ETFs are by far the most popular investment option in the Pearler community.

But, as you might have noticed, not all ETFs are the same.

Some are plain vanilla index funds, which hold every company in the market. Other ETFs vary widely in terms of strategy, style, and focus.

One type of ETF that has become incredibly popular in recent years is the thematic ETF. That is, ETFs which are built around a certain ‘theme’ such as green energy, healthcare, or robotics – just to name a few.

In this article, we’ll discuss the pros and cons of thematic ETFs, what to look out for, and whether they might be worth adding to a diversified portfolio.

Examples of Thematic ETFs and how they work

Thematic ETFs are essentially a portfolio of companies which have been selected around a particular investing ‘theme’.

There’s a mammoth amount of ETFs out there these days, so we can’t look at all of them! But here are some examples of thematic ETFs currently available in Australia…

• ACDC: Global X Battery & Lithium ETF
• HACK: Betashares Global Cybersecurity ETF
• CLNE: VanEck Vectors Global Clean Energy ETF
• ASIA: Betashares Asia Technology Tigers ETF
• ROBO: Global X Robotics & Automation ETF
• ESPO: VanEck Video Gaming Esports ETF

As you can see, there are a few key fund managers which are focusing on thematic ETFs. Which isn’t surprising, given Vanguard and BlackRock already dominate the vanilla low-cost index fund space.

So how do these ETFs operate? Many funds use an index to track a specific theme, while some others take a more hand-picked approach, with the fund manager researching and selecting which individual companies to put into the ETF.

The portfolios typically comprise between 25 and 80 companies which are all involved in various businesses and services relating to the core theme. So, there is some diversification built in, making it far less risky than just picking one or two stocks around that theme (more on diversification later).

Main benefits of Thematic ETFs

Chance to beat the market. By getting in early on (hopefully) some of tomorrow’s best companies, it’s possible to earn outsized returns by having a more concentrated position in those companies. When a company is in a disruptive industry, it’s likely to be of a small size right now, compared to its business opportunity.

Invest in things you’re excited about. Let’s be honest: investing in broadly diversified funds can be boring. So adding other investments can certainly give your portfolio a bit more ‘flavour’. This is especially true if it’s something that you’re personally excited about – whether it’s battery technology, esports, or something else.

Placing ‘bets’ with less risk. Thematic ETFs allow investors to effectively bet on a particular outcome without having to do the research (and take the risk) of investing in individual stocks. This makes it easier for those who’d like to take a more laid back approach while still getting some upside by backing their chosen theme.

Main downsides of Thematic ETFs

Success may be ‘priced in’. One major issue I see with thematic ETFs is that almost everyone agrees on the future growth of certain industries. How many people actually think battery technology, clean energy, and artificial intelligence aren't going to grow? Exactly. And that typically means a lot of the upside is already priced in; companies are now more expensive for the very reason that it’s fairly clear what the future growth industries are.

May not perform as well as hoped. Even if we assume the above is only half true, there’s still uncertainty around long term performance. By definition, we’re betting on one particular theme, sector or idea. Despite the future looking predictable for certain industries right now, things can change quickly. That’s especially true as the pace of technology continues to accelerate. Plus, most thematic ETFs, just like stock picking, will inevitably underperform the market over the long term. Every ‘theme’ has a shelf life.

Higher fees. While the above issues imply a good chunk of uncertainty, one thing is absolutely certain. Thematic ETFs come with higher management fees, often much higher. And we know that a big driver of long term performance is the amount of money that gets syphoned away in fees. Uncertain higher performance, but guaranteed higher fees. Something to keep in mind for any investor constructing a portfolio.

Will it matter?

While I do have a couple of active picks in my portfolio, a thematic ETF isn’t one of them. My view is partly summarised like this…

If I’m bullish on a specific set of companies, and that view turns out to be correct, it will be reflected in the index over time. And if I’m wrong, then those companies will stay small and I save myself the risk and possible disappointment.

This means I don’t necessarily have to take a specific bet to benefit from the returns of those companies. Now, obviously some stocks are far too small to make much of a difference to an index, which is a fair objection. So it can still make sense to invest in certain businesses or themes we feel strongly about and if there seems like a decent chance of outperformance.

Speaking of which, it’s worth considering whether adding more ‘flavoursome’ ETFs will make much difference even if our view on the future is correct. Let’s say an investor allocates 25% of their portfolio to thematic ETFs, with the rest being market-tracking index funds. Further assume those funds outperform the market by 2% per annum after fees over the long term (itself fairly impressive).

Simple maths tells us this has the effect of boosting our investor’s overall portfolio return by 0.5% per annum. Not bad, but probably not the impact they hoped for. Of course, outperformance (if it occurs) could be larger than this. But in reality, strong outperformance is unlikely to last for a long time.

Every sector, industry and theme goes through their own cycles of ups and downs, and tends to revert to a long run average.

What to look out for

Okay, let’s assume we’re shopping for a thematic ETF for our portfolio. What are some of the things we should consider in our research?

• How many stocks are in the portfolio? More stocks will mean less volatility and less reliance on the performance of a few companies.
• Am I happy with the companies inside the ETF? Check the fund page for what’s actually in the portfolio. You might be surprised to find companies you don’t want in there, or which are barely related to the theme at all.
• How large is the ETF? Check how big the fund is. A small fund (say under $50m) has a higher chance of closing down, which would obviously be frustrating. Ideally, the fund has been running for at least a few years and is gaining assets rather than stagnating.
• Is this idea already popular? Probably the most important thing to consider. The wisest way to approach thematic ETFs is to find a theme or idea that many are sceptical about. If people are, that will mean you’re getting in at a cheaper price. No use backing a theme that everybody agrees on, because share prices are already higher due to the popularity of that idea.
• Does this seem like a fad, or are these companies profitable? You want to avoid getting in on a theme which is hot for six months and then fizzles out. As with any investment, approach it with a 10+ year view. Does this theme have a long runway, or could it be short term hype?
• Is this really just a sales pitch? A lot of thematic ETFs are created by a fund manager to gain some fee-earning assets. Make a basket of stocks around a popular story, add some slick marketing, and voila - a nice recurring income stream for them. Be honest: did you think of this theme all by yourself? Or were you influenced by marketing and stories you’ve read?

How thematic ETFs might fit into a diversified portfolio

Given the hurdles and potential issues we’ve mentioned, it’s worth carefully considering how much to invest in thematic ETFs.

One way to approach it is to take the ‘core/satellite’ approach. This is where the bulk of a portfolio remains in broadly diversified core holdings, say 80%. The other 20% of the portfolio can be made up of ‘riskier’ bets. This might include a thematic ETF, a couple of stock picks, or an active fund with a strategy you like.

While it varies from person to person, the core/satellite approach is what a lot of people tend to do naturally. I know very few investors who actually own nothing but diversified index funds. Managing a portfolio this way allows people to ‘scratch the itch’ of active investing, without running the risk of it affecting their long term goals.

Regardless of how certain you might be about a particular investment strategy of theme playing out, it’s smart to diversify. Why have all your hopes and dreams pinned to a single idea paying off?

Remember: you don’t need huge returns to build wealth and become financially independent. I mean, sure, it would be nice. But building a strong savings habit and being consistent is far more important. Besides, the likelihood of huge returns is pretty low. Don’t let impatience drive your investment decisions.

As always, increasing your income and improving your spending will do more to improve your situation than trying to invest in the Next Big Thing. It also puts the control and outcome back in your hands, instead of hoping luck will take you there.

Final thoughts

Fans and promoters of thematic ETFs often suggest they’re a simple and easy way to outperform. Pile up a bunch of good ideas and you’ve got a market-beating portfolio. Others say that, on average, they’re either best avoided or kept to a sensible part of your portfolio.

While we can’t know the future, I tend to fall in the latter camp. Don’t get me wrong, it’s easy to see why these things are popular. They serve a useful purpose for investors to bet on their own vision of the future. But the hurdles we described aren’t easy to overcome.

However you choose to approach it, I hope this article helped you think about both sides of the thematic ETF discussion.

Until next time, happy investing!

Dave