Thematic ETFs: Correct Narrative, wrong prices: A history of attention-grabbing wealth destruction?

Thematic investing has generated significant interest across the investment community in recent years. In tandem, thematic index investing is increasingly making headlines as investors seek passive options that offer the same exposure as an active thematic approach but with lower fees.

The issuers of thematic ETFs identify the popular trends in the market and issue products that track these investment themes. However, empirical evidence shows that by the time new ETFs enter the market, the securities they invest in have already reached their valuation peak. In other words, investors in newly launched thematic ETFs are erroneously extrapolating past performance into future performance. In short, new Thematic ETFs are designed to appeal to (largely retail) investors’ irrational beliefs.

What is a theme?

A theme is a top-down, innovative or disruptive trend that has a structural tailwind with the potential to drive above-average stock returns for companies participating in that theme. These themes are continuously evolving, and their returns cannot easily be explained by traditional country, sector or style factors. Examples of themes include fintech, the future of education, energy efficiency and automation.

Track-Record

The charts below illustrate the various performance measures of ASX-listed thematic ETFs with a track record of at least 12 months. 

Exhibit 1: Total Returns 6 Months after Issuance 

Source: Foresight Analytics Pty. Ltd.

Exhibit 2: Performance since Inception

Exhibit 3: Actual vs. Actual + Back-Tested Performance

Source: Foresight Analytics Pty. Ltd. Note: S&P/ASX 200 TR data in Exhibit 3 is over last 2 years

Exhibit 4: Maximum Drawdowns Last 2 Years

Exhibit 5: Drawdown Profile Last 2 Years

Source: Foresight Analytics Pty. Ltd.

 Exhibit 6: Thematic ETFs vs. Market Last 2 Years

Exhibit 1 illustrates the performance 6 months after inception. Exhibit 3 shows the differential between the back-tested performance of the ETFs (just before launch and typically measured over the prior 3-year period) versus the actual performance + back-tested performance once launched. Exhibits 4 to 6 illustrate drawdown performance – a key metric of capital preservation risk.

By any measure, the performance of the sector as a whole has not been good, though there are some notable exceptions (earliest vintages – see section below). The drawdown profile is particularly damning, with most thematic ETFs still being materially underwater. Exhibit 6 shows that when many of the stocks in thematic ETFs de-rate (both valuation and most likely an adverse sign in momentum/flows), they generally do not return to prior levels. In the context of the average drawdown over the last 2 years of the thematic ETF sector versus the market, the low drawdown correlation of 0.35 is not a positive. We believe there are fundamental issues with the thematic ETF sector and that this track record will likely continue.

Vintage Year - Thematic ETFs are Becoming Riskier

Exhibits 7 and 8 illustrate annualised returns since inception by years since issuance. Looking at Exhibit 8, if we consider the first 5 thematic ETFs issued, their top 10 holdings were mostly established, profitable, and proven businesses. As a result, P/E ratios are broadly in line with major equities markets. This is in stark contrast to the many thematic ETFs issued over the last 2-3 years. We posit that thematic ETFs have become increasingly risky in nearly every aspect (earnings, market capitalisation, industry dynamics, long-duration assets/interest rate sensitivity, etc.).

Exhibit 7: Thematic ETFs 1.0 vs. 2.0

Source: Foresight Analytics Pty. Ltd.

Exhibit 8: Thematic ETFs 1.0 vs. 2.0

In October 2022, an academic paper, ‘Competition for Attention in the ETF Space’ was published. It took a deep dive into a significant number of thematic ETFs. In its abstract, it states,

‘The interplay between investors’ demand and providers’ incentives has shaped the evolution of exchange-traded funds (ETFs). While early ETFs invested in broad-based indexes and offered low-cost diversification, more recent products track niche portfolios and charge high fees. Strikingly, over their first 5 years, specialised ETFs lose about 30% (risk-adjusted). This underperformance cannot be explained by high fees or hedging demand. Rather, it is driven by the overvaluation of the underlying stocks at the time of the launch. Our results are consistent with providers catering to investors’ extrapolative beliefs by issuing specialised ETFs that track attention-grabbing themes.’

The Cynical View – Thematic ETFs Serve the ETF Issuers, Not the Investors

In the study cited above, the authors state with respect to incentives,

‘We estimate that as of December 2019, thematic ETFs in the US managed 18% of the industry’s assets, yet they generated about 35% of the US industry’s fee revenues. In the market for broad-based products, ETFs hold large portfolios and compete on price by offering similar portfolios at a low cost. In the specialised segment, ETFs hold small and differentiated portfolios and charge higher fees.’

Thematic ETFs Tend to be Expensive

The 2 charts below illustrate the fees and bid/ask spreads associated with the thematic ETF and compared to the rest of the ETF sector. Readers should note that in relation to fees, the higher end of the spectrum largely relates to exchange-traded managed funds (ETMFs), which naturally have a higher cost base than passive index-tracking ETFs due to an active manager operating an investment analyst team.

Exhibit 9: Thematic ETF Fees

  Source: Foresight Analytics Pty. Ltd.

Exhibit 10: Thematic ETF Bid/Ask Spreads

Concentration Equates to Higher Volatility/Risk

Thematic funds are designed to exploit emerging trends, not to provide diversified, risk-controlled exposure. They are concentrated in their respective sectors of interest and often rely on a relatively fewer number of stocks compared with the typical diversified offerings. Exhibit 7 highlights these traits for Australian thematic ETFs. The risk of capital loss is high as sector or industry-specific idiosyncrasies have a huge bearing on the performance of such funds. Not to mention, adopting a passive approach in such scenarios can add more risk, given the few qualitative oversight, if any. As a result, investors may experience a rougher ride due to higher levels of volatility.

We also note that country exposure, and therefore FX risk, is concentrated in the US and, to a lesser extent, Europe. 

Exhibit 11: Thematic ETF Sector Exposures

Exhibit 12: Thematic ETF Key Portfolio Metrics/Costs

Index Issues

Survivorship Bias – Prior to the launch of a thematic ETF, an ETF issuer will engage an independent third party that specialises in the creation of such indices. As a part of this process, a basket of stocks is created that has loyalty (of varying degrees) to the identified theme. There are 2 problems with this process. It has a positive bias toward those companies that have performed well/have a larger market cap and, by definition, excludes those companies that may have failed and/or performed poorly.

The past is not the future, and particularly not in fast-evolving, often disruptive sectors. We believe the evidence contained in Exhibit 1 above provides quantitative proof of this assertion. Several global studies have produced similar findings.

Avoiding Theme-Washing - Theme purity is also a critical component of thematic investing. We think it’s essential that the companies a thematic portfolio invests in generate the majority of their revenue from the theme. We don’t believe that it’s reflective of a theme to hold a large conglomerate where that theme represents only a small part of the company’s business (and therefore, our exposure). For instance, does buying one of the US-based internet giants really give an investor direct exposure to fintech or autonomous technology? We would argue it does not. Unfortunately, we believe some thematic strategies and ETFs are sacrificing theme purity to raise as many assets as possible.

Furthermore, recent media scrutiny over thematic ETFs has led many to question their legitimacy and that of thematic investing more broadly. In our view, investors are correct to ask these questions as they see a rush of interest in a particular means of investing.

Crowding/Capacity Risks - Thematic strategies can also fall victim to capacity constraints. Theme-based investing frequently targets niche segments of the investment universe, which are often less liquid and less appealing from a valuation perspective. Too much money chasing too few ideas can stretch valuations and is not a recipe for successful long-term investing. But to be clear, this risk operates very much on the downside and is based on poor performance, potentially leading to material redemptions of an ETF and consequent selling of portfolio holdings.

An example of potentially competing for liquidity and/or selling significance is in Europe, where there are at least 46 different clean energy indices being replicated by ETFs. The S&P Global Clean Energy Index, alone, is being tracked by 5 separate ETFs. Australian ETFs are a part of this same competition pool – many Australian global ETFs are simply replications of those issued by the parent company in the far larger US and European markets. However, a good thematic index seeks to optimise the 3 pillars of purity, risk-return and liquidity.

Additionally, it’s dangerous for issuers to use benchmarks that are not market-cap-weighted, which tend to overweight smaller-cap securities and create a lower liquidity profile. Themes with a limited number of pure plays are also at risk of being over-concentrated. To combat this, ETF issuers often implement single stock weighting caps; however, these can mean small caps are allowed to be overweighted, resulting in the overall basket having a lower liquidity profile.

Another issue is the risk of an ETF holding small companies and receiving large sums of assets, meaning these smaller-sized holdings end up being materially owned by the ETF. On rebalance day, the ETF may then be forced to offload large sums of stock, an event capitalised upon by hedge funds, among others. The drawn-out process of these relatively illiquid holdings being reweighted ultimately comes at a cost to ETF investors.

We believe that passive implementation raises additional concerns that make it a challenging option for thematic investing. For example, when we look broadly at the major return generators in equity markets, in many instances, they are disruptors in an existing market. They are the new entrants that shake the foundations of the incumbents. In our view, this is even more pronounced in thematic investing, where the approach is all about identifying the key macro drivers of the future. Active thematic investing allows portfolio managers to seek out these disruptors and adjust course as the theme evolves or the probability of success changes.

Very simply, we see it as inconceivable that an investor can predetermine a range of securities that fit neatly into a theme that is constantly evolving. We believe the evolutionary nature of each theme is the exact alpha opportunity that presents itself to active managers. 

To evaluate this claim, let’s take, for example, the rise of electric vehicles. Electric vehicles (EVs) have been in existence for over 100 years, but it has only really been since the introduction of the General Motors EV1 and the Toyota Prius hybrid in the 1990s that the world started to actually consider using electric motors for mainstream automobiles. Today, electric cars have moved from the fringes of society to being viewed as the cars of the future.

However, to be the future, EVs - and thereby the theme’s underlying opportunity set - still have significant room for development. Charging and electricity storage technology must continue to progress; costs, power and distance need to be competitive with internal combustion engines, and the issue of battery recycling needs to be addressed.

Importantly, it’s not just the existing car manufacturers that will help to settle these matters and drive long-term opportunities for the EV theme. Battery makers, sensor manufacturers, rare mineral miners and many other EV suppliers and industry players will all play critical roles. As the existing challenges presented by electric vehicles get resolved, new issues will emerge, and the opportunity set will change.

The technology is developing, the theme is evolving, and so too must an investor’s thematic exposures. In our view, that’s what gives a theme its alpha potential. With such variables in play, how is it possible for an ETF to predetermine the market of a theme that will continue to evolve well into the future?

Despite these issues, we believe thematic investing, when conducted in a focused and considered manner, has the potential to produce significant alpha and act as a core allocation in a portfolio.

In our view, investors need to avoid broad-based approaches and predetermined markets and, instead, focus on targeted, active, pure-play approaches to thematic investing that can adapt to continually evolving themes. We therefore encourage investors to ask 2 simple questions before investing:

Question 1. What level of theme purity do you require when selecting a stock for your portfolio? We believe that stocks in a thematic portfolio must generate the majority of their revenue directly from the theme.

Question 2. How do you research a theme, and how granular is your process? We think that, when researching each theme, all the inputs required for the theme to play out must be clearly understood. It’s not enough to focus solely on the large conglomerates operating in the space.

Question 3. What is the time horizon of the theme? In our view, themes should play out over a minimum 5-year period. In contrast, short-term, opportunistic themes are frequently caught up in short-term speculation and media/commercial hype.

We believe thematic investing, much like electric vehicles, represents the future. But just like buying an electric vehicle, investors need to do their due diligence and ensure what they’re buying is what they want. Otherwise, they may have hoped for a supercar but ended up with a lemon. In our view, a targeted, active approach to thematic investing has the potential to help investors better capitalise on the key macro drivers of the future.

About Foresight Analytics

Foresight is a data-driven investment research, analytics, and consulting firm. Foresight is not owned by any product provider or manufacturer. The firm’s business model is purely based on fee-for-service. Using its innovative, evidence-based framework, Foresight provides analytical, predictive and market intelligence solutions to leading investment management companies, superannuation funds and wealth groups. Foresight’s capabilities are underpinned by leading data and technology infrastructure that blends statistical, fundamental, and behavioural insights.

Foresight’s fiduciary solutions include Diligence Services and Ratings (Investment, ESG, Risk and Operational Diligence), Advanced Portfolio Analytics and Strategic Research.

Foresight’s fund strategy solutions include Advanced Analytics for asset managers, Fund strategy positioning and benchmarking services, fund industry intelligence and research as well as assurance services.

About the Authors

Rodney Lay

Rodney has extensive knowledge of public and private market asset classes and investment strategies, with significant experience in the assessment and rating of investment products. Rodney has a deep understanding of credit/fixed-income markets, be it private low, mid-market debts, BSLs, Bank Loans, HY bonds, CRE private debt, Special Situations, RMBS/CMBS, ABS and specialty debt. He has a strong understanding of investment strategy structures and appropriateness to the asset class, be it ETMFs, LITs/LICs, open-ended trusts, or the new single pool dual unlisted/ETMF structure rolled out by Magellan. Rodney has extensive experience presenting investment views and product knowledge to internal and external parties, including investment committees, fund managers, advisor groups, industry forums and the media. He has produced multiple written thought pieces on product structures, markets and innovations.

Email: Rodney@foresight-analytics.com

Jay Kumar

Jay has over 25 years of investment and data-driven research experience with firms such as Morningstar, Optimix Investment Management, ANZ Wealth and Private Bank and the Reserve Bank of Fiji. Recognised by his industry peers as an innovator and thought leader, Jay’s predictive empirical work has been published in several journals covering diverse topics such as corporate strategy, financial distress, capital markets and disruptive trends within financial services. After identifying a gap for forensic research in the financial services market, Jay founded Foresight Analytics in 2015, utilising his research and significant institutional asset management experience.

Email: Jay@foresight-analytics.com

Disclaimer

The material contained in this document is for general information purposes only. It is not intended as an offer or a solicitation for the purchase and/or sale of any security, derivative, index, or financial instrument, nor is it an advice or a recommendation to enter any transaction. No allowance has been made for transaction costs or management fees, which would reduce investment performance. Actual results may differ from reported performance. Past performance is no guarantee for future performance.

This material is based on information that is reliable, but Foresight Analytics makes this information available on an ‘as is’ basis without a duty to provide updates or make warranties, express or implied, regarding the accuracy of the information contained herein. The information contained in this material should not be acted upon without obtaining advice from a licensed investment professional. Errors may exist in data acquired from third-party vendors and in coding related to statistical analyses.

Foresight Analytics disclaims any and all expressed or implied warranties, including, but not limited to, any warranties of merchantability, suitability or fitness for a particular purpose or use. This communication reflects our quantitative insights as of the date of this communication and will not necessarily be updated as views or information change. All opinions expressed herein are subject to change without notice.