In Focus: Megatrends  

What advisers need to know about thematic ETFs

  • To learn about thematic investing and be able to put it in context
  • To understand how thematic funds fit into a portfolio
  • To understand the benefits and pitfalls of thematic ETFs

First and foremost is the index the ETF is tracking. What are the rules that govern how the index is constructed? Are there measures in place to prevent significant exposure to any one company, for example a percentage cap?

What is the geographical breakdown and does it have high exposure to a single country, and if so, what is it? What is the ETF's market cap exposure, is it small-cap, mid-cap, large-cap or mixed?

Understanding how the index is constructed will help to identify how the thematic ETF will fit in with the rest of the portfolio and give a better handle on managing risk going forwards.

It will also ensure that you are getting the exposure you want and whether that exposure is targeted enough or too concentrated.

Another very important consideration when selecting a thematic ETF is its size. While size does not always matter, smaller ETFs will typically have higher total expense ratios, which can be found on the respective ETF websites, as they do not benefit from economies of scale.

Thematic ETFs look for growth in long-term structural trends, such as cyber security (Image credit: Photo by cottonbro)

In addition, smaller ETFs are more liable to closing (if they are not profitable for their masters) and can often have higher spreads, especially if they are investing in more niche areas that are further down the capitalisation food chain or in markets further afield. This brings us onto ETF liquidity. 

ETF liquidity consists of two components, the first is the volume of the ETF itself, ie how much is it traded, and the second component is the volume of the ETF's underlying securities.

Both of these components can impact an ETF's bid offer spread as well as its liquidity.

If an ETF has high trading volume, then buyers and sellers can be matched off and it requires little to no creation or redemption of ETF units. However, if demand outstrips supply, units need to be created or liquidated and securities bought or sold.

If the underlying asset is illiquid, then this can cause problems for the ETF, particularly if you are invested in themes that are based on relatively illiquid holdings such as infrastructure, the emerging markets or even green bonds. 

Finally, replication methodology is another important factor to consider.

If the ETF is synthetically replicated then there will be a swap involved with a counterparty, which introduces counterparty risk.

While a synthetically replicated ETF will typically track better and cost less, it does not come without additional potential risk.

A physically backed ETF, thematic or otherwise, will hold the underlying companies directly. Fortunately, the majority of the big ETF providers all offer physically backed ETFs, however, some of the newer and smaller providers that offer more exotic or niche themes do so via synthetically backed ETFs.