The explosion in thematic ETF uptake over the past few years has been difficult to avoid, but the nature of some return chasing products has resulted in a high burnout rate.

Despite being around for decades, the number of thematic ETFs and flows into these products has risen steeply since the coronavirus pandemic amid the lure of strong returns and exciting narratives. Thematic ETFs shot the lights out in 2020, sparking record asset growth that carried on into the first few months of 2021.

However, much of the return chasing flows will have missed the performance glut.

A recently updated academic study found the worst time to invest in a thematic ETF is following its launch– the peak of the theme – which is duly followed by a sharp fall in returns. The study, entitled Competition of attention in the ETF space, found thematic ETFs lose roughly 30% in risk-adjusted terms over their first five years.

One of the report’s authors, Francesco Franzoni of the Swiss Finance Institute, said this is primarily down to the overvaluation of the underlying stocks at the time of launch.  Furthermore, the survival rate of thematic ETFs is an issue.

Research by Morningstar found that just over half of thematic funds survive their first five years, begging the question: are thematic ETFs a fad?

Kenneth Lamont, senior research analyst at Morningstar said: “Thematic ETFs area bull market phenomenon, people are looking up, looking at gaining alpha, returns and growth potential. As soon as the market sentiment switches, they are not looking up anymore. We have seen it in multiple different cycles, you see many of these ETFs launching into bull markets and then closing in bear markets.”

Chasing returns

While some themes have experienced standout periods of success, the general perception from investors is they are too often launched in a bid to capture already realised returns.

Terry McGivern, senior research analyst at AJ Bell, believes ETF issuers are looking for evidence from investors they will be interested in the product before they create it, meaning generally you are investing after an uptick in performance.

“This creates a little bit of a problem because every time these products come to market, they can be late and a big chunk of the move has already happened,” he says.

The counter-argument is that many of the themes will eventually mature into sectors, meaning investors who use thematic ETFs as part of a buy-and-hold strategy are still able to benefit over the long run.

Jonathan Prout, chief investment officer at The Private Investment Office, said many of the products being launched are too of-ten chasing returns. “The problem is, particularly for new entrants, there is a conflict between spotting an opportunity in a subset of the market and then producing it.

“They should be long-term vehicles and a theme by definition is transitory. To a large extent, some of these thematic products are return chasing and that’s not what long-term investors should be doing,” he added.

Lamont agrees investors must consider their investment timeframe when thinking about using thematics as it is “unlikely all thematic ETFs will be here in 10 years”. He added the difficulty with launching a thematic ETF is it requires an element of crystal ball gazing when trying to predict the future revenue of companies.

“It is almost certainly not going to unfold exactly as we as we hope it is,” he said. “Part of the bet that investors are making depends on the timeframe. I do not advocate day trading, but some investors have very short time horizons and use these as tools to express their investment views.

“If you look at the survival rates of thematic funds globally, over long periods, they are not very high.”

As a comparison, Lamont said roughly 90% of internet funds that launched in the internet boom 20 years ago no longer exist, but neither do their stock: “It is somewhat reflective of the space you are operating in.”

Power of the narrative

An obvious driver of the thematic ETF uptake is they appeal to investors’ narrative of the market.

“The reason they are so popular, particularly on advisory mandates and retail investors, is they are extremely engaging to end clients,” Prout said. “It fits into a narrative-driven investing. There is an attractive story which is understandable for retail clients in a way that jargonised investing such as factors and asset classes are less so and this is incredibly dangerous.”

Despite this, Prout says it would be wrong to dismiss thematic ETFs completely but added investors must have a good understanding of the construction of the product. “It is important to understand what underlying companies they are buying, what methodology the index providers are using and why they are using it, rather than just trusting the narrative.

“Asset managers tend to build products for scale and this is the trade-off with performance. Often when we look at these products and the underlying companies, we have been underwhelmed.”

Lamont agreed it is important to invest with a thorough understanding of the product: “It is important for investors to understand the possible outcomes. It is about setting expectations and understanding them as part of the package.

“Compared to an S&P 500 ETF, they are risky, expensive, and less likely to survive. If you are comparing against single stock bets in technology, or something that is exposed to one of these growth trends, then they are less risky and more diversified.”

While McGivern believes the timing of thematic launches is problematic, he does not see them  going anywhere anytime soon: “The way we are seeing passive flows and asset allocation developing, theme-driven investments are probably going to be the way forward.”

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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