Written by: Jeff McCarthy, Head of ETP Listings, Nasdaq
Themes—whether in movies, books, parties, or décor—can be a powerful way to draw people’s attention. With this in mind, it’s no wonder financial advisors and individual investors have become more and more focused on themes in investing as well. Not only can thematic investing help target unique opportunities for growth, but funds that focus on Socially Responsible Investing (SRI) and Impact Investing also give investors the ability to align their assets with their personal values by investing in the things they care about most. Healthy foods and lifestyles. Green energy. Healthcare. Eco-friendly housing. Whatever the passion, there’s probably a theme to match. And yet this approach isn’t purely altruistic. The funds that focus on long-term trends can add alpha generation to the list of benefits—and potentially transform the portfolios of mindful investors.
The power of long-term thematic investing comes with its research-driven approach to identifying traits that make sense over decades—not months or even a single year. Yet the simple reality of a persistent trend doesn’t necessarily make it a strong candidate as a thematic ETF. According to Nick Cherney, chief investment officer at Janus Capital Group , the key to success is seeking precise exposure in areas that meet these three criteria:
The theme must be, above all, investable .
It’s one thing to recognize that Baby Boomers are aging. That’s a simple demographic fact. But determining a clear way to invest in that shift is vital. A spike in the need for healthcare providers isn’t enough to focus on the trend. But investing in long-term care services targets the trend by capturing investable stocks that create a long-term tilt towards the aging population—something that is certain to continue far into the future.
The numbers must support delivery in a strategic ETF.
Unlike picking a singular stock, the strength of ETFs sits with a fund’s ability to diversify through the power of numbers. Even if a theme is qualified as a long-term, investable trend, there must be enough strong stocks to include in order to dilute risk and increase the potential for long-term gain. When ETFs were first emerging a decade ago, organic food companies were beginning to trend, but there weren’t enough players to warrant a strong thematic ETF. With the number of companies in this theme increasing every day, organics can now deliver the numbers needed to support a well-rounded ETF.
The theme must be cohesive and contextual.
To pass the “sanity test” for investors, all stocks within a thematic ETF must have a strong common denominator. It can be tempting to boost the numbers of strong stocks in a fund by squeezing in a stock that doesn’t truly fit the theme. When developing a health and fitness themed ETF, including health club chains, fitness apparel companies, and outdoor athletic retailers makes sense. Each of these passes the test of being cohesive to the theme in both essence and context. While a major pharmaceutical company may have a best-selling line of supplements, forcing a large pharmaceutical stock into the fund would undermine the strength of the theme and, ultimately, dilute the value of the satellite exposure the fund is targeting in the first place.
Just like fund managers for non-thematic ETFs, managers focused on thematic ETFs must continuously analyze the universe of potentially eligible stocks within a given theme, as well as consider the sustainable revenue of the theme itself. Fund managers look carefully at how much revenue is driven by the theme, how the category may be evolving, and emerging trends and players within the theme. With hundreds of new ETFs launching every year, this type of focused exposure seems to be attracting a coveted level of attention. Examples include Janus’s Health and Fitness ETF (FITS) , and its SLIM ETF , which focuses on the care, treatment, and servicing of the obesity epidemic. The company also offers themes focused on Socially Responsible Investing, including its Organics ETF ( ORG ), billed as “the natural way to invest.”
FlexShares is also in the thematic space with two ESG (Environmental/Social/Governance) funds appropriately named FlexShares STOXX US ESG Impact Index Fund ( ESG ) and FlexShares STOXX Global ESG Impact Index Fund ( ESGG ). According to their website, these products “give investors the ability to put their money where their values are.”
In these cases and more, trading volumes for thematic ETFs have been surprisingly high, in large part due to interest by non-traditional investors such as non-profits and lower-net-worth individuals who are highly value driven when it comes to investing. While its always wise to look only at well-built, research-backed ETFs when investing, the power of a persistent and compelling theme may provide that added punch you need to gain a new level of exposure just where you need it most.
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