Thematic ETFs - Fad or Fab?

The number of thematic exchange-traded funds (ETFs) has exploded in recent years. But are they more than just another investing craze?

There are hundreds of thematic ETFs currently available, offered by both major fund companies and smaller managers alike. You can now invest in specific sub-sectors, market segments and demographics, or even align your portfolio with your moral values.

Are these themed ETFs simply a marketing tactic to entice investors with the latest shiny object? Or can they have legitimately useful role in investors' portfolios?

What is a thematic ETF?

Thematic ETFs allow an investor to buy shares in a range of companies involved in a specific niche or theme, such as robotics, artificial intelligence (AI), big data, cryptocurrency, genomics, or organic products. Compared to seeking exposure to a niche or theme by owning a small number of individual stocks, thematic ETFs allow you to own a whole basket of companies. Depending on the scope of the theme, your ETF could even hold companies from a wide range of industries. 

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Investing in your beliefs, causes and hobbies

Thematic ETFs also allow investors to align a portion of their portfolio with their values, passions or causes they care about.

For example, Global X's Catholic Values ETF (CATH) caters to Christian investors who wish to invest in line with their faith. In Europe, Muslim investors are the market for Blackrock's iShares MSCI World Islamic UCITS ETF (ISWD).

For those who want to consider the broader impact of their investments, there are a number of interesting thematic ETFs in the Responsible Investment category. For example, some ETFs screen-in companies committed to creating positive outcomes for a variety of stakeholders, including employees, customers, communities, suppliers, and stock and debt holders. Other ETFs align with causes, such as those that hold stocks only in companies that support LGBT equality in the workplace.

Some cause-based ETFs offer a compelling risk/reward story. For example, gender diversity mandates that invest in companies with higher levels of gender diversity in senior leadership, point to recent studies suggesting that companies with a higher proportion of female leaders perform better.

However, funds catering to ethical or religious interests are only a subset of a growing line up of thematic ETFs; another subset simply gives investors the ability to buy shares in line with their personal interests. Travel enthusiasts, for example, can own an ETF that gives investors exposure to the long-term demographic trends that favour the tourism industry. Other ETFs reflect growing trends that transcend specific industry sectors, such as companies involved in developing AI and robotics technology, holdings spanning many industries from several countries.

The pros and cons of thematic ETFs

Many of these ETFs can have dozens of companies represented, from several countries. So, if you want exposure to a theme, you can avoid the risk of investing in just one stock and also save the time that would be spent in researching individual firms.

Keep in mind, however, that some thematic ETFs are designed for active traders and are only suited to sophisticated investors who actively manage their investments.

On the down side, management fees can be higher than for typical ETFs, with expense ratios above 1% at the top end. And some of the more niche ETFs are small in terms of the value of their assets under management. As with any ETF or mutual fund, that's something to watch for because smaller funds may ultimately not be financially viable.

How thematic ETFs may fit in your portfolio

The right thematic ETFs can help you jump on board emerging sub-sectors. They offer a focus on a specific theme with less risk than buying single stocks.

However, given their narrow focus, thematic ETFs are likely to be more volatile than more broadly diversified ETFs. For this reason, they shouldn't be considered part of your core portfolio. Once you have an established, core portfolio, thematic ETFs can be a way to provide exposure to specific themes that you believe have potential for growth.

What to consider when evaluating thematic ETFs

Thematic ETFs can bring you exposure to sub-sectors or market segments that you believe are likely to grow. They can also help you invest in companies aligned to your moral or ethical beliefs or your interests. Before you invest, however, there are a few things to keep in mind.

It is important to have an established, core portfolio before considering niche ETFs. Traditional ETFs are about tracking market performance at the lowest possible cost. Thematic ETFs are about adding exposure to a niche that has the potential to outperform the markets.

Most thematic ETFs should be considered speculative plays, and for that reason you need to understand and be willing to accept the additional risks before you invest.

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The information contained in this article was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete. This material is for informational and educational purposes and it is not intended to provide specific advice including, without limitation, investment, financial, tax or similar matters.