How to choose the best thematic ETFs for your portfolio
What do investments known as HACK, ROBO, ACDC, ERTH, CRYP, FANG, DRUG and SEMI all have in common? They are all thematic exchange traded funds (ETFs) listed on the ASX and, although they have long, formal names, investors commonly refer to them as their snappy ASX ticker codes.
Thematic ETFs have grown by 400% over the past year. They cover various investment niches and include some that have performed well recently.
Some have done well in the pandemic, delivering eye-watering results such as the ETFs Battery Tech and Lithium ETF, which returned 20.6% for the year to December 20, 2021, and 31.9%pa over the past three years; the ETFS FANG, which returned 20.7% over one year; and BetaShares S&P/ASX Australian Technology ETF, which delivered 16.5% over the year to November 30.
There are 20 thematic funds out of the 277 ETFs in Australia.
Thematic ETFs have attracted $4.33 billion out of the total $132 billion. They are from ETF providers such as BetaShares, ETFS and VanEck Global. Globally, there are 475 thematic ETFs holding $US252 billion ($348 billion), according to Bloomberg, up from 330 thematic ETFs worth $US119 billion a year ago.
These ETFs can give investors an easy way to invest in areas that are on trend.
For example, HACK invests in global cybersecurity companies, ROBO in global robotics and artificial intelligence, ACDC in battery technology and lithium, ERTH in innovative climate change companies, CRYO in companies that are involved in cryptocurrency, FANG in new technology companies, DRUG in healthcare and SEMI in semi-conductor companies.
Catch the big trends
Not surprisingly, thematic ETFs have captured the imagination of investors, particularly younger, tech-savvy millennials. Tim Murphy, head of fund manager research at Morningstar, says they are typically self-directed investors.
"Overall, investors are increasingly turning to ETFs to add exposure to high-conviction megatrends in their portfolios," says Alex Vynokur, CEO of BetaShares, which has nine thematic ETFs and eight ethical ETFs listed on the ASX. "For example, many investors can see efforts to address climate change is a long-term megatrend that has decades of growth ahead."
Around 1.73 million Australians hold ETFs in their portfolios. Stockspot's ETF report estimates ETFs have saved Australian investors $500 million a year in fees compared with more expensive actively managed funds.
Murphy says the widely diversified, broad-based, low-cost index investing space is already taken up by managers such as Vanguard, State Street Global Advisors and BlackRock.
"There are only so many ways to track an index," says Murphy, who believes there are many ways to actively manage investments.
Some investors chasing past performance believe thematic ETFs can be a short cut to wealth, says Chris Brycki, CEO of leading robo adviser Stockspot.
But the problem with chasing past performance is that often much of the return is already built into the share price of the companies within the ETF by the time it launches. "Thematic ETFs usually launch when retail interest is already near its peak," he says.
Brycki tells his dad that if it's in the newspaper, it's already priced in the market.
"It's not useful information once it is in the market; it's only useful when people don't have the information."
Some thematic ETFs have performed poorly. For example, the BetaShares Asia Technology Tigers ETF has lost 6.95% over the year to November 30, 2021. Or the ETFS Biotech ETF has lost 9.3% over a year.
Place your bets, please
Then there is the dilemma about which theme to choose. With 20 thematic ETFs, how do you predict the next big thing?
The decision can be like a trifecta bet, says Ben Johnson, Morningstar analyst.
The three variables are:
1. Picking a winning theme.
2. Selecting a fund that is well placed to harness that theme.
3. Making your wager when valuations show that the market hasn't already priced in the theme's potential.
The chances of getting all three right so the fund will outperform over the long term are slim, says Johnson.
In contrast to the thematic funds, there are ETFs that incorporate a range of themes and sectors, so if one theme or sector underperforms, it is cushioned by its diversification.
Johnson says the index methodologies are the ETFs' DNA. They dictate and weight the investments. For example, the biggest ETF listed on the ASX is Vanguard's Australian Shares Index with $9.7 billion. It invests in the top 300 Australian companies as set down in the S&P/ASX 300 index.
These companies make up more than 97% of the ASX, with financial and resource companies making up almost 50% of the index, followed by healthcare, consumer, real estate, industrial, consumer staples, IT and communication services companies. The fee is only 0.1%. The ETF has had a strong year, returning 16.1% to the end of November
Broad-based ETFs have lower fees than thematic ETFs. Stockspot estimates the average fee of thematic ETFs launched on the ASX in 2021 is 0.77%, which is seven times higher than typical broad-market ETFs.
Most hot sectors of the market eventually lose their shine, which is why investors in thematic ETFs need to be cautious, says Brycki.
Data shows that new ETFs typically underperform after they list, according to Marc Jocum, investment manager at Stockspot.
"Investment sentiment is sometimes a powerful contrarian predictor of returns," he says.
Research shows that thematic ETFs launched in the US between 1993 and 2019 underperformed the broad market index by 4%pa for at least five years after they launched.
"Historically you would have lost around 20% over five years relative to the broad market if you have invested into all thematic ETFs when they launched," says Jocum.
Another study found that the maximum point of outperformance of a theme is usually when the product issuer lodges the application for an ETF, which is around three to six months before listing.
While it is tempting to place a large proportion of your investment capital into a high-performing product, investors need to be measured.
"Investors should use thematic ETFs as portfolio satellites to enhance returns," says Vynokur.
Take an ethical tilt
Vynokur recommends investors hold the core of the portfolio in low-cost ETFs that have broad exposure to large-cap Australian and international equities. But among the other assets there could be some thematic ETFs. He recommends BetaShares FAIR or ETHI, which invest in a portfolio of large Australian or international companies that meet strict sustainability and ethical standards.
"Thematic funds, like ERTH, could then be used to tilt the portfolio towards genuine investment megatrends and long-term growth sectors," he says.
He says investors recognise that investing in new industries, developing alternative energy sources or addressing climate change is not only the right thing to do, but also a business opportunity.
"On the back of this trend, ethical ETFs continue to grow in popularity as investors seek to align their portfolios with their values while at the same time meeting their investment goals."
Thematic ETFs often shut down because they don't attract enough funds to cover the operational costs. In the US, of the 277 ETFs that shut down in 2020, one quarter didn't make it to their third birthday. Jocum says that they shut down because of limited take-up and underperformance. "As time goes on, there is increasing riskiness that these funds may lag the broader market or subsequently shut down."
Once an ETF closes, investors are forced to sell, triggering capital gains tax, and they have to decide where else to invest. Ironically, one of the best times of performance can be after it shuts down, says Jocum.
He has three examples. The BetaShares Commodities Basket ETF shut in December 2020 right before the underlying commodity basket rose 35%.
The Russell Investments Australian Value ETF shut in May 2018 after the value factor endured a decade of underperformance, but value investing has bounced back. VanEck closed its Australian Emerging Resources ETF in July 2016, just before mid-cap miners rallied by more than 50% over the next two years.
Know when to get out
Rather than buying because of recent performance, Johnson recommends investors analyse the theme. He says the theme should be robust and logical as well as having data to back up the growth story.
Understand how the theme will age and over what timeframe it is expected to play out, because you want to know when to exit.
"Having pre-set exit criteria based on robust metrics such as valuation ratios will help protect against poor investment decisions. These should be monitored regularly," recommends Johnson.
There can be several approaches to harnessing a theme. Funds tracking a similar theme can end up being significantly different from one another. This creates an additional burden of due diligence and monitoring for investors.
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