Funds that specialize in artificial intelligence or gender equality might catch the attention of investors, but financial advisors should think twice about its risks and returns before recommending thematic ETFs to clients.
Research out of the EU Business School, suggests that thematic ETFs and their related underlying indices are in contradiction with the traditional rationale of index investing. Higher fees, higher tracking errors, lower liquidity and lower diversification made thematic ETFs riskier investments, the study shows.
“As an ETF holder myself, I question ETFs as a viable investment vehicle for my savings as well as for others,” the author, Lorenzo F.P. Merlo, wrote in the
The study comes as investor interest in thematic funds has increased dramatically in recent years, particularly since the beginning of the global coronavirus pandemic. In the trailing two years to the end of 2021, assets under management in these funds have grown nearly threefold to $806 billion globally. This represented 2.7% of all assets invested in equity funds, up from 0.8% 10 years ago, according to
Traditional ETFs usually have lower fees and lower capital gains taxes due to the passive management model. Issuers rely on their low prices to market their products. But this is not the case with thematic ETFs that are often actively managed with higher expenses.
The EU Business School research found a gap of about 0.4% in fees between broad market funds and thematic ETFs in 2019. Over longer periods, these funds' higher fees could contribute to relatively poorer performance versus broad market indexes, according to the study.
The ARK Innovation ETF (ARKK) that bet heavily on technology stocks such as Tesla, Roku and Zoom issued by Cathie Wood’s ARK Investment Management, for example, has been performing relatively poorly compared to traditional ETFs recently. In 2021, ARKK declined over 23% while S&P 500 ETF Trust (SPY) gained 29%. It also carries higher risks, with the Sharpe ratio for ARKK of -1.12, compared to the -0.13 ratio of the SPY.
“If you jumped into this thematic ETF after its incredible 2020, you are now down 64% while the S&P 500 is up 10%. So I am highly critical and skeptical of advisors that bought into ARKK or a thematic ETF chasing after incredible returns,” said Bryan Minogue, founder of Kardinal Financial.
According to some financial advisors, clients would invest in such a product because thematic ETFs can be used around the edges of a core portfolio to give the client access to something they are interested in, like an ESG fund.
“Building a portfolio based on thematic ETFs is likely not the best strategy,” said Jeff Burke, founder of 7th Street Financial. “But once the main investing objectives are addressed and it is risk-appropriate for the client, then a thematic ETF can be a way to reach for higher returns in a targeted sector that you can't get with an index fund.”
While these niche ETFs can help investors get ahead, it could also lead to rapid losses if there is a trend reversal. As a result of the early pandemic shock in 2020, the technology sector performed well while the energy sector suffered dramatically.
“To me, it’s no surprise that many thematic ETFs in vogue today focus on technology and not energy. But now here we are in 2022 with the energy sector up nearly 50% and the technology sector down over 20%. Things can change really quickly,” Minogue said.
Jeremy Bohne, founder of Paceline Wealth Management, typically doesn't recommend thematic ETFs to clients. He said people chasing those thematic trends are usually late to the game, making the funds expensive and not worth investing in.
“Some of the best investment returns don't come from products that are fancy and cool. They come from a repeatable investment process which has a track record,” Bohne said. “So in order to get investment before most of the returns have been earned by investors, you have to be doing something before it's super popular.”
Merlo’s study also points out the lower diversification in thematic ETFs, which he claims contradicts the rationale behind index investing. His study found that certain indices are built for short-term ETF trading rather than long-term saving growth as there seems to be high demand among high-frequency and active traders who can easily shift from one trend or sector to another.
“This induces greater noise, thus distorting fair values. Investors who seek a thematic exposure should review closer the activities in ETF trading before venturing in this area. They should also be aware of the valuation mechanism in stock markets,” he wrote.
Some experts argue that thematic fund launches are a bull market phenomenon. A
“New strategies are often introduced in periods of strong performance, like the new millennium and the mid-2000s. But they tend to wane during downturns. Those trends indicate that investors' appetites for these strategies and the desire for providers to offer them typically move in sync with the broader market,” eight researchers wrote in the
“One of the ways that advisors help clients is trying to basically peel back the layers of the onion to understand what matters most to them. And then my role as an advisor is really to find the most effective way to implement what they're looking to do,” Bohne said.
