What advisers need to know about thematic ETFs

A very important consideration when selecting a thematic ETF is its size. Smaller ETFs will typically have higher total expense ratios

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.

The benefits and pitfalls of thematic ETFs

Overall, thematic ETFs, particularly those by the more mainstream providers and those that consist of well-known names, can offer investors the ability to invest with a higher degree of conviction.

This conviction, if right, can help investors achieve greater long-term returns, particularly above standard market cap-weighted indices that will be slower to move with the times.

That said, adding a thematic tilt to you portfolio can lead to a higher concentration risk with less diversification across sectors.

Value versus growth is an important consideration, especially given the current inflationary pressures and a rising interest rate environment

On the theme of concentration risk, as the theme develops and becomes part of the way we do things, the successful companies within those themes will become larger components of the other funds within a portfolio and there can be a risk of doubling up, just consider how much of an index or themes a company such as Tesla might be in.

The same can be said for the geographical exposure within a portfolio.

Value versus growth is also an important consideration, especially given the current inflationary pressures and a rising interest rate environment.

Many thematic ETFs are more growth orientated and have endured a difficult period of late as investors reassess future cash flows.

Finally, as with all trends, they come and go and technologies that were heralded as the next big thing can quickly be replaced or made redundant by new technologies.

Not all of the so-called mega-trends will play out as planned and there will be significant bumps in the road for those that do.

While thematic ETFs can give your portfolio an edge, knowing which mega-trend to target is the hardest part and something that investors have been trying to do since time began. 

Chris Baynes is ETF specialist at Raymond James Investment Services