Investing

'Fortunes can be made and broken' with thematic ETFs, expert says. Here's what you need to know

"You're going to want to pick a couple and have them be a satellite to your core portfolio."

Share
Twenty/20

Have you ever been certain that a particular technology or industry was the way of the future, so much so that you'd be willing to put your money where your mouth is? Then you're likely among the growing group of investors taking interest in so-called thematic funds.

Rather than focusing on a market index, these exchange-traded funds hold baskets of investments that theoretically stand to benefit alongside the long-term emergence of a particular theme. Think federal legalization could spark a boom in cannabis firms? Think artificial intelligence is likely to change the American workforce? Think that we're headed for a future where space travel becomes commonplace? There's likely a fund for that. There's probably more than one.

Investors are increasingly attracted to this idea. As of the end of March of this year, total investor dollars in such funds stood at $160 billion, up more than triple from about $49 billion at the end of 2019, according to Morningstar.

But just because investing in these funds is popular doesn't mean it's foolproof. These niche investments come with high potential returns, but also a unique set of risks that could damage your portfolio if you're unaware of them.

"Sometimes they work. Fortunes can be made and broken, but it's really hard," says Drew Voros, editor-in-chief at ETF.com. "You're going to see some themes flame out."

Here's how investing experts recommend getting involved.

VIDEO8:2208:22
ESG investing: How investors are trying to do good and make profits

Video by Helen Zhao

What are thematic ETFs, and why are they popular?

Investors have been flocking to thematic funds for two reasons. For one, they're easy to understand, says Voros. "If people see an ETF with video gaming or sports betting in the name, they know exactly what that is," he says. "When retail investors wanted to make a bet on the airline industry after Warren Buffett sold his airline stocks, they piled into [ETF] JETS, which holds a collection of airlines. It makes sense to people."

And like many other investments in what has been a go-go market coming off pandemic lows, some prominent thematic ETFs have delivered big returns. The Ark Innovation ETF, which focuses on disruptive companies, shot up 153% in 2020. The iShares Global Clean Energy ETF delivered a 142% return over the same period.

Though both have come back to Earth a bit so far in 2021, the message to opportunistic investors remains clear: Pick the right theme at the right time, and there are returns to be had.

Experts say that carving out a small portion of your portfolio for one or two of these funds isn't a bad idea. "You're going to want to pick a couple and have them be a satellite to your core portfolio — a smaller subset of your broader holdings," says Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA. "Pick some themes that you think have strong, long-term prospects and you wouldn't find commonly within your core portfolio."

VIDEO2:5802:58
What is an ETF and should you invest in one?

Video by Jason Armesto

Navigating thematic ETF risks

But before you go shoveling money into what you think is going to the next, hottest theme, experts say it's important to ask yourself three key questions:

1. Does this ETF hold the companies I want to invest in?

If you're considering investing in a particular theme, you're likely to run into a few ETFs that are marketed the same way. "Asset managers are clever with the tickers. If you want to invest in infrastructure, there's PAVE and IFRA. Cannabis investors can invest in YOLO, TOKE, and CNBS," Rosenbluth says. "They all sound like they're giving you the same exposure, but you need to look inside them and understand what you're getting."

The big concern to watch out for is overlap with your core portfolio, Rosenbluth says. "If you own broad market funds, Tesla is probably part of your core," he says. "So if you're investing in self-driving cars or electric vehicles, you want to make sure that ETF doesn't own a significant slice of Tesla. Otherwise, you could find yourself overexposed to that one stock."

Investors should be wary of any thematic fund that's invested predominantly in just a handful of stocks, says Voros. "If the portfolio you're buying has 20 stocks in it and two of them crater, now 10% of the portfolio is hurting," he says.

The same is true in the other direction of course, but investors should understand that while broad index funds like those following the S&P 500 are "slow climbers," thematic funds will behave more erratically, he says. 

2. What will it cost me to buy this fund?

It pays to assess the cost of any thematic fund you're considering, says Voros. "Expense ratios for these funds will be much higher," he says. The average annual fee for thematic funds is 0.62%, according to ETF.com — not extortionate, but significantly higher than the 0.13% average for passively managed funds.

Investors would be wise to check out any fund's assets under management — the fund's share price multiplied by the number of shares outstanding. The mechanics behind ETF trading mean that investors receive a worse price when buying or selling shares of small funds, says Voros. "You'll pay more on a trade going in and out," he says, adding that funds with assets of $100 million or less should raise red flags for investors, as they tend to be thinly traded and therefore difficult to buy or sell at a favorable price.

VIDEO1:4401:44
Why boring investments are actually better

Video by Courtney Stith

3. What's the long-term future of this investment?

Before buying a thematic ETF, ask yourself how long you plan to hold, says Voros. "It's all about your time horizon," he says. "Are you playing the long game and holding, or are you trying to capitalize on the theme and bail?"

Fund firms are happy to open up an ETF to try to attract buyers looking for the latter. It didn't take long for "work from home" themed ETFs and the like to pop up after the start of the pandemic, Voros points out. "When all of these Covid themes came out, I thought, 'three years from now I hope we have this thing licked.' It's like coming up with a bird flu ETF," he says.

Because ETF issuers tend to build funds around popular, fast-growing names, they often perform well in the short term: 80% of thematic funds outperformed the global stock market in 2020, for instance, according to Morningstar. But over the past decade and a half, nearly half of all available thematic funds have been forced to shutter.

"When there's no news, they just kind of go away," says Voros. "The theme has to stay in the headlines for the fund to continue to draw interest."

More from Grow: