Why most thematic ETFs fail to deliver

Investors are suckers for a good story. Raw data and financial statements are fine for savants, but storytelling is what captivates the masses – to their detriment.

This is what thematic investing is all about – spinning a narrative around those trends and disruptions with the potential to drive big-time future returns.

Thematic exchange-traded funds, which are baskets of stocks that focus on niche long-term trends, have exploded in popularity over the last few years, as investors have piled into bets on artificial intelligence, clean technology and cyber security.

The problem is that they don’t tend to perform very well. Morningstar’s last study of the thematic universe showed that just 18 per cent of these funds survived and outperformed the market over the 12 months up to end of last June.

Granted, anything can happen in any given year. But take the long view and the results go from bad to worse.

Over the past 15 years, thematic ETFs globally had a failure rate of 91 per cent. That means fewer than one in 10 that were available at the start of that period survived and outperformed.

“This is a classic case of the industry selling things that are good for them and bad for clients,” Joe Wiggins, director of research at St. James’s Place, a British wealth manager, wrote in a recent blog post.

Thankfully, investors seem to be catching on. Gone are the wild inflows of the pandemic-era bull market, when assets held in thematic ETFs globally swelled by US$600-billion in two years. Since peaking in 2021, the thematic space has shrunk by more than one-third.

In Canada, 2024 was the first negative year for thematic ETF flows, with a net of $240-million being yanked out of these funds.

This boom-and-bust cycle has seen investors retreat from once sizzling hot themes like electric vehicles, environmental, social and governance (ESG) investing, and most conspicuously, the ARK Innovation ETF, widely known by its ticker ARKK.

Led by star stock picker Cathie Wood, ARKK rose to prominence after some well-placed bets on “disruptive innovations” hit big during COVID-19 lockdowns.

But the hordes of ARKK faithful would soon be disenchanted when the fund went into freefall, declining by as much as 81 per cent by the end of 2022. Last year, Morningstar estimated that the firm was responsible for wiping out US$14.3-billion in shareholder value over the previous 10 years.

The thematic ETF space has also been wounded by the backlash against ESG, particularly in the U.S., where Republican legislators have demonized sustainable investing as wokeism in financial form.

The ETF graveyard is filled with other bygone themes. There was once a whiskey ETF tracking the spirits industry. Fund provider FaithShares offered a suite of Christian-themed funds, with separate ETFs tailored to the values of Baptists, Catholics, Lutherans and Methodists. There was even an ETF built on exploiting growth in the ETF industry itself.

Thematic funds shut down with great regularity. Nearly half of the funds that existed 10 years ago are gone, Morningstar numbers show.

But rest assured, the industry is busily spinning off new themes all the time. “It is easy for firms to launch lots (which they do) and hope that some stick,” Mr. Wiggins wrote. “That most of them fail is of no great concern.”

Some of the buzzier thematic funds now look to capitalize on aging populations, infrastructure development, and defence technology. A pair of ETFs launched last year are designed to profit from the boom in obesity drugs, like Ozempic. The Roundhill GLP-1 & Weight Loss ETF, for example, has the ticker OZEM.

Funds like these can tell powerful stories that are easy for any investor to understand. But they face long odds of ever making the returns they seek, even when betting on trends and businesses that will legitimately drive future growth.

To do so, you need to get three things right. You need to identify the right theme. You need to time your entry in that theme correctly. And you need to pick the right fund.

Getting one of these wrong could spoil the whole investment.

Through the pandemic, for example, an entire ecosystem of health care and biotech companies, as well as funds that package them up, flourished. Seemed like a no-brainer in a world being fundamentally altered by an historic global disaster.

But then the pandemic trade receded, and many of those once-sure bets crumbled. The iShares Genomics Immunology and Healthcare ETF is down by 60 per cent since 2021. The Horizons Global Vaccines and Infectious Diseases Index ETF was delisted in 2023, to name just a couple of examples. Good theme, wrong time.

The ETF wrapper makes it easy for fund providers to quickly seize on whatever is the flavour of the month. But fad investing has always existed, said Daniel Straus, managing director of ETFs for National Bank Financial.

“Before ETFs, people would go and buy the most speculative single stocks in those areas,” he said. “At least an ETF is diversified.”

Investors in the cannabis stock craze, for example, faced the real risk of a single-stock bet going to zero. Cannabis ETF performance, on the other hand, has been merely terrible.

It’s no big deal, Mr. Straus said, as long as one is dabbling in thematic funds with a small share of their portfolio.

But best not to get too wrapped up. Sometimes a good story is a dangerous thing.