In Focus: Megatrends  

How to manage risk in thematic ETFs

  • To understand what is driving the boom in thematic investing
  • To understand how to assess risk in thematic ETFs
  • To learn what to look for when picking a thematic ETF
CPD
Approx.30min

Liquidity risks

Beyond market risk, thematic ETFs tend to be more exposed to liquidity risks than the average broad diversified equity fund.

In their search of companies with the highest exposure to emerging themes and those with the highest growth potential, thematic funds often invest in the smaller, less liquid stocks.

Thematic ETFs with the highest exposure to micro-cap stocks in Europe:

NameTickerBroad themeThemeMicro-cap exposure %Fund size (€mn)
Rize Ucits ICAV - Rize Medical Cannabis and Life Sciences UCITS ETFFLWRSocialCannabis53.835.0
The Medical Cannabis and Wellness Ucits ETFCBDXSocialCannabis45.528.5
Global X Genomics & Biotechnology Ucits ETFGNOMTechnologyLife Sciences32.03.7
Cleaner Living ESG-S Ucits ETFDTOXSocialWellness30.81.5
ETC Group Digital Assets and Blockchain Equity Ucits ETFKOINTechnologyFintech30.63.2
Rize Education Tech and Digital Learning Ucits ETFLERNSocialWellness27.510.9
VanEck Digital Assets Equity Ucits ETFDAPPTechnologyFintech24.430.5
Legal & General UCITS ETF Plc - L&G Digital Payments Ucits ETFDPAYTechnologyFintech24.013.5
WisdomTree BioRevolution Ucits ETFWDNATechnologyLife Sciences22.21.2
HAN-GINS Indxx Healthcare Megatrend Equal Weight Ucits ETFWELLTechnologyLife Sciences20.611.5

Source: Morningstar

In the table, the thematic ETFs with the highest exposure to micro-cap stocks in Europe are listed. The Rize Medical Cannabis & Life Sciences ETF, for example, has more than half of fund assets invested in micro-cap stocks like Little Green Pharma Ltd, Australia's first locally-grown medical cannabis producer.

Micro-cap stocks can offer large upside potential, but a lack of liquidity means trading in and out at short notice may be costly.

The surge in popularity of thematic ETFs, which tend to have narrow exposures and are compelled to buy and sell in line with index rules, has raised questions surrounding stocks' liquidity.

In the case of ETFs, should the liquidity dry up in a portfolio stock, the increased trading costs will be passed on to the ETF investor through larger spreads, and tracking error versus the underlying benchmark will increase.

In fact, the runaway success of some alternative energy ETFs caused their own growing pains in late 2020.

The combined assets of iShares' Europe and US-domiciled alternative energy ETFs catapulted to $10.7bn (£8.21bn) by the end of first quarter 2021 from $0.8bn at the beginning of 2020.

With so much money gushing into such a narrow portfolio of small and mid-cap stocks, and amid questions about liquidity, the S&P Global Clean Energy Index has been forcibly broadened. Any additional trading costs associated with this switch were absorbed by fund investors.

When evaluating the liquidity of a thematic fund, investors should look directly at fund holdings.

Metrics like market capitalisation of the stocks and average daily traded volume can be used to estimate how difficult it would be to sell holdings at short notice. A fund with large exposure to small and micro-cap stocks is worth further scrutiny.

Kenneth Lamont is senior research analyst at Morningstar

CPD
Approx.30min

Please answer the six multiple choice questions below in order to bank your CPD. Multiple attempts are available until all questions are correctly answered.

  1. According to the author, advisers allocating to thematic funds are making a three-way bet on getting which factors right?

  2. Some say fundamental changes in the way the global economy functions have supported the growth of thematic investing. True or false?

  3. When picking a thematic fund, what does the author suggest advisers to look at closely?

  4. Thematic ETFs tend to be more exposed to liquidity risks than the average broad diversified equity fund. True or false?

  5. What should investors look at when evaluating the liquidity of a thematic fund?

  6. Each thematic fund takes a different approach to selecting and weighting holdings, which can result in very different outcomes. True or false?

Nearly There…

You have successfully answered all the questions correctly, well done!

You should now know…

  • To understand what is driving the boom in thematic investing
  • To understand how to assess risk in thematic ETFs
  • To learn what to look for when picking a thematic ETF

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