What is a Thematic ETF? Investing in a specific theme via a tracker is trendy, but be mindful to avoid certain pitfalls.

There is no need to remind our readers about the tremendous growth in recent years of ETFs (Exchange Traded Funds), which are (mostly) passively managed and traded on a stock exchange. In 2020, the asset flow of ETFs exceeded $7,000 billion for the first time and represented one-third of total assets managed by funds. According to Moody's, ETFs could soon surpass the combined size of traditional mutual funds. Initially, ETFs replicated well-known country or regional equity indices like the S&P 500, with, for example, the famous SPDR or QQQ replicating the Nasdaq 100. A few years ago, trackers on specific sectors were in vogue.

A ""Clean Tech'' ETF can invest in the entire value chain.

More recently, thematic ETFs have started to gain in popularity. They allow investors to invest via a single instrument in a basket of stocks exposed to a specific theme, such as electric cars, cannabis, cybersecurity, clean energy, or vegan products. While the composition of sector ETFs mostly follows a classification and hierarchy defined by an existing index, thematic ETFs are exposed to several different sectors.

For example, the Global X Robotics & Artificial Intelligence ETF is invested in semiconductors, industrial stocks, software, and medical devices. A Clean Tech ETF can invest in the entire value chain, from engineering to marketing to end buyers. Companies as different as Marvell, Plug Power or First Solar can be found. What do they have in common? Their exposure to the same theme.

Related: Why New Investors Should Start With Some Allocation to ETFs As They Build Their Portfolio

A growing success

Currently, thematic ETFs represent no less than 800 instruments with more than $180 billion in assets under management. Their leader is Ark Invest, founded by Catherine Wood, the new "star" of Wall Street. In just a few years, the New York-based company has become the 7th largest ETF asset manager with over $300 billion in assets under management. Their "secret sauce": themes that speak to investors (innovation, genomics, robotics, fintech, etc.) but also exceptional performance (105% on average over the year 2020). Ark Invest's success is such that it is inspiring a new investment strategy on Wall Street: copy or even anticipate Catherine Wood's investment decisions.

But beware! Ark Invest's exceptional success is shadowed with failures, too. More than half of the thematic ETFs launched in the last ten years have disappeared. Indeed, these trackers are often launched based on purely commercial logic, i.e., to attract assets as quickly as possible to maximize management fees. Often, it is not a matter of selecting securities according to a proven index or based on certain fundamental factors, but rather of "manufacturing" a story that will appeal to retail investors. However, when performance is not forthcoming, the ETF's assets fall to levels insufficient to cover operating costs, forcing asset managers to close the ETF in question. Among the thematic ETFs that have closed 2020 are SLIM and DIET (nutrition).

Related: Exchange Traded vs. Index Funds

Thematic ETF's: advantages and disadvantages

For many investors, building a portfolio is not always an easy task. When the markets have risen sharply, the fear of an imminent correction dampens the enthusiasm of novices. On the other hand, a market downturn is often accompanied by bad news on the macroeconomic level - which is not conducive to a "big jump" into the financial markets. First-time investors will more easily take the plunge by identifying with a theme on which they have a personal conviction. For example, many of us are convinced that innovative companies have great potential. Therefore, an ETF labeled "Innovation" is more likely to "pull money out of your pocket" than a "Balanced Risk Profile" type fund.

At the end of the day, thematic ETFs offer little diversification to investors.

Thematic ETFs allow investors to invest in convictions in a diversified way, with low initial investment and low management costs (even if they remain higher than for "classic" ETFs). As far as theme exposure is concerned, managers use complex quantitative tools, sometimes based on artificial intelligence.

However, there are pitfalls to avoid. For example, thematic ETFs offer little diversification to investors. For example, the cannabis theme has had its ups and downs. As the stocks are highly correlated with each other, the volatility of cannabis ETFs is not very far from that of the underlying assets.

Another disadvantage - and a significant one - is performance. A recent study conducted at Fisher College in Ohio shows that thematic ETFs have recorded below-average risk-adjusted-performance. This performance is also correlated to fund flows. Thematic ETFs are often marketed when the theme has already performed very well. But when the trend turns around, investors decide to sell their ETFs, creating a vicious circle of negative flows and poor performance. The same study also found that the underlying assets were overvalued when the ETF was created. On average, thematic ETFs generate a negative alpha of -4% per year and therefore do not add any value for investors.

Related: 3 Sector ETFs to Buy Now

Conclusion

Are thematic ETFs to be avoided? Not necessarily. As with any investment, it is important to thoroughly analyze the fundamentals of the underlying instruments (valuation, growth prospects, etc.), the diversification properties of the basket, but also the technical aspects such as the prospectus or the solidity of the issuer. Generally speaking, this type of instrument can be useful on the periphery of a portfolio diversified across the main asset classes.