The riddle of thematic ETF investing
Good potential for growth, but discipline needed to find success
Okay, we will start this week with full acknowledgement that this edition is a bit self-serving; it’s about thematic investing, and yes, we recently launched a thematic-focused strategy. But we would like to share “Why” we created this strategy, beyond the obvious fact that we manage money. We believe investors face a number of big hurdles when investing in thematic ETFs, which we are trying to address.
The essence of thematic-focused investing is, at its core, a really good idea. There is no denying that the world changes over time, and often there are long-term tectonic shifts. In years past, we have all witnessed the rise of smartphones, or the rise of cloud computing, and healthcare spending due to advances in solutions and aging populations. Identifying these trends isn’t that difficult as they become increasingly evident as society evolves and behaviours change demand patterns.
More recent themes include EGaming, cyber security, AI, and the ever-popular rise of electronic vehicles (EVs). Securing electronic data in an ever more electronic world remains a top priority for people, companies, and governments. Demand to secure data from unsavoury characters is something that will likely continue to grow faster than the overall economy for many years to come. Or EVs, which continue to gain market share among total vehicles sold, is forecast to continue for many years, if not decades.
Naturally, creating an ETF or fund that attempts to capture one of these faster-growing or exciting themes is a good idea. And investors agree if you measure agreement by the inflows into thematic ETFs. The previous chart is the number of shares outstanding in thematic ETFs, which has exploded over the past few years. We use shares outstanding instead of market value as this avoids the impact of changing market prices. Even in the past couple of years, which have been more of a risk-off environment for investor appetites, thematics have increased.
But, there are some hurdles investors face with investing in these high-growth potential thematic ETFs.
Which one(s) to invest in?
To put it plainly, thematic ETFs can offer outsized returns, but they can also offer outsized losses. The variability or disparity of performance is massive. If you are buying a Canadian bank and you pick the wrong one, it’s unfortunate, but the disparity is low, so not too much of an issue. Pick the wrong thematic – yikes! What if you chose the marijuana theme? Tough times of late. More optimistically, if you picked AI, you won.
The chart above shows the 50 largest thematic ETFs listed in the U.S., indicating the 1-year price change. Yes, you are reading the chart correctly, that is from +47% to -32%. Even those poor-performing themes are still enjoying a long-term growth trend in their industry. But investor appetite is a fickle thing; it can change a lot from one year to the next. Or a theme can experience a headwind of some sort or another, such as changing legislation.
Pick the right one, you win. Pick the wrong one, you lose. Even some of the poorest-performing thematics over the past year are still focused on a theme that has great prospects. Some are down because they simply went up way too far the previous year. Picking who will win in the next year, now that is challenging.
The lure of performance chasing
Performance-chasing is evident in all kinds of investing; it is very evident in the thematic space. An artificial intelligence (AI) ETF is one of the big green bars on the left of the chart above. Up about 40% over the past year, with all that gain reached by the end of May this year. In other words, flat over the past five months. At the end of May, there were 9 million shares outstanding for this ETF, today, there are 24 million. In simple terms, most of the money in that ETF came in after its gains.
To further show this performance chasing, we broke down thematic ETF price range into four equal buckets (quartiles). Quartile 1 was the lowest 25% of prices over the past five years. Quartile 2 was the next 25%, still below average but not as cheap. Quartile 3 is above average, and Quartile 4 is the most expensive. We then measured ETF flows during these four price ranges (see chart below).
Guess what? The vast majority of inflows from investors occurred during the more expensive price ranges. In fact, during the cheapest quartile, there were outflows. Buy-high, sell-low has never been a viable long-term strategy.
With the same universe of thematic ETFs, we measured the actual return experienced by investors using money-weighted returns. Comparing this dollar-weighted return to if an investor had simply held the ETF all along. This is more evidence that the average investor has had a tough go with thematic ETFs (see chart below).
No sell discipline
Contributing to the previous evidence of poor timing is an apparent lack of sell discipline. Even thematic ETFs that have seen their share price fall 40%, 50%, or even 80% over the past few years have seen very few sell. One of the largest thematic ETFs in the U.S. is down 75% since early 2021 and still has about the same number of shares outstanding. Congrats on being a stable investor and sticking with your conviction. Unfortunately, you are now poorer.
The challenge is, if you believe in the long-term theme, why would you sell? Yes, 50% of cars sold in 2035 may very well be EVs, so just stick with the EV thematic ETF and ride out the peaks and troughs. But what if the composition of the ETF doesn’t capture the theme as the companies involved change over time? Most auto manufacturers now sell EVs, clearly not pure plays like in years past when it was just one or two new companies making EVs. One of the biggest EV ETFs was up 62% in 2020, up 28% in 2021, and down 34% in 2022. Yet the theme continues its path.
Unfortunately, you can’t use valuations as a sell signal. Many times, the underlying thematic companies are very expensive to begin with. They can become more expensive and may still be expensive even if they fall by 50%.
A lack of sell discipline and stubborn attachment to thematic ideas has caused many investors to take the full ride, up and down. Sometimes, it’s more down than up.
Thematic ETFs can offer a growth boost for portfolios. Plus, given the composition of the TSX and its lack of growth (lots of dividends, not as much growth), many Canadian investor portfolios are light on the growth factor. There are many options available, covering many different themes, from many different ETF providers that could actually experience a positive tailwind for many years. But the data clearly point out that picking a theme or two or five and jumping on board is not the best path.
Thematic ETFs are an exciting part of the market that lack a disciplined investment process. To help solve this problem, we launched our strategy.
Craig Basinger is the Chief Market Strategist at Purpose Investments Inc. and portfolio manager of several Purpose funds, including Purpose Tactical Thematic Fund.
Notes and disclaimer
Content copyright © 2023 by Purpose Investments Inc. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared on the “Market Ethos” page of the Purpose Investments’ website. Used with permission.
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