Should you invest in thematic ETFs?
The rising popularity of ETFs offer a diverse range of investment options.
The popularity of Exchange Traded Funds (“ETFs”) continues to rise with over 50% of Australian investors holding an ETF in their portfolio. Last week I shared Morningstar’s best resources for ETF investing amidst a saturated market.
What are thematic ETFs?
Over the last decade, investors have showed an increased appetite for thematic funds. Such funds focus on long-term trends or themes representing a niche in the market and select holdings based on companies likely to benefit from this trend. Arguably, owning a thematic ETF is like individual-stock megatrend investing with most of the work completed for you.
I have previously written on Megatrend Investing and how investors can capitalise on emerging themes of the future through gaining exposure to companies who may service the megatrend. However, an ETF can be an effective way to invest in a trend without the single-stock risk.
The thematic landscape
Targeting exciting new opportunities from artificial intelligence and blockchain to cannabis legalisation and clean energy – there is a thematic ETF for everything. Aptly expressing the duality of thematic investing, some of the best and worst performing ETFs of 2024 were thematic in nature.
The best performing ETFs in 2024 were cryptocurrency based, bolstered by the rise of Bitcoin and Ethereum following the US election. On the contrary, clean energy themed ETFs largely failed to impress after a tough year of performance with the impact of higher borrowing costs weighing in on earnings and ultimate share price performance.
What I don’t like about thematic ETFs
Higher fees and failure rates
On average, both active and passive thematic funds charge higher average management fees than their non-thematic counterparts. To illustrate, the chart below shows the average fund fees in the United States across passive and active strategies.
The difference is striking when we look at asset-weighted fees, highlighting how popular thematic funds tend to charge fees many multiples (in the passive case, almost 6x) higher than non-thematic funds.
For the first time since 2008, we saw thematic fund closures outnumbering launces in the first half of 2024. In the three years to mid-2024, only 9% of thematic funds survived and outperformed global equities. As we know, fees tend to have a direct correlation with returns therefore over longer periods, high thematic fund fees contribute to this poor performance. The graphic below shows the extend of thematic fund survival and success rate relative to global equities. This emphasises the dismal odds facing investors selecting a thematic fund that won’t fail.
Most thematic funds don’t beat global equities over longer periods
The allure behind these type of investment vehicles is clear – pick the winner and collect eye watering returns well above the market.
However, the data shows that sticking to broader, benchmark-tracking investments improve your chance at long term success. Chart 2 above illustrates the returns for thematic funds, which are unflattering to say the least. Investors should avoid being tempted by short periods of eye-catching returns (such as the post pandemic bull market) and stretch their observation window out to include the trailing 15-year return which shows that only 1 in 10 fund overperforms in the long term.
In total, 70% of thematic funds that plot in the Morningstar Style Box exhibit a growth bias, while just 7% have a value tilt. Chart 2 indicates that this growth proposition is often not borne out.
It encourages poor investor behaviour
I love a compelling company story just as much as the next investor. However, I think that is where thematic ETFs end – as a compelling story.
I recently explored the Morningstar’s annual Mind the Gap 2024 study in my article are you an emotional investor. The findings showed that there was an average 1.1% lag on investor returns and fund returns for every dollar invested in US mutual funds and ETFs. This returns gap is widely attributed to mistimed purchases and sales likely driven by emotionally irrational decisions.
What is most notable is the sector equity fund returns gap. Whilst not perfectly aligned, this category of funds bears the closest resemblance to where thematic funds would reside. From the chart above we can conclude that sector equity funds had the largest returns gap of 2.6%. I think this largely supports the argument that thematic investing further exacerbates the issue of mistimed investments and poor investor behaviour.
A returns gap of this proportion can have devastating effects on investment goals. Put it into dollar terms, a 2.6% reduction on returns is a noteworthy difference after one year, over the long-term the difference is stark.
Consider a principal investment of $10,000 over one year at 8% inflation adjusted returns. This would give us a $10,800 return and a $10,540 return after adjusting for the 2.6% gap. This difference of $260 becomes much more impactful when we extrapolate this over 10 years, producing a returns gap of ~$4669. This could be the difference between achieving your goals or delaying your date of withdrawal.
Market narratives and crowding often encourages investors to play into the hype cycle amidst elevated volatility which can exacerbate poor investor behaviour and therefore investment decisions.
When do thematic funds work?
We believe that there are generally established characteristics of successful funds. These include low costs, well-regarded parent organisation and an experienced management team.
If applying the core satellite approach, thematic funds can allow investors to take a targeted ‘punt’ at a trend they believe may eventuate, however this approach has a string of considerations that can be further explored in our podcast episode: should I allocate part of my portfolio to having a punt.
Furthermore, such funds can be a sound opportunity for individuals to align their portfolios to their individual values – e.g. ESG funds. If conviction is high for a megatrend, a thematic fund offers desirable exposure to a target theme whilst diversifying away single-stock risk.
It is important to note that these funds typically require enough risk appetite to stomach staying in the market despite above-average volatility.
Key considerations
In short, when you invest in thematic funds, you’re taking the gamble on several assumptions being correct:
- Your ability to identify a long-term theme. Having the foresight to identify a theme before the wider market requires an informational or analytical edge. Chances are – if a thematic ETF exists, the market has already caught on. Furthermore, being correct that the theme will eventuate past a simple fad is another element of consideration.
- You’ve selected the right fund. Research has shown, many thematic ETFs have been closed or merged out of existence. With only 9% of funds surviving and outperforming in the three years to June 2024, what are the realistic chances you have picked the successful one? This may be a bet that few investors are willing to take.
- The investment is profitable. The market often prices in a theme’s potential, leading to higher valuations that erode the growth tilt. Often thematic ETFs are launched after the initial gains have already occurred. As we know, thematic ETF fees are substantially higher than their non-thematic counterparts. To make things worse, higher fees are seldom correlated with outperformance, in fact – the inverse occurs. Fees become a larger consideration when the ETF is held over a long-term horizon.
Conclusions
The attraction is clear – thematic ETFs capture upcoming investment trends that saturate our media with promising growth stories. Upon a closer look, they may not represent a convincing n investment proposition in the long term. These funds often come with higher costs, increased volatility, and unique complexities that require additional due diligence.
To put simply, thematic funds are volatile. The winners reward you handsomely, and the losers can decimate your portfolio. The need to evaluate your risk appetite is crucial when considering such funds. Undoubtedly the payouts can be large, but at what cost?
