Benefits and Risks of Thematic ETFs

Key Takeaways

Thematic ETFs carry greater risks but also potentially more lucrative rewards than broader ETFs.
Since thematic ETFs focus on specific themes or trends, they often lack the diversification found in more traditional ETFs, like those that track indexes like the S&P 500.
Despite market challenges, thematic ETFs have had resilient growth.
The popularity of some thematic ETFs has been boosted by their alignment with environmental, social, and governance (ESG) principles.
Thematic ETFs can provide early exposure to emerging sectors such as renewable energy, robotics, and blockchain.

The Growth of Thematic ETFs

The number of thematic ETFs has increased in recent years, boosted by their appeal to investors wanting to tap into specific industry trends or sectors. This growth has persisted despite challenges in sectors covered by thematic ETFs, showing the continued appeal of these specialized investment vehicles.

Thematic ETFs has also been fueled by the alignment of some thematic ETFs with environmental, social, and governance (ESG) principles, which have surged in investor interest. It's also been fueled by public interest in emerging technologies or practices. For examples, these ETFs include sector-specific ETFs, ESG ETFs, or megatrend ETFs. Let's discuss each of these (and others) in the next section.

Types of Thematic ETFs

There are countless thematic ETFs based on very niche topics. Below are some examples of the more popular or common types of thematic ETFs.

Technology ETFs

Technology ETFs concentrate on companies that are leading technological innovation. This can include firms in cybersecurity, artificial intelligence, blockchain technology, cloud computing, or any other field of technology. These ETFs provide investors with a way to tap into the rapid advancement of technology, which is often characterized by high growth potential but also increased volatility.

Healthcare ETFs

Healthcare ETFs are designed to capitalize on the healthcare sector's growth and the increasing global demand for health-related products and services. These ETFs typically invest in companies related to biotechnology, pharmaceuticals, medical devices, healthcare providers, and healthcare technology. Healthcare ETFs may also encompass areas like genomics and telemedicine.

ESG ETFs

ESG ETFs are designed for socially responsible investors. They aim to include companies in their portfolios that meet specific ESG criteria, such as sustainable environmental practices, positive social impact, and strong corporate governance. Note that companies in some of the above ETFs could also double as an ESG-friendly addition. Clean energy ETFs are a more niche the of ESG ETF. They focus on companies involved in renewable and clean energy sources such as solar, wind, and hydroelectric power.

Consumer Trend ETFs

Consumer trend ETFs focus on investing in evolving consumer preferences and behaviors. These ETFs target companies at the forefront of consumer trends, such as the rise of wellness and healthy living, changing dietary preferences, or emerging fashion and lifestyle trends. Though poised with growth potential, trends come and go and so can the popularity of the underlying companies.

Emerging Market ETFs

Emerging market ETFs offer investors exposure to undeveloped or underdeveloped markets. These economies are typically characterized by rapid economic growth and development. These ETFs may cover regions like Asia, Latin America, or Africa, providing access to the growth potential of these markets. However, they often come with higher risk due to factors like currency fluctuations and political instability.

Benefits of Thematic ETFs

Targeted Exposure: Thematic ETFs enable investing in specific sectors, trends, or fields, such as blockchain or crypto. This can be particularly beneficial for those who strongly believe in the potential of a certain theme, like robotics, healthcare, or renewable energy.

Niche but Diversified: Thematic ETFs typically speculate on companies across several sectors of the economy. This spreads risk and provides diversification despite their emphasis on a specific field, such as robotics. For example, a thematic ETF for technology may have hardware developers, software developers, start-ups, and blue-chip stocks.

Flexibility: Thematic ETFs trade on an exchange like common stock, meaning investors can buy or sell shares at any time during the trading day at market price. Investors, thus, can react quickly to changes in the market. Be mindful that if you hold an ETF in a retirement account such as an IRA, you may have less flexibility in exchange for tax advantages.

Early Access: Thematic ETFs provide a simpler way to speculate in newer but fast-growing sectors like artificial intelligence, blockchain, or renewable energy. Though broad small market cap indexes can also be involved in small companies, these thematic ETFs can allow investors more directly choose what niche areas that may just starting to invest in.

Professional Management: Those interested in robotics, ESG-managed firms, or other themes often find it difficult to get up to speed in specialized areas like technology or best environmental practices to know where to invest. Thematic ETFs are managed by experts who should understand the field well, including its challenges and where growth can be found. This professional oversight can be a boon for investors, given the necessary specialized knowledge.

The Risks of Thematic ETFs

Risk of Concentration: While thematic ETFs offer exposure to a specific sector or trend, this focus can also include concentration risk. The ETF could suffer significant losses if the particular theme or sector underperforms or experiences a downturn. For example, consider how the broad real estate market may move together; diversification across entities or companies may not be that strong.

Market timing risks: Thematic ETFs often revolve around emerging trends or sectors. Predicting the success of these trends can be difficult, and if your timing is off, you could face significant losses. In addition, by the time the thematic ETF is created, the market may have already moved or matured.

Hype and overvaluation: Investors should be wary of funds that are part of speculative bubbles in trendy themes that fail to pan out. Part of this issue is not truly understanding what a thematic ETF may be invested in. Instead of getting caught in the hype of a neat sounding ETF, make sure you understand the weights and holdings of the portfolio.

Liquidity risk: Some thematic ETFs, particularly those focused on niche themes, may not be as heavily traded as more traditional ETFs. This can result in liquidity risk, where an investor might find buying or selling shares difficult without affecting the market price.

Pros & Cons of Thematic ETFs

Pros

Enables investment in specific sectors or trends.

Spreads risk across several sectors or companies.

Can be bought or sold at any time during the trading day.

Can take care of research into firms that best fit and are most likely to succeed.

Cons

High exposure to a single sector can lead to significant losses.

It is difficult to predict if it's too late to enter a market to profit from the success of emerging trends.

Some thematic ETFs may not be as heavily traded, affecting the ability to buy and sell.

This can lead to overvaluation as speculators run to the most trendy fields.

How to Choose a Thematic ETF

Thematic ETFs can be a valuable tool for investors looking to capitalize on specific trends or sectors. However, they may be more intricate to research compared to more traditional investments. When considering investments in thematic ETFs, think about these key aspects as you review during your research:

Investment Objective

Start by understanding the investment objective of the thematic ETF. Ensure that the theme aligns with your investment goals and risk appetite. Thematic ETFs can be quite specialized, and their objectives can range from high-growth opportunities to socially responsible investing. It's crucial that the theme matches your financial objectives.

Fund Performance

Historical performance is a key aspect to evaluate, but it's important to remember that past performance is not a guarantee of future results. Analyze the ETF's historical returns to get a sense of how it has performed in different market conditions. Compare the ETF's performance against relevant benchmarks to assess its relative strength.

Fund Holdings

Examine the companies held within the ETF's portfolio. Are these companies leaders in their respective fields, or are they promising up-and-comers? Remember that there may be different thematic ETFs for the same niche (i.e. different Technology ETFs). If you don't quite like the underlying holdings of one thematic ETF, consider searching for one similar.

Expense Ratio

The expense ratio is also something important to think about. It represents the annual costs associated with managing the ETF and is expressed as a percentage of the fund's assets. Lower expense ratios generally mean more of your investment remains in the market, allowing for greater potential returns. All else being equal, because thematic ETFs are more specialized and may require a little more oversight from a portfolio manager, expense ratios are generally a little higher than other ETFs.

Liquidity

Liquidity is also an important consideration, as it affects your ability to buy or sell shares. Check the trading volume of the ETF. Higher trading volumes typically indicate greater liquidity and make it easier to enter or exit positions. Low liquidity can result in wider bid-ask spreads, potentially leading to higher trading costs.

Management Team

Last, think through the expertise of the ETF's management team is critical. Look into the backgrounds and experience of the fund's managers. Experienced managers are better equipped to navigate market volatility and manage the risks associated with specific themes or sectors. Different managers may also have different experiences in niche markets, so consider not only their investment experience but their exposure to the underlying ETF theme.

Are Thematic ETFs for Long-Term Investing?

This depends on the specific ETF and your individual financial situation and goals. While some thematic ETFs may offer strong growth potential over time, they also have risks and may be more volatile than broader market ETFs. It's always prudent to consult with a financial advisor before making investment decisions.

What Is the Difference Between Thematic ETFs and Sector ETFs?

While both concentrate on specific market areas, sector ETFs focus on traditional industries like finance, defense contracting, or real estate, while thematic ETFs speculate more broadly. Thematic ETFs often cross several sectors to tap into overarching trends or themes. For example, the Global X Robotics & Artificial Intelligence ETF doesn't hold assets in one industry but includes firms from various sectors that use or build robotics and AI technologies. Thus, it might have stocks from a healthcare company using robotics for surgeries and diagnostics or from firms using artificial intelligence for smart homes. By investing in a thematic ETF, you're not just speculating on the results of the sector that builds robotics or the technology behind AI but also on their widespread adoption across various industries.

Do Thematic ETFs Pay Dividends?

Some do. This depends on the individual companies within the ETF's portfolio. The ETF may distribute these to shareholders if it holds companies that pay dividends.

How Frequently Are Thematic ETFs Rebalanced?

This will vary. Some may rebalance quarterly, while others do so annually. The prospectus of the ETF should provide its rebalancing schedule.

How Do ESG ETFs Work?

ESG has been an increasing part of investment decisions for some institutional investors and many individuals. Some thematic ETFs specifically target companies that meet certain ESG criteria within given sectors or fields, while others are broadly trying to capture ESG-managed firms across the economy. These ETFs incorporate ESG factors into their investment criteria to varying degrees, and if you're interested in ESG, you should check the ETF's prospectus for more details.

The Bottom Line

Thematic ETFs can be attractive investments since they allow you to gain from evolving trends but not be locked within traditional sectors. They offer the chance for diversification and potential growth and have a higher risk because of their focused nature. As with any investment, it's crucial to complete comprehensive research and understand your risk tolerance before diving in.