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With the faltering of growth stocks in 2022 and lingering headwinds this year, it’s easy to rehash old diminishing of thematic exchange traded funds.
Those histrionics and clarion calls include calling thematic ETFs “fads,” too much of a good thing, too nuanced and complex, prone to large losses and outright “stupid.” A research paper by Itzhak Ben-David, Francesco Franzoni, Byungwook Kim and Rahib Moussawi – “‘Competition for Attention in the ETF Space,” – suggests many thematic ETFs are launched at the peak of the underlying theme with issuers attempting to capitalize on unwitting retail investors’ overly enthusiastic views.
That criticism has some merit and to be sure, some thematic ETFs are far too nichey and fail to gain traction among advisors and investors. Still, there are scores of examples of success stories in this space, including funds with hundreds of millions and north of $1 billion in assets under management. Plus, the concept of thematic ETFs has drawn some of the biggest issuers in the business, including plenty which advisors are highly familiar.
Confronting Thematic ETF Challenges
Chances are a fair amount of clients, particularly those in younger demographics, are interested in thematic ETFs and likely allocating to some of these funds in discretionary accounts. Accounting for ordinary investors’ penchant for selling low, advisors can play pivotal roles in helping clients see the forest through the trees with thematic strategies.
“In our opinion, one of the most challenging aspects of thematic investing is resisting the urge to sell into short-term weakness,” according to First Trust research. “Those that succumb to this temptation may not only miss a short-term rebound when it occurs but may also find it difficult to determine an acceptable price to re-establish a long-term position. To counter this impulse, we believe it’s critical to gain an appreciation of the investment thesis supporting a theme, as well as the period over which it may be expected to play out. Establishing appropriate entry and exit points up front may help manage clients’ return expectations and avoid making emotionally charged behavioral mistakes.”
Another challenge investors face, without proper guidance, is knowing how to deploy thematic ETFs within their portfolios. Some don’t have enough thematic exposure or any at all while others may be too cavalier and overly allocated to such strategies. On that note, advisors can help clients balance the risk and return opportunity set thematic funds present.
“One strategy for targeting an acceptable level of overall portfolio risk is to include lower beta strategies within a portfolio’s core equity allocation, while incorporating potentially riskier thematic ETFs as satellite allocations,” adds First Trust.
Thematic ETF Benefits
One of the primary benefits of thematic ETFs is the fact that a lot of these funds hold stocks that are under-represented or not found at all traditional benchmarks such as the S&P 500 or Russell 1000.
Second, advisors might want to consider conveying to clients that not all thematic ETFs feature far-flung investment cases. In fact, many focus on arguably basic concepts, including biotech, cloud computing, cybersecurity, infrastructure and real estate. Count those among the benefits offered by this corner of the ETF arena.
“By appreciating the distinct investment theses and time horizons of thematic ETFs, how their inclusion may affect sector and geographical allocations, as well as the overall risk and return attributes of a diversified portfolio, we believe investors may be well-positioned for the pursuit of long-term outperformance with thematic ETF,” concludes First Trust.