Using Themed ETFs In Portfolios

They usually look like great ideas, but keep the risks in mind.

Reviewed by: Debbie Carlson
Edited by: Debbie Carlson

[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.”

Clever Investing With Themes
Opsal suggests there’s another type of thematic ETF besides long-term plays, and that’s opportunistic themes. He defines “opportunistic thematic funds” as those chiefly benefiting from the current economic environment. These may be used strategically or tactically, but the point is to sell them when there’s a regime change, Opsal notes.

He uses the Renaissance IPO ETF (IPO) as an example. 2019 has been a banner year so far for IPOs, and year to date, as of press time, IPO is up 44%, and up 19% on a three-year time frame.

“That’s an ETF that’s going to work as long as we have these bullish animal spirits, money gushing in,” Opsal said. “There’ll be other times in the economy where credit is tight, and going public doesn’t work worth a darn.”

Chanin says thematic ETFs can also be used very short term tactically to benefit from a news announcement. He points to the spring rally in the VanEck Vectors Rare Earth/Strategic Metals ETF (REMX), when China hinted about restricting the exportation of rare earth metals as part of the ongoing trade dispute with the U.S.

Keeping Risk In Mind

Jackie Reeves, managing director at Bell Rock Capital, says she’s used a few thematic ETFs including the ETFMG Alternative Harvest ETF (MJ). Reeves keeps thematic ETFs to a very small percentage of clients’ portfolios—generally no more than 10%. She looks at a client’s total portfolio and how a thematic ETF can augment their holdings, based on their risk profile and how the client wants to invest.

Reeves runs some socially responsible investing portfolios, which requires an extra level of analysis to make sure the ETF’s holdings don’t violate any edicts against certain investments. That has ruled out some popular thematic ETFs that might otherwise be a good fit.

Financial advisor Morris Armstrong says he’s used thematics to try and get a few extra basis points of performance. He also keeps portfolio holdings to a very small percentage so it doesn’t change the risk profile. “It’s always a relative position to the broader market,” he said.

Armstrong adds he’s used the First Trust Nasdaq Artificial Intelligence and Robotics ETF (ROBT) for aggressive portfolios, and has held the iShares Global Clean Energy ETF (ICLN) for a number of years. He notes he’ll likely liquidate ICLN, because the fund hasn’t given the performance boost he wants.

Return/Volatility Trade-Off
“I like to think clean energy has a place in our future, as does AI, but the trade-off is between return and volatility on the allocation,” Armstrong said.

BlackRock’s Spiegel notes the key to properly using thematics is to incorporate them without adding risk. Because themes are more broadly constructed than sector ETFs, with careful planning, they could be used in place of other broad-based index ETFs and still end up with similar total portfolio risk.

“Effectively, what you’re doing there is getting exposure to this opportunity to drive long-term benchmark outperformance,” he explained, “but you don’t have to deviate too far from the asset allocation and the risk level that you or your clients are looking for.”

Debbie Carlson focuses on investing and the advisor space for U.S. News. She is an internationally published journalist with bylines in publications including Barron's, Chicago Tribune, The Guardian, Financial Advisor, ETF Report, MarketWatch, Reuters, The Wall Street Journal and others.