2021 will be the year of the thematic ETF. That's if you believe Kanish Chugh of ETF Securities. Granted, as head of distribution for a specialist exchange-traded fund provider, he would say that. But his declaration merits investigation.

Flows into a handful of thematic ETFs this year, broadly defined as investment strategies that try to profit from trends in the economy, have been dramatic. Consider Chugh’s examples. Flows into the ETFS Battery Tech and Lithium ETF (ASX: ACDC) totaled $47 million in 2020. This year alone, the fund has pulled in $68 million (to Feb 2021). Similarly, the ETFS ROBO Global Robotics and Automation ETF (ASX: ROBO) has already surpassed its total flows in 2020. BetaShares Asia Technology Tigers ETF (ASX: ASIA) has attracted a staggering $127 million in the first two months of this year, while VanEck Vectors Video Gaming & eSprts ETF (ASX: ESPO) has an another $27 million under management.

Chugh says retail investors were a large driver of flows into three of their thematic funds in 2020—ACDC, ETFS FANGS+ ETF (ASX: FANG) and ETFS S&P Biotech ETF (ASX: CURE)—and will continue to be so this year.

"I think retail investors are really going to drive the ETF market to the next level," he says.

Global Thematic AUM Growth by Region (USD Billion)

Source: Morningstar Research. Data as of 31 December 2019

Answering the question of whether 2021 will be the year of the thematic ETF arguably shows the changing nature of the ETF industry, but does it help investors? If retail (you and me) investors continue to stream in, and certain thematics keep their position at the top of performance tables, we'll certainly see a proliferation of products, tracking every imaginable sector (see the US ETF market). For providers, thematic ETFs present an opportunity to differentiate themselves. There are fewer competitors than there are for broad market funds, and the products can support higher fees. But the question investors should be asking themselves is “should 2021 be the year or thematic ETFs?” Or, put bluntly: should I be adding thematics to my portfolio this year?

Thematic ETFs are hard to classify. Distinguishing a “theme” from a “sector” is blurry. But if we look across the most obvious and popular examples (in terms of flows), Morningstar analysts hardly cover any of them. Director of manager research Aman Ramrakha says analysts tend to focus on core building blocks of portfolios, and as such, have refrained from initiating coverage.

"We have always thought of coverage in overall portfolio construction terms (ETFs being no exception)," he says.

"As such country, sector or thematic tend not to feature much in our coverage.

"The basic premise is that investors should be building diversified portfolios and allocating to such products can prove problematic by overly titling the portfolio.

"Accordingly, we would advise that allocations should be limited to avoid the potential for undue volatility."

ASX-listed thematic ETFs | Flows

ETF Securities' ACDC ETF has attracted more flows in the first two months of 2021 than it did over the whole of 2020. It was the top performing ETF in 2020 returning over 60 per cent to investors.

Source: Morningstar

Tell a good story

Thematic ETFs appeal to investors because they are relatively easy to understand, particularly when you consider the amount of jargon in financial products, say Morningstar research analysts Kenneth Lamont and Hortense Bioy.

"Investing themes tend to tap into powerful narratives that are often well-known to investors, such as aging populations or the shift to a digital economy, making them easy to relate to," they say.

Morningstar senior behavioural scientist Sarah Newcomb endorses this theory, saying stories—be it the rise of electric vehicles or the burgeoning legalisation of cannabis—exert a strong pull on investor emotions.

"Stories are really powerful to us because they're easy to remember. They're small and easy for our minds to understand. A story is a self-contained thing that has meaning in our lives. Our brains love self-contained things that have meaning."

Global Thematic AUM by Theme (USD Billion)

Source: Morningstar Research. Data as of 31 December 2019

Chugh says thematic ETFs appeal to local investors because of the diversification benefits across a chosen theme.

"If they want to buy Tesla, they can buy Tesla, whether that be through a CommSec or a nabtrade etc," he says.

"If they want biotech exposure, they can buy CSL. But what they may find is with Tesla is they're up 20 per cent one week, down 20 per cent the next.

"With CSL, last year the stock was down 15 per cent but our S&P Biotech ETF was up 40 per cent to 60 per year over a 12-month period. Investors want diversified industry exposure."

Bull-market phenomenon

Morningstar's analyst Daniel Sotiroff, who covers the US ETF industry, warns that for long-term investors, latching on to trendy investments can be dangerous. Thematic funds, which he says are often launched in the final years of a bull market, are likely to hold stocks with strong recent performance, which sets them up for poor future performance.

"These funds are typically launched late in bull markets, when asset prices are high and investors are more likely to feel adventurous," he says.

"Tapping into popular trends means these strategies likely hold stocks with strong recent performance - those that are more likely to be trading at prices above their intrinsic values.

"Thematic strategies are not immune to the relationship between price and expected performance, with sky-high prices translating into low expected returns.

"Even if a thematic fund isn't holding the hottest stocks, it is still exposed to market risk. So, these funds can head south when the market turns."

Morningstar analysts Ben Johnson and Kenneth Lamont say investors in thematics must make a trifecta bet (to borrow a horseracing analogy). They're implicitly betting 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.

"Getting the theme right is one piece," Johnson and Lamont say.

"Getting the fund to actually match the theme is another all-important piece. What we see oftentimes is that many of the businesses that are represented in these thematic funds' portfolios have only a sliver of their revenues that are generated from anything that has anything vaguely to do with the theme in question.

"And the third and maybe the most important thing to get right is valuations. How much of this anticipated growth is already priced into these stocks within the portfolio? If you're paying the wrong price if valuations are stretched, even if you get those first two things right, it's probably not going to matter over the long term."

Passing fad or enduring theme?

Sotiroff adds the trends these funds chase seldom remain popular for long. One reason for this, he says, lies with the durability of certain themes, leading to fund closures. In the US, historical survivorship rates show that roughly 94 per cent of thematic funds made it through their first year, but less than 15 per cent managed to endure for 15 years or longer.

Internet funds dominated the landscape between 1996 and 2000, while water conservation and alternative/clean energy investments were popular between 2005 and 2008. Today, it's difficult to identify a consistent theme. Asset managers have targeted a range of themes including online retail, cannabis, and artificial intelligence.

"The popularity of a theme changes over time," Sotiroff says. "Those that resonate in one period may not last to the next, making it difficult for a thematic fund to continue attracting money after interest has waned."

"Short life spans are problematic as they prevent thematic funds from capturing the benefits of long-term compounding."

In Australia, terminations are infrequent but they have occurred. Consider, for instance, the number of mining funds terminated since the end of the mining boom, or the technology funds after the tech wreck. Last year the ASX lost 16 funds, two of which focused on niche (not necessarily thematic) areas of the market - BetaShares Agriculture ETF CcyHgd(Synth) (FOOD) and BetaShares Com Basket ETF Ccy Hgd(Synth) (QCB). At the time of its delisting, FOOD held total assets of just $3.2 million and was one of BetaShares' smallest funds.

Limit your exposure

Sotiroff says thematic ETFs are worth consideration, but are a high-risk/high-reward bet on niche segments of the market. He says they’re best used to complement rather than replace existing core holdings.

"Given their concentrated portfolios, high fees, and low survivorship rates, thematic funds should be used as satellite holdings," he says.

"The odds of picking a long-term survivor, let alone an outperformer, are small."

For those unable to resist, Johnson and Lamont say some thematics, when used at the margins of a portfolio, can be used to reduce portfolio risk. "For example, alternative energy funds can be substituted for core energy holdings to reduce carbon risk," they say.

When analysing the theme, Johnson and Lamont say it should be logical, with a convincing narrative and a compelling growth story. The strategy should be "loose enough to adapt, as the specifics of the chosen theme inevitably evolve through time", but not so loose that it dilutes any potential gains and becomes like a broad equity strategy. Investors should also understand the key risks and return drivers for the theme.

MORE ON THIS TOPIC: Thematic ETFs: why knowing how to spot one is half the battle

Beyond the story, Johnson and Lamont urge investors to consider implementation. "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," they say. "This is because there are often few firms that represent pure plays on any given theme."

Inquiring as to how the stocks are selected for the index, whether by company revenue or investment committee, and how the index is weighted, will also go to understanding which types of companies you're likely to invest in and to what degree.

Like all investments, investors should also consider basic traits such as fees, size, style and diversification. For performance considerations, investors can compare technology funds, for example, against a global equity manager who's overweight the tech sector.

It’s also crucial to avoid doubling up on a sector. Those considering thematic ETFs may already be getting exposure to a particular theme through a broad-market, diversified ETF—e.g. an investment in the NASDAQ which is already weighted heavily towards the tech sector.

"The themes are always compelling," Johnson says. "They always have an element of appeal, of curb appeal.

"But don't let all of the cocktail banter about whatever the theme du jour might be leave you blind to the real risks involved in investing in these funds.

"And the fact that you're making a trifecta bet, which has small odds of paying out, but investors oftentimes look past the odds and at those prospective payouts, which can be large. They're just exceedingly rare."

ASX-listed thematic ETFs | Performance 

Source: Morningstar