It’s been a weird year for the exchange-traded fund marketplace. On one hand, the emergence of thematic ETFs has provided new investment opportunities. On the other hand, the rise of thematic investing hasn’t slowed the pace of ETF closures.
There have been 198 ETF closures in the U.S. year to date, according to FactSet. These include thematic funds linked to legislative policies (PLCY), organic food (ORG) and sustainable investing (ESGW). In each case, the promise of investing in narrow themes never matured.
Thematic funds generally fall into two key groupings: single theme and multi-theme.
The Direxion Work from Home ETF (WFH), which launched in June, is an example of a multi-theme fund. WFH targets four key themes comprising cloud technology, cybersecurity, remote communications and online work collaboration. The fund has nearly $122 million in assets, making it among the year’s best thematic funds by asset growth.
Other multi-theme ETFs with a longer performance history—such as ARK Invest’s product line focused on disruptive innovation—have delivered impressive results. Since 2014, ARK has amassed nearly $15 billion in its lineup of seven thematic ETFs.
Thematic ETFs are different than sector funds because the latter is usually derived from broader indexes.
For example, the 11 industry sectors within the S&P 500 are a result of the S&P committee classifying and organizing stocks within the index according to their industry group. In contrast, thematic funds are typically actively managed or linked to newly created indexes with the specific purpose of targeting a certain investing trend or theme.
And as you might imagine, risk greatly increases the narrower you get when it comes to investing themes, so it can be a hit or miss proposition.
For example, the hype from a few years ago that 3D printing would totally upend product manufacturing hasn’t lived up to its promise from an investment angle. The ARK 3D Printing ETF (PRNT), which tries to capture this theme with a portfolio of 53 stocks, has significantly lagged the performance of both the Invesco QQQ Trust (QQQ) and SPDR S&P 500 ETF Trust (SPY). Over the past five years, PRNT has registered a total return of just 29% versus 178% for QQQ and 89.5% for SPY over the same period.
Cybersecurity is another example of a promising theme with lackluster performance. The ETFMG Prime Cybersecurity ETF (HACK) has gained just 91.4% during the past five years, which failed to beat QQQ and just barely outperformed SPY. In retrospect, the concentrated risk and volatility of owning cybersecurity stocks probably wasn’t worth it.
In other cases, ETF providers can suddenly backtrack on themes by changing a fund’s objective.
For example, the PureFunds Drone Economy Strategy ETF (IFLY) was introduced in March 2016, just as public interest in this narrow segment was peaking. Among IFLY’s top holdings when it launched was Boeing and Honeywell, large-cap stocks that derived minimal revenue from drones compared to their other business lines. As interest in drone investing waned, so did the fund’s performance and assets. In April 2020, IFLY’s ticker symbol and drone strategy were abandoned and folded into the Wedbush ETFMG Global Cloud Technology ETF (IVES), which has $47.5 million in assets under management.
What are the lessons of investing in thematic ETFs?
First, financial advisors should carefully monitor the thematic ETFs they choose for client portfolios. Instead of choosing higher-risk funds tied to single themes, ETFs that utilize a multi-theme approach can help to alleviate a single-pronged, hit-or-miss strategy.
Next, be sure to compare an ETF’s underlying holdings to other investments held in your clients’ portfolios. If there’s needless duplication in stock holdings, or if the ETF is just another large-cap fund posing as a thematic ETF, it’s probably best to take a pass.
Finally, thematic ETFs are usually best used as satellite positions that complement much larger core positions in broadly diversified funds.
Ron DeLegge is founder and chief portfolio strategist at ETFguide, and is the author of “Habits Of The Investing Greats.”