Thematic ETFs: no more — and no less — than good stories

ETFs that promise to follow a market trend may not make you rich. But perhaps that is to miss the point…

Justin Reynolds
The Patient Investor

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In an investment world that still attempts to cultivate image of sobriety thematic ETFs are unashamedly ‘cool’.

Tracking a market trend rather than an asset class or region, thematics promise to allow investors to follow an evolving megatrend, be it wind, solar, hydrogen, blockchain, space, the metaverse, or even gender equality. Shopping for an ETF, usually marketed with oracular titles and futurist imagery, is rather like browsing the sci-fi section of a bookshop, or an electronica playlist on Spotify.

The better known include the ARK Innovation ETF and the iShares Global Clean Energy UCITS ETF, but the future can also be accessed through offerings such as the KraneShares Electric Vehicles & Future Mobility ESG Screened UCITS ETF, the Global X Uranium UCITS ETF, the VanEck Space Innovators UCITS ETF, the L&G Hydrogen Economy UCITS ETF, the VanEck Crypto and Blockchain Innovators UCITS ETF, the Global X Video Games & Esports UCITS ETF, and, for those betting on cannabinoid products, the ETFMG US Alternative Harvest ETF.

Thematics bloomed when investors rushed towards tech during the pandemic, Morningstar reporting that nearly two-thirds of the more than 700 thematic ETFs currently listed were launched after January 2020. In the words of Rob Powell, head of thematic and sector product strategy at BlackRock, they offer a way to invest in ‘the secular, disruptive, long-term trends that are set to define the future of the global economy.’

Thematic ETFs are still something of a niche product, accounting for just 2.5% of worldwide equity assets under management, but they are the fastest-growing equity fund segment, managing €300bn worth of assets through the three years to June 2022, a 200% increase. And they have continued to multiply through the market downturn, the number in the European market rising from 115 in January 2022 to 164 this February. Even the venerable Investors’ Chronicle allowed four Blackrock thematics into its yearly roundup of core ETFs, the aforementioned iShares Global Clean Energy UCITS ETF, the iShares Automation & Robotics ETF, the iShares Ageing Population UCITS ETF and the iShares Digitalisation UCITS ETF.

But, significantly, no more than four. The list’s compilers, like the wider finance industry, have profound reservations about the effectiveness of thematics as long-term investment vehicles. Though marketed as intelligent plays on long-term market trends, many seem rather more like opportunistic gambits on short-term fluctuations.

Thematics and the ‘narrative fallacy’

Thematic managers claim to identify emerging sectors with the capacity to generate robust returns now and into the future. But their performance in the wild suggests that whatever momentum a fund’s constituents might have enjoyed prior to its launch evaporates shortly afterwards. There’s not much difference between identifying a story capable of generating price movements and identifying price movements capable of generating a story. And of course fund managers excel in presenting stories. In the acerbic assessment of FT columnist Stuart Kirk, investors should ‘Buy when no one is talking about a theme and sell once everyone is. Easier said than done as most funds are launched only when a theme is exciting enough, and by that time it’s too late.’

Those investors expecting alpha returns from thematics may be inclined to — as Nassim Nicholas Taleb termed — the ‘narrative fallacy’, our natural tendency to read patterns into noise. Confronted with the sheer contingency of the world we look for cause and effect rather than the play of chance, for stories with beginnings, middles and endings. But, unless one believes in ‘fate’, or the ways of God, there is no narrative, just one thing after another. In his analysis of the power of stories to drive financial events, Narrative Economics, Robert Shiller quotes Garry Kasparov’s observation that his opponents ‘would fall into the trap of seeing each game of chess as a story, a coherent narrative with a beginning and a middle and a finish, with a few twists and turns along the way. And, of course, a moral at the end of the story.’

The world of investment, of course, is driven by stories, a coping mechanism for attempting to make sense of the ceaseless flux of the markets. Successful fund managers are masters of the art, assuring investors that periods of good performance can be attributed to skill rather than luck, and fallow years to market conditions that are certain to change. This storytelling facility has gone into overdrive in the world of thematics, where ephemeral trends in price movements can be readily turned into compelling narratives, and, through evolving indexing technology, a new range of ETFs.

As well as being based on rather dubious claims about future share movements, thematics tend to be built from rather fragile materials. Focused on emerging technologies they are often constructed from a narrow set of companies with small market caps, generating the kind of liquidity risks vividly highlighted last year when the cluster of small stocks that constituted the iShares Global Clean Energy UCITS ETF was overloaded by investor demand, necessitating the complete reconstitution of the fund’s index to improve liquidity and diversification.

The performance of thematics so far suggests that — at best — the jury is out. They soared during the tech boom but have fared poorly since market conditions turned against growth stocks, their vector symbolised by the Icarian flight of the ARK Innovation ETF, which soared around 150pc in 2020 before halving in value the following year. Morningstar data published last month reported that every ETF theme has posted negative returns over the past year. More than €2bn has continued to flow into thematics over the same period, but that is largely attributable to the surge in demand for clean energy that followed the outbreak of the Ukraine conflict, energy transition ETFs accounting for 91% of thematic inflows during the period.

Though designed to be held for the long-term thematics are volatile. The dramatic ebb and flow in their values has encouraged short-term speculative trading, and, worse, many have simply disappeared: a third of thematic funds launched a decade ago have not survived. Faced with choosing between so many — quite possibly transient — vehicles for riding a theme investors who do indeed wish to buy-and-hold must peer through the hype and discriminate carefully. Recent inflow patterns suggest that the field is maturing somewhat, as witnessed by the expansion of prominent funds such as the iShares Global Clean Energy.

It’s not always only about money…

Though we should be rightly sceptical of thematic ETFs I think they have a future. Yes, thematics can be rather fragile. Yes, their value has oscillated wildly. And they are most certainly oversold, loaded with false expectations that investors can both follow their favourite market stories and enjoy outperformance. But perhaps all that’s necessary is a shift in perspective. The most appropriate way to view thematics, perhaps, is as a kind of ESG fund: a mechanism for allowing investors to take a particular market position at the possible expense of falling short of the market return. They are no more — and importantly no less — than vehicles for following a megatrend. And they promise to do so at lower cost than active funds.

ESG funds have been rightly criticised for promising to square the circle of meeting investors’ moral and monetary demands. Many will oblige their holders to forego some return, screening out potentially profitable stakes in ‘compromised’ securities that conventional index funds will include. And that is surely as it should be. Not every investment decision needs to be motivated purely by profit. As the sector matures, thematics may come to be viewed in similar light to ESG funds: ideal for investors with a keen interest in a particular sector willing to accept a degree of extra risk, and whose wider portfolio is well diversified.

A long-term stake in space exploration, blockchain or nuclear fusion may yield alpha returns. It may very well not. And that uncertainty will be a price worth paying for those wishing to back those technologies. Futurism may be educated. Or perhaps not so educated. Every good library, one might say, needs canonical works like the Bible and Shakespeare. But there’s surely room for a sci-fi shelf as well.

The image is based on a still from footage of a NASA/SpaceX launch.

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Justin Reynolds
The Patient Investor

A London-based financial writer and essayist. Edits The Patient Investor. Twitter @_justinwriter.