Interactive Investor

Pros and cons of investment trusts and ETFs for thematic investing

27th August 2021 11:07

Tom Bailey from interactive investor

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For an investor looking to gain thematic exposure, such as clean energy or space exploration, which is best suited?

Thematic investing has become increasingly popular. Over the past couple of years, there has been a surge of inflows into exchange-traded funds (ETFs) that track a so-called theme. A theme is some sort of big structural trend or macro change, or potentially a new, yet-to-be defined sector. Examples of themes include clean energy, space exploration, video gaming and cloud computing.

There has also been an uptick in interest in investment trusts with a thematic focus. For example, we recently saw the launch of HydrogenOne Capital Growth investment trust (LSE:HGEN). This can be seen as a rival to both the L&G Hydrogen Economy UCITS ETF (LSE:HTWG) and the VanEck Vectors Hydrogen Economy UCITS ETF (LSE:HDGB). Likewise, soon after the launch of the Procure Space ETF USD (LSE:YODA), a competitor emerged in the form of Seraphim Space Investment Trust (LSE:SSIT). Meanwhile, the many popular clean energy funds also have investment trust rivals.

For an investor looking to gain thematic exposure, which investment vehicle is best? There is no straightforward answer, and it depends on the preferences of the investor. Below, we run through some of the key differences of the two fund types for thematic investing.

Public or private?

Usually, an ETF tracks an index of publicly listed companies. It is not possible for an ETF to gain exposure to companies that have not yet listed on the stock market.

In contrast, an investment trust is an ideal tool for gaining access to unlisted companies. As a result, many new thematic trusts aim to do just this. For example, HydrogenOne Capital Growth aims to have 90% of its portfolio in unlisted companies. The Seraphim Space trust will also aim to have primarily unlisted companies.

The benefit here is that it allows the trust to gain access to companies in an earlier stage of their development and potentially reap greater rewards as this is typically the fastest growth stage. Added to this, over the past two decades companies have become less likely to list on stock exchanges and when they do, it is typically when they are at a more mature stage.

The potential benefit of investing in unlisted companies has seen several non-thematic trusts increasingly dip into private markets. Thematic ETFs, in contrast, cannot access these companies.

However, unlisted companies also tend to be riskier investments. At an earlier stage, a company is more likely to fail. This can result in substantial losses. The investor is relying on the expertise of the trust’s manager and research team.

Once a company has reached the maturity to list on a public stock exchange, in theory, it is a safer bet. Although it is also the case that many of the niche small-cap companies that would be found in a thematic index will also be relatively risky compared to other listed companies.

Forwards or backwards-looking?

The idea behind the thematic ETF is to follow a basket of companies with some sort of relation to the theme, implementing some form of rules-based approach. There are several ways to decide which companies should be included, but the most popular is to look at revenue. Indices require a minimum amount of a company's revenue to be derived from the theme.

This intuitively makes sense and is both data-driven and transparent. But it is not without downsides. Principally, this revenue approach can be backward-looking. A firm may be investing heavily in developing some sort of product related to a theme, but this has not yet shown up in the revenue.

As Kenneth Lamont, a senior analyst focused on manager research and passive strategies at Morningstar, notes: “This can leave investors gazing in the rear-view mirror, which may be particularly problematic in rapidly developing areas such as technology.”

In contrast, an investment trust manager and their team will, in theory, have the ability to better identify which companies are part of the theme and assess each company in the portfolio. As a result, the investment trust approach has the potential to be more forward-looking.

However, there are several ways ETF and index providers have tried to improve on their index selection. For example, many providers use a committee to make subjective decisions about the inclusion of companies. The committee will make use of quantitative data about revenue, supplemented with their own qualitative analysis to ensure the theme is being captured. Often specialist organisations such as trade bodies play a role here. Of course, for the investor who is attracted to a passive, rules-based approach, this may not be so desirable.

Another way round this is the use of data beyond just revenue. In the US, several ETFs have started to use algorithms to comb through academic papers or patent applications to work out which companies have a better exposure to the theme in question.

Lamont notes: “The advantage of this approach, particularly in the fast-moving world of technology, is that it is forward-looking (patents signal intention). There are also claims that this approach can help generate an informational edge. A downside is the black-box nature of these strategies.” Most ETFs and indices, however, have yet to incorporate this and the jury is still out on how effective it is.

Premiums and discounts

Investment trusts are fixed pools of capital. Shares in the trust trade on the open market. As a result, the net asset value (NAV) of the trust will often be different to its market capitalisation. The underlying assets could worth £100 per share, but the actual shares are trading at £110, giving it a 10% premium. Or, the shares could be trading at £90 per share, giving it a discount of 10%.

This adds a level of complexity to investing in trusts. Investors may not want to buy a trust on a large premium, as they are potentially overpaying for access to the trust’s holdings. Or, if markets have a sell-off, losses can be exacerbated if the large premium collapses. However, many investors like this feature of trusts as it can often create an opportunity to buy shares at a discount, potentially boosting returns if that discount narrows over time. 

With investment trusts that invest in publicly listed companies, this is all relatively easy to determine. The price of the shares the trust owns are determined on the open market. So, the difference between the NAV share price and market share price can be fairly easily calculated.

However, it becomes more complicated with trusts heavily focused on unlisted companies. By definition, the shares of these companies aren’t traded on an open market. Therefore, it is never entirely clear what the value of the underlying assets actually is on a daily basis. Therefore, there is always a risk of valuations disappointing, leading to sharp write-downs in value later down the line. 

This isn’t a risk with thematic ETFs, as the assets are publicly traded. The structure of ETFs also works to keep premiums and discounts at a minimum, so investors are usually getting access to the stocks for close to the market value.

Liquidity

To try and gain thematic exposure, ETFs and indices will often select relatively niche and small-cap stocks. Due to the relatively restricted number of stocks for a thematic ETF to choose from, the usual market cap weighted approach can lead to large weightings in a small handful of shares. To protect against this, many indices have a limit that restricts the weighting. Others adopt an equal weighting approach. Both approaches reduce the dominance of larger companies. However, it can also further increase the small-cap bias.

Generally, small-cap stocks are less liquid. If a thematic ETF becomes very popular, as the iShares Global Clean Energy ETF (LSE:INRG) has over the past couple of years, it can mean an increasing amount of money flowing into the small-cap stocks in the index. This can lead to the ETF owning increasing amounts of one of the shares. As a result, if the ETF needs to sell a portion of its underlying holdings, this can incur huge costs. The ETF may be required to sell shares due to regular rebalancing, an index removing a company or investor outflows. 

To reduce this liquidity risk, many thematic ETFs opt for “place holders”. These are often shares with a more tangential relation to the theme. However, their inclusion is seen as necessary to ensure liquidity. Alternatively, as the iShares ETF did, it can expand the index universe, reducing revenue requirements for inclusion. All this adds liquidity. However, it also potentially reduces the thematic purity of the ETF. ETFs, therefore, are often stuck between trying to ensure liquidity and protecting the purity of the thematic exposure.

Investment trusts don’t quite have this issue. Thematic trusts are likely to also invest in small and niche companies. However, the pool of capital to invest is fixed. If more investors buy the shares of a trust, it is not required to buy more of the shares in the company it holds. Instead, the shares will simply trade at a premium. Likewise, if investors sell out of the trust, it is not required to sell any underlying assets and the shares will just trade at a discount.  

Of course, there are potential issues here. If shares are trading at a large discount, investors may demand that the trust carry out share buybacks to reduce the discount. Likewise, if it is trading at a large premium, typically a manager will issue new shares, raising capital to invest.

However, in the case of thematic trusts with a large proportion of small-cap and unlisted exposure, buying or selling parts of their portfolio for discount/premium control reasons may not be ideal, and presents the same transaction cost and liquidity issues. As a result, trusts with large unlisted exposure can often trade on wide discounts or premiums.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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