X-Plained: What are Thematic ETFs?
The world is a constantly evolving organism, and as it evolves, megatrends emerge. Megatrends are shifts in society that usually come in the form of significant advances in technology, or global dynamics which have the potential to reshape entire industries. As investors, these global macro-movements create long-lasting opportunities called ‘thematics’.
- What are thematic ETFs?
- How do you identify a thematic?
- What’s the difference between a thematic and a bubble?
- What is your thematic investing timeline?
- Why invest in thematic ETFs?
What are Thematic ETFs?
Thematic ETFs are tools that allow you to capitalise on these long-term trends by encapsulating a basket of all the stocks that may benefit from the developments. They are formed by looking at a larger universe of stocks and then applying strict rules to ensure significant exposure to the desired thematic. Examples of thematics and their ETFs include the rise of electrification (ACDC), the digitisation of finance (FTEC), and the advancement of medicine and biotechnology (CURE).
How do you Identify a Thematic?
Thematics are often backed by strong governmental or institutional initiatives that promote investment, thus opening numerous opportunities for investors. However, structural backing is just one part of the puzzle as thematics require time to fully materialise. A historical example would be the advent of personal computing (PC), a thematic which took the better part of the past half-century to come to fruition despite growing government backing (annual government funding toward computer science grew from $180 million in 1976 to $960 million in 1995) and record corporate spending.1 Looking at the PC industry now, it is easy to see how steadfast investors could have reaped utterly incredible returns as the thematic grew to maturity.
What’s the Difference Between a Thematic and a Bubble?
The identifier of a true thematic lies in the ability to cause a paradigm shift within an industry or the broader society. When seeking to differentiate bubbles from thematics formed by megatrends, investors can once again benefit from looking at historical instances.
Beanie Babies, once the pride and joy of the US toy collector and now an icon of the speculative bubble, were part of a frenzy that gripped household investors in the late 90s. Collectors clamoured to possess exclusive plush companions in hopes that their rarity would be key to unlimited price potential. And for a fleeting year, the speculators were right; by the tail end of the mania, prices had soared from $15 per toy to astronomical valuations of $5000 or more.2 But as with most non-constructive speculation, hysterical pricing precipitates a devastating fall. By February 2000, only a year or so after its rise, beanie babies were selling in packs of three for $10, and the manic episode was over.3
In contrast, the rise of electric vehicles (EVs) is representative of a truly long-term thematic trend. Beyond the buzz and excitement, the increasing popularity of EVs encompasses a profound shift in transportation and sustainability, necessitated by a warming climate and net-zero targets. Governments and consumers worldwide all recognise the urgent need for cleaner and greener alternatives to traditional ICE (internal combustion engine) vehicles, with spending in the sector growing rapidly year-on-year.4
Driven by technological advancement, the growth of EVs has all the markers of a truly systematic change, unlike that of a toy-based mania.
What is Your Thematic Investing Timeline?
The ‘Diffusion of Innovations Theory’ (DOIT), a concept first proposed by Everett Rogers in 1962, is a model of categorisation and adoption that is particularly useful in describing the assimilation of new technologies or concepts into society.5 There are five categories of adopters in the model: Innovators, Early Adopters, Early Majority, Late Majority, and Laggards.
As shown in the above graph, the five categories each represent a stage of market share and development in the advancement of a thematic trend. The ‘S-Curve’ shown in the background represents the speed at which the thematic may grow.
Taking a look at the specific categories – In the early stages of any thematic, ‘Innovators’ take on the role of pushing the limits and exploring all the possible applications of their inventions. At this stage of development, markets may be sceptical or even dismissive of their potential (thus growth can be slow). Current examples of emerging thematics in this category include hydrogen fuel, the Metaverse, and blockchain technologies.
Skipping forward to the ‘Early Majority’, these thematics have already taken hold of their respective industries, but still have the potential to continue expanding at a rapid rate. Here, one can see the speed of adoption along the S-curve is at its steepest. Investors may find that many of the highest-growth companies of our time sit in this category. Examples include e-commerce, video gaming and cloud computing.
When thinking about thematic trends, it is crucial to understand the stage of development of a particular industry and appreciate the appropriate timeframes for each themed allocation. An investment in a hydrogen fuel producer may yield high, long-term potential but demonstrate low short-term growth until further adoption is observed, whereas an investment in a proven technology may be more lucrative in the short term but experience a slowdown as markets reach saturation.
Why Invest in Thematic ETFs?
Thematic investing is not as simple as picking any one company exposed to your megatrend of interest. Companies are not valued on growth potential alone, but also on fundamentals such as financial health and experience of management. Furthermore, some firms may not be as exposed to a chosen thematic as they seem (e.g., Revenue purity). So, there may be an inherent risk to picking only one or two specific companies as your exposure to a chosen thematic. This is where a thematic ETF can provide significant advantages.
By utilising thematic ETFs, investors can gain pure-play exposure to a diversified portfolio of stocks that represent the entirety of a theme. This diversification helps to reduce individual stock risk and can also improve overall performance through survivorship whereby poor-performing companies, or companies no longer representative of the thematic, are removed from the index. ETF diversification is also cost-effective and professionally managed, ensuring liquidity and often providing high-quality research to help cement your investment thesis.