Thematic ETFs continue to grow in popularity. But, how is this type of ETF different from the broad-based ETFs, like those that track the S&P 500? In this post, we discuss several points to consider when investing in thematic ETFs.
What is an ETF “theme”?
ETF themes can come from nearly anywhere in the investment world. As discussed in this recent WSJ article, themes are often found to hopefully align with “beliefs or interests” that investors may have. In the U.S., assets invested in thematic ETFs have doubled in the past three years. However, there have been quite a few closures along the way too. Closures are typically due to the ETF’s expense ratio failing to produce sufficient revenue to match the expense of running the ETF. This WSJ article suggests that ETFs without $50M in assets after three years are most vulnerable.
We agree. In fact, the initial evaluation of the ETFs we use in our portfolio construction process discards ETFs that haven’t existed for several years or have less than $50M under management. Our approach helps avoid the many issues associated with ETF closures.
Opportunities of Thematic ETFs
The obvious attraction of these ETFs is their opportunity to make more “concentrated” investments in companies within its theme. For example, investors interested in companies involved in automation could buy the ROBO Global Robotics and Automation Index ETF (ticker: ROBO). Or, if an investor wishes to make investments in solar companies, they can buy the Invesco Solar ETF (ticker: TAN). The image below shows the top ten holdings of this solar ETF.
However, theme-based ETFs also lack diversification inherent in broad-based ETFs like iShares Core S&P 500 ETF (ticker IVV). And, they are typically are less liquid. For instance, the average bid-ask spread of the Invesco Solar ETF was 0.11%. The iShares Core S&P 500 ETF bid-ask spread was much lower, at 0.01%, according to ETF.com.
Risks and Rewards of Thematic ETFs
Having more concentrated holdings than a broad-based index usually means higher risk. The chart below shows how the risk, measured by volatility, for the automation and solar ETFs compare to the S&P 500 ETF over the last three years. Clearly, these thematic ETFs exhibited greater risk. For the solar ETF, this higher risk level was compensated by a higher total return. However, the automation ETF’s higher risk levels didn’t produce returns higher than the S&P 500, lagging it by about 1% a year.
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