Thematic exchange-traded funds, or ETFs, typically come with a good investment story. These include things like the increasing adoption of robotics and artificial intelligence, electric vehicles and genetic research, or demographic shifts.
On the surface, some thematic ETFs may seem like great ideas. They attempt to capitalize on a seemingly inevitable long-term trend or a well-publicized long-term macro trends that transcend the business cycle. It may seem plausible that stock prices don’t fully reflect those trends, given the widely held perception that the market is focused on the short term.
ALEX BRYAN, director of passive strategies at Morningstar, tells investors to exercise caution. He believes that investors in these funds must get three bets right for these stories to translate into market-beating performance.
- The macro trend must play out as expected.
Long-term trends don’t always play out as expected. For example, in the late 1990s, investors were enamoured with Internet stocks, convinced they would fundamentally transform the economy and allow e-retailers to take market share away from brick-and-mortar stores. The story was right, but the timing was wrong. It took longer than many expected for that transition to happen, which prevented many from profiting from it.
- Companies in the portfolio must benefit significantly from that trend.
It’s tempting to take for granted that the stocks in a thematic ETF are positioned to benefit significantly from the targeted theme. After all, fund providers wouldn’t be doing their jobs if they delivered a portfolio incongruent with the fund’s mandate.
Yet it’s often challenging to craft a portfolio of companies that are pure plays on a given theme, particularly when that theme is still in its early stages. Consider First Trust Indxx Innovative Transaction & Process ETF, which targets firms that are developing or using blockchain technology.
While many of its holdings are leaders in blockchain adoption, this technology isn’t a significant earnings driver for many of them, like AT&T, Microsoft, Amazon, and London Stock Exchange. As such, it may not have a significant impact on their stock prices. At the very least, this fund’s performance will be influenced by many things other than blockchain.
Even funds that target the same theme often have very different portfolios. For example, iShares Robotics and Artificial Intelligence ETF, Global X Robotics & Artificial Intelligence ETF, and Robo Global Robotics & Automation ETF all target stocks that are likely to benefit from the growing adoption of robotics, automation, and AI. Yet there is little common ground among their portfolios.
Usually, more diversification is a good thing. However, there aren’t many companies that offer clean exposure to robotics and AI. So, to improve diversification, one defines its theme more broadly than the others, or has less stringent requirements for inclusion, diluting its exposure to the theme.
The point being made is that it is necessary to look beyond the fund name to understand the exposure the portfolio delivers. Not all thematic funds will effectively profit from the growth of their targeted trend.
- Stock prices don’t fully reflect the impact of this expected growth.
Even if a trend plays out as expected and a fund is well-positioned to take advantage of it, that won’t necessarily translate into market-beating returns. The market may have already priced in that trend. Macrotrends aren’t a secret. If you know about it, the odds are so does everyone else. The key is to identify underappreciated trends, which is no easy feat.
The relationship between earnings growth and stock returns is tenuous at best, as faster-growing companies tend to trade at higher valuations, which offsets the benefit of that growth.
What matters is growth relative to the market’s expectations, not the absolute level of growth. It is difficult to forecast the impact of a trend on businesses more accurately than the market. Doing so requires more than just an understanding of the macro story, but also understanding what the market is currently pricing in and how the competitive landscape might evolve. That’s a tall order.
Given the difficulty of getting all the above three bets right, most thematic ETFs fail to beat the market. In fact, most don’t survive over the long term.
According to the Morningstar Global Thematic Funds Landscape report, published in February 2020, only 45% of all thematic funds listed at the end of 2009 survived until the end of 2019. Of the funds that survived, just 26% beat the MSCI World Index.
So, the odds of picking a winning thematic fund from the lineup that existed at the end of 2009 were 11.7% (45%*26%). While investors could improve those odds by sticking to lower-cost funds and digging into portfolio construction, it’s clear that good stories often don’t translate into strong investments.
Conclusion
- Good stories are often the best thing thematic ETFs have going for them; they don’t necessarily make sound investments.
- Most investors would probably be better off skipping thematic ETFs altogether.
- It’s tough to find thematic ETFs that will likely beat the market. Most also come with high active risk, narrow portfolios, and unintentional sector and style bets.
- That said, the above active risk also creates considerable upside potential for those fortunate enough to find one of the few winners.
- If you find a thematic ETF appealing, it’s generally prudent to keep the position small and do your homework before buying.
