Thematic ETFs: The future is trending now

Three-digit returns in a single year is a milestone rarely reached by most funds. Yet in 2020 the best performing exchange-traded funds (ETFs) managed to make this look easy. They shared the same investment case – thematic investing.

Based on highly marketable ideas that target up-and-coming themes, thematic ETFs are a relatively new concept, but one that is generating a lot of attention. Anne-Valère Amo, Head of ETF Selection at Trackinsight, said that “Thematic investing through ETFs has found a large audience in 2020, breaking usual sector and country allocations”.

The strong momentum around thematic investing is shaking up the world of ETFs. Until now, ETFs had grown in popularity mainly on the back of passive trackers replicating reference market indices at low costs. It is not too surprising then that the ETF industry is yet to agree on a common definition for thematic ETFs.

As a result, there are wide discrepancies in reports on the thematic ETF landscape. Reported numbers for ETF count and assets under management vary widely across sources. For example, Morningstar and Global X, reporting respectively for Europe and US-domiciled ETFs, count less than 200 ETFs with around $135bn in assets. In contrast, other consultancy firms like ETFGi declare there are more than 600 thematic ETFs for close to $400bn in assets.

To help investors cut through the noise, we at Trackinsight are working on a global and independent classification. We aim to build a universal reference framework to help investors worldwide in the identification and selection of thematic ETFs. Through this article we hope to give you a better idea of the thematic ETF landscape, as well as an overview of our work so far.

The rise of thematic ETFs

Sources might disagree on the final number but everyone agrees on the trend surrounding thematic ETFs assets: they are growing - and growing fast.

To compute our numbers, we looked at ETFs focusing on long-term macro trends that will transform the way we live and work – with an investment approach breaking away from standard sector and country classifications. Themes can range from disruptive innovations in technology, healthcare to new energies and touch on various aspects of our daily lives.

Our data might differ, but the conclusion is the same: thematic ETFs are rising. Their assets under management have trebled since 2018 and more than doubled over 2020 alone. As the Covid crisis changed the way we live and work, many investors have seen opportunities in related themes such as innovative healthcare or remote working and learning technologies.

This year’s first quarter flows into thematic ETFs are already close to matching those of 2020 full year. This is the best start to a year so far, as more and more ETF providers are joining the race. We count more than 100 ETF providers with thematic offering – a 50% increase compared with 2018.

The popularity of thematic investing owes a lot to the rise of ETFs. As shown by money flows, investors recognize ETFs’ many benefits such as low costs, easy diversification, liquidity and transparency. Recently, the competition between providers lowered costs even further and new disruptive players developed the offer of available indices, allowing more complex and specialized strategies to be replicated by ETFs. Today as a result, thematic ETFs offer investors a cost-efficient and easy alternative to participate in the macro trends shaping our future.

Besides trackers, there is a growing number of actively managed thematic ETFs being launched. Nearly one in six thematic ETFs are active and they represent 40% of new launches in the US so far in 2021. Some investors think thematic investing is more art than science, which makes the case for active management. Those discretionary approaches can end up with more concentrated portfolios in an attempt to generate alpha and capture the best opportunities.

Passive or active, thematic ETFs have a bright future ahead. Recent research at Trackinsight surveyed 373 professional ETF investors around the globe and more than half of them (53%) plan to increase their allocation to thematic ETFs over the next 2-3 years. However, there are disparities in geographies. Widely popular in the retail driven US market, thematic ETFs have yet to settle in Europe, where they represent less than 20% of total ETF assets, while the trend has barely started in Asia.

One in four new ETF launches is thematic

Thematic ETF launches have continuously increased in number for each quarter since the beginning of 2020. They also represent an increasing share of all ETF launches. Over the first quarter of 2021, close to 25% of all new launches were thematic ETFs.

Source: TrackInsight, data as of 31-03-2021

Not all regions are seeing the same growth. In the last two quarters, most of the new thematic ETFs were listed in North America - and they collected most of the assets too. Interestingly enough, the most popular themes in the US strongly differ from those in Europe.

A large portion of new launches in the US revolved around disruptive technologies, while in Europe almost all new launches (95%) focused on environment-related themes such as climate change, carbon transition and clean energy. With sustainable thematic ETFs at the intersection of thematic and ESG investing, the old continent can build on a higher ESG-awareness among investors to boost its market share in the thematic ecosystem.

Humbling truth about thematic investing

Despite some funds delivering outstanding returns, thematic investing is not a get-rich-quick scheme. Thematic strategies, like all specialized strategies, can experience high volatility in their performance. Past winners might be tomorrow’s losers. Among the top 10 performers of 2020, only one ETF managed to remain in the top in Q1 2021. Themes are subject to strong rotations. If in 2020 the winners were clean energy ETFs; they have been replaced with cannabis ETFs so far in 2021.

Source: TrackInsight, USD returns – data as of 31-03-2021

Recent research produced in collaboration with the ETF Hub at Financial Times highlighted the low survival rates of thematic ETFs[1]. SLIM and BUZZ ETFs are unfortunate examples of funds that closed just before a tremendous rebound in performance of their respective benchmark indices. This effect is amplified in the US with the high share of retail investors in the thematic market – which might have a shorter horizon investment than institutions.

Beyond a higher risk of closure, thematic ETFs often have a higher concentration risk than more traditional broad market strategies. As an example, at Trackinsight we analysed the level of diversification in ARKK and MOON ETFs[2]. Results show that even though they hold approximately 50 stocks in their portfolios, the effective number of shares is actually closer to only 27 stocks. This means that their diversification actually corresponds to an equal-weight portfolio of just 27 stocks.

High concentration also raises the question of potential liquidity risk. Some thematic strategies tend to invest in smaller cap stocks – due to the niche market segment they cover. The rapid and sizeable inflows into thematic ETFs might impact on the underlying stocks valuations and liquidity issues might arise if the funds face sudden waves of redemptions.

Additionally, issues have been raised around some active ETF managers with significant ownership in some stocks. They could see their status re-defined as “informed investors” [3]. This would prevent them from actively trading those stocks with frequent ins and outs. Also they might have to return a part of their gains to the companies, which would hurt investors in those ETFs.

All in all, some thematic ETFs are built better than others. Some have a stronger focus on managing those risks. Due diligence can help investors select products they are comfortable with.

Conclusion

The industry has yet to settle on a common definition for thematic investing but this does not keep investors from buying them. Flows into the segment will likely keep accelerating over the next few years as thematic ETFs’ unique approaches to investing differentiate them from broad market or sector specific exposures and stimulate investors’ interest for this growing market. ETFs have made thematic investing a cost efficient and easy alternative for investors. While some had stellar returns in 2020, their concentrated bets often mean thematic investing is far from a peaceful ride. Positioned to benefit from potential shifts in technology, society, the environment and demographics over time, thematic ETFs are here to stay.

[1] Financial Times, “From veganism to #BLM: Big Data promises to transform niche ETFs” (November 8, 2020)

[2] Trackinsight, “MOON ETF: Not an ARKK Copycat” (March 25, 2021)

[3] Financial Times, “ARK Invest: big stakes and a short swing” (March 5, 2021)