Thematic ETFs - are they worth the punt?

Ever since the launch of the first ETF in 1993, the ETF industry has grown dramatically, with the industry now valued in excess of US$10 trillion.

The first ETF was State Street’s ‘SPY’ which tracked the S&P 500, giving investors an easy and low-cost way of buying into the broader US market.

While early ETFs tracked broad-based indices, in more recent times ETFs have evolved to now track themes.

Today’s thematic ETFs, contain a basket of somewhere between 30 and 100 stocks that follow a particular theme, such as climate change, innovation, robotics or healthcare.

The fees associated with thematic ETFs are generally in the range of 0.5% to 0.75% which is higher than traditional ETFs.

In a study by academics, Ben-David, Franzoni, Kim and Moussawi, of Ohio State University, it was found that on average, new thematic ETFs underperformed the wider market in their first five years of listing. On average the new thematic ETFs declined by 30% in value.

The researchers attribute this underperformance to the overvaluation of the ETF’s underlying stocks at the time of launch, which is caused by the attention-grabbing nature of the theme. Putting it simply, the launch of the ETF occured when the thematic was popular creating a buy high sell low situation. 

Thematic ETFs

In the US there are over 300 thematic ETFs, and in Australia we have around 20. The Australian thematic ETFs contain stocks from all around the world.

Some examples of Australian thematic ETFs include HACK (Cybersecurity), ERTH (Climate Change Innovators), ACDC (Battery Technologies and Lithium), ESPO (Gaming and eSports), CRYP (Cryptocurrency), CLDD (Cloud Computing) and DRUG (Healthcare).

Of the above ETFs, in the last 12 months, ACDC and DRUG have held their price, CRYP has fallen around 85%, whilst the others have dropped between 25% and 40%. By comparison the ASX200 fell around 3%

Looking back to their inception dates, ACDC, DRUG and HACK have all outperformed the ASX200, whilst ERTH, ESPO, CRYP and CLDD have underperformed the ASX200.

So given the mixed results, why would investors own thematic ETFs?

Pros

The key ‘Pro’ to thematic ETFs is that they provide investors with an exposure to a particular theme or sector that they may not already have exposure to.

Thus, thematic ETFs can be used to plug a diversification hole in an investor’s portfolio. As these themes may be global, it could be that the themes are not picked up in the investor’s existing broad-based ETFs such as those that track the ASX200.

Another advantage is that given it’s an ETF, it allows investors to get exposure to a theme without having to do the research needed to find the best companies within that theme. Having exposure to a thematic ETF, does reduce some stock specific risk, but doesn’t reduce any theme specific risk.

Thematic ETFs are useful when an investor wants exposure to a theme that they believe will outperform into the future.

Cons

The key disadvantage to thematic ETFs is the exposure to thematic risk. This has played out with the ARK Innovation ETF, which is down 75% over the last 12 months. The CRYP ETF is also down 85% over the last 12 months. Both of these ETFs show the dangers of investing in a theme that falls out of favour.

Thematic ETFs are often launched near the top of the market when interest in that theme is at a high. As a result, the stocks in the thematic ETF can start overpriced, resulting in underperformance.

Another disadvantage is that just like it can be hard picking winning stocks, it can also be hard picking winning themes. Also, knowing whether the thematic ETF is overvalued or undervalued can be difficult.

Given that themes come and go, knowing when to exit can also be a challenge. With traditional broad-based ETFs, having an exit plan is not so much an issue, as the wider stock market tends to rise over time. However, this is not the case with themes.

Summary

Thematic ETFs with their higher fees and lower diversification, are certainly not for everyone, and the main reason why InvestSMART does not hold them in any of their portfolios.

Traditional broad-based ETFs are the building blocks for all InvestSMART portfolios, with high diversification, low fees, and lower risk. Investing in a portfolio of broad-based ETFs and contributing as often as you can is a far better investment strategy for long-term performance than punting on the latest popular investing theme.