Thematic ETFs: Where Active Mgmt Makes Sense

August 22, 2016

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Ben Lavine, chief investment officer of 3D Asset Management based in Hartford, Connecticut.

With Fidelity’s recent registration for a new version of actively managed ETFs (see these ETF.com articles authored by Matt Hougan and David Nadig), it is only a matter of time before much of the traditional actively managed mutual fund universe migrates to some form of ETF structure, even if it is in the hybrid form proposed by Fidelity.

Whether this will help stem the outflow of investor assets from active to passive management remains to be seen, given that ETFs are not the primary reason why passive leader Vanguard is gaining the lion share of this outflow from active management.

As an aside, I believe traditional active management can play a role in investment programs primarily because professional investors ultimately determine where best to allocate investor capital depending on price and opportunity (see “Here’s How Active Can Compete With Low Cost ETFs”).

Active management also brings social benefits as professional managers provide feedback signals to corporate management on the effectiveness of their capital allocation decisions. However, there are continuous debates on 1) where active management should be employed (i.e., public versus private markets, equities versus fixed income, small-caps versus large-caps); and 2) how it should be employed (i.e., quantitative versus fundamental, diversified versus concentrated/high conviction).

Thematic ETFs Ripe For Active

One area of opportunity ripe for active management is in thematic-based ETF investing. As an ETF strategist, I’ve been drawn to some of the thematic-based ETFs that are constructed not around groupings (i.e., sectors) or factors (e.g., low volatility), but around “themes” as a way to capture more qualitative growth trends using screens.

Some of the more popular themes include technological innovation and security: PureFunds ISE Cyber Security ETF (HACK), ARK Innovation ETF (ARKK), 3D Printing ETF (PRNT); longevity: The Long-Term Care ETF (OLD), Global X Longevity Thematic ETF (LNGR); and health and wellness: Global X Health & Wellness Thematic ETF (BFIT), The Health and Fitness ETF (FITS).

What has held me back in considering these thematic ETFs largely come down to: 1) expenses; and 2) questionable portfolio construction.

Sector Funds Wrapped In Thematic Clothing

You can screen for thematic ETFs using the ETF.com screener by selecting the “More Filters” option on the home screen, then selecting the “Selection” tab and scrolling down to “Principles-based,” and that will populate the screen with the 23 thematic ETFs.

Most thematic ETFs can be thought of as sector-based ETFs, where certain sectors are mapped by the ETF provider that fit the targeted theme and then invest in stocks with those sector IDs. Yet thematic ETFs tend to charge much higher fees versus plain-vanilla sector funds (roughly 20-70 basis points higher than what Fidelity, SPDRs and iShares charge on their sector ETFs).

Now this may be an unfair generalization of the thematic process, since some firms use a proprietary methodology for identifying stocks that fit the specific theme. However, even for these funds, their proprietary methodology would undermine the transparency of the ETF itself, reducing its overall appeal.

Portfolio Construction Creaky

In addition, many thematic-based ETFs tend to treat portfolio construction as an afterthought, where security weighting is either based on market capitalization or just equal-weighting.

Most of the ETF sponsor’s “intellectual property” goes into the screening mechanism for ETF basket inclusion, not much into how the basket should be constructed.

In other words, membership becomes the sole determinant for portfolio construction. For example, several ETFs that play on the “longevity” theme end up being a play on health care REITs, with nursing home facilities being one way of playing “longevity.”

Other thematic ETFs can have heavily concentrated positions in individual names, with little to no transparency as to what is driving those concentrated positions.

 

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