Thematic selection: How to choose an ETF within a theme

Choosing which thematic ETF to invest in has never been tougher

Theo Andrew

Future themes for thematic ETFs

When attempting to understand the growth of ETFs across Europe, a good place to start would be analysing the evolution of thematic ETFs over the past few years, as many believe it will be the driving force of the industry in the future.

A PwC survey recently found the industry expects thematic ETFs to be the fastest-growing area of the European market over the next three years. According to the survey, which interviewed 60 executives from ETF issuers, service providers, market makers and asset managers, 82% believe it will be the biggest growth area.

There are currently 129 thematic ETFs domiciled in Europe, with roughly €49.7bn in assets under management (AUM), as at the end of February, according to data from Bloomberg Intelligence.

The boom means investors are devoting more time than ever to selecting thematic products to fit into their portfolios.

Highlighting how much due diligence is needed, themes such as clean energy and technology have 20 and 21 ETFs for investors to choose from, respectively.

Thematic ETFs are often growth or momentum-orientated, and in some cases, indices can be highly correlated. On the other hand, investors need to understand there can be more than one way to play a particular theme. This can have a dramatic impact on a portfolio from a performance perspective but also liquidity issues and unanticipated tailwinds.

Andrew Limberis, investment manager at Omba Advisory & Investments, said: “It can be really difficult and it depends how broad the theme is. For example, clean energy has 10 or 20 different ways to invest, whereas for cyber, most of the issuers tend to be much more similar.”

Aligning investment objectives

The first place for any investor to start is by fully understanding how you want to play thematic ETFs within the broader portfolio, as well as how the strategies align with your investment objectives, before selecting a specific theme.

Rob Powell, head of thematic and sector product strategy at BlackRock, said: “You need to have a conviction within the field of the theme, and then it is about looking at the product options that are available within the market across thematic ETFs.”

Taking the robotic theme as an example, Powell said it is important to first establish what exactly that theme means to a specific provider.

“How do the investment managers define the theme? What boundaries are in place? What do automation and robotics mean to that provider? Does that align with your definition of what you think will drive the theme over the long term as the potential investor in the fund?” he said.

Through its engagement with clients, BlackRock sees three common approaches to incorporating thematics within an investor’s portfolio. Firstly, a core-satellite approach, designed to act as a performance ‘kicker’. Secondly, replacing part of an investor's global equity allocation, and finally, using thematics as the starting point for portfolio allocations, a core approach.

Limberis said the way to select an ETF within a theme very much depends on your portfolio. Omba Advisory & Investments takes a macro approach to thematic ETF selection.

“Within themes, the macro environment is more important than in the traditional sectors,” he said. “For example, we are seeing a bit of a regime change in central banks and fiscal policy as a result.”

However, it would not put him off investing in thematic ETFs despite leaning towards growth-orientated companies which are likely to be hit by rising rates, but added the trick is to look for companies within the ETF that have good cash flow.

“We like to look at the cash flow in some of these companies. That certainly gives us a lot more comfort on any short-term down that they will weather the storm,” he noted.

Another approach, similar to the core-satellite strategy of BlackRock, is to a thematic ETF as a kicker in a sector portfolio.

Terry McGivern, senior research analyst at AJ Bell, said: “We do not necessarily have thematics as distinct asset classes. We have used them as more of a higher beta variant of order allocations.”

For example, McGivern said in the past they have added the iShares Automation and Robotics UCITS ETF (RBOT) to its tech allocation or the iShares Smart City Infrastructure UCITS ETF (CT2B) to its broader infrastructure exposure “to give you a little bit more of a tech bullet”.

Pure or broad play?

ETFs within a theme can either have a high correlation between indices, as seen in the broad-based catch-all products, or be highly focused on a pure-play strategy. It is up to the investor to decipher which one will fit better in their portfolio.

Powell said the breadth of the theme is important to maximise value for investors effectively.

“It is always a balance between increasing the breadth of exposure to the theme and reducing the purity of exposure to the theme. If you go for a very broad index with lots of stocks, then you have a higher correlation with global equity markets but you are potentially reducing the purity of exposure to the theme,” he explained.

“For investors looking to get exposure to long-term disruption, but do not want to have high idiosyncratic risks, then the individual themes can be a solution for that,” Powell added.

Limberis said he would not favour the purer expression of a theme because of the importance of some of the larger companies.

“A lot of product providers place too much emphasis on purity and why their purity index rules are better than the others,” he said. “What is equally important is what you are missing. For example, cloud ETFs could be missing Microsoft and Amazon.”

Liquidity concerns

An ETF within a theme that is too pure or too concentrated also raises risks that investors should be aware of.

The issue came to the fore in April 2021, when BlackRock was forced to sell and replace billions of dollars’ worth of holdings after both the iShares Global Clean Energy UCITS ETF (INRG) and its US-domiciled equivalent recorded huge rises in AUM.

The S&P Global Clean Energy index that the ETFs tracked consisted of just 30 stocks, a decent proportion of which were small caps.

Limberis said investors must take into account the underlying basket of stocks, particularly when you are trading £10m-£100m: “With those kinds of figures, it is important to understand the underlying quality of the basket, where it is trading in the world, the average daily volume of the underlying shares.”

Powell added it is a vital element to selecting an ETF within a theme, ensuring it is robustly constructed from both a risk and liquidity perspective.

“We spend a lot of time performing scenario analysis before the launch of a new thematic ETF to define the liquidity constraints with regards to the average daily trading volume and market caps of the individual companies in the theme in the theme,” he said.

“From an investor’s perspective, how diversified a theme should be is an important element, as well as is ensuring that the fund that you're investing in is aligned with your personal risk objectives as an investor,” Powell added.

Under the bonnet

Thematic ETFs have come under fire in the past for offering exposure to different megatrends while including the same stocks, however, it is also important to understand that ETFs within a theme can vary wildly.

According to Bloomberg Intelligence, there was an average performance gap of 28 percentage points between the best and worst performers in each thematic ETF category in Europe in the 12 months to July 2021.

Powell notes this is one of the most important aspects of selecting the right thematic ETF within a theme:

“If you look at some funds that are out there, you can have a name which appears to be thematic, but when you look under the bonnet, they do not appear to reflect the reality of the theme.”

“As we have seen an expansion in the numbers of thematic ETFs available to investors in Europe, there is more emphasis on the investor to perform due diligence and to ensure that the funds that they're investing in are truly reflective of their view on how a theme should be captured,” he noted.

“We work closely with clients on their due diligence for our products, but the sheer number of thematic ETFs in the industry means that there are probably more things for them to consider with different providers,” Powell added.

Limberis said investors are spending more time than ever selecting thematic ETFs due to the growing number of products, but added that ultimately the choice is a good thing for the end investor.

He said: “It is becoming bigger and harder for investors, but equally, the choice is a positive thing. In five years, it will be interesting to see which thematic ETFs will come and go.”

This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.

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