Thematic ETFs have become popular in recent years — with a more focused approach and concentrated investments, these ETFs bring the possibility of higher returns, but also higher risks.
We explore the risks and opportunities of investing in thematic ETFs.
Why are thematic ETFs popular?
If you read newspapers, magazines or newsletters focussed on investing one thing stands out: the media tends to report about investing with an angle that entices the interest of the reader.
And not only the media is interested in stories, but also their readers, which are predominantly retail investors. Hence, the investment industry has created products which are tailored to feed the need of following a topic or trend rather than selecting investments based on fundamental criteria.
As a result, thematic ETFs were born and the industry hasn’t looked back since.
Most popular ETF themes in 2023
Especially with the rise of interest in artificial intelligence at the beginning of 2023, thematic ETFs have again gained popularity as investors seek to capitalise not only on the AI theme but on themes aligned in general with futuristic and growing industries.
With AI in question, we identified a few themes which are trending at the moment:
Industrial revolution
This topic covers everything which falls under the term of the 4th industrial revolution, ranging from automation to big data, the internet of things and related technologies. The interplay of these technologies is projected by many to spur growth in industry and hence to offer good investment returns. Especially, pick-and-shovel companies which are selling their technology services to industries undergoing a transformation may benefit.
Reshoring supply chains
As globalisation has come to a halt after problems during the Covid pandemic and now with global supply chains stoked after Russia’s attack on Ukraine, investors are looking at opportunities where various industries bring production back to their home countries. This covers opportunities in traditional manufacturing as well as tech, such as the semiconductor industry,
Core bonds
As the bond market tanked in 2022, many investors see an opportunity in picking up attractively priced government bonds to generate stable yields and counterbalance periods when equities are weak, offering stability in uncertain markets.
High-Yield bonds
Similar to the core-bond theme, high-yield bonds are also en-vogue due to high fixed returns, earning their name again as investors seek higher returns in a still stable economic environment.
Technology and AI
Similar to the industrial revolution theme, the general theme around technology, big data and artificial intelligence (AI) has gained a boost due to the advancements in the AI sector. ETFs in this theme can range from broad technology ETFs to very narrowly focused AI themes.
Thematic ETFs risks
Thematic ETFs, while they offer investors the chance to capitalize on emerging technologies and structural shifts to possibly earn excess returns, also come with their own set of inherent risks. We’ll look at a few of them so you can form a better picture for yourself in case you decided to add thematic ETFs to a portfolio that is right for you:
Concentration risk
Thematic ETFs invest in a niche industry or theme, resulting in a very small number of concentrated holdings. If the industry, theme or public opinion towards the technologies experiences a downturn, this can lead to losses for investors, which are often much in excess of what a diversified ETF would experience.
Volatility
Thematic ETFs tend to be more volatile than broad-based ETFs, meaning the value of their holdings can fluctuate significantly over short periods. The reason for this is that the themes are often clustered around new technologies, nascent industries and general high-risk topics. Even if in case a thematic ETF does not perform worse than a well-diversified one, strong fluctuations in value may make risk-averse investors unsettled and prompt them to sell at the wrong moment.
Restricted investment scope
As ETFs focussed on a particular theme only invest in stocks related to their specific topic, this results in a non-optimised portfolio. Even more, the fund managers are constrained in switching allocations in case they believe the theme has run its course.
Lower returns
Late-to-the-game investors may not benefit from the full growth potential of a thematic ETF theme, leading to lower returns than expected. This is especially the case if investors buy into a certain theme which is hyped up in the media.
Very often, at peak-hype, stocks of an trending industry are highly overvalued and only have poor return perspectives — even in case the industry does deliver on its growth promise.
For example, over the past years some themes have resulted in large losses for investors:
The five worst-performing themes in 2022 were:
1. Cryptocurrency ETFs: These ETFs invest in cryptocurrency or crypto-related equities. As an example, the Valkyrie Bitcoin Miners ETF (WGMI) lost more than 65% in 2022 and was one of the worst-performing thematic ETFs that year.
2. Marijuana ETFs: Cannabis-focused ETFs, such as the AdvisorShares Pure Cannabis ETF (YOLO), saw a decline of 65% in 2022.
3. Psychedelics ETFs: Similar to Cannabis ETFs, the AdvisorShares Psychedelics ETF (PSIL) underperformed as well, losing more than 65% mirroring the negative performance of the Cannabis Theme.
4. ARK Innovation ETFs: Once highfliers, three ARK Investment ETFs made it to the bottom in 2022. The tech and internet focussed ETFs of ARK lost heavily, all of the following 3 ETFs, the ARK ARK Next Generation Internet ETF (ARKW), the ARK Innovation ETF (ARKK), and the ARK Fintech Innovation ETF (ARKF) dropped by more than 65 per cent in 2022.
High fees
Thematic ETFs usually come with higher fees than traditional ETFs, which can eat into returns. The reason for higher fees are higher costs for the ETF issuer, because the individual ETF often only serves a niche audience: if an ETF issuer needs an Index provider to create a custom index based on a theme which can only attract a few million dollars in investor money, they need to recoup the costs by upping their fees.
Often fees for thematic ETFs are far in excess of 1 per cent per annum measured in the ETFs TER (total expense ratio). Hence, before investing in a theme-based ETF, make sure you check their fee structure thoroughly.
Conclusion
While thematic ETFs are a possibility to earn excess returns by benefiting from an emerging investment theme, one should not forget the risks such investments carry, which include high volatility, high fees and risks of losing a significant or all of the investment.
Hence, such investments only make sense in a well-diversified portfolio and as a small portion for example in a core-satellite investment strategy.
ot forget the risks such investments car If you enjoyed this piece then you may well be interested to read about the risk that comes with leveraged ETF opportunities.
