The basics: what is a thematic ETF?

A thematic ETF is a type of fund that invests in a portfolio of equities or other assets tied to a specific theme or market trend. Unlike traditional ETFs that track broad indices like the S&P 500 or FTSE 100, thematic ETFs focus on particular sectors, industries, or trends expected to benefit from long-term structural changes in the economy, society, or technology.

Example: the Amundi S&P Global Luxury UCITS ETF aims to closely replicate the performance of the S&P Global Luxury index, both upwards and downwards. The index contains 78 companies in the luxury sector, including Hermès, Compagnie Financière Richemont, Ferrari, LVMH, Marriott, Royal Caribbean Cruises, Diageo, and others.

What are the problems with thematic ETFs?

For investors, an emerging trend presents significant future profit prospects. As a result, it's not uncommon for capital to flood quickly and massively into potential winners within a given theme. However, this involves four key challenges.

1/ Speculation

A massive influx of capital into a new theme often leads to speculation, causing valuations to drift away from the company's fundamental metrics.

  • Example: during the COVID-19 pandemic, pharmaceutical labs, biotech firms, and medical equipment manufacturers saw their share prices soar. Moderna was a big winner, amassing over $20 billion in profits in two years. The company transitioned from a small, unprofitable firm to an S&P 500 component. But its stock price is now six times lower than its September 2021 highs, as the valuation had become unsustainable.

2/ Poor market timing

It's challenging to time a trend perfectly. If you buy too early, there may be no companies available, or those that are may not yet be the trend's main beneficiaries. If you buy too late, the trend might already be widely known or overvalued. Thematic ETFs are often launched after the trend is already well established.

  • Example: by the end of January 2023, just two months after OpenAI launched ChatGPT, Nvidia had already rebounded 76% (to $20) from its October 2022 low. It was difficult to enter the stock after such a rise, despite the favorable context. A cautious investor might have thought the AI wave had already peaked.

3/ Long-term investment: a vague concept

Asset managers promote long-term investment as the goal of thematic ETFs. However, funds need to adapt to market conditions as trends evolve.

  • Example 1: the DWS Science and Technology fund, created in 1948 as the Television Fund, added electronics over the years and underwent four name changes. The original themes did not stand the test of time, forcing the ETF to adapt.
  • Example 2: several metaverse funds were closed after Facebook rebranded as Meta Platforms in 2021.

4/ Thematic investing can counter basic stock market principles

"Don't put all your eggs in one basket"—or, diversify—is a fundamental stock market principle. However, thematic ETFs can contradict this rule, leading to underperformance.

  • Example: the Future AI & Tech ETF, which promotes exposure to artificial intelligence, has only broken even since the start of the year. Meanwhile, Nvidia, the sector's star, has gained 125% since January 1. Meta Platforms, Super Micro Computer, and Broadcom have also soared. However, funds are typically based on equal weighting of stocks or risk distribution across many companies. As a result, they only partially benefit from the rise of certain companies. The same applies to Novo Nordisk and Eli Lilly, involved in weight-loss drugs.

How to profit from a trend?

ETFs are still an excellent way to diversify. However, if you want to invest in a specific theme, there are a few things to consider. First, understand what's behind the ETF's name. Check what the ETF invests in and the weightings of the various assets. Next, consider the timing of incorporating the theme into your portfolio. This is tricky, but look for companies already profiting from the theme, evaluate the market structure, consider future demand, and monitor valuations. Pay attention to the ETF's characteristics: fees, assets under management, listing place, liquidity, replicated index, number of holdings, etc. Finally, when a clear leader is identified, it may be more appropriate to invest directly in the company rather than in an ETF tied to the trend.

Note that this paper was inspired by an article published in the Wall Street Journal.