Thematic investment funds work best when they provide exposures to megatrends that Australian investors cannot easily source here.
These funds are less effective when product issuers seek to cash in on popular trends after prices soar – a problem with some thematic Exchange Traded Funds over the years.
Thematic investing – investing in trends or themes such as artificial intelligence, infrastructure or electric cars – has its place in portfolios. Done well, it can provide exposure to trends with years or decades of growth ahead.
The problem is that investors often underestimate how many companies lose money in the early stages of trends and how losers tend to vastly outnumber winners.
Consider the car industry. Not every car marker goes bankrupt, but many have faced severe financial challenges over the years, despite rising demand for cars.
Investing in artificial intelligence for example, seems like a no-brainer given soaring investment in AI technology. Yet the Betashares Global Robotics and Artificial Intelligence ETF (ASX: RBTZ) has returned only 7.7% since inception in September 2018. That modest return might change, but investment themes are never as clearcut as they seem.
Another promising trend – cloud computing – has also disappointed. The Betashares Cloud Computing ETF (ASX: CLDD) has an annualised return of -4.47% since inception to end-August 2024.
The long-term growth prospects of video games and e-sports were also touted. The VanEck Video Gaming and Esports ETF (ASX: ESPO), however, has an annualised return of a 5.4% over three years to end-August 2024. It’s done better in the past 18 months.
Some investors also underestimate additional risks in thematic ETFs. Unlike broad-based equity ETFs that hold hundreds of stocks, thematic ETFs also provide concentrated exposure, holding only a few dozen stocks in some cases.
In addition to concentration risk, unhedged thematic ETFs that invest in global equities also have currency risk. Higher fees are another consideration.
Arguably the biggest risk is ETF issuers launching a thematic ETF after its underlying asset class has rallied. A 2021 US academic study, Competition for Attention in the ETF Space, found that specialised (thematic) ETFs lose about 30 per cent in risk-adjusted terms over their first five years after launch, on average.
Caveats aside, thematic ETFs can play an important role in portfolios. Several high-potential sectors and themes, particularly in technology, are under-represented on ASX. Also, there tends to be fewer thematic unlisted managed funds, meaning investors who want exposure have to use ETFs over global equities.
The key is understanding how to incorporate thematic ETFs into portfolios. As with direct shares, they should be considered as portfolio “satellites” that can potentially generate alpha – a return greater than the market return – and boost the portfolio’s total return. Few thematic ETFs should be held in the portfolio core.
In a portfolio core/satellite approach, investors typically hold low-cost funds, such as ETFs in the core for broad market exposure. And higher-cost risk funds or stocks as satellites that can potentially generate higher returns.
Every investor is different, but 70-80% of the portfolio in core exposure and 20-30% in satellites a reasonable starting point for consideration. A smaller allocation to a few thematic ETFs within that satellite exposure can suit long-term, growth-focussed investors.
Here are two thematic ETFs launched this year that have caught my eye:
- VanEck Global Defence ETF (ASX: DFND)
Launched this month, DFND is the latest ETF to list on ASX and one the few ways for local investors to gain exposure to global defence stocks.
DFND offers exposure to a portfolio of listed companies involved in the military and defence industries. That includes mostly large companies in the aerospace, communications, security software and training sectors.
Global defence industry spending is expected to grow nearly 40% to US$3.1 trillion by 2030, according to research cited by VanEck. In percentage terms, growth in defence spending in 2023 was the strongest since 2009.
That’s no surprise as geopolitical threats rise, war rages on in Ukraine and an escalation of conflict in the Middle East looms. Longer term, the threat of a China-Taiwan war is another trigger for greater military spending in the region.
DFND screens out companies involved in controversial weapons manufacturer, such as anti-personnel mines, cluster munitions and biological and chemical warfare – a requirement in many equity funds on Environmental, Social and Governance (ESG) grounds.
I respect investors who do not want to exposure to defence companies in their portfolio on ethical grounds. One need only recall recent protests at a defence sector expo in Melbourne to understand the opposition in some quarters.
To my thinking, investing in the defence-related companies is broader than war. Many are developing = technologies that have military and industry applications and provide a range of services to the defence industry that extend well beyond combat applications.
As always, it pays to look “under the bonnet” of an ETF to understand it. DFND’s largest stock exposure, Plantir Technologies, is a US company that specialises in software platforms for big data analytics. Its third largest holding, Booz Allen Hamilton is a management consulting firm that specialises in the government and military sectors.
The ASX only has a small number of defence stocks, and most are micro-caps. Gaining exposure to expected growth in defence spending, through an ETF comprising leading defence companies, has appeal for long-term investors who are comfortable with the ethical aspects of owning defence-related companies.
DFND has an annual fee of 0.65% and is unhedged for currency movements.
Chart 1: VanEck Global Defence ETF (ASX: DFND)
Source: Google Finance
- Global X US Infrastructure Development ETF (ASX: PAVE)
Launched in June 2024, PAVE provides exposure to a diversified portfolio 0f 99 companies involved in the US infrastructure sector.
PAVE is among the more interesting thematic ETF launches in recent years. It doesn’t have the glitz of an ETF over artificial intelligence companies or other hot trends. But the US infrastructure trend has plenty of substance, given so much more spending on US infrastructure is required.
As Global X notes, the American Society of Civil Engineers gave a C- grade to the state of US infrastructure in its 2021 report card.
For an advanced economy, it’s amazing how many ageing, depilated infrastructure assets, such as roads and bridges, exist in the US. The US government, through various acts, has committed almost US$1 trillion to fund its ageing infrastructure.
Donald Trump has promised to increase investment in US infrastructure if he wins the US Presidential election in November. If he does not, the US still has higher infrastructure spending ahead under Kamala Harris.
Global infrastructure is a useful asset for long-term portfolio investors, particularly those seeking more defensive investments. Also, few large infrastructure stocks remain on ASX these days, making PAVE a useful tool for exposure to that sector
PAVE has an annual fee of 0.47% and is unhedged for currency movements.
Chart 2: Global X US Infrastructure ETF
Source: Google Finance
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 25 September 2024.
