What do thematic ETFs hold after explosive growth?

ETF feeds The Big Call: Thematic ETFs event saw experts examine key questions in the space, including how to choose the right thematic strategy, how the best thematic indices are constructed, and how to navigate an uncertain future for booming megatrends.

These discussions took place against a backdrop of remarkable growth in the thematic ETF category, with more than a hundred such products launched in Europe between the end of 2019 and the beginning of 2022. At the same time, assets under management (AUM) within product class more than quadrupled, from $10 billion to $41 billion.

water safety

The opening ceremony was Thomas Schumann, Founder of Thomas Schumann Capital, who highlighted the importance of sustainable water management and investment – ​​as highlighted in the sixth UN Sustainable Development Goal (SDG) United.

Schumann pointed to Carbon Disclosure Project (CDP) estimates that suggest the financial impact of global water risks could reach $301 billion, with at least $55 billion needed to mitigate these risks. He added that the MSCI ACWI catch-all index allocates 40% of its weights to water-stressed regions.

In conclusion, Schumann said thematic water games need to look beyond just water utilities and begin to assess water risk by overweighting low water stress constituents.

The recipe for building thematic indexes

Afterwards, BITA CEO Victor Gomez told attendees that the 1,400 theme funds available worldwide mean “it’s getting harder and harder for investors to choose the right strategy.

“There is also a lot of overlap between products while others offer very different exposures,” he added. “From a search perspective, subject indexing is probably one of the most challenging areas.”

Other challenges include maximizing the purity of the theme. Before that, however, index providers need to work out concrete definitions for each theme while coming to terms with the fact that newer themes simply don’t have established datasets – hence, an element of judgment is necessary.

“The key is to build an index where if the theme changes, the companies in your index move,” Gomez explained. “We don’t take a top-down approach to classification. We go bottom-up on the exposed companies, then we validate the companies with purity. »

Choosing the right megatrend

Jordan Sriharan, fund manager at Canada Life Asset Management, celebrated thematic ETFs for offering even retail investors access to specialized and game-changing sectors.

“Thematic ETFs aren’t a fad, they’re a natural evolution for investors looking for alpha but don’t want to pay active management fees,” he continued.

Additionally, Justin Oliver, deputy chief investment officer at Canaccord Genuity Wealth Management, said the first step when choosing an investment theme is to consider timelines – and the sustainability of the theme is far more relevant than the short-term flare-ups.

He also noted that it is unlikely to be possible to achieve 100 percent theme purity within an ETF, so investors must make “subjective judgement” on how to balance the purity, liquidity and diversification of a product’s theme.

Along the same lines, Veronique Morel-Kane, senior wealth manager and branch manager at Raymond James, said: “We look at the index methodology, replication and tracking error of an ETF . Also the production of indices, the reputation of an issuer and the viability of a theme.

Green energy transition

Discussing the most popular group of industries in the thematic ETF family, Morgane Delledonne, head of investment strategy for Europe at Global X, said that the energy transition in Europe had reached an important milestone in 2020, since 38% of the electricity was produced from renewable sources.

Already buoyed by regulatory tailwinds such as the EU taxonomy and the Sustainable Financial Disclosure Regulation (SFDR), the alternative energy theme was buoyed by Russia’s invasion of Ukraine, sparking the emergence of an energy crisis. Since day one of the invasion, 60% of European thematic feeds have gone to cleantech and renewable energy ETFs.

Delledonne told attendees, “This is a tipping point because it has shifted long-term strategies to tackle climate change to short-term needs for economic and security reasons.”

Around 260 billion euros will go to climate change initiatives aligned with the Paris Agreement, but how this will be allocated by different countries will vary greatly depending on clean technologies, the electrification of transport and the debate on scaling up nuclear capability.

New economy real estate

Chris Gannatti, global head of research for WisdomTree, highlighted another theme gaining traction this year: the future real estate sector spanning logistics and e-commerce, data centers, towers and telecommunications.

The real estate of the future combines a thematic approach with a game on real assets. The result is a structural player that benefits from the perpetual need to build digital economy infrastructure to meet growing capacity needs and the demand for increasingly efficient networks.

This is seen in the deployment of 5G networks among cell tower operators and cloud computing capability among data centers.

Basically, WisdomTree’s approach is to use an index provided by infrastructure-focused asset manager, Centersquare, which incorporates valuation metrics – a consideration often overlooked in future charts.

Shocking real estate

In addition to Gannatti’s thoughts, Gregg Guerin, Senior Product Specialist at First Trust, highlighted how the real estate of the future is displacing traditional segments such as shopping malls.

In fact, data centers have gone from 0% to 9% on the FTSE EPRA NAREIT index since Amazon launched its AWS service in 2006.

Guerin added that using thematic REIT products could present an effective hedge against inflation and interest rate hikes.

Dividends from the real estate sector have doubled the rate of inflation over the past 25 years, while REITS have posted average annualized returns of 9% over the past two decades.

Additionally, US REITs have posted positive returns in five of the Federal Reserve’s seven rate hike cycles since 2000, comfortably outperforming US equities during those periods.

What future for thematic ETFs?

While investment in the crystal ball is often discouraged, a small amount can be excused in thematics, as Tom Bailey, HANetf’s Head of Content and Research, has identified themes that are likely to benefit from tailwinds in the years to come.

It first looked at the billion people expected to enter the consumer class over the next decade – many of whom will be in emerging market economies – with McKinsey identifying it as one of the biggest trends to watch on the steps.

Next, Bailey highlighted the importance of regulatory tailwinds in industries such as sports betting and cannabis in the United States. On the first, the Supreme Court overturned a 1992 ruling against the expansion of sports betting and 25 states have legalized sports betting. Of the latter, the cannabis market is expected to be worth $126 billion over the next five years.

Finally, he highlighted the shift in consumer preferences towards greater sustainability, including healthier and plant-based foods, clean energy, ethical health and beauty, electrified transportation, and efficient infrastructure and buildings. .

Thematic ETFs and liquidity

Wrapping up the day, Sebastien Lemaire, head of ETF research at Societe Generale, issued a necessary health warning about investors needing to tread carefully when accessing exciting growth stories.

He said “thematic indices compete for liquidity”, as demonstrated by 46 different clean energy indices tracked by ETFs in Europe – and the S&P Global Clean Energy Index alone tracked by five separate ETFs.

“Building a good index aims to optimize the three pillars of purity, risk-return and liquidity,” explained Lemaire.

Dangers are encountered in cases such as when issuers use benchmarks that are not market capitalization weighted, which tends to overweight small capitalization securities and create a lower liquidity profile.

Themes with a limited number of pure games also risk being too concentrated. To combat this, ETF issuers often implement unique equity weighting caps, but this can mean that small caps are allowed to be overweighted, resulting in an overall basket with a lower liquidity profile. .

Another issue highlighted by Lemaire was the risk of an ETF holding small companies and receiving large sums of assets, meaning that these smaller holdings end up being physically owned by the ETF. On rebalancing day, the ETF may then be forced to dump large sums of stock, an event capitalized on by hedge funds, among others. The lengthy process of reweighting these relatively illiquid holdings ultimately comes at a cost to ETF investors.

To watch on-demand recordings of Big Call: Thematic ETFs, click here.

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