Sizing Up Thematic ETFs

August 16, 2018

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


Roger NusbaumRoger Nusbaum is chief investment officer and a portfolio manager at Your Source Financial, a blogger and a regular contributor to sites such as Seeking Alpha and His has 30 years of experience in the investment industry and writes frequently about sector and thematic investing. ETF Report recently spoke with him about the nature of theme ETFs.


What exactly is a thematic ETF?

I refer to these in my blogging as broad-based sector funds versus narrower, and then I usually put in parentheses, “theme or niche funds.” That’s the starting point of how I think about it.

Looking at something like the iShares U.S. Healthcare ETF (IYH)—which is not a client holding—it’s broad-based, market-cap-weighted, health care sector exposure. You’ve got the big drug companies, device makers, any sort of large biotech—that’s the definition of a broad-based sector exposure.

In terms of going narrower from there, one name I own for clients is the iShares U.S. Medical Devices ETF (IHI). That focuses on just one thing. My expectation is that something like IHI will generally be more volatile than IYH. My hope is that when things are going well in markets, that something like IHI will outperform the broader sector fund. And the other side of that is the acceptance that something like IHI will underperform when things are going poorly in the market.

That, to me, then leads to the next thing of sizing accordingly if health care has something like a 12% or 13% weighting in the S&P 500. If I'm assuming IHI to be more volatile, I don’t really want to have 12% or 13%—all of my health care exposure—in something that’s likely more volatile than the overall sector.

Is volatility something investors need to consider when they're looking at subsets of larger sectors or approaches that cross sectors?

Yes. I think the better way to think about that is that the narrower you go—comparing apples to apples—the more volatile something’s going to be. I use plenty of individual stocks, along with thematic funds and broader funds to build portfolios.

It’s crucial to understand the term volatility profile of any holding that you have. And again—just apples to apples—a broad sector is going to be less volatile, the vast majority of the time, than some sort of narrower industry group or theme fund. And that narrower fund, more often than not, is going to be less volatile than an individual stock.

We’re seeing ETFs launching now that target the artificial intelligence space, the virtual reality space, drones, gaming, blockchain, etc. What do you see as a category that’s too “out there”?

I don’t think anything is too far out there. The way I would think about it is, there was a cycle to Electronic Arts where there was a period in the year where it would outperform, based on the cycle of when the new version of the Madden NFL game came out.

Gaming is a thing, and I think you can apply this to any type of theme. If you would have some level of interest in learning about a gaming stock and decide, yes, this has some level of merit, well then, why wouldn’t the thematic ETF that has 5% or 15% or 20% in that same stock also have some level of merit? It may turn out it’s not something you end up investing in. But it’s not too far out there if you’d be interested.

Drone growth is happening. I don’t have numbers to cite for you. That growth is either compelling or it isn't, but it’s definitely happening. Let’s say I'm interested in learning about drone companies and the drone theme. Are there any stocks worth owning? Let’s see what the choices are. Oh, here are a couple of stocks that’re interesting. Oh, they have large weightings in a drone ETF. Does the ETF make more sense? Yes or no?

What role can a thematic ETF play in an investor’s portfolio?

I don’t think of this as isolating a theme to answer this question. But the way I’d build a portfolio is, I’d look at the sector weightings in the S&P 500. If a sector has a 10% weighting in the index, I've got to think long and hard about ever having say a 20% weighting in that sector. To me, that’s a huge bet. By the same virtue, if something has a 10% weighting in the index, having zero exposure to it is also a huge bet. Each of these themes is part of some broader sector.

Drones are technology. That’s going to be part of my tech exposure. If the tech sector has a 25% weighting for now—until this transition is complete, at least—do I want to be overweight or underweight in technology? Do I want to be equal weight technology? And then, from there, how am I going to populate my exposure to technology?

With something like drones, I don’t want a 10% weighting. That’s a lot of volatility for the typical client. I would think of something that narrow—like drones, or marijuana, or blockchain, or the ETF theme—as being so narrow as to be similar to an individual stock in terms of how I would want to weight it. And my preference is to usually start an individual stock out at a 2% or 3% weighting of the client’s portfolio.

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