Why criticisms that cite concentration risks are missing half the picture
Over the past two years, the stock market has gone through a significant period of euphoria, with investors piling into exciting investment vehicles such as thematic index ETFs. But as today’s volatile markets put the squeeze on some of those strategies, many investors are experiencing firsthand some of the challenges faced by funds with passive exposure to a particular investment theme.
“Oftentimes, a down market is associated with greater price volatility, which can make the rebalancing more difficult from a trading perspective,” said Rahul Sen Sharma, Managing Partner at Indxx. “That's not unique to thematic indexes; that's common across all indexes.”
A pioneering provider of thematic indexes, Indxx has built benchmarks for a wide assortment of U.S.-listed funds, including the Global X U.S. Infrastructure Development ETF (PAVE), the First Trust Indxx Metaverse ETF (ARVR), the First Trust Indxx Global Natural Resources ETF (FTRI), and the First Trust U.S. Agriculture ETF.
“Thematic indexes tend to be a little bit more concentrated in terms of the number of their holdings,” Sharma says. “And though it’s not always the case, companies on the thematic side can also be smaller.”
Especially during bear markets and times of market volatility, he says portfolio rebalancing within indexes is a vital form of maintenance. Because excessive price volatility in the markets tends to distort and warp the weights of portfolio holdings, it’s crucial for index providers to periodically review and reconstitute their indexes and make sure they achieve the desired investment goals and intended exposures.
The upshot is that thematic funds may see a lot of turnover in their holdings during times of market volatility and downturns. As smaller names within the index fall below the market cap or liquidity thresholds that its methodology requires, they end up getting removed, which could potentially cause considerable turnover of the underlying portfolio. To mitigate those negative effects, Sharma says Indxx has introduced a set of buffer rules to allow a security to stay within an index during a rebalance period, as long as it’s within a certain percentage of the threshold.
“What we’ve found is that people like thematic index exposures, because they tend to lead to less concentration risk than if investors were to try to get exposure to a particular theme themselves,” Sharma says. “If someone were to try to access the global robotics and artificial intelligence space themselves, for example, they’d be taking on a whole plethora of trading costs and risks, not to mention the time and effort for due diligence and rebalancing. Using the index model, where they gain exposure to our robotics and artificial intelligence index through an ETF, is a lot quicker and easier overall.”
Detractors may also question thematic indexes, saying that because they tend to be more concentrated, they’re more vulnerable to losses than the broad market during times of volatility. But Sharma notes that the argument cuts both ways: while some of the thematic indexes within Indxx’s stable have been harder hit than their comparable broad country or regional market, it also has other thematic indexes – including its Global Natural Resources Income Index and its Global Aerospace and Defense Index – that have outperformed with double-digit returns so far this year.
“Thematic indexes are really a double-edged sword in that you're getting more concentrated and targeted exposure,” he says. “As a result, you should expect to either have outperformance or underperformance, that does tend to be a little bit more exacerbated with the movements of the market cycle.”
