The Role Of Themes In Portfolios

August 21, 2018

[This article appears in our September 2018 issue of ETF Report.]

Got a hunch that artificial intelligence is going to change the world, or that water will be the new crude oil? There’s an ETF for that.

Thematic ETFs allow financial advisors and their clients to invest in big, macroeconomic or demographic trends and structural changes that will play out for decades. These ETFs might take a narrow approach to a larger sector, such as the ETFMG Prime Cyber Security ETF (HACK), or take a cross-sector approach, like the Global X Robotics & Artificial Intelligence ETF (BOTZ), which straddles industrials and technology.

Advisors can use thematic funds to express a bet on a big idea, but because these can be volatile, they’re best suited as satellite holdings. They’re not foolproof, either, as sometimes big ideas don’t necessarily translate to investable topics.

Todd Rosenbluth, senior director of ETF research for CFRA, says most people are attracted to these ETFs because they find the theme compelling or the ETF has had an impressive short-term track record.

Pinning Down Themes
Technology is a popular area, and several funds are producing outsized returns and gathering respectable flows, such as the Global X FinTech ETF (FINX), which has a one-year return of 33.9%, or the ETFMG Prime Mobile Payments ETF (IPAY), up 26% on the year. FINX has $298 million in assets under management and IPAY has $404 million in AUM.

Because themes can be very broad, financial advisors can use them in different ways. A popular way is to augment a sector view, or to diversify.

As an example, HACK, the largest cybersecurity ETF, with $1.6 billion in AUM, focuses specifically on hardware and software companies in the high-growth cyber space, something a broad market technology fund like the Technology Select Sector SPDR Fund (XLK) can’t offer. Sam Masucci, chief executive officer of ETFMG, says broad market tech ETFs are diluted.

“The benchmark returns are set, but if you want outperformance, then you need to be in a narrower sector,” Masucci said.

Thematic ETF goals can be understood a little easier by clients, too, he says: “Cybersecurity is a great example of a thematic idea that people identify.”

These ETFs overlap with main sectors, but depending on the index construction, they may offer some diversification. Rosenbluth says a fund like HACK doesn’t include Microsoft, even though it’s a software company, or other big technology heavyweights like Apple or Intel, so the exposure is different than a broader tech fund.

“Because the exposure is going to be quite different, the returns are going to be quite different as well,” Rosenbluth cautions.

In the short term, HACK and XLK have year-to-date returns of 13.8% and 10.3%, respectively. The three-year return for HACK is 6.7% and for XLK is 20.1%.

Indexes Matter
Index construction can differentiate competing ETFs on the same theme. Jay Batcha, founder and chief investment officer at Optimal Capital, which uses thematic ETFs, says advisors need to look even more critically at the analysis being done—at the stock-picking methodology and the investment process.

“We’ll look at the individual holdings to see if it’s a bunch of stuff we’ve never heard of, or if these companies are more household names that have a presence in the space,” he said. “It’s fine to have a little bit of both. You just want to know what you’re getting and how much risk is in the portfolio.”

Batcha, whose firm holds the Reality Shares Nasdaq NexGen Economy ETF (BLCN), says he relies on the ETF creator’s intellectual capital to assemble the desirable investment vehicle.

“For someone whose core competency is not in that specific industry, it becomes difficult to separate the winners from losers,” Batcha added. “How do you play artificial intelligence or robotics or blockchain?”

Because these funds can take a cross-sector approach, financial advisors need to look at their total portfolio to see how they fit. At first blush, BOTZ appears to be a technology fund because of its focus on robotics and artificial intelligence, but Jon Maier, chief investment officer at Global X, says they see it fitting more with industrials.

“Robotics and artificial intelligence are making machines smarter and more capable, allowing robots to do very sophisticated things and tasks, and making production more accurate,” he noted. “So from our perspective, robotics and AI are disrupting industrials.”

Using Themes
Eric Ervin, chief executive officer of Reality Shares, says thematic ETFs should be considered satellite holdings, keeping them to 5-15% of a portfolio.



“Where people can get themselves into trouble is saying, ‘It’s going to be the next big thing, so we want to really allocate heavily there,’” he said. “What they should be saying is, ‘We think it could be a big thing, so we want to have exposure there, but if it really is a big thing, then we don’t need that much.’”

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