Morningstar’s Lamont answer questions on thematics

by , 9th November 2018

Last week we featured on the report from Morningstar that showed that interest in thematic ETFs had skyrocketed in the past three years, with technology-themed funds being of particular interest. We connected with the man behind the report, Kenneth Lamont, a passive strategies research analyst at Morningstar, to ask him what he thought of the findings and what he thinks the results tell us about where thematics is heading.

ETF Stream: Are thematic funds potentially more associated with a bull market? Do we have any idea how they might perform in a market downturn?

Kenneth Lamont: The majority of ETFs in Europe have too short a track record for us to evaluate their performance over periods of prolonged market stress. We can look at the individual factor, size, and sector/geographical exposures of a given fund to help us understand how it might perform in a given environment. As a general rule thematic funds tend to invest in smaller companies, which acts as a tailwind in bull markets but means they can be hit harder in a downturn. They can also be very narrow (some only hold 20 stocks) which usually means a higher volatility than the broad benchmark.

ETF Stream: Is there an issue around investors piling into thematics that cover areas of the market they are already invested in with their other fund investments? Is there enough differentiation within the make-up of these funds?

Kenneth Lamont: Overlap with existing exposures should certainly be considered when investing and monitored through time (this is true of any fund added to a portfolio). Ultimately, if a thematic ETF has drivers of risk and return that are distinct from other portfolio holdings, adding it can bring diversification benefits and potentially boost overall portfolio performance. If, however, the risk and return drivers are not distinct enough from (cheaper) existing holdings, investors should question the purpose of tracking the theme altogether.

ETF Stream: Is the European market merely a pale shadow of the US market for thematics and therefore how the market develops is largely dependent on what happens in the US?

Kenneth Lamont: The European Thematic ETF market is smaller in both assets and number of funds than the US market. But in some ways this is a blessing in disguise, we have (so far) been spared some of the more questionable thematic launches here. The launches that have recently been ’ported’ to the European market – have already cut their teeth the US – which, while offering no guarantees does act as a sanity filter of sorts.

ETF Stream: What did you think the high mortality rate says about thematics? Does it suggest too many of them are designed around investment fads? or is there simply not enough depth of market beyond the top 10 funds in this area?

Kenneth Lamont: There are any number of specific reasons why thematic funds have closed in the past – but all ultimately stem from one; a lack of assets. High fees haven’t helped the situation. As I mention in the report, while fees remain high compared with passive peers, they have been dropping. My colleagues in the US talk about the ‘spaghetti canon’ approach employed by some ETF providers there – fire it at the wall and see what sticks. To some extent it is natural that as we move away from tried-and-tested strategies fund mortality rates will rise. In Europe, most of the funds which failed to attract assets and closed track similar strategies to surviving peers which suggests less of a problem with ‘faddish’ launches and more with the depth of the market when they launched. Rising assets spearheaded by the popular robotics ETFs shows demand for these products is growing and ready if the idea catches the imagination.

ETF Stream: Are thematics simply another technology play? Are there potentially better vehicles for investors keen on gaining exposure to technology?

Kenneth Lamont: Each thematic fund should be evaluated on its own merits. We showed in the paper that most recent launches have been in the technology space. The EMQQ ETF recently launched invests in emerging market e-commerce companies, which is likely to have a very different risk and return profile from a standard global tech sector ETF.

ETF Stream: Are thematic funds very expensive for what investors are getting? Is the price of thematic funds likely to come down?

Kenneth Lamont:  The report shows that not only are thematic ETFs, with an average ongoing charge of 0.59%, much more expensive than the average equity ETF (0.38%), but they are also pricier than sector (0.35%) and strategic-beta ETFs (0.37%). The asset-weighted average fees across each cohort tell a similar story, with thematic ETFs levying an ongoing charge of 0.53% versus 0.39%, 0.37%, and 0.27% for sector, strategic beta, and all equity ETFs, respectively. While there is undoubtedly a cost to researching and sourcing relevant data for a given theme, a lack of assets and the competitive forces they bring with them have caused fees to remain elevated. However, we can be sure that the recent success of certain thematic funds will attract new players to the market, likely applying downward pressure on fees. Ongoing charges have already begun to fall, with eight of the 10 cheapest thematic ETFs having been launched since August 2016.