Interactive Investor

Why thematic ETF investing is becoming more popular

29th March 2022 09:40

Kenneth Lamont from ii contributor

Here’s what is driving demand for ETFs investing in world-changing trends.

In recent years, the global menu of thematic funds has expanded in number and breadth like never before. These funds attempt to harness secular growth themes ranging from artificial intelligence to the metaverse. The result has been a steady supply of ever more niche and complex investment strategies from asset managers, and increased demand from investors for greater clarity with respect to how these funds are built and how they might (or might not) fit within their portfolios.

What are thematic funds?

Thematic funds select holdings based on their exposure to one or more investment themes. These themes may connect to macroeconomic or structural trends that transcend the traditional business cycle. Examples include demographic shifts or technological advances.

Our definition includes funds such as cannabis ETFs, which hope to capitalise on the commercial application of cannabis, or related products. We exclude funds that might be useful for making tactical economic calls but lack a cohesive longer-term narrative, such as those that target Japanese exporters.

Although many active managers select investments based on exposure to a theme as part of their investment process, at Morningstar we have isolated a distinct subset of funds that explicitly target these themes.

​​​​​Rise of thematic funds

Over the trailing three years to the end of 2021, thematic assets under management have grown nearly threefold to more than $800 billion worldwide. To put that into perspective, assets represent 2.7% of all assets invested in equity funds globally, up from 0.8% a decade ago.  

In Europe, the largest thematic fund market, assets more than quadrupled over the trailing three years to $437 billion (£331 billion). Interestingly, the European market is dominated by traditional active funds, whereas in the US ETFs are the vehicle of choice.

This growth has been supported by a nearly unbroken streak of positive quarterly net inflows. These net flows peaked towards the end of 2021, but have been growing globally since the beginning of the global pandemic.

It is worth pointing out that the growth of thematic funds has been a global phenomenon, and we have seen enthusiastic uptake in Western markets such as Europe and the US, but also in markets like China and Korea too, which suggests that the shift in sentiment towards thematic investing is symptomatic of a global trend.

The recent boom in thematic investing globally has been driven by several different developments.

1) ESG popularity has boosted thematic fund demand

The booming popularity of ESG funds in Europe has spilled over into the world of thematic investing. In late 2020, the promise of huge government spending plans announced by the newly elected Joe Biden administration in the US prompted massive inflows into funds with an energy transition theme. Despite a subsequent drop in net flows, funds seeking to profit from the transition away from hydrocarbon-based energy sources, such as the HanETF Solar Energy ETF, have risen to become the second-most popular theme grouping in the region.

2) Polarisation of growth

Companies with exposure to certain potentially world-changing technologies have benefited from rapid growth and soaring stock prices, which have offered investors outsized returns. This outperformance has attracted still more flows. This was particularly obvious over the initial stages of the global pandemic, when most thematic ETFs outperformed the broad market by a comfortable margin.

Aside from offering the potential for outsized returns, in some ways this was a period of validation for thematic funds as they demonstrated distinctive risk and return drivers.

The large differences in performance between funds tracking similar themes also shone a light on the importance of picking the right thematic fund.

3) Growing irrelevance of traditional sectors and geographic breakdowns

Where a stock is listed can have very little bearing on where it sources its revenues, for example London-listed BP (LSE:BP.) derives a fraction of its revenue from the UK. Equally, sprawling tech giants that operate in a kaleidoscope of emerging and existing industries are testing the boundaries of traditional sector frameworks.

4) Data improvements

Steady improvements in the quality and granularity of financial data mean that highly targeted indices and investment strategies can now be constructed and maintained.

5) Increased access to financial markets

Low-cost platforms, such as interactive investor, have been at the vanguard of the democratisation of finance and have helped increase retail participation in financial markets. Retail investors have historically been attracted to thematic investments with strong narratives, which has contributed to the success of stocks and funds connected with themes.

But it is important to look beyond the narrative

When assessing a thematic fund, it is crucial that you look beyond the narrative. Each thematic fund takes a different approach to selecting and weighting holdings, which can result in very different outcomes.

At the time of writing, one global battery ETF had a 42% exposure to Chinese stocks, while another just 3%. In terms of sectors, the first had 46% exposure to resources, while the other had just 20%.

As you can see, the exposures of tracking the same theme can be very different. These differences should be well understood before investing.

Kenneth Lamont is a senior analyst focused on manager research and passive strategies at Morningstar. 

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.

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