Thematic ETFs meet resistance from academics and financial advisers

Funds specializing in artificial intelligence or gender equality might attract investors’ attention, but financial advisers should think twice about its risks and returns before recommending thematic ETFs to their clients.

Research from the EU business school suggests that thematic ETFs and their related underlying indices are at odds with the traditional logic of index investing. Higher fees, higher tracking errors, lower liquidity and lower diversification made ETF thematic investments riskier, according to the study.

“As an ETF holder myself, I question ETFs as a viable investment vehicle for my savings as well as others,” wrote author Lorenzo FP Merlo in the work paperr, which has not yet been peer reviewed. “Risk-averse savers should be wary of financial advisers who recommend thematic ETFs. Pension plans should be based on a long-term, risk-averse investment strategy.

The study comes as investor interest in thematic funds has increased significantly in recent years, particularly since the onset of the global coronavirus pandemic. Over the past two years to the end of 2021, assets under management for these funds have nearly tripled to $806 billion globally. This represented 2.7% of all assets invested in equity funds, compared to 0.8% 10 years ago, according to Morningstar data.

Traditional ETFs generally have lower fees and capital gains taxes due to the passive management model. Issuers rely on their low prices to market their products. But this is not the case with thematic ETFs which are often actively managed with higher expenses.

The EU Business School study found a ~0.4% spread in fees between broad market funds and thematic ETFs in 2019. Over longer periods, higher fees of these funds could contribute to relatively weaker performance compared to broad market indices, according to the study.

The ARK Innovation ETF (ARKK) which bets heavily on technology stocks such as Tesla, Roku and Zoom issued by Cathie Wood’s ARK Investment Management, for example, has performed relatively poorly recently compared to traditional ETFs. In 2021, ARKK was down over 23% while the S&P 500 ETF Trust (SPY) gained 29%. It also carries higher risks, with a Sharpe ratio for ARKK of -1.12, compared to the ratio of -0.13 for the SPY.

“If you jumped into this thematic ETF after its incredible 2020, you are now down 64% while the S&P 500 is up 10%. So I’m very critical and skeptical of advisors who have bought ARKK or a thematic ETF looking for incredible returns,” said Bryan Minogue, founder of Kardinal Financial.

According to some financial advisors, clients would invest in such a product because thematic ETFs can be used alongside a core portfolio to give the client access to something that interests them, such as an ESG fund.

“Building a portfolio based on thematic ETFs is probably not the best strategy,” said Jeff Burke, founder of 7th Street Financial. “But once the main investment objectives are met and are appropriate for the risk to the client, a thematic ETF can be a way to achieve higher returns in a targeted sector that you can’t achieve with an index fund.

While these niche ETFs can help investors get ahead, they could also lead to quick losses in the event of a trend reversal. Following the early pandemic shock of 2020, the technology sector performed well while the energy sector suffered significantly.

“To me, it’s no surprise that many thematic ETFs in vogue today focus on technology, not energy. But here we are now in 2022 with the energy sector up nearly 50% and the tech sector down more than 20%. Things can change very quickly,” Minogue said.

Jeremy Bohne, founder of Paceline Wealth Management, generally does not recommend thematic ETFs to his clients. He said people who pursue these thematic trends are usually late in the game, which makes funds expensive and not worth investing in.

“Some of the best returns on investment don’t come from fancy, cool products. They come from a proven, repeatable investment process,” Bohne said. “So to get investment before most of the returns have been made by investors, you have to do something before it’s very popular.”

Merlo’s study also points to the low diversification of thematic ETFs, which he says contradicts the logic of index investing. His research found that some indices are designed for short-term ETF trading rather than long-term savings growth, as there seems to be high demand among active, high-frequency traders who can easily move from one trend or sector to another.

“This induces more noise, thus distorting the fair values. Investors seeking thematic exposure should take a closer look at ETF trading activities before venturing into this area. They should also be aware of the stock market valuation mechanism,” he wrote.

Some experts say thematic fund launches are a bull market phenomenon. A report by Morningstar shows that the second half of 2020 saw almost as many thematic fund launches as all of 2019 as zero interest rates pumped money into the market.

“New strategies are often introduced in periods of strong performance, such as the new millennium and the mid-2000s. But they tend to decline during downturns. These trends indicate that investors’ appetite for these strategies and the desire of providers to offer them are generally moving in step with the broader market,” eight researchers wrote in the Morningstar Research Rating.

“One of the ways advisors help clients is basically peeling back the layers of the onion to understand what matters most to them. And then my role as an advisor is really to find the most effective way to implement what they’re looking to do,” Bohne said.