Thematic ETFs: A paradigm shift
Often criticised for their risk-return imbalance, funds focused on an investment theme have taken off in the pandemic.
Thematic funds have long been viewed as esoteric, but those days are long gone. A new report from Morningstar analysts shows the "black swan" of the coronavirus pandemic led to a paradigm shift for funds that exploit emerging trends.
Six out of the 11 thematic ETFs available to Australian investors were launched over the last year in what analysts say is an "increased appetite for thematic investors". And while the market comprises a small part of the Australian ETF industry - just over $1.9 billion of the total ETF funds under management ($110 billion) - several thematic ETFs, as categorised by Morningstar, have grown significantly over the last year.
Analysts Kongkon Gogoi and Zunjar Sanzgiri attribute the growth to the Covid-19 pandemic, which they say, "evoked investors’ sentiment toward disruptive trends and sustainable investing across the world".
Australia's thematic ETF industry has grown from $8 million in January 2017 to $1.9 billion today
Net Assets - Share Class (Monthly)
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Source: Morningstar Direct. More information about Morningstar's thematic funds taxonomy can be found in our latest Global Thematic Funds Landscape.
But should investors feature them in their portfolio? Gogoi and Sanzgiri urge caution. They note that if chosen carefully, thematic ETFs have the "potential to complement an existing diverse portfolio with added alpha". However, they say the risks are notable.
First, they say setting performance expectations is hard.
"Many strategies with more-esoteric themes have short track records, and distinguishing whether the underlying theme is really a transformational trend or simply the latest fad takes time," they say.
"In the interim, factors like regulatory scrutiny, further technical advances, or a shift in investors’ collective psyche may result in an abrupt boom or bust of a particular theme. In either scenario, however, forming a forward-looking view on absolute or relative performance can be precarious."
As such, Gogoi and Sanzgiri say thematic ETFs are not suitable as the main building blocks of a diversified, goal-orientated portfolio.
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Second, analysts say investors are likely to experience a rough ride due to higher levels of volatility. Thematics, they say, do not provide diversified, risk-controlled exposure. They are typically concentrated in their respective sectors of interest and often rely on a relatively fewer number of stocks compared with the typical diversified offerings.
"The risk of capital loss is high as sector- or industry-specific idiosyncrasies have a huge bearing on the performance of such funds," they say.
"Not to mention, adopting a passive approach in such scenarios can add more risk given the little (or lack of any) qualitative oversight."
This table highlights these traits for Australian thematic ETFs.
Thematic ETFs are generally concentrated in a few sectors
(Click to enlarge) Source: Morningstar Direct
Third, analysts note that thematic ETFs are expensive. The fees across the current cohort of Australian thematic ETF range from 57 basis points to 95 basis points, which is substantially higher than their more-diversified peers, the report says.
Thematic ETFs charge substantially higher premiums for accessing emerging themes
(Click to enlarge) Source: Morningstar Direct
Trading thematic can also be costly with substantially high bid-ask spreads compared with broad-based ETFs.
Substantially higher bid-ask spreads of thematic ETFs compared with a broad based ETF
(Click to enlarge) Source: ASX. Investment Products Monthly Update
Finally, Gogoi and Sanzgiri say thematic strategies can also fall victim to capacity constraints.
"Theme-based investing frequently targets niche segments of the investment universe, which is often less liquid and less appealing from a valuation perspective," they say.
"Too much money chasing too few ideas can stretch valuations and is not a recipe for successful long-term investing."
Compared with the broad market valuation, thematic ETFs’ valuations have been historically stretched on the P/E metrics basis versus the Morningstar Global Markets Index
(Click to enlarge) Source: Morningstar Direct. Note: Only ETFs with more than one year of data are considered here
Worth the risk?
The higher risk exhibited by thematic ETFs raises the question: are investors adequately compensated for taking this risk?
Analysts note that over the trailing 15 years through May 2021, the risk-adjusted performance (Sharpe ratio) of the global thematic funds has been modest compared with pure passive ETFs. And while the Australian thematic ETF market is in its early stages, they note the sector exhibits similar global trends with either middling or, in some cases, worse risk-adjusted performance compared with passive ETFs like Vanguard Australian Shares (VAS).
"More than two-thirds of thematic funds globally survived and outperformed global equity markets (as proxied by the Morningstar Global Markets Index) in the year ended March 2021," Gogoi and Sanzgiri say.
"However, this success turns pale when longer periods are considered. For example, stretching the observation window to include the trailing five years, success rates drop to 43%.
"When viewed over the trailing 15 years, more than half of thematic funds globally have shuttered and just 22% have survived and outperformed the global equities benchmark.
"These figures paint a bleak picture for investors, and suggest that the odds of picking a thematic fund that survives and outperforms global equities over longer periods are stacked against them."
Approaching themes
For investors who do wish to add 'themes' to their portfolio, analysts advise they are best used as a 'supporting player' in a diversified portfolio, as a complement rather than to replace existing core holdings.
"This is because of their narrow exposure and higher risk profile," they say.
Analysts also advise investors to undertake additional in-depth research and due diligence as the fortunes of any theme are at the mercy of multiple factors—such as government policy, advances in technology, interest rates, and shifts in investors’ own biases.
"What is considered a theme can evolve through time and can become increasingly complex and nuanced," they say.
"For example, in an extremely specific theme, such as global food scarcity, the burnout rate can be high.
"Information technology is another such sector that is prone to perpetual changes. Once the flag bearer of the “revolutionary tech” theme, giants like Facebook (FB), Alphabet (GOOGL), Netflix (NFLX), Alibaba (BABA), and Tencent (00700) (among others) no longer fit that definition following the 2018 MSCI GICS reclassification.
"It is incumbent upon an investor to apprise themselves on the fundamental drivers of risk and return of the theme of their interest."
Where a theme's longevity has been established, analysts advise investors to identify an ETF that holds the companies most likely to benefit. They say thematic ETFs also require investors to place greater emphasis on valuation, requiring a higher level of fundamental research (similar to individual-stock research).
"Determining appropriate valuation is difficult in these scenarios, but nonetheless an indispensable part of the due diligence required to minimise the risk of capital loss," they say.