With the end of tax year fast approaching, it is not too late to consider using thematic exchange-traded funds (ETFs) to bolster an ISA portfolio.
Thematic ETFs are a low-cost way to gain exposure to long-term megatrends. So, if you are using an ISA to generate wealth in tax-efficient way over the long run then thematic ETFs could be a good fit as they aim to try and capture multi-decade themes.
You can find products which track any number of trends from AI to solar power, battery technology to climate change, cloud computing to the future of food.
WHAT YOU NEED TO THINK ABOUT
Lotfi Ladjami, senior ETF sales specialist at Franklin Templeton, tells Shares: ‘Successfully implementing a thematic investment strategy requires correctly identifying structural shifts and finding companies with high exposure to those shifts and having a longer time horizon to allow these trends to play out.’
The ongoing charges associated with thematic ETFs are typically lower than those for an actively managed fund or investment trust.
According to WisdomTree, a leading provider of global ETFs, the average total expense ratio (TER) of thematic ETFs in Europe – in total 197 – is 0.51%.
‘We have seen the significant growth of thematic ETFs in Europe in recent years, driven by several factors: investor demand from retail and institutional investors, innovation, and technology – as new technologies and innovations continue to emerge; thematic ETFs allow investors to participate in these advancements and the rise of environmental, social and governance (ESG) has contributed to the growth of thematic ETFs across Europe,’ says Franklin Templeton’s Ladjami.
Most thematic ETFs are more expensive than holding straightforward ETF which tracks a mainstream index, and it is worth conducting proper research into what index the ETF is tracking before you begin investing.
UNDERSTAND THE INDEX
ETFs can track various indices, for example, the L&G Artificial Intelligence UCITS ETF (AIAG) tracks ROBO Global Artificial Intelligence which in turn captures the performance of companies which derive most of their business revenue from the AI sector.
Chris Mellor, head of Invesco’s Europe Middle East and Africa (EMEA) ETF equity product management team says: ‘The type of index an ETF tracks is an important tool for an investor so they can assess the value and the performance of the ETF.’
GAIN ACCESS TO DIFFERENT INVESTMENT THEMES
A key advantage of investing in thematic ETFs is diversification. Thematic ETFs often invest in a range of companies involved in a particular theme providing investors with some diversification compared to investing in single stocks.
‘Some investors may use thematic ETFs as a core position for example within a sustainable portfolio or a satellite position within a broader portfolio to add a tilt to the exposure. This can be a source of excess return and contribute to overall portfolio returns,’ adds Franklin Templeton’s Lotfi Ladjami.
Pierre Debru, head of quantitative research and multi asset solutions for WisdomTree says: ‘Thematic investing allows investors to focus on specific trends and ideas expected to significantly impact the economy and society.
‘These trends often transcend traditional sectors and countries and are driven by broader macroeconomic and social factors.
‘By investing in companies that are positioned to benefit from these trends, investors can potentially capture higher returns than by investing in broad sectors or countries.’
WHAT ARE THE DRAWBACKS?
There are issues to consider when investing in thematic ETFs. Some might be ‘too obscure’ or ‘too niche’ or might have a small market cap – under £50 million for example.
This can cause problems. If an ETF is too niche and invests in something too specialised there is a danger that it might not attract enough interest from investors. This can result in liquidity risk for the investor – in the form of a big spread between the price at which you buy or sell the product. A thematic ETF with limited assets might also merge with another ETF or shut down permanently.
Last year a record number of ETFs closed in the US despite the industry as a whole raking in $598 billion.
Another potential drawback associated with investing in thematic ETFs is they tap into a theme after relevant businesses have already seen big increases in their share prices and the smart money has already been made. The ETF itself could even feed into a speculative bubble.
A thematic ETF specifically focusing on AI, for example, can suffer from concentration risk. Stocks in the AI sector have rocketed in the past year making chipmakers like Nvidia (NVDA:NASDAQ) and ARM Holdings (ARM:NASDAQ) household names.
Products like Global X Robotics & Artificial Intelligence UCITS ETF USD Accumulating (BOTZ) hold chip maker Nvidia and it accounts for 17.5% out of portfolio which numbers 39 holdings.
Over the past year Nvidia shares are up 283%. No doubt Nvidia’s share price movement has benefited the performance of the ETF but if the stock takes a tumble or the trend or sector falls out of favour with investors so will the performance of this ETF.
PORTFOLIO CONSTRUCTION
An important thing to note with thematic investing says Invesco’s Chris Mellor is to understand ‘how a fund is identifying stocks that are exposed to the theme and how the portfolio is constructed to maximise exposure whilst being investible.
‘For example, the businesses with the purest exposure to a cutting-edge theme may be part of a much larger listed company or may be a newly listed small cap company with limited liquidity,’ Mellor adds.
‘There are several ways that a fund can deal with these issues and one advantage of investing in a theme via an ETF is that the portfolio selection approach is codified in the index methodology. This means that an investor can see exactly how stocks are identified and included in the portfolio.’
It is this transparency which lies at the heart of the appeal of ETFs and this applies just as much to thematic products as it does to any others.
Why ETFs close
Reasons given by data provider Morningstar for ETFs closing are low assets under management (AUM), high fees, poor performance and short track records. In 2023, 244 US ETFs closed and they had an average lifespan of 5.4 years and average assets under management of only $54 million.
These articles are provided by Shares magazine which is published by AJ Bell Media, a part of AJ Bell. Shares is not written by AJ Bell.
Shares is provided for your general information and use and is not a personal recommendation to invest. It is not intended to be relied upon by you in making or not making any investment decisions. The investments referred to in these articles will not be suitable for all investors. If in doubt please seek appropriate independent financial advice.
Investors acting on the information in these articles do so at their own risk and AJ Bell Media and its staff do not accept liability for losses suffered by investors as a result of their investment decisions.
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