Thematic ETFs Find Their Niche

[This article appears in our July/August 2020 issue of ETF Report.]

Thematic exchange-traded funds have come of age.

Once considered gimmicky or speculative, advisors and investors are using thematic ETFs to get niche exposure to emerging industries, or to express a tactical view in a small area of the market.

Still, people who want to dabble in these vehicles should do their due diligence before proceeding. Only a handful of thematic ETFs are deep and liquid, so many funds risk being closed if assets under management (AUM) flounder. They’re costlier than plain-vanilla, broad-based ETFs, and if not added to a portfolio correctly, they can lead to greater-than-expected overlap in certain names.

Defining Thematic ETFs
The differences between an investable theme, a sector and a one-off niche-y ETF are hazy, and for some investors, these distinctions may not matter. Elisabeth Kashner, CFA, director of ETF research at FactSet, explains that investors can identify themes and sectors in similar ways, such as by business activity; however, sectors have neat hierarchies—such as technology or real estate—and branch out from there, while themes can combine industry types from disparate sectors.

For example, a robotics-themed ETF may incorporate industrials and technology. A natural resources ETF might pull from energy and basic materials.

Kashner adds that FactSet also waits before adding new themes to its fund classification system: “We want some indication of investor interest.”

There should be at least two funds addressing the same theme, with one fund holding a minimum of $100 million in AUM, or both having a total of $75 million.

With that criteria, blockchain is a theme, as it’s a well-defined opportunity cutting across multiple sectors. There are four funds with combined AUM of well over $75 million. The Amplify Transformational Data Sharing ETF (BLOK) is the biggest, with $92 million in AUM.

Agriculture is a nontechnology theme, Kashner observes. There are five ag funds, with the VanEck Vectors Agribusiness ETF (MOO) amassing the bulk of assets, at $566 million.

FactSet doesn’t consider ETFs like the U.S. Vegan Climate ETF (VEGN) as capturing a theme, since it’s viewed as being demographically based. The ETF selects securities according to their compliance with vegan and environmental principles.

“It’s more about what types of consumers might like that, rather than splitting things up by sector and industry,” Kashner says, adding that FactSet would lump this type of fund in a size and style fund.

A Renaissance
Ed Lopez, head of ETF product at VanEck, a pioneering thematic issuer, says thematic investing started as a way to offer investors narrow slices of exposure. They fell out of favor when smart beta ETFs became popular. Now as technology propels certain industries, there are new opportunities for thematics.

Jay Jacobs, head of research and strategy at Global X, agrees. Global X is another firm that’s launched several thematic ETFs over the past decade, including the Global X Cloud Computing ETF (CLOU).

A majority of the investor interest is in technology-focused thematic ETFs, he says: “We live in a very disruptive time. It doesn’t take a financial analyst to realize you’ve spent a few thousand dollars to make your home a smart home.”

Jacobs remarks that Global X considers three points when creating a thematic ETF. First is conviction; does it believe that the theme will have a “massive disruptive impact” on the world economy? Second, is it investable? An ETF needs to hold at least 20 publicly traded companies. Global X would need to find 20 companies that are pure plays or that are highly exposed to the theme. Third is time horizon. The firm looks at long-term structural trends that will play out over multiple decades.

He notes that Global X has come up with about 65 to 70 themes, but less than 20 are able to meet all three elements, he says, with many failing the investment criterium.

Lopez concurs. Thinking structurally is a key part of building thematic ETFs, since investors often use such funds to capture growth and diversify from broader-based exposure. The VanEck Vectors Video Gaming and eSports ETF (ESPO) has received strong inflows this so far year, benefiting from greater interest in online sports during the pandemic as people stayed at home, he says. But it’s hard to guess what themes will take off. “You don’t know which ones are going to hit,” he notes.

Portfolio Use
One niche ETF in the limelight lately is the US Global Jets ETF (JETS). Although FactSet doesn’t consider JETS a thematic ETF, many investors think it is. The ETF is being used in part as a way to bet on the global economy or the pandemic-devastated airline industry. Its AUM is now over $1 billion, compared with  about $65 million at the start of 2020, says Mike Matousek head trader at U.S. Global Investors.

Select Thematic ETFs

Source: FactSet, 6/17/2020

He says buy-and-hold investors were first buying JETS as a way to scoop up a basket of cheap airline stocks, but he notes that hedge funds are using it as a “compare trade,” where these investors will use the ETF as a hedge versus a singular airline name, such as buying JETS and shorting an airline stock with the idea that the overall basket of airlines will outperform, or vice versa.

“There are people finding ways to pull money out of the market using ETFs in unconventional ways that most retail people would never think of or heard of,” Matousek said.

Samuel Deane, financial planner at Deane Financial Partners, uses two thematic ETFs, the ETFMG Alternative Harvest ETF (MJ) and the ETFMG Prime Cyber Security ETF (HACK). His clients are millennials in the technology field, and he likes that a lot of the thematic ETFs focus on innovation.

However, Deane relates, he’s choosy about which thematic ETFs he’ll buy: “I want to be able to get my clients exposure to emerging trends, but not too early in the development where it may eventually be tied into a bigger theme.”

One of those trends is cloud computing, he explains, noting that it’s too early to see if this is a viable niche versus being included in a broader information technology theme. When Deane incorporates thematic ETFs, he’ll keep the exposure relatively low, between 5-10% of total holdings, and view the position tactically.

When choosing a thematic ETF, FactSet’s Kashner notes investors should keep in mind these funds are narrowly focused and built on a very particular economic hypothesis; there are a lot of embedded bets in making that choice: “You can win really big with them, but you can also lose really big.”

Narrow Focus
Thematic ETFs’ narrow focus is one reason Chuck Self, chief investment officer at iSectors, doesn’t use these funds across the 21 portfolio types his firm manages.

“These tend to overlap what you already own. You may think these offer diversification, but you’re really getting more concentration,” he says, adding that he’d rather use cheaper sector indexes if he wants to amplify a position.

Global X’s Jacobs agrees that overlap can be a challenge for thematic investors, so they need to think carefully about diversification. He points out that CLOU includes tech heavyweights like Amazon, Google and Microsoft, but that the fund caps its exposure at 10% collectively for those firms.

“People already have those,” he explained. “While they’re super important to the space, they’re not deriving 100% of their revenue from the cloud like a Salesforce. That’s why we’re very focused on pure-play exposure.”