Research houses grapple with the rise of thematic ETFs

As thematic ETFs gain popularity among advisers, rating houses have told Money Management of their unique challenge to compare these niche products and assess their long-term viability.

Thematic ETFs, focusing on specific investment themes ranging from renewable energy and artificial intelligence to cyber security and video games, are gaining traction in the Australian market.

There are over 40 such funds available on key exchanges, according to a recent Global X report from March, with a total of some $5.5 billion invested in these products.  

Money Management previously explored how thematic ETFs are also assisting advisers in tapping into specific growth themes and portfolio diversification.

However, thematic ETFs also present a unique challenge for research houses, which are having to adapt their methodologies to incorporate factors such as the underlying theme’s long-term potential, the quality of the index provider, and the manager’s ability to execute the strategy.

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According to Michael Elsworth, senior investment analyst at Lonsec, research houses are tasked with “scratching the surface” to understand more about these ETFs and make “judgement calls” regarding its exposures.

“Most, nearly all of them, track an index and the objective is really to track an index rather than outperform an index like the ASX 200 or the S&P 500. A lot of research is around understanding what the index is,” he told Money Management.

“They all have various rules of index construction, and it’s really scratching the surface there and understanding what the rules are and ultimately what investors get exposure to.”

While some themes, like hydrogen or battery technology, can be specific, others like cyber security can be quite broad and require further discussion, he said.

Looking at the example of cyber security, a theme that has grown significantly popular in recent years, Elsworth pointed out that it “means different things to different people”, leaving research houses like Lonsec to look at how indexes choose to define these exposures.

Betashares Global Cybersecurity ETF offers “exposure to the leading companies in the global cyber security sector” while the equivalent Global X Cybersecurity ETF focuses on holdings which “stand to benefit from increased adoption of cyber security”.

Elsworth said: “You do look at some of these thematic ETFs and think ‘that just looks like the NASDAQ to me’ because the rules can be so loose – are you really getting an exposure to the cyber security industry?” 

“There is a judgement call there as to whether or not you are achieving a genuine exposure. That’s probably the most difficult thing with these thematic ETFs.”

The lack of track record for new indexes and evaluating against a small, albeit slowly growing, peer group can also prove challenging, Elsworth observed.

“When you look at [thematic ETFs] as a peer group, what makes a theme stronger than another? That’s a more difficult exercise, I would say, than what makes this Aussie equity manager or this global equity manager better than another.

“There’s a bit more to distinguish active managers and actively managed funds than there is to distinguish thematic ETFs,” he observed.

Ibbi Warfield, manager research analyst at Morningstar, agreed the difficulties in drawing peer and benchmark relativities mean they are not a current priority for the research house.

Currently, thematic ETFs are not a focus for Morningstar’s qualitative manager research coverage for Australia, he told Money Management, as such funds typically feature in its miscellaneous categories “where peer group composition varies widely”.

“Our primary goal is to provide efficacious research that guides investors towards long-term, durable investments. While thematic ETFs may suit certain aims, they are niche and often lack durability, as they are based on dynamic trends that come and go. This makes them less ideal for through-the-cycle investment,” Warfield said.

“Their focused – and sometimes hyper-focused – exposures make it difficult to draw peer and benchmark-relativities.”

Looking under the hood

But with a good research rating being critical to a fund’s future prospects and sales, ETF providers are trying hard to provide as much information as possible to alleviate research managers’ concerns.

For financial advisers in particular, they are unlikely to offer a fund to their clients or place it on their approved product list (APL) without a research rating, potentially meaning providers miss out on a crucial audience if they lack one.

Manny Damianakis, head of sales at Global X, confirmed to Money Management that it can be difficult to gain a rating with the timeline ranging from a few months if the research house has a specialist ETF team to three years if they want a solid track record.

“I wouldn’t say it was easy and not every research house rates thematics,” he said. “The ones who have done it before know what to look for, to do the research into the benchmark and its provider and the depth of liquidity of stocks in that benchmark. 

“Thematics aren’t a homogenous group, there’s lots of differences in each one and that’s where the research plays a good role. We end up to-ing and fro-ing on the different questions, they meet with us to go through the investment process and meet the team, but that’s no different to any other fund.”

Speaking to Money Management, Cameron Gleeson, senior investment strategist at Betashares, highlighted there are three key considerations for the ETF provider ahead of launching a thematic ETF.

These are: 

• The theme is investible, with a mature industry and a deep-enough pool of companies with adequate liquidity. 
• The theme is more than a trend and can unfold over multiple decades.
• There is a “pathway to profitability”.

“Sometimes the industries are quite nascent and they might not be at a stage of significant profitability, but we must be able to see profitability or a path to profitability, so these companies must be able to exploit the opportunity, the structural growth, and find ways to monetise the theme,” he explained.

Betashares offers over a dozen thematic ETFs on the ASX, and according to Gleeson, works closely with research houses in terms of getting research ratings for these products.

“The process really starts after we’ve launched the fund and we spend a long time discussing the funds with them. It’s a fairly engaged process […] there’s a lot of back and forth before and afterwards,” he explained.

Role in advisers’ portfolios

Gleeson said he found that a consideration for research houses beyond the investments in the fund was how it would play a role in an adviser’s portfolio. With their singular focus, thematic funds are typically aimed at high-net-worth or institutional investors but are gaining interest with advisers.

“They’re quite thoughtful in terms of the way they look at any satellite exposure or any exposure at all. We find them to be very engaged and they’re very interested in understanding how we think about how these funds can be used in the context of an overall portfolio.

“For example, looking at cyber security, they’re not just interested in what does this theme look like, what does the fund do, but they’re also saying, ‘How does a client use this fund with, say, Australian equities or fixed income?’”

Lonsec’s Elsworth echoed this and said an understanding of the fund’s potential role in a particular portfolio forms part of the ratings process.

“It’s generally a question we ask to make sure we’re on the same page, that we think similarly to the product provider about the role that this fund can play within a portfolio,” he said.

“The vast majority of the times, you’re going to be like-minded, but occasionally you’ll see a fund and you might have a difference of opinion about the role it plays in a portfolio, and that’s really a sign or trigger for doing some more work on the fund to make sure we understand exactly what’s going on.”

Daminakis added he felt advisers were gaining more knowledge and awareness themselves about thematic ETFs, which was being picked up by the research houses.

“Financial planners are typically trained and monitored to run very conventional investment portfolios. But I think advisers are now more interested in diversifying and having some different types of investments.

“Thematic investing is definitely becoming more mainstream and we are seeing more take-up and more knowledge sharing, so the research houses and APLs from advisers are starting to pick that up.”

Looking ahead, noting the transparency benefits and cost-effective nature of ETFs, Elsworth said he believes the trend of thematic ETFs is unlikely to abate.

“I think we’ll continue to see more of them. They are reasonably cheap to set up, there are establishment costs and ongoing costs, but I think it’s one of the reasonably timely and cost-effective ways of accessing a theme.”