Thematic ETFs are rising in popularity as investors seek ways to gain unique exposure to niche areas of the market. A thematic ETF aims to invest in a broad economic theme. One example of a thematic ETF we’ve bought for clients is CLOU, which tracks an index comprised of the leading cloud-computing companies in the stock market. Another is IDRV, which invests in companies potentially poised to benefit from the growth in electric vehicles, battery technologies and autonomous driving technologies. But how do you choose which thematic ETFs to buy? Here are four considerations that go into our decision making process:
- identifying the theme
- being mindful of fund overlap
- active vs passive & benchmarking
- keeping expenses in check
Picking a good thematic ETFs theme
The idea of picking a good theme involves a lot more luck than skill, but the key criteria is that it should make sense. I.E. don’t invest in a theme you don’t believe in yourself. That way if you get it wrong you don’t have the regret of investing in a theme you didn’t really believe made economic sense. One of the first thematic ETFs we bought was CLOU, so we’ll use that as an example. We liked CLOU because there was growing evidence that cloud computing adoption was on the rise, even though it is was past the point of being a new industry. Two factors that were really important to choosing CLOU were:
- There was a track record of consistent growth for the industry
- It’s an industry that has strong secular trends in place to support future growth
We liked the track record of existing growth for cloud computing because it meant we weren’t trying to predict the future. Now, Covid obviously accelerated the demand for cloud computing services even more, and that’s where the luck came in (we were allocating to CLOU through out much of 2019 and early 2020).
Another way to pick a good theme is to identify a stock you think has a long runway ahead of it, and then ask if this is a stock specific story or a secular trend story? IDRV, for example, is a thematic ETF we invested in after we answered that very question with regards to Tesla stock. We felt, and still feel, that Tesla is representative of a long-term economic shift underway towards environmentally friendly technologies.
Use ETF.com to filter for specific stocks
ETF.com is a free website you can use to conduct a lot of ETF research. One of the neat features they offer is their stock finder tool. You can use this tool to look up ETFs that own a specific stock. It will then sort the ETFs by the allocation to that specific stock. This can be a good starting point for identifying ETFs that have exposure to a stock you think is a part of a thematic economic trend. For example, TSLA being representative of the growing adoption of electric vehicles and smart driving technology.
Be mindful of fund overlap
After you’ve identified a thematic ETF you think you want to invest in, the next thing to do is make sure it doesn’t overlap too much with your existing investments. Fund overlap can be a hidden risk in your portfolio, so you have to be mindful of it. During our initial research phase on CLOU, we compared it to another cloud-computing fund, SKYY. One reason we chose CLOU instead of SKYY is due to fund-overlap. SKYY has 15% overlap to our large-cap growth ETF, IWF, and 12% overlap to our S&P 500 ETF, VOO. CLOU on the other hand, only has 8% overlap to IWF and 6% overlap to VOO.
Portfolio overlap of SKYY and IWF (15%) versus CLOU and IWF (8%)
Portfolio overlap of SKYY and VOO (12%) versus CLOU and VOO (6%)
In effect, an investment in SKYY would have increased our concentration risk to large-cap tech. That’s because Amazon (AMZN), Microsoft (MSFT), and Google (GOOGL), are three of the largest holdings in SKYY. Those three companies are also three of the largest holdings in the S&P 500 (VOO). None of CLOU’s top holdings on the other hand, are even listed in the S&P 500. So when you’re choosing to invest in a thematic ETF, make sure you use a website like this one to identify potential fund overlap.
Active versus passive
Another key thing to pay attention to when choosing which thematic ETF you invest in is to study if the fund uses a passive or active approach to investing. A passive ETF will try to replicate the performance of a benchmark by owning the stocks, or at least a sampling of stocks, that make up the benchmark. Active ETFs, however, will either not follow a benchmark at all, or may try to outperform the benchmark. This means its holdings can change quickly and without notice.
The simplest way to find out if a thematic ETF is passive or active is to do a google search of the fund and click through to the fund sponsor’s website. For example, searching for CLOU ETF in google brings you to GlobalX’s CLOU homepage. One clue that CLOU is a passively managed thematic ETF is that the fund’s objective is to generate returns that track the performance of an index:
Compare that to the objective of Cathie Wood’s ARKK ETF, which is a thematic ETF for investing in innovative and disruptive technologies:
Aside from ARKK stating its an actively managed ETF you should also note that companies need only be, “relevant to the fund’s investment theme of disruptive innovation.” This is important because that language allows ARKK to subjectively define which companies that might be. Put simply, your definition of disruptive technologies might differ from ARKK’s, and there is no benchmark ARKK needs to follow to keep those definitions in check. That’s not a bad thing necessarily, it’s just something to be aware of when you’re conducting your research on thematic ETFs.
Studying the benchmark
In the case of CLOU, the fund references a benchmark, the Indxx Global Cloud Computing Index. A simple google search gives us more information on this specific benchmark with which we can factor into our decision making process. For example, the index only reconstitutes and rebalances itself two times per year, and each security is subject to a 4% max allocation. This tells us two things:
- If we buy the CLOU the day after it rebalances, the holdings will not change for six months
- If a position inside of CLOU has grown to more than 4% of the total fund, that position will be sold down at the next rebalance date
Information like this is useful because we know that what we own won’t change, and we know there is a rules-based process for taking profits on big winners within the ETF. This shouldn’t be construed as an endorsement of CLOU over ARKK, but rather a simple point about some of the differences you see when comparing an actively managed ETF to a passively managed ETF.
Pay attention to expenses
According to ETF.com, actively managed ETFs charge an average of 0.69% per year compared to 0.18% for index ETFs. We couldn’t find any official data on thematic ETFs, but our own internal data shows we pay an average of 0.49% on the thematic ETFs we invest in. ARK funds, far and away the most popular thematic ETF provider right now, charges an average of 0.75% per year. In general, actively managed ETFs are going to be more expensive than passively managed ones.
Thematic ETFs are becoming a popular source of allocations in portfolios. But be sure you keep your thematic ETF appetite in check. These types of ETFs are best kept in an “other bets” investment category that you factor into your total allocation framework. When deciding which thematic ETF to buy, start with identifying a secular economic trend that is underway and has more room to go. Be mindful of fund overlap between your thematic ETFs and index ETFs. Consider the strategy the thematic ETF is using, and if they are going to follow a benchmark or not. Lastly, understand what the expenses are and make sure you’re not paying too much in fees.
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