Thematic ETFs have been growing in popularity over the last several years. Data from ETF.com shows that assets under management in the space reached $168 billion at the end of the second quarter. This was a 195% increase from the previous year.
Though they remain a small part of the industry overall, making up just 2% of total ETF assets, there is no denying that interest in this type of investment vehicle is growing.
However, thematic ETFs require a further level of due diligence relative to more traditional ETFs that provide exposure based on attributes like region, style tilt or market cap. Investors cannot rely on the ETF’s name alone to understand what might drive performance.
Energy In ESG
Take for instance ESG ETFs, and whether energy may or may not be under the hood. The iShares ESG Aware MSCI USA ETF (ESGU) offers exposure to large and midcap stocks with favorable environmental, social and governance (ESG) practices. In spite of this ESG lens, the fund looks fairly similar to the SPDR S&P 500 Trust (SPY), which tracks a similar slice of the market.
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Both funds hold a comparable amount of the portfolio in energy names, making up just under 3% of the allocation. ESGU holds 14 names in the energy sector, including ExxonMobil and Chevron. According to Sustainalytics, a provider of ESG risk ratings, ExxonMobil is considered to be “high risk” and Chevron is in the “severe risk” category.
(Use our stock finder tool to find an ETF’s allocation to a certain stock.)
The overlap in names between ESGU and SPY, a fund with no specific ESG mandate, is further underscored by the performance of these two funds. Year-to-date, performance of the funds is separated by less than 0.3%.
Surprises In Niche ETFs
Thematic ETFs that cover a niche area of the market can also have surprises lurking within their portfolio. The more focused a thematic ETF is, the higher the chances that it will need to expand its definition of the theme, because there are not enough pure-play companies to build out the portfolio.
The ARK Space Exploration & Innovation ETF (ARKX), for example, holds a 1.5% allocation to John Deere. This company is mainly known as an agricultural and heavy equipment company. John Deere has partnered with NASA to improve its self-driving tractor technology. So while the company has space “ties,” it seems like a stretch to say the company should be a holding in a space exploration fund.
A similar issue pops up in the ProShares Pet Care ETF (PAWZ). This fund tracks a tier-weighted index of global equities related to pet ownership. Merck & Co., a multinational pharmaceutical company, is currently the seventh-largest holding within the portfolio, at 4.4%.
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While Merck is indeed involved in the animal health sector, this business line makes up less than 12% of total sales for the company through the end of the first quarter. The company does fit the theme, but its stock price is likely to be more correlated with pharmaceutical sales that make up the bulk of their revenues.
Same Theme, Different Returns
When choosing to invest in a specific theme, investors often have multiple choices in terms of investment selection. It is important to discern how each ETF is defining the theme and constructing the portfolio. These choices made by the issuer can have a dramatic effect on the return stream, even if each ETF is investing in the same space.
An example of this can be seen by comparing the ETFMJ Alternative Harvest ETF (MJ) and the Amplify Seymour Cannabis ETF (CNBS). Both funds invest in global companies related to cannabis. However, CNBS has dramatically outperformed MJ over the past year.
Courtesy of StockCharts.com
MJ was the first cannabis ETF and it came to market after being converted from a Latin America real estate ETF. Many of the holdings within this fund are not pure-play companies in the cannabis space. The fund includes companies that trade or produce tobacco products, fertilizers, plant foods, pesticides, or equipment for cannabis and tobacco.
CNBS is an actively managed fund that, unlike MJ, uses a revenue requirement to build its portfolio. The fund invests in securities that derive 50% or more of their revenue from the cannabis and hemp ecosystem.
There are 15 holdings that overlap between the two portfolios, but as evidenced by the stock chart above, performance between the two funds can diverge significantly.
There is no right or wrong way to build a thematic ETF. Some might prefer pure-play ETFs for a specific theme, while others might prefer a more diversified portfolio with less industry-specific risk.
The bottom line is that investors need to understand the portfolio construction methodology of the specific ETF to ensure they know what they are investing in.