The Thematic ETF BoomPhoto from Defiance ETFs

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A picture can replace a thousand words. This graph shows the cumulative daily flows into various categories of Exchange Traded Funds since the beginning of 2020. The dark blue line of thematic ETFs begins to rise above the others in August 2020, and then accelerates away, to reach over $70 billion by March 2021.  The others remain on or around the $10 billion mark. As the value of US-listed ETFs crosses the $5 trillion point, what is happening in this space and what can this tell us about broader trends in the investment world?


Thematic ETFs are Booming

Funds invested in thematic ETFs now exceed those in any other industry-defined sector. Indeed at $183 billion, thematic ETFs hold more than double the value of any other single sector. And while they hold less than 2% of industry assets, they account for about 6% of revenue. 2 Thematic ETFs have taken in more flows over the past three years than all other sector ETFs combined3: Since the last quarter of 2020, AUM has increased 430%.4. Their assets now stand at over triple their level at the end of 2019.5 There are now 163 thematic ETFs, up 13 since the end of the last quarter with no closures.6

What are Thematic ETFs?

Something significant is clearly happening here. Let’s take a minute to understand what a thematic ETF is, and how it fits into the broader ETF space.

An Exchange Traded Fund (ETF) is a group of stocks bundled together that can be traded on the stock market throughout the day, just like a single stock. The net asset value of the ETF depends on the value of its composite stocks. ETFs have become a convenient way for independent retail investors as well as institutional actors, to achieve exposure to a range of equities, thereby mitigating some of their single stock risk.

The “thematic” part of the ETF becomes relevant when we ask how securities are selected for inclusion in the ETF? Some ETFs simply reflect the composition of the Index of stocks in the S&P500, the Nasdaq or other stock exchanges. Others might target a particular sector. The Global Industry Classification Standard categorizes stocks into eleven sectors: Energy, Materials, Industrials, Consumer discretionary, Consumer Staples, Healthcare, Financials, Information Technology, Communication Services, Utilities and Real Estate.

Thematic ETFs do not fit neatly into any one of these sectors. Thematic ETF constituent companies are usually included because they contribute in some way to or are involved in overarching disruptive trends, or  they that stand to benefit from the realization of those trends. These trends travers sectors and by definition manifest a long-term investment strategy. They include technologies or practices that are set to transform existing paradigms of how people live, work, receive healthcare and pursue leisure.

Examples of recent thematic ETFs include 5G, quantum computing, cutting-edge health care, hydrogen power, robotics, or cannabis. Goldman Sachs recently summarized the largest themes in this chart:

Source: ETF Spotlight: Sizing Thematic Growth and the State of the US-Listed ETF Ecosystem, Goldman Sachs Equity Research, March 21, 2021, p.9

Investors in thematic ETFs may be looking for exposure to the transformative themes or trends of tomorrow; you could say, to the sectors that have not even formed yet.

What is driving this thematic ETF boom?

Who is choosing these thematic ETFs, propelling the market so dramatically as we see in the graph above? In contrast to historical tendencies for retail and institutional investors to turn away from the stock market in times of crisis, one suggestion is that the Corona pandemic has actually exacerbated a trend that was already on the rise.

Thematic ETFs generally speak to young, independent retail investors, who respond well to the compelling narrative developed around certain themes, and who want to invest in what they believe in or what they see happening round them like electric vehicles, blockchain and artificial intelligence.

These investors might have had more time on their hands recently, given the Covid-19 layoffs and work-from-home policies. They might be searching for alternative sources of income or larger returns, given the historically low interest rates. They might be riding the new wave of easier access and information provided by no-commission trading platforms. There is some indication that the thematic ETF space is benefiting from a move towards barbell-shaped portfolios. This means investors place the majority of their assets in low-cost index funds and allocate a certain proportion to higher volatility thematic ETFs that have greater chance of higher returns (or losses).7 Choosing a theme allows for individual expression and meets investors’ need for precis positioning.

From gaming to ecommerce, pet care to cloud computing, thematic ETFs are proving an attractive investment vehicle. The growth in retail investment activity sits well in this analysis, as themes are both appealing and accessible to the Robinhood trader. Institutions are also partaking, however, in a market that could potentially become a $500 billion category over the next five years