Using Themed ETFs In Portfolios

August 27, 2019

[This article appears in our September 2019 issue of ETF Report.]

 

If there’s a niche investment idea out there, chances are there’s a thematic ETF for it.  Thematic ETFs may get a lot of press coverage, because they offer exposure to difficult-to-access investment areas or have cute ticker symbols that evoke associations with the theme, but financial advisors need to be thoughtful when using them in portfolios.

Several ETF market watchers say these funds work best as satellite holdings to complement existing core positions. “You may be in a broad-based tech fund, but if you believe certain areas of technology are going to outperform, you may use a thematic ETF to get exposure to a specific area,” said Andrew Chanin, co-founder and CEO of ProcureAM, which issued the Procure Space ETF (UFO).

Scott Opsal, director of research for The Leuthold Group, notes that because thematic ETFs purposefully uncouple themselves from the broader markets, building an entire portfolio with thematic ETFs would mean missing out on broader market moves, and could lead to investing regrets. Still, he adds, he’s a fan of these ETFs.

“In general, I love the idea that you can make these finer and finer bets on themes through an ETF. I think it’s a fantastic development over the last decade,” Opsal said. “To me, a thematic fund is any fund where you’ve got an idea that something specific is very attractive, and now you can buy it pretty easily and cheap.”

 

 

Diversification & Longevity
Unlike sector ETFs, which only pull holdings from one sector, thematic ETFs are built using holdings from different sectors related to the theme, increasing diversification, Chanin remarks. In contrast, some sector ETFs’ top holdings can represent as much as 40% of the fund’s composition, heightening concentration risk.

“That’s the beauty of thematic ETFs,” he added. “It’s this instant diversification, and if you want to really be overweight a couple of those names, you can do that outright.”

He gave a couple of tips to keep in mind when evaluating a thematic ETF. First, make sure the theme potentially has a long trajectory that won’t get phased out by technology or other structural changes.

Jeff Spiegel, U.S head of megatrend and international ETFs for BlackRock, concurs. When creating its new megatrends category, they studied which themes they believed had the greatest staying power.

“We wanted to separate out the more faddish opportunities and focus on what the really long-term transformational forces are that are changing the way we live and work,” he said.

BlackRock singled out five megatrend themes: demographics and social change; changing economic power; technological breakthrough; rapid urbanization; and climate change/resource scarcity. It launched two ETFs under these themes: the iShares Cybersecurity and Tech ETF (IHAK) and the iShares Genomics Immunology and Healthcare ETF (IDNA).

Chanin and Spiegel suggest investors look at index construction when evaluating thematic ETFs. Does the theme offer unique exposure? Does it overlap with other products or have a high correlation with other holdings?

“When you build out that portfolio, ask yourself, are you actually providing what people want?” Chanin said.

Building Portfolios
The idea that long-term secular plays can boost portfolio performance is the main selling point for thematic ETFs. But big themes may not give investors outsized or even consistent returns, Opsal notes, another reason to keep these funds to a satellite position in a portfolio.

“They sound good, are good for humanity, good for the economy, but there are just no economics behind them,” he explained.

Wind energy is an example, he explains, citing the First Trust Global Wind Energy ETF (FAN). Its 10-year track record has it up 1%: “There’s no barrier to putting up more wind turbines. [It’s a] great idea, but I’m not sure if the economics will ever generate the profit stream.”

History shows that cool technology may not equate with good investments, says Katherine Schoen, manager of Baird’s private wealth management equity and fixed income research team, echoing Leuthold’s Opsal.

She points to the dot-com bubble of 2000-2001, when the internet was just taking off: “We’re using the internet and that technology like crazy over the past 20 years, but unfortunately, if you’d’ve invested in tech in that time, you wouldn’t have made money.”

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