Thematic ETFs: overcoming performance anxiety through purity of exposure

Dominic Maister
By Dominic Maister
June 22, 2023

We are all being measured. Constantly. From the time we are born and the doctor wrote down our height and weight for our birth announcements, to the playground where someone was picked first, tenth or last to join a kickball team, to our SAT scores for college admission, to insurance companies judging our ability to drive a car (80% of drivers think they are better than average [1] ), or measuring the stock-picking ability of active managers, there has generally been an accepted benchmark for being above or below average. 

Benchmarking performance in the “new new thing” is challenging and could lead investor astray

The Dow Jones Industrial Average [2] , by its full name, was created in 1896 [3] . While it was one of the first two stock indeces[3] and is still widely referenced, its peculiar price-weighting methodology [4] has relegated it down the list of measuring tools for most equity managers offering exposure - and hoping for alpha [5] - in the “Morningstar Style Box” [6] segment of client accounts. In U.S. equities, most managers prefer to be measured against cap-weighted [7] indexes such as Russell or S&P. For international equities, most are benchmarked / measured against indexes from MSCI or FTSE. But, in terms of new fund offerings, what about the fast-growing segment of the ETF market known as thematics?

What is the right benchmark for an ETF (or mutual fund) targeting exposure to something as narrow as fintech, technological breakthroughs, high-end consumer brands/luxury goods or specific diseases such as obesity or cancer? Surely, we don’t want to compare a Future Fintech fund to the S&P Financials Index [8] that is heavily weighted towards traditional banks – the exact exposure investors in that fund are likely hoping to avoid. Similarly, it seems somewhat irrational to compare a genomics, obesity or oncology focused ETF to the broad healthcare index that includes companies offering medical insurance/benefits and health care providers.

A simple focus on recent performance is likely insufficient for thematic fund selection

According to ETF.com, there are now over 315 thematic ETFs. Whether those ETFs are active or indexed, one could argue that measuring against an established benchmark may not paint a complete picture. In fact, looking at past performance as a key driver of fund selection might not be relevant at all for thematic ETFs. Many companies offering the purist exposure to an emerging theme are, themselves, relatively nascent and may have only recently gone public. If investors thinking about immunology in early 2020 had demanded a three-year track record before investing, they would have overlooked Moderna (IPO December 2018) and BioNTech (IPO 2019), who were at the forefront of the COVID vaccines. Furthermore, the companies generating the most amount of revenue or profits from some emerging themes may only be generating a small percentage of their total sales from these newer businesses (Amazon generated less than 16% of its total sales from WebServices/Cloud over the past three years [9] ).

“The Good, the Bad and the Ugly” - exposure can explain an awful lot about performance

And what if the 1-3 year historical performance of a thematic ETF does compare favorably to a traditional benchmark, or even its peers? Should I buy the best and avoid the worst? Can it be that simple? Probably not. Early in my career,  an advisor who self-identified as “an old-timer,” advised me that “planning for your future and watching CNBC is like taking a cross-country trip and measuring your progress with a ruler.” Funny…and true. Investors deciding to allocate a portion of their portfolio to a theme are generally making a long-term bet that the theme has potential for long-term open-ended growth in the future, not that it has historically been an important driver of returns. All of these thoughts raise questions as to whether investors should think about track record at all - or, instead, focus on how pure the exposure of the fund is to the theme that they are targeting.

Thematic investing seeks to capture the essence of structural shifts, nascent and volatile as they may be

Many of these themes have long-term tailwinds, but recent performance can be incredibly volatile based on the market environment and factors such as a pickup/slowdown in the economy or rising/falling interest rates. Many thematic funds offering the purist exposure to themes have high growth, low profitability (i.e., are more speculative) compared to the broader market. So looking at recent performance might simply tell us more about a fund’s beta [10] rather than its prospects or exposure to the theme we are targeting.

Investor shouldn’t just buy what has recently performed “well”

Looking back at 2022 as a reference point, and according to ETF.com, there are 5 thematic ETFs focused on FinTech. One was launched in 2022 so we don’t have full year performance. The other four delivered returns ranging from -24% to -65% [11] . The “theme” was out of favor. So should investors who believe that new technologies will emerge to improve and automate parts of financial services such as payments, tax preparation, banking, e-commerce, and investing simply buy the fund that delivered a 41% better return?

Purity of exposure diverges in thematic funds

What if I told you that the “best” performing of those 4 funds had a 5% weight to consumer staples such as Nestle, a 2% weight to Utilities, and that over 10% of its exposure came from mega-cap technology companies such as Cisco, Oracle, IBM and Microsoft? Contrast that to the “worst” performing fund which had absolutely none of those exposures. No consumer staples. No utilities.  Instead, this pure but lagging fund was heavily weighted to stocks like Intuit (revolutionizing financial software for individuals and small businesses) and Shopify (a cloud-based e-commerce platform for online stores and retail point-of-sale systems). It remained true to its core despite its short-term underperformance.

Thematics funds performance highly linked to their underlyings

What one can observe is that 2022’s top performing fund appears to be more diversified. Not just in its exposure to more companies (40 vs. 30), but also including companies that are questionably at the forefront of advancements in FinTech and in the way it weights those positions. That best performing fund currently has no position making up more than 3.5% of its portfolio, while the worst performing fund has one stock at a 12% weight and a total of six names each with a weighting above 5%.  Digging into the exposure, one would conclude that the worst performing fund is certainly riskier (higher beta) but also that its exposure appears to be more precise. As a result, when the theme was out of favor, it fared poorly.Not surprisingly, year-to-date, as some risk on sentiment has returned to FinTech, those performance ranking have been completely reversed. 2022’s best-performing fund is now the lowest of the established funds at +6%, and 2022’s worst-performing fund is now the best at +31%. What this underscores is the importance of focused long-term purity even in the wake of short-term performance pressure.

Thematics are convinction positions that ultimately offer specific exposure

Thematic funds are not likely to make up the bulk of most clients’ equity investments. More likely, they will be used as satellite positions around a core of either index of active managers providing exposure to a diversified mix of U.S. and international large-, mid- and small-cap stocks. And that’s a good thing. Not only because these themes are highly volatile in the short run, but also because they are relatively expensive. Hence, a more precise/targeted fund allows investors to allocate a smaller percentage of their portfolio in an effort to keep overall costs lower. Balancing that out, if there is going to be an allocation, we want to get rewarded handsomely if we are right. Conversely, while the theme is playing out over the longer-term, there will be bumps along the way and the drawdowns [12] can be painful.

Bottom line

In short, diversification and asset allocation remain as important as ever for investors. Thematic funds have many compelling attributes for investors betting on change. But they also provide unique challenges - either because they lack track records, established benchmarks or simply because of their volatility. While some of that volatility can be managed through right-sizing the position for a given investor’s risk tolerance, additional diversification from the fund manager through a broader but highly focused basket of securities, as well as prudent capping on the size of individual positions within a fund can be helpful. But for the investors buying into thematic ETFs, we feel the most compelling fund option is likely the one providing the greatest bang for their buck. Or stated differently, purity of exposure.

Read more on thematic investing

Footnotes

[1]Source: The Open University, Are you better than the average driver?

[2]The Dow Jones Industrial Average, or Dow Jones, is a stock market index of 30 prominent industrial companies listed on stock exchanges in the United States. The DJIA is one of the oldest and most commonly followed equity indexes.

[3]Source: Library of Congress, Dow Jones Industrial Average First Published

[4]Price-weighetd index: A price-weighted index is a stock index in which each company included in the index makes up a fraction of the total index proportional to that company's share stock price per share.

[5]Alpha: measure of performance, is the excess return of an investment relative to the return of a benchmark index over a certain period

[6]The Morningstar Style Box is a nine-square grid that provides a graphical representation of the "investment style" of stocks and mutual funds. For stocks and stock funds, it classifies securities according to market capitalization (the vertical axis) and growth and value factors (the horizontal axis), Source: Morningstar

[7]A capitalization-weighted index, also known as a market value-weighted index, is a type of stock market index in which individual components of the index are included in amounts that correspond to their total market capitalization (shortened as "cap")

[8]The S&P 500 Financials: comprises those companies included in the S&P 500 that are classified as members of the GICS financials sector.

[9]Source: Amazon 10-K filling 2019-2022

[10]Beta: the volatility, or systematic risk, of a security or portfolio in comparison to the market as a whole, in other words the responsiveness of a stock's price to changes in the overall stock market

[11]Source: Bloomberg

[12]Drawdown: peak-to-trough decline during a specific period for an investment, trading account, or fund.