Cathie Wood’s Ark Innovation ETF—the most well-known “thematic” ETF—had lost half its value by mid-February, reports an article in Financial Times, as investors continue to sell their shares in droves. Though Wood claims that the innovation stocks held by the fund are very undervalued, a group of investment academics have put forth research that indicates instead that, on average, investors in thematic EFTs lose money. And the worst time to buy thematic ETFs, they say, is when they launch.
These types of ETFs typically launch right after their theme peaks, and that is followed by an almost immediate drop in returns. The group of academics—Itzhak Ben-David, Rabih Moussawi, Francesco Franzoni, and Byungwook Kim—analyzed U.S. equity ETFs and found that thematic ETFs struggled, as did sector-focused ETFs. Both categories account for almost 20% of assets under management.
There are many reasons thematic ETFs falter. Often, the theme is overvalued from the get-go, and the funds generally charge higher fees, eating into returns. They are also less diversified and therefore riskier, the article contends. But big returns can still be had from thematic ETFs. Ark Innovation investors who bought in 2014, its first year, have garnered nearly 270% in returns, and its sister fund, Ark Genomic Revolution, was a solid bet in 2020 with 180% in returns.
Still, that doesn’t mean thematic funds are a good bet in the long term. Some themes may never mature, Moussawi maintains, and some themes exist across multiple sectors, such as innovation or women’s empowerment, which means they won’t ever mature in their own right. So even though an investor might buy into a good long-term theme, the fund they choose might not perform.
Many investors overlook these possibilities because they believe in something, and thematic ETFs play into investors’ desire for an appealing narrative. And the excitement for a certain fund has already been priced in before that fund makes it to the market. Despite these possible pitfalls, thematic funds can still have a place in a portfolio, some analysts believe. Including them in a basket and keeping bets on them narrow could bring in returns in the short term. But they would need to be reviewed in the long term as the likelihood that they’ll remain winners forever is slim; in the gap between total returns of a fund and investor returns, theme-based sector funds fell particularly short, according to research from Morningstar that is cited in the article.