This is a snippet from Morningstar's annual Global Thematic Funds Landscape report.

The global menu of thematic funds has grown in recent years alongside investor interest. These funds attempt to harness secular growth themes ranging from artificial intelligence to cannabis. While payouts from these funds can be meaningful, the odds of winning are low.
But how do you know if you're holding a thematic ETF? Is a technology ETF a thematic fund or a sector fund? And once you've identified a fund, how do you know if it fits in your portfolio? This steady supply of niche and often gimmicky funds from asset managers has increased demand for clarity and guidance.

What are thematic ETFs?

We define thematic funds as those that select holdings based on their exposure to one or more investment themes. These themes may pertain to macroeconomic or structural trends which transcend the traditional business cycle. Examples include demographic shifts or technological advances.

Our grouping for thematic funds is based on intentionality rather than on fund holdings. To identify intentionality, we have relied on a combination of fund name (a strong indicator of intentionality) as well as information gathered from funds' prospectuses, marketing materials, and index methodologies (in the case of index funds).

Sector or theme?

The line between sectors and themes can be blurry, especially as sectors’ definitions have drifted through time. As a rule of thumb, we have excluded funds that too closely resemble mainline sector funds from our definition of thematic funds.

Perhaps the most challenging distinction to make is between technology sector funds and those that track one or more technology-related themes. To be included in our grouping for thematic funds, broad technology funds must explicitly target one or more technology themes, such as disruptive or next-generation technologies.

Global Thematic AUM by Theme (USD Billion)

Thematic ETF themes

Source: Morningstar Research. Data as of 31 December 2019

Analysing thematic funds

Analysing the Theme

The first port of call when evaluating a thematic fund is the theme itself. A robust theme should be logical. Is the narrative convincing? Is there a coherent and compelling growth story behind that pet care 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. Will that trade war strategy still be relevant given a change in US foreign policy? On the other hand, it shouldn’t be so loose that it dilutes any potential gains or becomes too similar to often cheaper, plain-vanilla existing sector or broad equity strategies.

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.

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 look beyond the growth projections and to fully understand the regulatory risks associated with that theme.

Implementation

A strong narrative should not distract us from looking more closely to see exactly 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.

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 like 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 judgement of the committee and is therefore opaque. The committee is often given credibility by being overseen by specialist organizations (like a trade association) or well-known experts in their fields.

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.

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.

Size

At the time of writing, 88 per cent of thematic funds globally had a smaller size profile than the MSCI World Index, a proxy for global large and mid-caps. 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 two thirds of these funds have a growth bias. This number rises to over 75 per cent for technology-themed funds. Only 9 per cent of all thematic funds had a value tilt at the time of writing. Among that minority, 93 per cent of assets sit in funds grouped into the Physical World broad theme.

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 MSCI World Index.

Almost 90 per cent of thematic funds globally offer diversified exposure spanning traditional market sectors. The remaining 10 per cent of funds offer more concentrated sector exposure by selecting stocks largely within the confines of a single GICS sector.

We see a similar story with geographic exposures. Three out of every four thematic funds globally are geographically diversified (no country takes up more than 75 per cent of the portfolio). Those that do focus on one country tend to isolate large markets like the US, China, Japan, or South Korea.

Fees

It is hard to understate 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 non-thematic 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 45 per cent of all thematic funds launched prior to 2010 had survived to see 2020. Of these, only a quarter managed to beat the MSCI World Index.

Although, those that do win, can win big. For example, those who invested in the ARK Next Generation Internet ETF back at the beginning of 2015, would have raked in annualised returns of 27 per cent through the end of 2019—3 times the return of the MSCI World Index over the same period.

More than 90 per cent of all surviving thematic funds registered a higher standard deviation than the MSCI World Index over the five years to 31 December 2019. For some, like the ETFMG Alternative Harvest ETF, which gained 39.9 per cent in 2017 only to lose 28.5 per cent in 2019, the volatility has been upsetting.

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-dampening diversification benefits of broader equity holdings.

Fitting thematic funds into your portfolio

Because of their narrow exposure and higher risk profile, thematic funds are best used to complement rather than replace existing core holdings. More-narrow exposures might also be considered as single-stock substitutes for those investors looking to express a view on a particular theme, but who lack 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 them around the margins of a core portfolio might yield diversification benefits.