In Focus: Megatrends  

Adding thematic funds shows clients we are thinking actively

Elliott Frost

Elliott Frost

Advisers and other discretionary managers should consider thematic funds as a tool to express a view on a particular theme.

Thematic investing is an attempt to identify long-term structural trends, and then invest in the sort of companies that will, in theory, benefit from them.

Thematic exchange traded funds take advantage of changes that these trends could bring by investing in specific industries, rather than just sectors, factors, or geographies.

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Combined with a lower cost core, thematic ETFs used as satellite holdings add higher risk, but bring higher reward opportunities too.

There are many options – for example blockchain, cyber security and electric vehicles – that enable clients to have exposure to early-stage themes in a more diversified manner, while remaining tilted towards an area of the market where investors have a particular conviction. 

One benefit of thematic funds for advisers is being able to explain the narrative to clients. For example in financials, retail banks have been hit particularly hard over the past five years or so, but there remain interesting opportunities within its sub-sectors, such as insurance.

Adding thematic funds shows clients we are thinking actively, while providing reassurance that their portfolios are not overly concentrated.

However, there are a few things to bear in mind when dealing with thematic funds.

In the current market environment we prioritise liquidity over opportunity, and therefore do not currently hold thematic ETFs. However, this does not mean that we would flatly refuse to consider them.

Advisers should be aware that ‘pure play’ thematic ETFs typically have less liquidity, as ETFs with the highest revenue exposure are more exposed to small-caps, due to their early-stage themes.

Not only is it unlikely for a thematic ETF to have 100 per cent exposure to a given theme, but they are also thinly traded, which adds costs when the ETF rebalances. This means that thematic ETFs are often more expensive than traditional ETFs.

They are also not immune to bubbles, and the danger is spotting a theme too late and buying when valuations are too high.

By the time many thematic funds make it to market, enthusiasm has already been priced in. At Lumin Wealth we are cautious about paying above a company’s intrinsic value, so we would think twice about investing in strategies at historically high levels.

Academic research has shown that investors in thematic ETFs lose money on average. The reason is principally because funds tend to launch just after the peak of their theme. 

Active vs passive

There are benefits to holding passive thematics, one being an increase in portfolio weightings to ‘winners’ with rising market cap over time.

This removes the ‘emotional’ element that is inevitable in an active strategy. As well as this, many active managers use the global indices as their benchmark, which in no way reflects their universe.