Thematic ETFs, the new scam?

Increasingly popular, thematic ETFs are making their way into most investor portfolios. After all, no one wants to miss the train of the future, and everyone wants a piece of the futuristic pie: cannabis, green energy, cybersecurity, blockchain, artificial intelligence, and so on. The reason for this is the well-oiled marketing of ETF creators, driven by hype and influencers too young to even have a driver’s license. Today, in this article, we’ll see why these ETFs are the worst investments in existence and why you might as well burn your money.

What is an ETF?

To fully understand this article, you must first understand that the world of ETFs is broadly divided into two categories: those with a loaded gun and those who dig deeper. Sorry, those that passively track major indices at low costs to provide diversification to investors, and those that are more specialized, called thematic ETFs, which actively track popular trends for higher fees than passive ETFs.

The Different ETF Categories

Category 1 ETFs are traditional ETFs that track the SP500, the CAC40, emerging markets, the real estate sector, etc. Category 2 ETFs are Cathie Wood’s ARKK Innovation, Green Energy ETFs, Robotics ETFs, Water ETFs, etc.

These have an understandable appeal, as it’s very easy to get excited and excited about genomics. For example, a new field of biotechnology that uses genetic mapping and DNA sequencing has the potential to revolutionize medicine and save millions of lives. New technologies like these often come with a compelling and easy-to-understand story. Except that good stories aren’t often the most profitable, especially when compared to the risk taken by investors.

ETF Performance

Let’s start by taking a look at the historical performance of these ETFs. Contrary to what you might think, thematic investing isn’t new. Every decade brings its share of trendy themes. Electronics in the 1960s. Japanese tech in the 1970s. Biotech in the 1980s. The Internet in the 1990s. Mobile in the 2000s. Cannabis in the 2010s. A few years later, almost all of the stocks operating in these “future” niches have now either disappeared or are looking for a breath of fresh air, like Canopy Growth, a specialist in medical cannabis.

But back to ETFs. In an excellent study called “Competition for Attention in the ETF Industry,” the authors compared the historical performance of all US ETFs created between 1999 and 2019, both broad and thematic, and the results are clear.

Thematic ETFs underperform the markets

by an average of 4% per year, adjusted for risk, at least five years after their creation. Whereas

General ETFs in blue will roughly follow the markets, albeit slightly below them due to the natural effect of management fees. Thematic ETFs in red are on average -30% relative to the markets after 5 years. Of course, these are averages, and you’ll always find thematic ETFs that perform better than others. But generally, not for long. The SP500 is up 57% over the past 5 years. While the world’s largest thematic ETF, ARK Innovation, managed by Cathie Wood, is up 49% after the bursting of a mega-bubble during the pandemic.

The second-largest thematic ETF, FIRST TRUST INTERNET, has posted a negative performance of -46% over the past 5 years. The third is the ARK GENOMIC REVOLUTION, which displays a gross performance identical to the SP500 but actually inferior when adjusted for risk, taking into account fees, and assuming that the investor psychologically survives the big pandemic bubble.

A trendy ETF that seems to be doing well is the ISHARES GLOBAL CLEAN ENERGY ETF, with an incredible performance of +121% over the last 5 years, but when you look at the longer term, it turns into the red, with a completely lost decade where the ETF did nothing.

So why are ETFs still so popular?

Despite this observation, money continues to flow increasingly into thematic ETFs from individual investors due to the growing interest in an investment that aligns with their individual values, their vision of the future, and their beliefs. Because what a thematic ETF does is sell you a story that you buy into without necessarily being aware of the risks. A first indicator of the level of risk that could tell us to be careful is when we compare the popularity of these ETFs among individuals and institutional investors.

In the same study cited earlier, the authors show that institutional investors on the left are much more exposed to traditional ETFs in blue than to thematic ETFs in red.

ETFs only for individuals?

While the opposite is true on the Robinhood brokerage, which represents individuals, where thematic ETFs are purchased much more than traditional ones. The fact that institutional investors shun thematic ETFs, even though they are much better informed than individuals, shows that these ETFs are dedicated to crowds who, collectively, are sheep. We are all collectively sheep. And we don’t see the details of how these ETFs work, as they generally invest in small stocks, which are less profitable and more expensive than the rest. Three typical aspects of high volatility.

In a Morningstar comparative study of thematic ETFs and the general US market, we clearly see that over the past 10 years, the annual performance of thematic ETFs has been lower than the market, while having a higher standard deviation and a risk/return ratio that is half that of the market. Worse still, these calculations only take into account thematic funds that are still in existence.

What is the real performance of thematic ETFs?

They don’t show the performances of funds that have been discontinued. Because what no one is going to show you is this graph that shows the proportion of funds outperforming the market, underperforming the market, and the proportion of funds discontinued 1 year, 3 years, 5 years, 10 years, and 15 years after the launch of a thematic ETF. And we see that, on average, 5 years after their launch, 39% of thematic ETFs outperform the market. 30% underperform, and 31% are discontinued. After 10 years, 20% continue to outperform, 30% continue to underperform, and 50% are discontinued. And after 15 years, only 10% have survived and are outperforming the market. 15% have survived and are underperforming the market, and more than three-quarters no longer even exist. It’s chilling, but the reality is that

by investing in a thematic ETF with a long-term perspective, there’s little chance your ETF will still be around in a few years, and if it does survive, there’s even less chance it’ll outperform the markets.

Why are thematic ETFs bad investments?

Now that we’ve looked at the historical performance and risks, we need to answer the question everyone’s asking: why are these thematic ETFs such bad investments when, from the outside, they have everything they need to explode by riding a megatrend of the future. In fact, the problem is threefold. There are three reasons why these types of ETFs will naturally wreak havoc on your portfolio.

First reason: fees!

First, fees. Whereas a simple Lyxor PEA SP500 ETF will charge 0.15% in annual management fees, the Lyxor PEA Water ETF will charge 0.6%, or four times more. It’s even worse in the United States, where a simple Vanguard S&P 500 ETF will charge 0.03% in fees, while the ARK Innovation ETF will charge 0.75%. Overall, thematic ETFs are the most expensive to buy. They are more expensive than factor ETFs, sector ETFs, and general ETFs. And just like dividends, fees accumulate and compound. So, over the long term, a high fee can be the sole cause of a fund’s underperformance.

Second reason: double concentration

The concentration is twofold. First, the fund itself is focused on a particular niche. A Cannabis ETF, as its name suggests, is an ETF exclusively focused on cannabis. While you may be super motivated by the prospects of this niche, neither you nor other investors control the demand, but rather the end users. As great as it may be sold, no one can truly predict how a market will evolve. By investing in a thematic ETF, you allocate

some or all of your money to the craziest, in a highly concentrated niche

with very little or no diversification. The second type of concentration is the concentration of a large portion of the shares of small companies in the hands of

a few funds, or whales in crypto jargon. Cathie Wood’s ARK fund, for example, holds 14% of Compugen’s outstanding shares. This concentrated ownership in a single ETF means that share prices can be subject to the whims of the fund’s investors. All it takes is for a certain number of investors to divest from the ARK ETF for Compugen’s share price to collapse, sending the ETF itself into a downward spiral.

Third and final reason: weak performance

The poor performance of thematic ETFs, and this is the main reason, is that by the time ETFs are created and launched on the market, it’s already too late to invest in the targeted theme. Let me explain. An ETF issuer like Lyxor or Blackrock never creates demand for a specific theme; rather, the opposite: they create an ETF to meet an already existing investor demand and capitalize on it. The issuer will see, for example, that robotics stocks are exploding, that everyone is talking about it, that the media is talking about it, that FOMO is at its peak, and so they will decide to launch a Robotics ETF to ride the wave. The problem is that by the time the issuer decides to create this ETF, the wave and stock prices are already at their highest. Add to that the time for formalities, implementation, and the launch of the ETF on the markets, and it still takes several months. So, by the time the ETF is available for purchase, it’s already too late. The stocks comprising the ETF are much more likely to deflate after the hype than to continue to explode. So, there’s a bit of an old-fashioned investment aspect to it. This is what we see in this graph, which compares the average performance of each type of ETF after its launch. In the case of thematic ETFs, we can clearly see that they miss the peak of the hype for their theme and begin to collapse right at the moment they are introduced.

Thematic ETFs with weak performance – the smart investor

What’s the big question that comes to mind after all this information?

Everything we’ve just seen in this article leads us to a second burning question: with such a poor overall track record, why do fund issuers persist in continuing to create thematic ETFs? The answer is simple and straightforward: money. 18% of existing ETFs are thematic, and despite their low weight, they generate 36% of fund issuers’ revenues thanks to their high fees. Basically, thematic ETFs are the cash cows of Blackrock, Amundi, and company. They therefore have no incentive to stop making them, even though they know full well that their clients won’t make more money by paying higher fees; on the contrary, they’ll probably lose money.

To conclude this blog post in one sentence, it would be: don’t buy bullshit! As we’ve seen, thematic ETFs are generally terrible investments, at least for investors, not for their creators. You may have noticed that I didn’t specify the themes themselves, but rather the ETFs that capitalize on these themes, which are mediocre in their composition and operation.

If you’re convinced that a certain theme is the future, I think it’s better to take the time to do your own research and select conviction-based stocks directly.

A person who bought Amazon and Google in 1998 did much better than a guy who bought an Internet ETF at the same time, for the simple reason that 90% of Internet ETFs from that time no longer exist today.

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