Invest in the past, not the future!

by , 30th November 2018

Thematic ETFs are a big growth area right now. Many are sold on the basis that they offer exposure to the big growth trends of the future. Thematic investing is all about spotting future trends and the shares that should benefit from those trends.

Trouble is, thematic ETFs are often late to the party and possibly overvalued too.

Some of the big future trends developing technology, ageing populations, and climate change.  Specific themes for the ETFs include robots, artificial intelligence, gender equality and many others. I call these funds ‘growth thematic’ ETFs.

ESG investing doesn’t fall into this thematic bracket. ESG (environmental, social and governance) ETFs tend to invest in a wide portfolio of companies, and the portfolio usually has an ethical or environmental slant. Thematic ETFs normally have a smaller portfolio, and are focused purely on just one theme.

Past versus future

The crucial point about thematic investing is that you’re trying to spot trends and themes that you think will be winners in the future. And you don’t have much history to guide you when you look for future trends. (All you can do is see how previous structural changes have played out.)

But with most other investment strategies, you’re very much focusing on the past. Consider ‘plain vanilla’ passive investing. The FTSE 100 has had its fallow patches, but history suggests that if you’re prepared to invest in the Footsie for the long-term (10 years or more), you’ll probably do pretty well. What’s more, the largest companies in the Footsie are inevitably companies that have done well. That’s why they’ve become so large!

So if you invest in a FTSE 100 tracker, you’re taking a bet that these large companies will continue to prosper. And you’re also taking a bet that flagship stock market indices will continue to deliver a decent return.

It’s a similar story with smart beta investing.  With smart beta, you’re looking for strategies, or factors, that have worked in the past. Value investing, for example, has had a poor run over the last decade, but over the very long-term, it’s done well. I’m pretty confident that its strong performance over the last 30 years will be repeated, so I’m happy to put some of my money in value ETFs. I’m hoping that the past will repeat itself.

Plus points

Let’s now look at some of the plus points of thematic investing.

I think the biggest is that it’s simple to understand. You don’t need to get bogged down in complicated financial metrics. Instead, it’s all about the story. Evy Hambro at BlackRock says thematic investing is ‘trying to think about what is happening in our daily lives and how we can get exposure to those themes in the way that we invest.’

So, for example, we all know that robots are going to be more and more widely used, so surely it makes sense to invest in that? If you believe that story, you can invest in two very popular thematic ETFs: the iShares Automation & Robotics UCITS ETF (RBOT) and the L&G Robo Global Robotics & Automation UCITS ETF (ROBO).

Thematic investing can also diversify your portfolio – getting you away from the biggest stock market beasts. In fact, most thematic investing ETFs have a bias towards smaller companies.

And at its best, thematic investing isn’t constrained by geography or sectors. An example of breadth is the iShares Digital Security UCITS ETF (LOCK). It doesn’t just cover cyber security software businesses, it also invests in hardware, biometric identification, and software tokens. It covers the wider value chain around this theme. This becomes clearer when you look at the portfolios of some of these funds. They often include companies that you wouldn’t necessarily link to the theme of the ETF, but they often have a bigger exposure than you might think. An example of this would be a lithium miner for an electric car fund.

ETF providers can now create these thematic ETFs much more easily, because the quantity and quality of data available has improved so much. That’s partly down to the rise of ‘big data’ but also because companies in emerging markets are now obliged to give much more information to shareholders in company reports.

With plenty of data, ETF providers can create baskets of firms linked to a theme, and the process of selecting firms for the basket can be completely mechanical and objective.

Thematic ETFs can also be used for hedging purposes. Traditionally, if your portfolio was heavily weighted towards oil, you could short the oil price to give you a hedge. But with thematic ETFs, you can invest in a ‘new energy’ ETF that invests in renewable energy, batteries and so forth. That kind of ETF should prosper if/when we start to use less oil in the global economy.

Jay Jacobs, Head of Research at ETF provider, Global X, wrote in a research paper: ‘while thematic investing is not a perfect hedge, it may serve as a useful counterweight to the longer term risks investors face.’

Minus points

Let’s now turn to the minus points of Thematic ETFs.

I think the biggest problem is that you could end up chasing fads. Peter Sleep at 7 Investment Management says: ‘they tend to be flavour of the month and relatively late.’ Spotting the trend and then taking it to the market can take a fair bit of time for the ETF provider and the danger is ‘you’re often late to the party.’

What’s more, it’s hard to know if the valuations are reasonable or not. Sleep continues: ‘you’re not buying on value, you’re buying on a story and I don’t think many analysts just pitch a story without have some financial thought to it. You’re often buying quite a narrow range of stocks, many of which may be illiquid. And if you’ve got a lot of money going into a small sector, you’re going to ramp those stocks for a good bit when money piles in. And when the money goes out you have the reverse effect.’

The high ‘mortality rate’ is also an issue. Research by Morningstar shows that 80% of thematic ETFs launched before 2012 are no longer running.

On top of that, thematic ETFs have higher charges than other ETFs. According to Morningstar, the average smart beta ETF has an annual charge of 0.37% a year whereas the average thematic ETF has a 0.59% charge. That said, newer thematic ETFs have mainly come in with lower charges so competition should drive down charges across the board in time.

The performance of thematic has also been mixed. This chart shows how five leading thematic ETFS have fared when compared to the MSCI World Index:

Source: Morningstar

For new thematic ETFs, it’s very hard to know how well they’ll do in the future. You just have to hope that the ETF provider has got the timing right and that the importance of theme is about to be much more widely recognised by investors, which should push up share prices.

So for me, I’d much rather focus on smart beta and plain vanilla investing. I can see that these strategies have worked well on many occasions in the past, and that reassures me. I might be tempted to put a very small part of my portfolio in higher-risk thematic ETFs, but overall, I think it makes sense to focus on what’s worked in the past rather than what just might work in the future.

But if you don’t agree with me, here’s a list of the some of the most interesting thematic ETFs in Europe:

Selection of UCITS Thematic ETFs

ETF Ticker Assets under management Ongoing

Charge %

Launch date 1 Year Performance % 3 Year

Performance

(annualised)  %

iShares Automation & Robotics RBOT $2.1 bn 0.4 8/9/16 -12.0
L&G Robo Global Robotics & Automation ROBO $1.1 bn 0.8 23/10/14 -10.9 20.3
Lyxor World Water WATL 481m euros 0.6 10/10/07 -7.4 9.7
iShares Global Water DH20 $542m 0.7 16/03/07 -2.0 12.8
iShares Digitilisation DGTL $430m 0.4 08/09/16 6.8
iShares Healthcare Innovation HEAL $415m 0.4 08/09/16 8.9
Lyxor Gender Equality ELLE $40.5m 0.2 12/10/17
First Trust Dow Jones Internet FDN.LN $7.9m 0.6 18/06/18
HAN-GINS Cloud Technology SKYY $2.23m 0.8 05/10/18
EMQQ Emerging Markets Internet & Ecommerce EMQQ $1.9m 0.9 02/10/18

Fore more on thematic ETFs, read:

Morningstar’s Lamont answers questions on thematics