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Riding trends with thematic ETFs

01 Nov 2022

There's been an explosion of thematic ETFs launched in recent years. It's now possible to get targeted investments in everything from cybersecurity to climate change. But how do these thematic ETFs work and what can they bring to an investment portfolio?

Riding trends with thematic ETFsRiding trends with thematic ETFs

What are thematic ETFS?

Traditionally, the most popular ETFs have been based on large, familiar indices such as the S&P 500 or FTSE All Share, meaning they simply match the underlying investments in that index. But increasingly, investors are using ETFs to tap into large structural trends in the global economy - such as the energy transition, cloud computing or cyber-security - to put their money behind the movements that they believe match their values, will nab them a profit, or preferably both!

How do they work?

A passive thematic ETF will track an index of companies that benefit from a specific trend. Often the index will have been specifically designed to get the maximum exposure to the theme. Only companies that generate a specific proportion of their revenues from - say, cybersecurity or cloud computing - will be included in the index. The result should be that investors get very targeted exposure to a single part of the market.

Edward Malcolm, Head of UK ETF Distribution at JP Morgan Asset Management, says, “The aim is to combine AI and quantitative tools with bottom-up fundamental research to choose the winners within that theme".

There are also actively-managed thematic ETFs, which include shares from a range of companies which fit within a predetermined theme - such as clean energy, for example - and the fund manager is able to shift and reallocate assets at their own discretion, usually when they subjectively decide that an opportunity has arisen to outperform the market.

What type of themes are available?

These days, there's an abundance of choice on thematic ETFs, from healthcare to biotech to commodities and more. The most popular ETFs have tended to focus on areas of obvious structural growth, such as climate change, robotics, cybersecurity and other technology themes, but there really is an ETF for any occasion. A simple Google search will show you the wealth of options for whatever area you're interested in.

What are the risks?

By their nature, thematic ETFs will be concentrated in a specific area, and if the theme doesn’t pan out as expected, the fall out can be quite painful. There will be areas where structural growth seems assured but is derailed by unexpected events or increased competition. For example, e-commerce companies or streaming services appeared to be growth sectors of the future as we always went online to buy pyjamas and watch endless hours of TV during the pandemic, but their recent performance has called that into doubt.

There is also a danger of 'herding'. If a theme looks like it's going to be a winner, investors can crowd into the sector, sending share prices soaring. All may seem well and good, but if sentiment changes, it can prompt painful falls even if the underlying theme remains intact. This happened with some of the climate change themed ETFs between 2020-21, which saw a spectacular boom followed by a spectacular bust as investors fell in and out of love with the theme during the pandemic.

How can you use them in a portfolio?

Thematic ETFs can be a great opportunity to put your money behind an area or movement that you're passionate about - like the energy transition, agriculture, or even robotics. They're generally low cost, transparent, and can be bought and sold on standard investment platforms.

But despite all these big green ticks, it's important to remember that thematic ETFs are often higher risk than non-thematic ETFs due to their more concentrated nature and, as such, should sit within a balanced portfolio rather than forming the dominant part of any investor's holdings.

Nevertheless, they're a good option to super-charge specific areas of a portfolio and tap into your own personal interests.

Top performing thematic ETFs

The thematic ETFs with the highest returns in 2022 were:

  • iShares Global Clean Energy UCITS ETF [INRG] | 6.04%

  • Invesco Solar Energy UCITS ETF [RAYS] | 6.01%

  • L&G Clean Energy UCITS ETF [RENG] | 1.49%

Source: justETF. Data correct as at 01/01/23.

Something not making sense? Don't know what an acronym means? Check out our ETF Glossary!

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