Themes can be a powerful driver of investment returns as followers of the recent proliferation of AI (artificial intelligence) as a hot topic in the financial markets and beyond could attest.

The fast-growing thematic ETF (exchange-traded fund) universe provides a straightforward way to invest in various themes, including AI. Typically, the focus is on long-term structural changes (often called megatrends), affecting society.

Examples include investments tied to environmental, social and corporate governance (ESG) factors, the robotics and automation industry, blockchain technology and semiconductors.

STRONG INVESTOR INTEREST

Investment interest in thematic ETFs remains strong according to industry information provider Trackinsight’s Global ETF Survey 2023.

More than 40% of those surveyed said they would increase their thematic ETFs allocation over the next few years because of diversification, strategic allocation, liquidity, costs and the underlying index methodology.

Other reasons why investors have been piling into thematic ETFs this year include interest in technological innovation and environmental change, according to the Trackinsight survey.

More than 90% of respondents declared either being invested in (68%) or interested in (24%) thematic ETFs which address disruptive technological innovations.

Environmental strategies were also popular with 81% of respondents interested and invested in this area.

FOCUS ON GENUINE TRENDS NOT INVESTMENT FADS

A danger associated with investing in thematic ETFs is that by the time a product has been created to capture a hot theme, the easy gains will already have been made and potentially it may start to lose momentum. On the flipside if a theme is too niche, then any ETF set up to track it may struggle to attract assets, be harder to buy and sell, have higher costs and ultimately might end up being shut down.

Pedro Palandrani, director of research at Global X ETFs, says if investors are going to invest in thematic ETFs it is best to take a long-term approach ‘making market timing less of a factor’.

Palandrani also says identifying a thematic opportunity early on can help an investor to mitigate potential losses. To which the counter argument might be, in the initial stages of a theme there may not be a relevant product available to a retail investor.

Investors need to distinguish between fads and investment bubbles and genuine long-term trends. Doing so is not necessarily an easy task.

Palandrani says: ‘We believe long-term investors should prioritise identifying structural themes rather than cyclical ones. Given the longer-term nature of these themes and their disruptive nature, we have found that structural themes can be less dependent on timing entry and exit points and can be significantly more powerful in magnitude.’

The table shows the performance of US-listed Global X thematic ETFs over three years. The average performance of these products is only just in positive territory and there is a wide dispersion between the best performing product (offering exposure to the lithium and battery technology space) and the big decline for the cannabis-related strategy.

In WisdomTree’s latest quarterly thematic report for Europe, the global ETF provider said that over the past two years thematic ETFs had experienced bouts of volatility across many themes, ‘especially in technology-focused thematics’ and ‘longer-duration assets more sensitive to interest rate hikes’.

But these themes have started to make a recovery this year. If we look at WisdomTree’s top inflows in Europe ETFs year-to-date we can see that technology-focused thematic strategies lead the pack, with semiconductors and blockchain posting the biggest gains across the themes. WisdomTree’s ‘Rise of the Middle Class’ and ‘Millennials & Gen Z’ themes have also resonated.

WHAT NEXT FOR THEMATIC ETFS?

‘Thematic ETFs related to technology and AI will continue to be popular with investors this year,’ predicts Pierre Debru, head of quantitative research and multi-asset solutions for WisdomTree Europe.

Dina Ting, head of global index portfolio management at Franklin Templeton ETFs, agrees. Ting says: ‘There has been growing investor confidence in the intersection between AI and mixed reality applications that appears to be benefiting the metaverse theme. As Nvidia (NVDA:NASDAQ) is a top portfolio holding in our metaverse fund (Franklin Metaverse UCITS ETF (METE)), its strong earnings have also boosted performance.

‘Furthermore, year-to-date, our Franklin S&P Paris Aligned Climate UCITS ETF (500P) has outperformed the broader market. The fund is a cost-effective strategy focused on mitigating climate-risk exposure and capturing the growth opportunities arising from the low carbon transition through alignment with the goals of the Paris Climate Agreement.’

Ting says thematic ETFs give investors a chance ‘to align their values and convictions with their investments’.

‘With thematic ETFs, investors can look beyond more traditional geographic and sector groupings for diversification and targeted outcomes. Thematic ETFs are popular and easy-to-use vehicles for tactical asset allocation purposes aimed at generating alpha in a portfolio.

‘They can be used to capture growth in a secular trend that may be occurring over a long-time horizon, but they are also flexible enough to be used for shorter-term strategies,’ adds Ting.

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