There is a long way to go before thematic ETFs gain widespread acceptance from the investment community amid concerns of liquidity risks, high exposure to expensive growth stocks and long-term underperformance.
While the idea in principle is simple – offering exposure to powerful long-term structural trends that are set to disrupt the way society behaves – thematic ETFs that are created do not always perfectly align with the theme they are trying to capture.
As well as purity of theme, ETF issuers must also consider diversification and liquidity risks which can lead to stocks being included in the indices that do not fully represent the megatrend.
Furthermore, popular themes such as robotics, cybersecurity and clean energy tend to incorporate more growth-orientated stocks which have – until recently – been trading at frothy valuations.
Highlighting this, research conducted by David Blitz, head of quantitative research at Robeco, found 36 thematic indices from MSCI had a negative value exposure of -0.41 and a profitability exposure of -0.57 over the past three years, as at the end of April 2021.
“From an asset-pricing perspective, this implies that investors in passive thematic indices could potentially face lower long-term expected returns,” Blitz added.
As a result, timing is everything. However, this has not been ETF issuers’ strong suit with many launches occurring at the peak of a megatrend’s excitement in order to capture maximum attention.
This is also when the underlying holdings are at their most overvalued and can lead to significant underperformance after a theme has launched, as academics Itzhak Ben-David and Francesco Franzoni found in their study Competition for attention in the ETF space.
According to the study of 526 specialised – thematic and sector – ETFs, they delivered an averaged risk-adjusted underperformance of -3.1% a year post fees in the five years after they came to market.
“This analysis suggests specialised ETFs do not create value for their investors by providing outperforming investment strategies,” the academics said. “Consequently, the high fees and lack of diversification of these products remain a puzzle.”
Despite this, however, investors have been lured in by the promise of high returns and a compelling narrative to tell clients.
According to data from Bloomberg Intelligence, thematic ETFs in Europe currently total €49.7bn assets under management (AUM) across 120 strategies, up from €2.4bn at the end of 2016, highlighting just how significant the demand has been over the past two years, in particular.
Time will tell whether thematic ETFs will deliver on their promise of strong returns over the long term, otherwise the segment risks being pushed to the sidelines, rather like the fate of smart beta ETFs.