ve pulled together a few tips on what to look for when picking one.
AI fatigue finally hitting.
What are thematic ETFs?
Before I get ahead of myself and confuse people by my seemingly unprompted assault on thematic ETFs, let me explain what they are. These ETFs target a specific theme (AI, clean energy, defence etc) and invest in companies that might be well placed to benefit in the future.
Doing so through a fund allows investors to gain access to a theme they have conviction in, without the risk of having to pick individual stocks. Such funds can be either indexed strategies or actively managed bets on a basket of companies.
These ETFs aren’t new by any means. By 2010, there were already over 50 listed globally. Today that number has surged well past 1000 and like most things (Taylor Swift songs, TikTok financial advice…), there’s arguably just too many to digest.
But given these funds come with higher costs, increased volatility, and unique complexities there are some things to get clear on when making your selection.
Know what you are betting on
Investing in thematic funds isn’t just about backing a trend. It’s a gamble on a series of assumptions, coupled with a bit of luck.
Firstly, you’re wagering on your ability to successfully identify a long-term theme, ideally before the broader market catches on. This foresight requires an informational or analytical edge – something I’d argue most everyday retail investors struggle with. You’re also betting that the theme will endure beyond a simple fad.
The ETF market is vast, and we’re faced with an array of options, from niche focused plays to cross-themed hybrids. This makes it even more important to ensure that you’ve chosen a compelling theme, but also one that is coherent and can be clearly defined.
The second consideration is whether you’ve picked the right fund. Sounds painfully obvious, but it’s actually harder than it seems. Research has shown most thematic funds have been closed or merged out of existence with around 10% surviving and outperforming in the 15-year period to June 2024.
What are the realistic odds you can choose a winner? This might be a bet few are willing to take, but I hope that this article helps you along this process.
Looking under the hood
Thematic ETFs often come wrapped in slick marketing and compelling stories. But beneath the surface, it’s critical to examine methodology, looking at how the fund is built, what companies are included and the parameters surrounding them.
Select funds may bet heavily on small, speculative names with minimal revenue, while others apply more disciplined filters. Take Global Robotics & Automation ETF ROBO for example. It uses a rules-based index that requires companies to meet minimum revenue thresholds from robotics and AI, alongside liquidity and market cap parameters. A far more rigorous approach than funds built around vague criteria like “innovation.”
Thus, I introduce the infamous ARK Innovation ETF ARKK, which defines its theme as “disruptive innovation”, loosely described as any tech that could change how the world works. However, buried in its Summary Prospectus I found a key disclosure:
“The Fund may invest in a company that does not currently derive any revenue from disruptive innovations or technologies, and there is no assurance that a company will derive any revenue from disruptive innovations or technologies in the future.”
In other words, the fund can hold companies with no current exposure to the theme, which makes little sense for an investor.
Weak or vague methodology is a red flag for all funds in general, but it’s especially common in thematic ETFs where objectives can be loosely defined. If the theme isn’t clearly reflected in the holdings or index rules, it’s worth asking whether the fund is selling a strategy or simply a story.
The trouble with timing
“Time in the market beats timing the market”. That is the conventional wisdom. But in the unique case of thematic ETFs, when you buy can make a meaningful difference to outcomes.
Thematic funds are championed for their meteoric rises, posting eye-watering gains over short time frames. But history has shown these bursts of performance tend to be fleeting.
Global thematic fund survival and success rate vs global equities. Morningstar. 2024.
Because these strategies tend to chase compelling growth stories, much of the upside is already priced in by the time investors take notice. The market often anticipates a theme’s potential, inflating valuations and eroding the very growth tilt these funds aim to capture. In many cases, thematic ETFs are launched after the initial gains have occurred.
I’ll use ARK Innovation ETF ARKK again as a case in point. The fund saw a flood of investors pour in after aggressive bets on ‘disruptive innovation’ returned over 150% in 2020. But most only took notice once valuations had already ballooned and the fund has since earnt a reputation as one of America’s largest wealth destroyers.
Competition for Attention in the ETF Space (2021), a study by Ben-David, Franzoni, Kim, and Moussawi discusses this phenomenon. The authors found that thematic ETFs are commonly launched when media coverage and investor interest in a theme are peaking. But as the saying goes, if it’s in the headlines, it’s already in the price. Investors tend to extrapolate past performance and thus might be left disappointed with future returns.
In a previous article, I spoke with Morningstar CIO Matt Wacher to discuss how professionals approach ETF selection. Matt reiterated the importance of a valuation-driven mindset within our Investment Management team.
Intuitively, when the market or security is trading above fair value the potential for returns is lower and the risk of losses is higher. This logic is flipped when something is trading below fair value. The framework is particularly important when assessing thematic funds, as they are frequently launched after a run-up in the price of their underlying holdings.
Investors must evaluate if recency bias is distorting their performance expectations and whether sentiment is inflating asset valuations. Just referring to short-term performance can lead to misguided assumptions about future returns.
Concluding thoughts
I like to think part of my job is to save investors from being the collateral damage of their own behaviour.
Throughout this article I’ve made a concerted effort to keep my thoughts reasonably balanced, so I’ll end with a personal reflection. I am not a thematic investor. Beyond the points above, thematic funds typically carry much higher management fees than low-cost broad market options. But what truly fuels my skepticism is a deeper irony that I can’t really reconcile with.
Most investors use thematic ETFs as part of their ‘satellite’ allocation, whilst the ‘core’ of their portfolio is parked in low cost, broad market ETFs. The fundamental existence of a core portfolio allocation relies on the belief that active management struggles to outperform passive funds in the long term. Yet, thematic ETFs encourage us to step outside of this notion (ignoring what the data has to say), all to pay higher fees and make active bets on specific themes.
It’s not necessarily wrong, but it’s worth acknowledging the cognitive dissonance involved in this process. Most retail investors have done the research and are well aware that they can’t consistently beat the market. But for some reason, an obscure voice in our head convinces us that we’re different, that we’re better, that we can be more successful than peers and deliver higher returns. Consistency can be boring, and thus the satellite part of our portfolio justifies throwing smaller amounts of money on speculative picks and wishing upon a star that they work out.
I think we’ve gamified investing to the point where logging into your brokerage account can feel like a rusty weekend at The Star Casino. I’m guilty of this too. Anytime I see a company’s share price surge or tank, I find myself poking around, checking bid-ask spreads, skimming the latest analyst notes. And sure, some of it is work-related, but I’m also looking out of interest from a personal investment standpoint.
The key takeaway here is that ultimately, I don’t act on these impulses. I don’t change my strategy or chase the highs. Having been there, done that, it rarely ends well. Applying a rigorous due diligence process should be part of any investment decision, but thematic funds present their own unique complexities.
