Alchemy Of Thematic ETFs

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

Thematic ETFs are popular vehicles for firms to issue, but not all of them are successes.

For every slam-dunk ETF such as Exchange Traded Concept’s ROBO Global Robotics and Automation Index ETF (ROBO), which boasts over $1 billion in assets under management (AUM), there are a handful of similar but shuttered thematic ETFs.

One of the most recent closures was the Rogers AI Global Macro ETF (BIKR), which ceased trading in July. Despite having a popular theme—artificial intelligence—and having star power from its link with famed commodity investor Jim Rogers, the ETF floundered.

There are a number of reasons why some thematic ETFs take off and why some fail. Success can happen because the theme is good, the time is right and the issuer can provide a bevy of education and support. Yet sometimes all of those positive attributes are behind a theme, and it still fails.

Art & Science
Christian Magoon, CEO of Amplify ETFs, an industry veteran who’s helped launch many funds, says that launching ETFs, especially thematic ETFs, is part art and part science: “Some things are just out of your control, so you need to concentrate on things that maybe are in your control.”

Jay Jacobs, director of research at Global X, explains that when they think about creating thematic ETFs, the firm has a three-step process: their conviction that theme has economic impact; it’s investable; and it has longevity. It’s identified about 60 themes, but he says to launch a fund, the theme has to meet those three points.

At its most basic, index construction and how well the ETF represents the space are two big reasons for an ETF’s success or failure, says Jared Dillian, editor of investment newsletter The Daily Dirtnap.

Quest For Purity
Magoon agrees. There’s been a rush of technology-based thematic ETFs, because many issuers want to claim first-mover status with an ETF that reflects an emerging field. But when ETFs don’t work, he suggests it’s in part because there’s no “purity” in the theme. That purity might not even exist in the underlying individual equities.

Magoon offers self-driving cars as one example. Google is putting a lot of resources toward this technology, but the revenue is a small part of Alphabet. “You hope that it becomes a bigger driver of their business, or maybe they spin it out,” he said.

That does happen. Magoon points out Amazon’s AWS Cloud makes it the largest cloud-computing company, and its earnings dictate a fair amount of Amazon stock performance, despite it being best known for e-commerce.

Timing Can Help
Themes need to be pure, and not significantly overlap with broader sector ETFs. One of the near-overnight thematic ETF successes was the ETFMG Prime Cyber Security ETF (HACK), which saw its AUM rise to over $1 billion in a matter of months. Sam Masucci, CEO of ETFMG, issuer of HACK, jokes that they wish they planned it that way, but says HACK’s embrace was a combination of unique index construction and lucky timing.

It was the first cybersecurity ETF of its kind, and offered access to companies that weren’t part of broader technology indexes, he explains, and the HACK ticker symbol expressed the ETF’s purpose. When HACK was launched in 2014, the concept of cybercrime was starting to come into the mainstream. “There were a few very visible cybercrimes that really helped bring visibility to HACK, notably [involving] Target and Sony Pictures,” Masucci said.

When cybercrime hits headlines, it helps draw investor interest, as people look for ways to find ETFs that’ll give them access to sectors such as cybersecurity, he adds.

Many of the well-known thematic ETFs come from the smaller ETF providers. These issuers can be at a disadvantage on the education and marketing side of ETF promotion versus the industry’s behemoths—like Vanguard, BlackRock and State Street Global Advisors—which can quickly raise awareness and have access to strong distribution channels.

On the flip side, Global X’s Jacobs opines, when a firm that specializes in thematic ETFs releases a fund, the issuer’s reputation can sometimes give a new fund gravitas. Global X has 14 thematic ETFs, including the $1.5 billion Global X Robotics & Artificial Intelligence ETF (BOTZ).

First-Mover Status
Brandon Thomas, chief investment officer for Envestnet, says a well-designed and well-managed thematic ETF with first-mover status may create a moat for the little-guy issuers, preventing others from launching a rival product: “Any follow-on ETF that may try to enter the space is going to have a hard time gaining assets, particularly when the theme is a little bit more niche-y.”

The Amplify Online Retail ETF (IBUY) may be an example of that. Magoon says he launched his company on the back of IBUY in 2016, and the fund had $279 million in AUM as of press time.

Because it was a brand-new company without the marketing budget of a big firm, IBUY was slow to gather investor attention and AUM. Plus, it was launched during a time when people were taking an overall negative view of retail, Magoon explains. But he says what’s helped is that people now see a difference between online and brick-and-mortar shopping, and that the ETF’s performance is strong.

“The way you surface, generally, to core ETF users who usually aren’t the most thematic friendly, is you have performance that stands out,” he explained. “Marketing and media help, but there’s nothing that sells like performance.”

IBUY’s annualized three-year performance is up 25% as of the beginning of August, versus -6.5% for the SPDR S&P Retail ETF (XRT) and 14% for the SPDR S&P 500 ETF Trust (SPY).

Graveyard Of Ill-Fated ETFs
Many things can doom an ETF, explains Envestnet’s Thomas. High costs can be a detriment, as most thematic ETFs cost much more than a plain vanilla S&P 500 fund. Costs come into sharp focus, he notes, since thematic ETFs are usually a very small portion of an overall asset allocation.

What kind of distribution capabilities an issuer has to promote, market and sell the ETF can make a difference, and without it, some ETFs may not take off. With the growth of asset allocation portfolios of ETFs in robo platforms, it can make a difference if one thematic ETF is included over another.

“If you’ve got a very large provider of strategist portfolios, and they have a particular theme they want to present,” Thomas explained, “that gets incorporated into the model and it gets widespread distribution.”

Forces outside of an issuer’s control can also hurt a thematic ETF, he adds, such as if another issuer launches a competing ETF with more desirable traits for investors, which can lead to a fund losing AUM.

Tell A Good Story
Jacobs says some themes have all the right characteristics, but telling the story about the theme and why it’s important can be challenging. That can lead to a fund languishing before investors notice it. Not all themes are sexy technology funds.

He used the Global X Longevity Thematic ETF (LNGR) as an example. The fund launched in 2016, has $21 million in AUM and focuses on companies serving an aging population.

“There are stories that come out about longevity, but I don’t think it’s a story that really has captured people’s attention in the way that robotics or fintech has …,” Jacobs notes. “When you have a decline in populations around the world, that’s really when it starts to become a social issue that people are talking about every day.