Watch Out for Investment Biases in Thematic ETFs

Passing Fad or Enduring Theme?
Thematic funds rightly have to fend off accusations of being ‘gimmicky’ and tapping into fashions that will soon swing out of favour as investor interests shift to the ‘next big thing’. Caution is therefore warranted. As usual, a sceptical approach will yield the best investment outcomes. While fund providers will give you plenty of reasons you should invest, it pays to examine their claims closely.

A robust strategy should be loose enough to adapt as the specifics of the chosen theme inevitably evolve through time. There would have been a big difference in outcome between investing hypothetically in a Digital Music ETF and a rival MP3 Player ETF back at the turn of the millennium. On the other hand, it shouldn’t be so loose that it dilutes any gains or too similar to more vanilla existing sector or broad equity strategies.

Understanding Biases
Thematic strategies are often unconstrained by traditional sector, geographic and size groupings. For example, the iShares Ageing Population ETF (AGED, listed in London) selects stocks globally based on their exposure to the ‘grey economy’. This means it invests in stocks as diverse as UK-based funeral services provider Dignity Plc, Indian hospital specialist Fortis Healthcare and US-based travel and restaurant website Trip-Advisor.

This diversity results in several biases which should be understood before investing.

Size
Virtually all the thematic ETFs in Europe have a lower size profile than the MSCI World index meaning that they invest in smaller companies. This is an important consideration because while smaller-cap stocks have historically exhibited higher returns than larger stocks over the long term, they have also exhibited higher volatility, making them worth sticking with even through periods of underperformance.

Geography
Although most thematic ETFs available in Europe are global in scope, depending on the themes tracked, their geographical footprints can be strikingly different from broad global benchmarks like MSCI World. For example, the iShares Global Timber & Forestry ETF (DWOD, listed in London) has 13% exposure to emerging markets.

Style
It is also important to understand style exposures. Most thematic funds in Europe track a technological theme and therefore invest in growth and momentum stocks.

Sector
Some ETFs offer diversified global exposure across all traditional market sectors, whereas other narrower offerings like the L&G Pharma Breakthrough ETF (BIOT, listed in London) select stocks largely within the confines of a single Global Industry Classification Standard sector such as healthcare.

It is important to remember that as themes are constantly evolving, biases need to be monitored through time accordingly.

Assessing Performance
The idiosyncratic nature of thematic funds means that evaluating their performance can be tricky. While thematic ETFs can be assessed against broad-market and/or sector indexes, it is also encouraged to create more targeted peer groups, where possible.

Fitting Thematic ETFs into Your Portfolio
Due to their narrow exposure and higher risk profile, thematic ETFs are best used to complement rather than replace existing core holdings.

Some, like the Lyxor Global Gender Equality (DR) ETF (ELLE, listed in London) may be used as part of a core allocation, as they use geographical and sector caps to retain some of the characteristics of a broad global benchmark.

Thematic ETFs track macro- or structural trends that are expected to play out over many years. This means that they are most suitably deployed over longer investment horizons.

Most thematic ETFs will be used with the hope of boosting returns over the investment period, but some can be specifically used to reduce portfolio risk. For example, alternative energy funds can be substituted for core energy holdings to reduce carbon risk. They fit especially well with ‘ex-energy’ funds.

Even if we set aside the bold claims of absolute outperformance from asset managers, if a thematic ETF has drivers of risk and return that are distinct from other portfolio holdings, adding it can bring diversification benefits and potentially boost overall portfolio performance.

If, however, the risk and return drivers are not distinct enough from cheaper existing ETFs, investors should question the purpose of tracking the theme altogether.

A version of this article appeared in Money Observer magazine in the U.K.