ETF Insight: What’s the big idea? How thematics work

ETF Insight Thematic ETFs

The idea of thematic investing has a lot of appeal. Picking up on an investment trend early enough has the potential to deliver superior returns over the long term, however, there are factors investors need to take into account when selecting a theme.

What makes a business trend worthy of a thematic ETF? A recent example of a theme being picked up as a potential investment opportunity comes from Solactive which at the end of October announced it had licensed its Video Games & Esports index for use by Global X.

The Global X Video Games & Esports ETF will track the performance of 38 companies working in the gaming space including the leading eSports games publishers. More than just fashion, the existence of multi-billion dollar companies working in a space gives a hint that an area such as eSports is worthy of investment consideration.

“We concentrate on long-term developments in the field of thematic indices,” Timo Pfeiffer, chief markets officer at Solactive, says. “For an investment theme to be successful, firstly, the expected underlying economic advancement has to play out in the future, and secondly, investors will need to have a long-term commitment.”

These two foundation blocks for an index are vital as interest can rapidly disappear if a theme or industry fails to live up to expectations. “Just picking up on a trend can be associated with short-term investing,” Pfeiffer adds. “As opposed to that, we believe that passive investing is a long-term commitment that requires thoughtful thinking and assiduous work from ETF providers and index providers.”

As perhaps with eSports, thematics are often associated with technology-driven disruption. This is not just about ETFs but generally, from an investment perspective, for a theme to work it has to be driving structural change or be at the forefront of fundamental changes to the economy.

“To strip it back, how is a theme changing society and our lives and how we work?” Howie Li, head of ETFs at Legal & General Investment Management (LGIM), asks. “But more importantly from an investment perspective, it is asking how it is disrupting things.”

Wheat meet chaff

In effect, the decision regarding whether a trend in investment might be a theme worth following comes down to a process of separating the signal from the noise, to use Nate Silver’s phrase.

As Li explains, a recent example comes with the interest in clean energy and the lithium and cobalt that is a vital component (for now) for all electric batteries. “We get questions, for instance, about lithium ETFs, or cobalt ETFs?” he points out.

“The connection is that clean energy will be the main source of the future and energy storage is the challenge. So, therefore, the theme is energy storage, not the specifics within that.”

It is, then, the search for an investment story that stands up to scrutiny which defines whether a thematic investment thesis will work. As Richard Lightbound, chief executive for the EMEA region at specialist robotics, AI and healthcare index provider ROBO Global, says, there are a number of factors determining whether a theme is investable.

One is whether the theme represents “large-scale global developments” which have a widespread impact on sectors, industries and wider society.

Second, there will be the industry expertise and research capabilities to “understand, access and track” them over time.

Third, a universe of public companies that is significant enough to allow for “broad and diversified exposure” and lastly, the strategy should not be constrained traditional fundamental risk management overlays that “tend to deliver later-stage large-cap exposure only”.

“Historically, the stock market tends to underappreciate the scale of opportunity enjoyed by leading providers of new technologies during the early phase of development,” Lightbound says. “This fact creates a remarkable opportunity for investors who understand the scope of the theme or technologies and who take action at a time when the theme is disrupting industry as we know it and forcing us to rethink the world around us.”

Fashion is perhaps not a word that many would like to be associated with investing, associated more with the fleeting taste rather than long-term value. But as Pfeiffer points out, it is only when a topic in “in vogue” that resources in terms of research and product development are shifted towards any give market demand.

“Product suppliers always try to be ahead of demand to have a quick or first-mover advantage,” he adds.

Coming back to the number of companies necessary to form a definitive index, Pfeiffer says there are certain rules and regulatory guidelines laid out by the European Securities and Markets Authority (ESMA). But other than that, it then comes down to the rule of thumb.

“Twenty stocks could be seen as a lower bound for the number of constituents in an index,” he continues. “However, increasing the number of stocks comes at the cost of diluting the purity of a thematic index.”

“Developing a fully rules-based process can be challenging, and it requires profound knowledge to find constituents that fit as closely as possible in the respective theme.

“The core issue is to construct an index that reflects a certain topic precisely. Purity is an essential success factor for thematic indices and ETFs. Sometimes it is difficult to use just a sector or industry classifications for theme identification.”

What is driving the boom in thematic ETF launches?

Lightbound suggests issuers “absolutely need a significant universe” to provide a broad enough exposure.

“It is too early to be taking concentrated bets in these early stages of the theme,” he says. “Our three investment strategies focused on robotics and automation, artificial intelligence and healthcare technology each have 70 to 90 members and employ a modified equal weighting strategy with quarterly additions/deletions and rebalances.”

Taking control

LGIM is a partner with ROBO Global on the L&G ROBO Global Robotics and Automation UCITS ETF and has a full range of thematic funds running through healthcare, mining, clean water, e-commerce and clean energy.

Li says the company “starts with the experts on the ground” in order to take in their views and their classifications and parameters. “We get them to help us define the industry and then we bring that to the index provider,” he adds.

However, it sometimes can be the other way around, says Pfeiffer. “If we believe in an index strategy, like, for example, the Future of Nutrition, we formulate a consistent methodology and set up the index concept without any client-commitment necessary.

“Thereafter, we make it available to our client-pool. If it is the other way around, clients typically have an idea or concept and reach out to the index providers.

“Usually, it requires some adequate adjustments, and several iterations are possible until the index is ready to go live with the customisation that a client may desire. At the start of the development process, investor commitment definitely helps, however, it is not a requirement.”

Li says the structure of ETFs is particularly suited to thematics, adding the universe of funds is now more developed than with mutual funds. “People like the vehicle’s flexibility and the structure’s transparency.”

But is it still an active process, particularly in defining the theme in the first place. “We are just trying to capture these opportunities earlier in the journey,” he says. “It needs to be an active approach, to identify the ideas and where the innovation is coming from.”

He issues a final rallying cry as a summing up of the case for thematics. “We just encourage free-thinking. Where are we going? If society is heading a certain way, do not investors want to be aligned too the strategic growth. Therefore, let’s free ourselves.”

ETF Insight is a new series brought to you by ETF Stream. Each week, we shine a light on the key issues from across the European ETF industry, analysing and interpreting the latest trends in the space. For last week’s insight, click here.

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