Factors to consider before adding a thematic ETF to your portfolio

Factors to consider before adding a thematic ETF to your portfolio

In the quest to launch successful products, ETF sponsors have ventured into thematic segments of the financial markets. Think robotics, artificial intelligence, fintech, online retail, cyber security, etc. There has been mixed success among issuers, as some of these products have rapidly grown to $1 billion in AUM such as ETFMG’s Prime Cyber Security ETF (symbol: HACK), while others never gained traction and were closed within a year.

Thematic ETFs fit into a portfolio as satellite positions for investors looking to add alpha to the portfolio. However, thematic ETFs may pull holdings from different sectors but remain related to the theme, increasing diversification.  However, as an investor narrows the scope of a security to a thematic level, security selection begins to play a larger part of the formula than a simple asset allocation process. For example, investors need to get the theme right – to be sure it has the ability to provide long-term secular growth with staying power- not just a fad that will fade away or be usurped by more modern technology within a few years.

With thematic investing, stronger consideration to the underlying holdings is required to ensure that the product is true to the theme. For example, some thematic ETFs are dabbling in areas so new or narrow that there are too few pure play companies in the space. For example, early ETF entrants into the cannabis themed ETF space included companies involved in fertilizer, alcoholic beverage or tobacco.

Thematic investing involves a higher level of risk, there therefore requires more involvement in security selection, market-calls, and being correct on both short and longer-term trends.

Costs of thematic ETFs tend to be higher than those of broader index ETFs, and investors should also consider these costs prior to investing. In general, ETF Model Solutions has not historically included sector or thematic ETFs to our allocation models. For more on this topic, see “Themes That Make Sense, Themes That Work” ETF.com/ETF Report September 2019.