How investors' infatuation with thematic ETFs could end in tears

Retail investor interest fuels top year for thematic funds, but experts warn they can disappoint

How investors' infatuation with thematic ETFs could end in tears

The Robinhood army of retail investors have proven to be a formidable force this year, creating tailwinds for fundamentally hopeless companies through sheer dint of demand. But aside from powering single-stock moves, their intractable appetite for compelling narratives has also proven beneficial for thematic ETFs.

According to an analysis by Bloomberg, 2020 is on track to be the best year of inflows for thematic ETFs, which have taken in more than US$20 billion up to November 15. Trading platforms claim credit for the trend as individual investors snap up funds that reflect their convictions and sensibilities, while professional money managers are reportedly keeping their distance.

“They’re too new for institutional investors to have likely even done the due diligence on them,” Todd Rosenbluth, director of ETF research for CFRA, told Bloomberg.

This year has seen a rise in retail investing as the COVID-19 pandemic forced a practically ubiquitous stay-at-home trend. The rise of some industries at the expense of others has created clear targets for the thematic fund industry, which have launched products aimed at themes like working from home, digital services, health technology, and gaming.

Holly Framsted, head of U.S. product at BlackRock’s ETF and Index Investments Group, said thematic ETFs are becoming important building blocks within investors’ portfolios. “These are themes that many investors intuitively want to play but don’t necessarily have the conviction to pick a particular stock,” she told Bloomberg.

Whether it’s to ride on the coattails of successful stories or simply to put money behind stories that capture their imagination, retail investors are becoming more comfortable in their use of thematic funds. But that path of romance will inevitably include patches of disappointment, if the history of thematic funds is any indication.

According to the Wall Street Journal, just one fourth of thematic funds that have been in existence since 2010 have beaten the MSCI World Index over that time. Ben Johnson, Morningstar’s head of global ETF research, ascribed that less-than-impressive track record to a broad failure to deliver on themes, or make their debut after investors have already bid up valuations of stocks that fit into their investment mandate.

“Investors need to approach this category with a healthy degree of skepticism, given its track record,” Johnson told the Journal.

Morningstar has also found that of all thematic funds that were created over a decade ago, less than half have survived. Even if it has a large-enough base of interested investors at first, a thematic ETF can go extinct due to other selective pressures such as wavering tailwinds, less-than-impressive performance in its holdings – which can be compounded by steep management fees – or a wave of redemptions set off by nasty bouts of volatility.

“If these funds have a place at all in their portfolios, it should be a small one, a more tactical allocation,” Johnson said.

 

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