Guide to Thematic ETFs

Though many of the first ETFs provided broad exposure to the markets and were soon followed by sector ETFs, thematic ETFs are a more recent innovation and have become an important and growing part of the ETF landscape. Not constrained by yesterday’s traditional sector classifications, thematic ETFs offer investors the ability to receive targeted exposure to megatrends that are defining the evolving economic landscape. This guide to thematic ETFs will help investors understand what they are, how these types of ETFs can be categorized according to specific trends and themes, and the benefits and risks of investing in thematic ETFs.

What are thematic ETFs?

Thematic ETFs are a specific type of ETF that allow investors to capture the investment opportunity of one or more themes in a single investment. Thematic investing is often focused on changes in technology or demographics that cut across companies and traditional sector classifications, providing a diversified way to get exposure to these secular, long-term shifts or “megatrends. 

What is the classification used for thematic ETFs?

All thematic ETFs can be classified under a three-tier structure that identifies five megatrends, which can be further broken down into trends and their underlying themes. 

All thematic ETFs belong to one or more of the following five megatrends: 

• Technology Innovation such as the rise of robotics, automation, and artificial intelligence.
• Urbanization or the transformation of cities into megacities, the so-called Smart Cities, built around demographic and environmental issues
• Environmental Changes resulting from global warming which opens the door to Alternative Energies to reduce climate risks
• Next Gen Economies referring to the awakening of emerging countries as new consumers and key economic and geopolitical players
• Demographic Shifts such as the birth of the Silver Economy resulting from populations aging across the globe and representing a new category of consumers with specific needs and expectations

These five megatrends can each be separated into several trends. For example, the Next Gen Economies megatrend is characterized by two distinct trends: Emerging Markets Awakening and Equality, Inclusion and Diversity.

Each trend can then be further deconstructed into distinct themes. Some examples of themes that fall under the Emerging Markets Awakening trend would be China Digitalization, Emerging Markets Disruptive Technology, and Sustainable Development Projects. 

By classifying all thematic ETFs into 5 Megatrends, 12 trends, and 68 themes, investors can have a transparent framework for ETF research, comparison, and analysis.

Sector vs. thematic ETFs: What’s the difference?

Though sector ETFs and thematic ETFs each seek to offer exposure to a specific slice of the market, there are some important distinctions. 

Sectors are identified according to The Global Industry Classification Standard (GICS) by MSCI, grouping businesses that share the same or related business activities. Sector ETFs offer exposure to these predefined sectors as Energy, Consumer Staples, or Utilities.

Thematic ETFs, on the other hand, offer exposure to a specific theme, even if the underlying companies fall into different sectors. Each ETF’s prospectus will outline how the theme is defined, with similar thematic ETFs often having different underlying holdings. Some thematic ETFs might track an index that uses a revenue screen while others might track an index that has no such requirement, including companies that are only tangentially related to the theme. Other ETFs might be actively managed, relying on the portfolio manager’s discretion to identify which companies fall under the specific theme. 

What are the benefits and risks of thematic ETFs?

Thematic ETFs offer a simple way for investors to get access to a defined theme in a diversified way. As more issuers enter the thematic ETF space and offer new ways of slicing up the market, investors have more options than ever when it comes to gaining exposure to specific themes no matter how niche. 

Compared to selecting individual stocks, thematic ETFs can reduce stock-specific risk. For example, an investor who wants to have exposure to growing consumer interest in electric vehicles can, in one transaction, buy a basket of companies related to this theme rather than buying Tesla stock alone.

However, this benefit does not come without risks. As the underlying holdings all offer exposure to the same theme, they often have a high level of correlation with one another. This can mean increased levels of volatility for thematic ETFs due to their narrow focus. For this reason, thematic ETFs should be part of a diversified portfolio rather than a core holding.

And as previously mentioned, even similar-sounding thematic ETFs can be quite different from one another depending on their underlying methodology. Before allocating to a thematic ETF, investors should understand how the theme is being defined as this can have a significant impact on the composition of the underlying portfolio.