Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 422

Thematic ETFs: is the juice worth the squeeze?

With co-author Zunjar Sanzgiri

Thematic funds were long viewed as esoteric, but not anymore. The ‘black swan’ event of the coronavirus pandemic proved to be a paradigm shift for thematic exchange-traded funds (ETFs). Burgeoning demand for funds focussed on environmental, social, and governance factors is a classic example of this. The outbreak of COVID-19 evoked investors’ sentiment toward disruptive trends and sustainable investing across the world, opening a long runway for growth for thematic ETFs. 

What is a 'thematic' ETF?

Our definition of thematic ETFs is based on intentionality rather than fund holdings. To identify intentionality, we have relied on a combination of fund names (a strong indicator of intentionality) and information gleaned from prospectuses, marketing materials, index methodologies, and Morningstar's own proprietary data points (such as investment objective) where possible. We have limited our universe to equity ETFs and excluded other asset classes, most notably fixed-income ETFs. 

Sustainable funds are included, provided they seek to capture a specific theme. This means that alternative energy funds, which aim to capitalise on the transition to a low-carbon economy, are included, but most broad ESG funds, which select a diverse group of stocks based on ESG scores, fall out of scope. Funds like the BetaShares Climate Change Innovation ETF (ERTH), which tracks a climate solutions theme, are included, but broad-based ESG-focussed funds like VanEck Vectors MSCI Australian Sustainable Equity ETF (GRNV) are excluded. The thematic funds taxonomy is elaborately noted in our latest Global Thematic Funds Landscape report.

The Australian thematic ETF market composes just over 1.7% ($1.9 billion) of the total ETF funds under management. However, the thematic market has seen a significant uptick over the trailing one year, with six out of a total of 11 Australian thematic ETFs launched during this period. This may reflect investors’ increased appetite for thematic investing.

Thematic ETFs, if chosen carefully, have the potential to complement an existing diversified portfolio with added alpha, but the risks are notable.

Setting expectations amid rapid change

Setting specific performance expectations from thematic funds is hard. Many strategies with more-esoteric themes have short track records, and distinguishing whether the underlying theme is really a transformational trend or simply the latest fad takes time. In the interim, factors like regulatory scrutiny, further technical advances, or a shift in investors’ collective psyche may result in an abrupt boom or bust of a particular theme. In either scenario, however, forming a forward-looking view on absolute or relative performance can be precarious. As such, thematic funds are not suitable as the main building blocks for a diversified, goal-focussed portfolio.

Is the juice worth the squeeze?

Thematic funds are designed to exploit emerging trends, not to provide diversified, risk-controlled exposure. They are concentrated in their respective sectors of interest and often rely on a relatively fewer number of stocks compared with the typical diversified offerings.

Exhibit 1 highlights these traits for Australian thematic ETFs. The risk of capital loss is high as sector- or industry-specific idiosyncrasies have a huge bearing on the performance of such funds. Adopting a passive approach in such scenarios can add more risk given the little (or lack of any) qualitative oversight. As a result, investors may experience a rougher ride due to higher levels of volatility.

Exhibit 1: Thematic ETFs are generally concentrated in a few sectors

Source: Morningstar Direct

The higher risk exhibited by thematic ETFs naturally raises the question as to whether investors are adequately compensated for taking this risk. Our latest Global Thematic Funds Landscape report notes that over the trailing 15 years through May 2021, the risk-adjusted performance (Sharpe ratio) of the global thematic funds has been modest compared with pure passive ETFs.

Academic research such as Competition for Attention in the ETF Space 2021 by Itzhak Ben-David, Francesco Franzoni, Byungwook Kim, and Rabih Moussaon, corroborates these results. While the Australian thematic ETF market is at the nascent stage, they also exhibit similar global trends with either middling or, in some cases, worse risk-adjusted performance compared with passive ETFs like Vanguard Australian Shares (VAS) that offer broader market exposure.

Exhibit 2: Australian thematic ETFs have displayed global trend of modest risk-adjusted return compared with broad-based ETFs

Source: Morningstar Direct

Most thematic funds don't beat global equities over longer periods but since the beginning of the global pandemic, many thematic funds across the globe, including from Australia, have chalked up impressive returns. More than two-thirds of thematic funds globally survived and outperformed global equity markets (as proxied by the Morningstar Global Markets Index) in the year ended March 2021.

However, this success turns pale when longer periods are considered. For example, stretching the observation window to include the trailing five years, success rates drop to 43%. When viewed over the trailing 15 years, more than half of thematic funds globally have shuttered and just 22% have survived and outperformed the global equities benchmark. These figures suggest that the odds of picking a thematic fund that survives and outperforms global equities over longer periods are stacked against investors.

Crowding risk

Thematic strategies can also fall victim to capacity constraints. Theme-based investing frequently targets niche segments of the investment universe, which is often less liquid and less appealing from a valuation perspective. Too much money chasing too few ideas can stretch valuations and is not a recipe for successful long-term investing.

Exhibit 3: Compared with the broad market valuation, thematic ETFs’ valuations have been historically stretched on the P/E metrics basis versus the Morningstar Global Markets Index

Source: Morningstar Direct. Note: Only ETFs with more than one year of data are considered here

What about the cost?

Thematic ETFs are not cheap relative to passive funds. While Australian thematic ETFs are in their early years, the trailing three-years data reveals that higher fees are being charged by these funds. This is a global phenomenon. The fees across the current cohort of Australian thematic ETF range from 57 basis points to 95 basis points (0.57% to 0.95%), which is substantially higher than their more-diversified peers.

Exhibit 4: Thematic ETFs charge substantially higher premiums for accessing emerging themes

Source: Morningstar Direct

Thematic investors not only pay a higher management fee but trading the thematic ETFs can be a costly affair, too. Exhibit 5 underscores the fact that the higher trading costs (gauged by bid-ask spread) mean a higher total cost of ownership associated with thematic ETFs. These higher spreads also point to the potential liquidity issues, specifically in stressed market environments.

Exhibit 6 shows data from research we published in February 2021 looking at spreads of all ETFs in a normal market environment (from 8 Jan to 20 Feb 2020) and in the stressed market environment during the COVID-19 market volatility (24 Feb to 3 April 2020).

Exhibit 5: Substantially higher bid-ask spreads of thematic ETFs compared with a broad-based ETF

Source: ASX. Investment Products Monthly Update

Exhibit 6: Liquidity during normal and stressed market environments

Source: Morningstar Tick Data. Normal Market: Data is from 8 Jan to 20 Feb 2020. Stressed Market: Data is from 24 Feb to 3 April 2020. Note: Only ETFs with more than one year of data are considered here. *Spread to $100K: Like the spread but calculated with the volume-weighted average prices derived from a notional $100,000 purchase or sale on either side of the order book. This spread is calculated only for periods where there is $100,000 in assets available on both sides of the order book.

Looking ahead

So how should investors approach thematic ETFs?

For starters, they warrant more in-depth research and due diligence than more-diversified funds. This is especially true because what is considered a theme can evolve through time and can become increasingly complex and nuanced.

In the case of an extremely specific theme, such as global food scarcity, the burnout rate can be high. Information technology is another such sector that is prone to perpetual changes. Once the flag bearer of the 'revolutionary tech' theme, giants like Facebook (FB), Alphabet (GOOGL), Netflix (NFLX), Alibaba (BABA), and Tencent (00700) (among others) no longer fit that definition following the 2018 MSCI GICS reclassification. As the fortunes of any theme are at the mercy of multiple factors - such as government policy, advances in technology, interest rates, and shifts in investors’ own biases - it is incumbent upon an investor to apprise themselves on the fundamental drivers of risk and return of the theme of their interest.

If a theme’s longevity is be established, it is critical for investors to identify the ETF which holds the companies that are most likely to benefit from the theme. 

Thematic investing is tricky and involves multiple moving parts. It is crucial that investors understand what they own but this is particularly true when picking thematic ETFs, which come in a variety of flavours. Regardless of how certain an investor might be on a theme, we believe a thematic fund is best used as a supporting player to a diversified portfolio, as the performance volatility that may ensue could make it a 'roller coaster' of a ride. Thematic ETFs are best used to complement rather than replace existing core holdings.

Download the PDF version of this report, including Australian market-data snapshot as of 30 June 2021.

 

Kongkon Gogoi and Zunjar Sanzgiri are Senior Manager Research Analysts for Morningstar. This article is general information and does not consider the circumstances of any investor.

 

RELATED ARTICLES

Why it's a frothy market but not a bubble

FANMAG: Because FAANGs are so yesterday

Evan Reedman: Australian ETFs from slow burn to rapid fire

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

Let's make this clear again ... franking credits are fair

Critics of franking credits are missing the main point. The taxable income of shareholders/taxpayers must also include the company tax previously paid to the ATO before the dividend was distributed. It is fair.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

Latest Updates

Investment strategies

Joe Hockey on the big investment influences on Australia

Former Treasurer Joe Hockey became Australia's Ambassador to the US and he now runs an office in Washington, giving him a unique perspective on geopolitical issues. They have never been so important for investors.

Investment strategies

The tipping point for investing in decarbonisation

Throughout time, transformative technology has changed the course of human history, but it is easy to be lulled into believing new technology will also transform investment returns. Where's the tipping point?

Exchange traded products

The options to gain equity exposure with less risk

Equity investing pays off over long terms but comes with risks in the short term that many people cannot tolerate, especially retirees preserving capital. There are ways to invest in stocks with little downside.

Exchange traded products

8 ways LIC bonus options can benefit investors

Bonus options issued by Listed Investment Companies (LICs) deliver many advantages but there is a potential dilutionary impact if options are exercised well below the share price. This must be factored in.

Retirement

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

Investment strategies

Three demographic themes shaping investments for the future

Focussing on companies that will benefit from slow moving, long duration and highly predictable demographic trends can help investors predict future opportunities. Three main themes stand out.

Fixed interest

It's not high return/risk equities versus low return/risk bonds

High-yield bonds carry more risk than investment grade but they offer higher income returns. An allocation to high-yield bonds in a portfolio - alongside equities and other bonds – is worth considering.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.