Are thematic ETFs just hype

Question

I have ACDC and ROBO in my autoinvest 'portfolio', one up 7% other down 17%. Recently heard commentary on thematic ETFs being overly hyped on launch, then drop to a more reasonable value and from there taking investors who bought the hype to wait years to actually see any growth. The money was to be made early before the general public were aware, before that demand caused the creation of the ETFs to satisfy demand. Should I be allocating new money elsewhere and watching these until they seem to start rising again possibly in a few years?

Answer

Hey David. This is a really interesting topic.

What you’ve heard about thematic ETFs and how they are overhyped in many cases (I would say) is generally true more often than not.  The reason we get excited about certain companies of themes is because it’s very easy to create a ‘bullish’ case for why they will be great long term investments, because the industry is growing or it’s a new technology which is clearly going to be useful in the future.

The problem is, everyone else can see these trends too, especially professional long term investors. So the price of these companies tends to get bid up very quickly to account for their bright futures. This means the ETFs holding them can have great short term performance (due to popularity), but then the ETF can lag for a long time, since it takes a long time for the company’s growth to catch up with the share price.  Many times, especially in the last 5 years or so, thematic or stocks built around a certain concept were bid up to insane prices that couldn’t possibly be justified.  And now many are experiencing the inevitable selloffs as they come back to earth, or more reasonable valuations.

As for where you should be allocating… that’s quite a personal choice.  I personally opt for a more diversified approach (like the entire index), given there is no need to bet on themes for a good long term outcome.  It also tends to be a lower risk given the diversification of an index.

If you want to be more of an active investor, there’s nothing really wrong with that. But maybe balance that with some more boring style investing too, so you can get the benefits of each, and not be too reliant on specific factors.

You might already be aware of what I’ve explained above, but it might also help other people reading it and wondering about this topic.

Hope these rambling thoughts are helpful in some way.  All the best with your future investing :)

Dave

Answer

Howdy David!

Great question mate.

Just so you know, I’m only able to provide general financial information via a Q&amp;A style forum. So the best place to go to get advice on what you should do is a licensed and trusted financial planner. Please don’t act on my information until you’ve spoken with an adviser, or at the very least, read the ETF’s PDS and understood the risks. Because you asked for advice on what to do next, I’m going to stray away completely from the ETFs you mentioned or what’s right for you (sorry mate, the financial advice laws are a prickly pear at times here in Australia).

Instead, I hope my rambling explains why some thematic ETFs make sense, and some don’t.

Studies (see below) seem to suggest that most thematic ETFs underperform for a given period of time post their launch, but this isn’t always the case so it’s not always a bad thing to be there on day one.

Over at Rask HQ, including on our Australian Investors Podcast or Australian Finance Podcast series, you may have heard us talk about studies which show, for example, thematic ETFs can underperform 2-5% for the first few years.

However, when you think about, most funds can underperform for a few years — which is why our industry almost always says to study Super funds, managed funds or ETFs over 3 years minimum. And never case returns from last year. But the world does it anyway! Hence the thematic ETF marketing.

On our Best ETFs Australia website, we use a quantitative scoring model (it’s not public) that effectively lowers the score of any ETF (thematic, index, whatever) that does not have a proper track record of at least 3 years and which we believe has a higher risk of underperforming (I can also overrule the model if something isn’t quite right). Us being sceptical (skeptical?) of new funds is the same idea I followed when I worked for Australia’s top fund/ETF research firm on Collins Street in Melbourne.

As a broad rule, therefore, at Rask, my general advice has always been to be ‘wary’ of new thematic ETFs and, as Charlie Munger would say, always know the incentives of everyone in the room all the time. And when I say ‘everyone’ I also mean ETF providers who extract fees from ETFs.

For example, we’ve seen some shocking ETFs over the past few years — including a BIG ETF that played on the rise of cryptocurrency speculation but didn’t even offer its investors exposure to the cryptocurrency itself (rather, it bought shares of companies involved in crypto). I wrote about this to Rask Core members.

The key things I look at are:
1. Is it a genuine theme for 5 or 10 years? (i.e. are companies genuinely making money or is it speculation)
2. What am I getting? (e.g. I wouldn’t invest in a gold ETF that didn’t invest in gold itself)
3. How is the portfolio constructed? (is it diversified, when is it rebalanced, are they companies I already own?)
4. (related) what are the index rules? (do companies get ‘turned over’ a lot — causing tax, what’s inside it, what’s the size of the market)
5. Do I have a sense of the track record? (beware ‘backtested’ portfolios)
6. Who is the ETF provider? (are they known for dumping lots of ETFs?)
7. Is an active fund offering me a better expression?
8. All the usual research I’d do for any ETF/fund

As you can see, there are a lot of things to consider. I don’t rule out thematic ETFs overall because I’m certain there will be some sectors or types of industries and companies that will do better over a 5 – 10 year period. For me, I bucket every investment as Core or Satellite. Most often than not, «thematic» ETFs fall into our satellite exposure.

Owen Rask

Some resources:
https://www.rask.com.au/our-philosophy
https://www.rask.com.au/subscriptions/
https://www.raskmedia.com.au/podcasts/
https://papers.ssrn.com/sol3/papers.cfm?abstr...
https://papers.ssrn.com/sol3/papers.cfm?abstr...

P.S. Global X is a long-term sponsor of Rask podcasts

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