Thematic ETFs: Are you getting the entry point right?

Last year was another thematic-driven year with thematic ETFs gaining popularity among Australian investors. According to the 2023 ASX Investor Study, the proportion of Australian investors using ETFs has grown from 15% to 20% over the past three years.

This surge of popularity comes on the heels of a record year for Australian ETFs, with their market capitalisation surpassing $177.5 billion. According to Betashares' latest Australian ETF Review, 2023 saw the highest ever funds under management increase to $43.7 billion, with $15.0 billion in new inflows.

While fixed-income ETFs dominated in terms of inflows last year, closely followed by Australian equities ETFs, some of the top-performing funds belonged to thematic ETFs.

BetaShares Crypto Innovators ETF, for example, was the star performer of the Australian ETF. It provides exposure to companies at the forefront of the crypto economy which have benefited from Bitcoin’s 166% surge over the past 12 months. The fund generated 214.5% returns and $5.3 million in inflows in 2023, shortly before the US Securities and Exchange Commission approved the first bitcoin-backed ETF.

Another standout performer also came from the thematic ETF category — the BetaShares Global Uranium ETF, which returned 56.5% and attracted $48 million in inflows. A rally in uranium prices driven by increased demand to help achieve net zero contributed to this success.

Worthy of investors’ attention

Amid the buzz surrounding ETFs, it's easy to assume that thematic ETFs play a significant role in the industry’ s AUM growth. However, while they excel at identifying winners in a transformation narrative, they make up only 3% of the Australian ETF market, according to Betashares.

Yet their advantages, such as providing low-cost access to growing trends, make them worthy of investors’ attention.

To clarify, thematic ETFs are not the same as buying an ETF that tracks the Australian share market. Instead, they provide investors with access to a range of stocks directly exposed to long-term investment trends like AI, decarbonisation and cybersecurity.

In essence, they aim to capture the performance of a particular trend, typically within a narrow segment of the market. 

Timing is key

It’s worth noting that investor demand for thematic ETFs does not always align with performance, and popular themes may not always be the best performing.

Despite the average returns on thematic funds being 7.3% p.a. over the five years to June 2023 (Morningstar), in reality investors in this space generated a more modest 2.4% p.a. return, indicating that investing in thematic ETFs doesn't guarantee significant gains.

The study showed that investors lost more value in targeted funds with highly concentrated portfolios of stocks like those tracking technology, AI, and alternative energy than in more diversified, broad thematic options.

These benign returns have contributed to waning investor interest within the thematic investment space, resulting in over $2.6 billion in outflows for ETFs focusing on thematic investments in the US last year. In particular, funds focused on themes such as Innovation, the Internet, and modern medicine healthcare experienced significant outflows.

Risks and challenges

Specialized ETFs often debut during the height of thematic excitement, propelled by investors' fear of missing out. So by the time the ETF becomes available, the thematic trend has been active for a substantial duration. This leads to potential overvaluation of stocks within thematic products at the time of their launch.

These considerations add a degree of complexity to the thematic investment landscape.

While it is easy to get carried away with sentiment, investing in a theme early in its lifecycle and holding until the theme matures can help investors avoid buying high and selling low.

Thus, investors in thematic ETFs encounter the dual challenge of managing market timing risks and determining whether a trend is lasting or passing. Adopting a "wait and watch" approach can be effective for understanding and thus navigating this space.

Additionally, diversification through investing in the likes of broad index funds may help reduce exposure to the company-specific risks thematic ETFs are more exposed to.

Key takeaways for investors:

-Specialised ETFs concentrating on an investment theme are typically launched during the rise or peak of thematic hype with fear of missing out often driving investors.

-The potential overvaluation of stocks in thematic ETFs at the time of their launch adds a degree of complexity to the thematic investment landscape.

-Investors in thematic ETFs encounter the dual challenge of managing market timing and determining whether a trend is lasting or passing. Adopting a "wait and watch" strategy can help investors understand and thus navigate this space.

Disclaimer: This article is prepared by Ankita Rai. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.