Exchange Traded Funds (ETFs) are a critical part of the emerging trend of thematic investing. Thematic investing breaks down investments by themes, which refer to specific risk areas to which the investor wants to gain exposure. Themes can be of any type; geography, commodity, industry. ETFs come in to play because the firms producing and marketing them have made themed ETFs, focused on specific industries, regions or sectors. This is a perfect tool for allowing investors to access the markets they want, at a relatively low cost.
What are ETFs?
ETFs are low-cost, passively managed funds that are traded on an exchange like an equity. They have a typical launch value of 100 which grows or shrinks depending on the funds returns. For example, an S&P500 ETF will buy stocks to track the proportions of different shares in the S&P500 index, with the aim of replicating the returns of that index. The fund will occasionally make trades in order to reflect changes in the composition or weighting of the index but for the most part holds a stable portfolio of assets. This allows investors to benefit from price changes in the index.
More specific, niche ETFs also exist. For example, you might have an American Oil and Gas ETF that tracks only the stocks of those companies that are involved in the oil and gas market in the US, in order to replicate their returns. This may or may not involve tracking a specific index. More obscure ETFs do not track indexes, and some are built on very broad investment ideas, such as global equities or global banks. These will hold a selection of worldwide equities. Banks like Saxo offer a broad range of ETFs to investors.
What is thematic investing?
Thematic investing involves selecting one or several themes that you use to guide portfolio distribution. For example, lets say you are bullish on the future prospects of the global shipping industry. It is not immediately clear what you should buy, assuming you have decided to buy a fund rather than individual stocks. If there are 20 leading global shipping firms, buying all of their stocks may be difficult due to the different markets involved, the problematic nature of carrying out research and son on. Alternatively, it’s unlikely dedicated active funds exist for such a specific investment theme, so mutual funds are not an option.
A (hypothetical) global shipping ETF would be an ideal solution. Such a fund would probably hold all of the relevant stocks, and maintain them in proportion to their relative contribution to the overall shipping market. This rebalancing differs from active management, asides from its lower fees, because the aim of the fund is not to enhance returns beyond the market rate but to replicate it accurately.
Why are ETFs well-suited to thematic investing?
ETFs are particularly well-suited to thematic investing because they are cheap, and because thematic ETFs exist. In theory, it would be perfectly possible to use actively managed funds or single stocks to gain access to the same markets, but these methods are either considerably riskier or much more expensive. ETFs benefit from low initial and ongoing fees, and are simple to trade on centralised exchanges.
Finally, compared to actively managed funds, which may have lockup periods and other withdrawal restrictions, ETFs are easy to buy and sell. The most heavily traded ETFs are extremely liquid, and it is quite simple to enter and exit positions.
The existence of thematic ETFs depends on these characteristics. Major ETF-offering houses are in fierce competition to meet the needs of thematic investors, including pension funds as well as retail traders, and so there is normally considerable innovation in thematic ETFs. The market has now reached a point where if you can think of it, there likely exists a themed ETF already. This is great news for investors, although it is important to keep an eye on costs. Although ETFs are low-cost investments, some of the more exotic ones do have ongoing fees which while smaller than those for mutual funds, can reduce returns.
Is thematic investing for me?
Thematic investing depends on a certain degree of market and economic knowledge. You have to know, for example, why you think investing in Chinese equities is a good idea. Simpler strategies, like using global equities ETFs to buy and hold, may be better suited to the less informed, but if you know enough to have formed an investment worldview than thematic ETFs are a great opportunity.
Most themes will have more than one ETF available. For example, if you are investing in European healthcare companies, you will likely have a choice of ETFs, each with a slightly different composition. In some cases, these differences are superficial, driven more by competition between giant funds looking to maximise volume while replicating the same indices. In others however, there can be major differences in composition. The small print and promotional opportunities of your fund will include all relevant details on footprint and holdings.
Be wary of ETFs with very few holdings, those with fees comparable to a mutual fund, or those which replicate returns using derivatives. Some ETFs have very specific functions, like replicating the downwards daily move in gold and multiplying it by two, and these arcane hedging products are inappropriate for retail investors. So long as you research and compare your fund with others available on the market, you should be able to avoid these problems.
Conclusion
ETFs have grown in tandem with thematic investing. A wealth of different products exist that you can use to invest in almost whatever theme you can think of. First, you will need a clear idea of which investment themes you want to focus on, and then you will need to be careful in how you select a fund. Remember to compare both one-off and ongoing fees, and check the holdings of the fund before you buy. If in doubt, speak to a financial professional who can offer further advice.