Thematic ETFs — What are they good for?

An exchange-traded fund, known as an ETF, has become increasingly popular over the last few decades. Born in the early 90’s, an ETF is a financial vehicle traded in stock exchanges and tracks the index it covers. For example, some ETFs track the S&P 500, and ETF shares are traded in accordance with the index, replicating the return of the index.

The Thesis

Stocks exchanges have a long history. Some argue that a stock market even existed in ancient Rome, but the first legal entity we know of for certain that offered its shares and bonds was the Dutch East India Company. In the seventeenth century, Amsterdam was the most notable financial hub, and later on, London was also a major financial center. Stock markets evolved in the capitals of the financial world in the seventeenth and eighteenth centuries. They even survived the South Sea Company bubble in 1720.

The young United States had a stock exchange of its own after one was found in New York in 1792. Back then, government bonds were mostly traded.  The stock market development in the nineteenth century can be attributed primarily to many technological inventions, such as the telegraph and the telephone.

The stock market has suffered many collapses and crashes since then, including the most famous one in 1929, which caused an 89% decrease in stock prices until 1932. Later on, the stock market recovered but had many ups and downs (along with the effect of World War II) until the late 60’s. The 70’s and the 80’s were not good for the indices, but they were even worse for those picking specific stocks.

The Antithesis

The history of attempts to time the market and beat the market is as long as the history of stock exchanges. Thorough academic research and empirical results based on a large sampling have shown the advantages of passive investing, which is a way to try to maximize your return in the stock market by keeping the amount of buying and selling as low as possible while investing for long periods of time. This course of action came from the notion that you can’t time the market. You will never know when the market is going to crash, and you can’t forecast the performance of any particular stocks in the short term. This strategy is also known as “value investing,” a method used by some notable investors.

This strategy was connected to another profound approach stating that you can’t beat the market. Maybe Warren Buffet can, but empirically, most people can’t over long periods of time. This fact led to the introduction of index funds in the 70’s, which replicate the return of the indices they track. In the 90’s, ETFs have joined the club as a financial vehicle that allows trading the index as if it were a regular stock. An ETF has a few advantages over mutual funds, mostly in terms of lower fees, which have also made it a popular vehicle strategy today. The biggest advantage of all is the ability to achieve full exposure to an index, as the ETF replicates the performance of an underlying index.

The industry has grown dramatically in the last two decades, and using ETFs is considered by many to be the best approach for passive investing and value investing, although mutual funds are still a much bigger industry, and active investing is still considered by many as a valuable strategy.

Synthesis

Statistics show that in a bearish market people invest more in ETFs than in mutual funds. However, when the market is bullish, people are more likely to invest in mutual funds. One of the main differences between the two is that mutual funds offer active investing to beat the market, and when times are good and every dollar becomes two, people believe they can beat the market or at least their mutual fund can.

The ETF industry has definitely seen a significant number of people interested in active investing, such as mutual funds.  “Smart beta” ETFs are now being offered that aim to beat the market, but these are just more of the same. They do not attract new people to the market and certainly not young investors. So, a solution was found—thematic ETFs.

Thematic ETFs

Mutual funds are offering many funds tracking the performance of major industries and particular regions. For instance, you can find mutual funds tracking the performance of the oil industry or some other industry, and you can find mutual funds tracking the performance of Asian stocks or European stocks, but you can’t find a mutual fund that tracks the performance of video game technology or drone companies.

Thematic ETFs were created specifically for this niche. In the last few years, these ETFs have been springing up like mushrooms after the rain (the rain of the subprime crisis). This mixture of passive investing in ETFs and active investing in mutual funds and the bullish market we have been experiencing for the past eight years has reinvented the ETF industry. Many of the new ETFs focus on a very narrow industry or subsector, aiming to achieve great returns by indexing some of the growing companies in this sector.

The sectors are mostly those that are particularly attractive, such as medical marijuana, mobile payments, health and fitness, as well as some other growing industries that are forecasted to have a CAGR much higher than the growth of the economy. If you have an industry you deeply believe in, thematic ETFs claim to have the answer. For example, if you want to invest in the aging population, you can invest in a “long-term ETF”; if you want to invest in obesity, you can find the “obesity ETF”; and you can even invest in the whiskey industry.

To buy or not to buy—that is the question

These ETFs are young, innovative, and probably more attractive to millennials, but thematic ETFs carry some of the disadvantages that brought us to this situation in the first place (see the antithesis section):

  • Diversification—These subsectors are small, sometimes too small. In terms of diversification of your investments, you won’t get much of it here, as you will be exposed to a tiny fraction of the total economy.
  • Risk—Companies in a small subsector are usually highly correlated with each other, which means that if something bad happens to this sector, all of them are affected. For instance, imagine that you are investing in medical marijuana ETFs and suddenly some new regulations are imposed. You’re screwed.
  • Volumes—Since we are flooded with thematic ETFs, many of these are not very tradable, and volumes are low. It’s hard to buy at a realistic price, and in a case of a downturn in the market, it will be even harder to sell.
  • Fees—The expense ratio of thematic ETFs is generally higher than that of regular ETFs. This can lessen your return over a long period of time.

But you also have some advantages: if you are comparing an ETF with a lone stock, less risk will be involved and more diversification will be present, as you will have more companies in your pool. Perhaps the most important advantage, though, is that when a new sector is born it is hard to project which companies will control the market in the future. Instead of betting on one company, you can bet on all of them, and if the market keeps growing, it will not matter if some components of the index do not survive as long as the survivors are still in it.  That is why thematic ETFs are not going away anytime soon, and they will probably keep growing.

6 comments On Thematic ETFs — What are they good for?

  • Roy, thanks for another great post. I definitely learned a thing or two (and probably even more). I have one question though:

    In your opinion, should investors be allowed to create and invest in any ETF they wished? and if not, where does the line go between a legitimate investment and an illicit gamble? For example, should there be an ETF for cryptocurrency, for which there are almost no regulations and proper supervision, just because there’s a demand for such ETF? should there be an ETF for video games or sport organizations (and if so, how different is such an ETF from gambling)?

  • Tal, as a matter of fact, there is actually an ETF for video games. If I recall correctly, there are even several ETFs for this industry.

    I think that most ETFs should be approved, as long as they can track the underlying asset accurately, and as long as the asset itself is legal.

    I believe that the markets can filter the good ETFs. The industry is really booming right now, but many of the newly issued ETFs have almost no volume at all and will probably cease to exist in a while.
    Your question is more legal in its essense, and I think it can relate to any stock issued – If the SEC approves issuance of a stock in the business of video games, why wouldn’t it approve issuance of an ETF in this field?

    Cryptocurrency, though, is a differenct story, since there is a problem to track the undelying asset, as cryptocurrencies are not traded on the floor. However, I think that some kind of financial vehicle that will track cryptocurrencies will be issued soon, since the demand is realy high.

  • Thanks for the comment, but that’s not exactly what I meant (or at least it’s only part of it).

    I don’t see a problem with an ETF that tracks the video games industry, as companies like Zinga, EA and more are publicly traded and properly regulated and supervised by the SEC. However, one can think about some video gaming entities, like e-sport teams and tournaments , that do not issue traditional securities in any way, but could be tracked as underlying assets for an ETF.

    As for the legality issue, that issue is a bit more complicated in my opinion, as sports events or other potential underlying assets might be perfectly legal under their relevant laws, but do not qualify for issuance of securities (for example, its perfectly legal to conduct the Tour de France, but would you say that an ETF that tracks the performance of a certain team in that tournament is perfectly legitimate?)

    It’s true that the SEC is the right regulator and could deem those problematic ETFs as illegal, but we also need to ask whether the SEC is equipped with the right tools to determine the legality of each type of each underlined asset in a potentially infinite world of underlined assets? or should it just prohibit creating ETFs that track assets which the SEC is not well positioned to regulate and supervise?

    You can also leave it to the market as you suggested, but then the SEC might expose the ETF investors to risks that investors in more traditional securities are protected against, and that might constitute as a market failure.

    • Well, it’s obviously a complex issue and there are some gray areas, but I think that the SEC mandate is to address only the technical parts of the ETF in order to approve or disapprove it.
      As long as there is no technical issue related to tracking the underlying asset, the SEC should approve the ETF.

      Therefore, there shouldn’t be any problem with ETF tracking E-Sports traded companies, but there is a problem with ETF tracking tournaments etc.

      There are some other financial vehicles that can be used for this type of “assets”, but ETF is not one of them, since the underlying assets need to be traded in order to be tracked accurately.

  • Hi Roy, another great one. I didn’t even know thematic ETF’s exist.

    Can you perhaps share a few case studies of interesting thematic ETF’s which present (relatively) high yields and the composition of their portfolio?

    • Thanks Ori.

      Thematic ETFs tend to be very affected by specific stocks. Therefore, some of the best performers in the last year among ETFs are LIT, an ETF of Lithium companies, which is very affected by the Tesla stock skyrocketing ; BOTZ – Artificial intelligence ETF, mostly affected by the performance of Intuitive Surgical and by the purchase of Mobileye by Intel; and I guess they are other ETFs that are also affected positively by some specific stocks performance.

      This is exactly the problem of thematic ETFs – they are not well diversified and can be deeply affected by a few companies, while the standard ETFs are much more diversified and allow exposure to several industries.

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