Thematic exchange-traded funds (ETFs) are not new but over the past year those with a sustainability and technology slant have captured the imagination. Inflows have surged but investors are advised to be vigilant and judiciously examine the index construction and approach. As past events have shown, it is too easy to be caught off guard by rebalancing or by stocks that may not fit the bill.
Some of the trends may also be fleeting but the appetite for thematic ETFs is set to continue to grow. Recent data from Bloomberg Intelligence shows that globally these products already exceed any single sector – and are more than double the size of any outside technology – with $183bn (€155bn). They may only account for a sliver – less than 2% of industry assets – but they represent about 6% of revenue.
Innovation and technology, with $31bn and $27bn respectively in assets under management, have been the stand-out sectors, followed by healthcare, at $24bn and clean energy with $21.9bn. Although they target specific sections of the economy, Chris Mellor, head of EMEA ETF equity and commodity product management at Invesco, believes that “thematic ETFs are just like any other investment, and they are subject to the same level of governance as any UCITs fund. These are index-based products which means everything is clear and transparent, but investors should look under the hood. What happened with the S&P Global Clean Energy index, for example, demonstrates the need to look at concentration and liquidity risks. They have to make sure that if $10bn flow in, the index can absorb it.”
END-USER DUE-DILIGENCE
Roxane Sanguinetti, head of fixed income and investor relations at GHCO, a liquidity provider specialising in ETFs, also believes it is the responsibility of investors to investigate the design of the index carefully. “ETFs do not just differentiate on cost, but the underlying methodology is very important,” she says. “If you have a small basket of underlying stocks, it will be open to greater risk which is what we saw with the S&P Global Clean Energy index.”
The S&P Global Clean Energy index, which originally had only 30 stocks, is the main benchmark used for the US-domiciled iShares Global Clean Energy ETF (ICLN) and its European UCITs equivalent (INRG). However, problems arose when their combined assets skyrocketed from $760m at the start of last year to $10.8bn following a sharp rise in inflows in the wake of President Joe Biden’s election in November and a 140% rally in the underlying index during 2020.
Capacity and liquidity issues ensued as the index was dominated by the two BlackRock ETFs along with 45% of the total money invested in non-fossil fuel energy ETFs. A report by Société Générale summed it up: “The problem stems from a cocktail of large money flows in the ETFs replicating an index launched 14 years ago, whose rules seem no longer suitable to the large assets collected by the ETFs. The index rules lead to a relatively high concentration, the selection of some poorly liquid stocks and the overweight of smaller caps at the expense of large caps.”
The upshot was a rebalancing to broaden the benchmark to more than 80 constituents. However, the wider eligibility gave rise to a different set of challenges. There were fewer pure plays as more stocks previously rejected for not being clean enough were included. In fact, the Société Générale analysis shows the original basket of 30 stocks had a 100% clean energy exposure – in other words this was the primary business of all the index’s constituents – but the figure dropped to 66% in the newer index.
In addition, the research shows that the index is expected to offer a 27% exposure to companies with a clean energy exposure score of 0.5, meaning they have only ‘some’ involvement in clean energy within their business models.
Against this changing backdrop, investors are advised to have their checklist ready. “The question investors need to ask is whether the ETF provider I am engaging is using the right index,” says Olivier Souliac, DWS head of passive index strategy and analytics. “The construction of the index is a key determinant of returns, so in the same way active investors need to get comfortable with a fund manager’s investment approach, thematic ETF investors need to look under the bonnet at the index driving their thematic ETF.”
LOOKS CAN DECEIVE
Sanguinetti encourages investors to read the labels very carefully. She notes that the names and companies slotted in might not only be misleading but might also result in high correlations. “They need to look across their portfolios because there may be overlaps,” she says. “For example, Tesla, Microsoft and Apple can be in the robotic, technology and vegan ETFs, which leaves investors overly exposed to these stocks. They also need to be aware that many of these themes are new and have only been in existence for two to five years which means most of the companies will be in small caps.”
In the case of the US Vegan Climate ETF, the top holding is not a plant-based food company but Microsoft, which accounts for 4.6%, and chipmaker Nvidia with 4.8%. They are not alone and, overall, their information technology peer group accounts for more than half or 52% of the vegan ETF.
“The thematic space is littered with a lot of funds that had their day but have dropped back” - Chris Mellor, Invesco
Investors should also be aware that thematic funds can have a short shelf life. The “thematic space is littered with a lot of funds that had their day but have dropped back,” says Mellor. “They did not catch the zeitgeist. However, it is also dangerous to write off a theme because there will be periods when it is out of favour. The question to ask today, for example, is will clean and renewable energy stocks, which are very popular, solve the climate problems over the long term.”
Kenneth Lamont, a passive funds research analyst for Morningstar Europe, echoes these sentiments. “Over 80% of funds open and close and never get to $100m in assets,” he says “By nature, many of these thematic funds choose to fish further down the spectrum and, if there is a rebalancing, then liquidity will be impacted. However, if they attract more flows then they will survive. This is why investors need to ensure that they have the right fund tracking the right theme at the right time.”
MANAGER’S RESPONSIBILITY
While investors should be responsible for conducting their own due diligence, asset managers and ETF providers also have a role to play. As Matteo Andreetto, head of SPDR, EMEA, at SSGA puts it, “As an index provider we have an obligation to track and replicate the index as well as make it more robust. Before launching we look at the research framework of the index providers. For example, with first generation thematic we were not comfortable launching products because there were certain mechanics of the index construction which could lead to concentration of risk in the index.”
“When we look at thematics, ESG and climate related strategies, we welcome a data-based approach on company reports and multiple data sources in the framework” - Matteo Andreetto, SSGA
He adds, “When we look at thematics, ESG and climate related strategies, we welcome a data-based approach on company reports and multiple data sources in the framework.”
Grégory Berthier, head of product, ETF & index solutions, Lyxor International Asset Management, also believes, “as an asset manager, it is our job to ensure the provider complies with the structure and frameworks put in place, The product has to be doing what it says. The methodology should cover a broad and diversified basket that captures a segment of the theme.”
