Investors seeking out a thematic investing ride in ETFs

Spurred by a rush of assets into several exchange-traded funds run by ARK Investment Management LLC, the category-defying, trend-chasing genre of thematic ETFs has taken off.

Through April 6, thematic ETFs attracted $26.4 billion in net new flows across 113 funds, compared with $26.1 billion for all last year. Aggregate assets now stand at $99 billion, according to FactSet Research Systems Inc., following a year in which nine of the 12 largest thematic products experienced returns of more than 100%.

Though such products have generally been the domain of retail investors and financial intermediaries, 29 thematic ETFs now top $1 billion in assets and many of those are making their way into more institutional portfolios.

"There's been a lot of attention to themes because they align with some investors' beliefs and give them something to connect with," said Lois Gregson, senior analyst for ETF analytics at FactSet, "but bringing out an ETF requires that there are enough stocks, with enough liquidity, to make it investible."

According to Ms. Gregson, theme products must cross multiple sectors, often focusing on a megatrend, without having too wide a berth. (ARK's flagship product, the $23.7 billion ARK Innovation ETF, for example, is categorized by FactSet as a "multithemed" ETF.)

Some of the more popular themes focus on specific emerging or disruptive technologies, sectors and industries affected by changing demographics and consumer attitudes, and shifts in regulation. Water, clean energy and infrastructure funds were among the earliest to launch, more than a decade ago, but now themes have exploded. Among the funds gathering the most assets this year include ARK Genomic Revolution with $3 billion, ARK Fintech Innovation at $2.3 billion, and iShares Global Clean Energy at $2.1 billion.

"We look at themes compared to the traditional GICS (Global Industry Classification Standard) sectors they are disrupting," said Jon Maier, chief investment officer at Global X Management Co. LLC, a unit of Mirae Asset Global Investments Co. Ltd. Global X manages 73 U.S.-listed ETFs with more than $26 billion in aggregate assets under management, including thematics focused on battery tech, artificial intelligence and more. It also publishes several model ETF portfolios that weight themes by forward earnings growth. Mr. Maier estimates that more than $300 million in assets are tracking thematic model portfolios published by Global X.

According to 13F filings, institutional owners of thematic ETFs include the C$475.7 billion ($378 billion) Canada Pension Plan Investment Board, The Workers Social Insurance Fund, $30.9 billion Employees Retirement System of Texas and Clal Insurance Enterprises Holdings Ltd.

One of the biggest challenges for ETF issuers looking at thematic fund development is determining when a theme can be indexed vs. when the theme would benefit from active management, said Christian Magoon, founder and CEO of Amplify Investments LLC. Amplify manages $4.8 billion in 11 ETFs.

"Can you really create a set of rules and constraints that deliver the exposures that the theme requires?" Mr. Magoon asked.

For example, Amplify chose a fully transparent active ETF structure for its cannabis and blockchain-related offerings, "giving more flexibility to the manager, particularly in buying new issues," Mr. Magoon said. "You don't want to be caught in an indexed approach where you might have to rewrite the rules every time a new use case emerges or a company enters the market for that particular innovation," he said. "You also don't want to have to wait for the next index reconstitution."

"As an issuer, the worst thing you can do with a thematic product is have it lack purity," Mr. Magoon said.

Despite the competition in many areas of thematics — cannabis, clean energy, infrastructure, water, blockchain — the products are generally priced significantly higher than plain-vanilla index funds or even smart beta ETFs. They are competing with, or are, actively managed funds and may have a more expensive subadviser or index fee. The median expense ratio for thematics tracked by FactSet is 0.6%, compared with less than 0.1% for several of the largest traditional index products.

FactSet's Ms. Gregson doesn't see the fee war that has rocked traditional index funds being as relentless within thematic ETFs. "I believe investors will pay slightly more for this specialized take in the equity markets," she said, "and it's still lower than traditional active management."

Scanning the names of some of the thematic funds, it may seem like the Wild West, but U.S. Securities and Exchange Commission rules help to serve as guardrails. First, funds have to test for diversification among holdings or state that they may not be diversified. Second, the funds must comply with the SEC's names rule that requires at least 80% of a fund's assets be aligned with the objective stated in its name.

Amplify's Mr. Magoon said that generally means a stock holding must derive at least 50% of its revenue from the stated theme or be at the top in market share. This explains why large-cap technology companies are not as prominent as small and midcap pure plays in some innovation-focused ETFs, he said.

For example, Amazon is only 1.8% of Amplify's Online Retail ETF, compared with 4% of Global X's EBIZ. And, as with most ETFs beyond the larger, staid index products, composition and concentration can vary significantly across thematics with similar sounding names.