Thematic ETFs Take Root & Grow

August 23, 2018

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

Theme investing breaks away from traditional portfolio-building strategies with an intuitive, top-down investment approach that resonates with advisors and their clients.

At its broadest definition, theme investing is a catchall term to describe an investment strategy based on an idea or market niche. A theme is usually associated with new socioeconomic trends or innovative factors that are not properly captured by traditional sector or industry classifications. Investors seeking to profit in this way veer from traditional regional, sector and size allocations, and aim for concentrated exposure to industries and companies benefiting directly or indirectly from their theses.

Theme investing’s popularity also stems from its easy-to-understand investment premise. For example, rising infrastructure spending and how an investor can profit from it is an intuitive and logical pitch for advisors to give their clients. Moreover, an investment theme is supported by a strong growth thesis. ETF issuers conscious of the demand for these products have launched several ETFs around prevalent themes.

Infrastructure
While there is no specific definition for infrastructure, people usually associate infrastructure with projects needed to sustain economic growth. Bullish infrastructure investors note the significant capital resources developing nations are deploying to create new roads, electric grids, water and sewage systems. At the same time, developed nations are upgrading their transportation networks and investing in new telecommunication and renewable energy services.

In today’s ETF market, there are 13 niche infrastructure ETFs. These funds  have an overweight exposure to the industrials and utility sectors as seen in Figures 1A and 1B, yet some funds also have significant exposure to basic materials and energy companies. The iShares Global Infrastructure ETF (IGF) is the biggest in the group, with $2.71 billion in assets under management (AUM); the fund takes a global approach and overweights utility companies in its portfolio.

Emerging Market Consumer
An economics-driven theme is the emerging market consumer, particularly in Asia, where rising incomes have increased the demand for discretionary goods as well as for access to modern financial markets, telecommunication networks and health care services.

 

 

Currently, four funds aim to provide exposure to this trend, with the Columbia Emerging Markets Consumer ETF (ECON) being the largest consumer ETF, with $581 million in AUM. ECON focuses on consumer goods and services companies, and has large exposure to China, South Africa and Brazil. Its main competitor is the WisdomTree Emerging Markets Consumer Growth Fund (EMCG). The Global X China Consumer ETF (CHIQ) and the Columbia India Consumer ETF (INCO) track China’s and India’s markets, respectively, with particular emphasis on local companies in both the consumer cyclicals and non-cyclicals sectors.

 

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Demographics ETFs
The demographics-related themes look at investment opportunities originating from changing social, cultural and generational patterns. From higher life expectancies to millennials entering their prime earning years, these ETFs look at companies benefiting from spending habits and lifestyle choices of different demographics groups.

The aging of population theme is found in two funds, the Global X Longevity Thematic ETF (LNGR) and the Long-Term Care ETF (OLD). These ETFs aim to target companies with products and services improving the lives of senior citizens. The two have different investment approaches, with LNGR having a larger exposure to health care sector companies, while OLD overweights specialized REITs and health care facilities for seniors. Both ETFs have attracted minimal assets, with $16 million and $10 million, respectively.

Alternatively, the ETFs targeting the millennial generation demographic tracks how the cohort’s interests, habits and needs are shaping the consumer goods and services industry. Investors aiming to profit from this trend may take a look at the Global X Millennials Thematic ETF (MILN) and the Principal Millennials Index ETF (GENY). Both funds tilt toward consumer cyclicals and technology stocks to achieve their investment mandates. A key difference between the two is that GENY takes a global approach and invests around 40% in overseas stocks, while MILN only holds U.S.-listed stocks.

Natural Resources
Natural resources investing covers companies that mine or collect raw materials; these include water, agricultural products, chemicals, oil and minerals. The concept is also broadened to include processing and distribution companies. The core drivers for investing in natural resources funds stem from potential rising demand driven by the growing population and infrastructure themes. At the same time, supply constraints due to depleting resources and technology underinvestment may pressure production costs. Both factors may cause another commodity boom.

Currently, 21 ETFs focus on the natural resources theme, as seen in Figure 2. ETFs with broad natural resources build their portfolios around companies that operate, manage or produce natural resources in the energy, ags, precious metals, industrial metals, timber or water spaces. These ETFs have large allocations to the basic materials and energy sectors, with a noticeable tilt to large-cap securities. The largest natural resource ETF is the FlexShares Morningstar Global Upstream Natural Resources Index Fund (GUNR), with $5.75 billion in AUM.

 

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There are six ag ETFs on the U.S. market, such as the VanEck Vectors Agribusiness ETF (MOO), with $846 million in AUM. Ag ETFs overweight large-cap companies in the food and chemical sectors. Five ETFs expose investors to the water theme, by owning the stocks of utilities, equipment makers and environmental services companies, which may benefit from rising water demand. There are also two timber ETFs holding stocks in forestry, paper and paper packaging industries.

Disruptive Technologies
A recent investment theme has centered on new and innovative technologies such as automation, robotics, artificial intelligence, cloud computing and blockchain. These niches offer potential opportunities to realize outsized returns if their products and technologies become widely adopted.

ETF issuers are creating products around these themes, as seen in Figure 3. Automation and robotics ETFs have successfully gathered assets, with the Global X Robotics & Artificial Intelligence ETF (BOTZ) and the ROBO Global Robotics and Automation Index ETF (ROBO) leading the segment, with around $2 billion in assets for each fund. These portfolios often look beyond the technology sector to companies that have applied automation processes in the industrial and health care sectors.

 

For a larger view, please click on the image above.

 

Another successful theme in the ETF market is blockchain ETFs. They have raised around $350 million in assets in a short period of time. The blockchain is a distributed peer-to-peer digital ledger that records transactions in linked blocks of data in a secured manner. It’s also the technology that powers the bitcoin cryptocurrency, which is designed to work as a medium of exchange. At the moment, no ETF directly tracks the bitcoin price in the U.S. markets, but several issuers have filed products to enter the market.

Risks
As with any investing methodology, investors also need to consider the risks with theme-based strategies. While the underlying theme may be grounded in a solid fundamental motif, it’s not a guarantee to make money. Market risk is present, and due to the concentration of holdings in these ETFs, investors should expect higher levels of volatility than they would with traditional diversified strategies.

A key downside to growth themes is that traditional valuation models are difficult to implement, as growth rates may not reflect actual adoption of new products, and early-stage companies may have negative cash flow earnings. Thus, investors need to monitor the spaces to ensure the themes remain valid.

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