Thematic ETFs have become the most popular trend in the exchange-traded fund world today. They’re also among the most complicated products to incorporate into a portfolio.
Assets in thematic ETFs, which focus on a narrow array of stocks that are thought to be the beneficiaries of a particular long-term social trend or technological innovation, ballooned 430% in the past year, to $133 billion, thanks to strong performance and strong inflows. That has led to a quickly expanding and ever-more confusing universe. Funds with similar names sometimes own very different stocks. The inverse is also true: ETFs that appear to be different can have remarkably similar holdings. Incorporating thematic ETFs into an existing portfolio—even when building a new one—requires a close look at the underlying stocks.
The whole point of a thematic ETF is to increase exposure to particularly exciting parts of the market. Most, if not all, of the companies in thematic ETFs are also in broad-market indexes, so investors are already making a more concentrated bet on those stocks. But when owning multiple thematic ETFs, investors run the risk of increasing that bet far more than they realize, and likely more than is advisable.
Traditional sector or industry funds follow established systems like the Global Industry Classification Standard (GICS). Companies that operate in multiple business areas are assigned to just one sector and industry, usually based on their primary revenue source.
(ticker: AMZN), for example, is primarily an e-commerce company, but also makes money from web services, advertising, and subscriptions. Still, it’s considered by GICS to be a “consumer discretionary” firm within the “internet & direct marketing retail” industry. That’s why most sector ETFs, which follow the GICS classifications, won’t have any overlap among their sector funds.
Things aren’t as clear-cut for thematic ETFs, whose active managers or index creators have full discretion to define their own themes and the companies that contribute to it: Amazon is a top holding in both
(ONLN) and
(SKYY).
What’s more, some thematic funds are focused on a very narrow niche that doesn’t have many publicly listed companies yet. Volatility and liquidity issues would further exclude the tiny-sized or thinly-traded names. As a result, those ETFs have to include companies that only generate part of their revenue from the related industry, or just remotely benefit from the trend.
So, funds that focus on different themes can invest in a remarkably similar group of stocks. For example, the
ARK Autonomous Technology & Robotics
ETF (ARKQ) has 45% overlap with
ARK Space Exploration & Innovation
(ARKX). Similarly,
(IPAY) and
(FINX) have a 38% overlap;
(WFH) and
First Trust NASDAQ Cybersecurity
(CIBR) have a 25% overlap; and the
VanEck Vectors Video Gaming & eSports
(ESPO) and
(SOCL) ETFs have 22% in common.
There are two opposite forces at play here, says ARK’s client portfolio manager Ren Leggi. On one hand, innovative technologies are converging and influencing each other. Artificial intelligence can be applied in genomics research, for example, and 3D printing is a key tool in space exploration. So the line between themes can be blurry, leading to even more overlap. However, the universe of innovative companies is expanding, and as industries mature and more firms become public, thematic funds will have more investment options.
Perhaps most importantly, the performance across many thematic ETFs has been strongly correlated, even among different themes—largely a result of so-called hot money. When that momentum reversed in February, many thematic ETFs tumbled at the same time. All the more reason to avoid owning too much of a good thing.B
