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Magazine Issues » March 2020

Thematic ETFs: Gimmick or growth opportunity?

GrowthAs the thematic exchange-traded fund sector continues to expand, Alex Rolandi asks whether they are simply gimmicks, or robust enough to provide long-term growth.

Over the past three years, thematic exchange-traded funds (ETFs) in Europe have grown their assets under management by more than five times to €8.5 billion, according to data from Morningstar.

Although total assets of thematic ETFs in Europe represent just under 1% of all ETF assets, the sector is growing rapidly. Nearly 30 of the 40 thematic ETFs listed in Europe date from 2018 onwards.

“We have seen a flurry of launches in the last couple of years, as the main providers build out their offerings in anticipation of continued growth in the area,” says Kenneth Lamont, senior analyst, manager research, passive strategies at Morningstar. “It’s just heating up now. Now is the right time to enter.”

Legal & General Investment Management (LGIM) is one such provider. It launched its first themed ETF about six years ago, focusing on robotics and automation. According to the firm’s head of ETFs, Howie Li, investors who had originally shunned the idea of thematic ETFs have since turned around and expressed interest in the sector.

“Back then [six years ago], the difficult part for investors was knowing how to put thematics into asset allocation. Fast-forward to now, the investing public is much more aware of how to use it,” he says.

His colleague Simon Hynes, regional head of retail distribution at the firm, says the sector is still in its early days – but there is a lot of room for growth. “There are a lot of future opportunities out there – it feels like the market is growing rapidly in terms of level of interest,” he notes.

“Themes are relatable,” Li adds. “It’s easier to relate to how an industry is growing versus a traditional fund.”

Check the narrative
Some of the early adopters of the L&G Robo Global Robotics and Automation Ucits ETF were wealth managers in Italy advising clients on traditionally fixed income-focused portfolios. Investors who by custom weren’t overweight equities would have a robotics fund in their portfolio. It is the story behind the theme that is exciting for the client or wealth manager reviewing the portfolio, Hynes says.

But it is also the story that can make thematic ETFs seem like a fad. Morningstar’s Lamont doesn’t believe they are always the best option from an investment point of view.

“You get a lot of narrow products, for example in the US you have a 5G ETF. How’s 5G going to sound in ten years’ time?” he asks. “That’s a particularly bad one – it’s an example of something too narrow, or too specific. They should call it ‘next-generation telecoms’. Maybe that’s a broader space you can play with.”

In many cases, Lamont believes, thematic ETFs don’t generally make a lot of sense. “For the guys who work on your pension funds, it’s a narrative – it’s a bit gimmicky.”

Li has his own concerns regarding the sector as well. It is getting a lot of attention. According to him, asset managers are increasingly coming out with thematic propositions – but they might not always be what they seem. “We’ve seen a lot of marketing around themes or traditional funds that have been around for a while, repositioning as thematic funds, and what we don’t want this to be – for us, at least, as a house – is a marketing label for investments,” he says.

“Thematic ETFs are supposed to provide a very pure and direct exposure to an investment opportunity that is currently experiencing a huge amount of foundational structural change.”

The LGIM ETF team has started to notice that many of the thematic portfolios coming to market are almost always entirely made of large-cap companies. “You’ve got to ask yourself why that it is,” Li says.

“For us, if you’re going to get pure exposure to a new sector or theme, these themes aren’t mapped as today’s sectors – we’re trying to create that map of what we hope should be the sector definition tomorrow.”

For WisdomTree’s head of research in Europe, Chris Gannatti, identifying the theme is the primary risk in thematic ETF investing.

“There are many concepts that might be considered ‘megatrends’, but it is uncertain which ones will have the greatest impact and widest proliferation,” he says. “Even if a megatrend does take off and attains widespread adoption, there is no guarantee that the companies that represent that type of exposure can actually deliver strong investment returns.”

ETF white-label firm HANetf’s chief executive, Hector McNeil, believes the biggest risk is ensuring the theme is not a fad. “You’ve got to make sure that it’s a trend that isn’t going to go away.”

High mortality rate
The mortality rate for thematic ETFs is high – around 80% of such strategies launched before 2012 have since closed. Taken in aggregate, the performance figures aren’t great historically, either, according to Morningstar analyst Lamont.

This is average performance, he points out, adding: “If you pick the right thematic strategy, it could be a very good investment for you.

“We live in a time of incredible change and if you look back at history, it is these huge structural changes that provide opportunities.”

As much as it’s about being in the right place at the right time, the theme has to be analysed in depth. “You’ve got to look at the theme itself – is it robust? Going back to the internet funds of the late nineties and early 2000s – how many of them are still around today? Not many.”

Even those that have survived won’t necessarily look the same as when they started. “None of those names would be the same as the themes themselves change,” Lamont notes.

He uses Pictet as an example – they’re not afraid to change theme, he says. “They had an agriculture fund, part of which was suggesting that we weren’t going to have enough food in the future – this sort of Malthusian scaremongering which has been going on for hundreds of years – and they changed it to a nutrition fund. Feeding the world, they felt isn’t actually the problem, it’s feeding the world properly.”

In many senses, setting up a thematic ETF is like trying to map out unchartered waters. There are no guarantees as to how the route taken will pan out. WisdomTree’s Gannatti notes that even the top companies within a given megatrend may not exist in a publicly listed independent manner for the long term as they could get acquired by other companies.

“The fast growth that tends to be emblematic of the excitement around megatrend investments often attracts larger companies trying to adjust to the disruption they might be seeing within their own markets,” he says.

Gannatti believes investors need to be aware of the process behind the strategy – whether it is driven by humans or algorithms. Although he says neither is better or worse than the other, it is important to understand the differences as well as what happens when companies are removed from the strategy due to acquisitions or other circumstantial changes.

“By working with third-party experts within a thematic field, like AI or cloud computing, you could have a better chance at being able to adapt to a changing landscape that a rules-based or algorithmic approach could miss,” he tells Funds Europe.

Data-mapping
A theme, by its nature, can traverse many different traditional sectors or business models. This means asset managers are dealing with different types of data. The investment strategy has to map its way through these sectors and unstructured data to find a common thread.

Before launching a themed strategy, LGIM’s ETF team spends time researching the theme. They then work with a dedicated expert who can give data on the underlying companies in that theme to find out who and what is driving growth.

It’s easy for companies within the same industry to understand the data shared between them. “But for us as an asset manager,” says Li, “although understanding the different pieces of data is useful, it’s not as easy and clean as just downloading it off Bloomberg. We’ve got to take that data, structure it, and implement an investment strategy there.”

A lot of active research goes into the construction of the theme. LGIM’s e-commerce logistics strategy was launched last year. Li explains that his team essentially had to construct the ecosystem that exists within that space – be it warehouses, last-mile delivery, or fulfilment.

“And to do that, you need to work with experts. That information is just not available on your Bloomberg terminal or investment data that you can just buy,” he points out.

Morningstar’s Lamont says it is important to consider that on average, in the past these strategies haven’t performed well – “but equally, how do you judge the performance of a robotics fund if the claim has always been that we’re not at the tipping point yet? There’s always an element of speculation here.”

The general consensus is that the thematic ETF sector is still nascent – and many themes are yet to play out. Things like AI and robotics are also still in their early days.

But providers would argue that this is the whole point of a thematic ETF – to get investors in early on what could prove to be the next money-making megatrend.

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