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. Their popularity has also been fueled by the alignment of some thematic ETFs with environmental, social, and governance (ESG) principles, which have surged in investor interest.

Thematic ETFs cover different fields that have had volatility. These ETFs include sector-specific ETFs, e.g., fintech, biotech; ESG ETFs covering companies with sustainable business practices; megatrend ETFs focused on longer societal or economic trends, e.g., the growth of AI, the aging of the population, or climate change; and factor-based ETFs concentrating on momentum, growth, and other value metrics.

The 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.

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.

Early access to new economic areas: Thematic ETFs provide a simpler way to speculate in newer but fast-growing sectors like artificial intelligence, blockchain, or renewable energy.

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.

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.

Hype and overvaluation: Investors should be wary of funds that are part of speculative bubbles in trendy themes that fail to pan out.

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

Targeted exposure: Enables investment in specific sectors or trends.

Diversification: Spreads risk across several sectors or companies.

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

Professional management: Take care of research into firms that best fit and are most likely to succeed.

Cons

Concentration risk: High exposure to a single sector can lead to significant losses.

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

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

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

Thematic ETF Types

There are various types of thematic ETFs, including the following:

Technology ETFs: These ETFs focus on companies in cybersecurity, artificial intelligence, blockchain, cloud computing, etc.

Healthcare ETFs: These ETFs speculate on companies that touch on health, such as biotechnology, pharmaceuticals, and medical care.

ESG-focused ETFs: These ETFs look for firms that meet specific environmental, social, and governance criteria, offering a way for investors to align their investments with their values.

Consumer trend ETFs: These ETFs target companies poised to benefit from changing consumer behaviors and preferences, such as trends in wellness.

Emerging market ETFs: These ETFs speculate in emerging markets, granting exposure to the growth potential of these economies.

Clean energy ETFs: These ETFs have stakes in firms that produce or use renewable & clean energy sources, like solar or wind power.

How to Choose a Thematic ETF

While thematic ETFs can furnish targeted exposure to specific trends or sectors, they also have certain risks and require thorough due diligence. Here's what to review as part of your research:

Investment objective: Confirm that the theme of the ETF aligns with your investment goals and risk appetite.

Fund performance: Look at the historical performance of the ETF, but remember that past performance does not indicate future results.

Fund holdings: Review the companies held by the ETF. Are they leaders in their field? Do they have a strong track record?

Expense ratio: Consider the fees associated with the ETF. Lower expense ratios typically mean more of your money is invested in the market.

Liquidity: Check the trading volume of the ETF. Higher trading volumes generally mean you can buy or sell shares more easily.

Management team: Look into the ETF's management team. Experienced managers should be better equipped to navigate market volatility and the risks involved in newer markets.

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

Interest in thematic ETFs has been on the rise. 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.