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An agricultural technology ETF, which could invest in small-cap companies using drones or robots to assist in farming, could be another potential new theme, says an expert.Jeff McIntosh/The Canadian Press

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Thematic exchange-traded funds (ETFs), which have seen dramatic growth over the past decade in North America, are poised to explode in popularity in the coming years.

These funds, which focus on market niches versus traditional industry sectors, have been the playground for smaller, start-up firms. But giant asset managers now want a bigger slice of this pie, which still only makes up about 2 per cent of total equity ETF assets in Canada and 2.6 per cent in the U.S.

New York-based BlackRock Inc., the global ETF leader known for its iShares passive index funds, recently signalled a more aggressive foray into “megatrend” thematic funds with the launch of its U.S.-listed iShares Emergent Food and AgTech Multisector ETF IVEG-Q and iShares Blockchain and Tech ETF IBLC-A.

In Canada, BlackRock recently introduced four thematic RBC iShares ETFs that are clones of existing U.S. funds. In January, BMO Global Asset Management launched a batch of ETFs, including five tracking “innovation” indexes developed with U.S.-based Ark Investment Management LLC. Ark founder Cathie Wood, a poster child for disruptive innovation ETFs, also runs funds sold by Emerge Canada Inc.

“It wouldn’t surprise me if, in the future, the absolute number of thematic ETFs comes to dominate” traditional core, passive index funds, says Daniel Straus, director of ETF research and strategy at National Bank Financial Inc.

There are currently 167 Canadian-listed thematic ETFs versus 177 passive market-capitalization and equal-weight funds, he says. In the U.S., there are 329 thematic offerings versus 598 market-cap and equal-weight ETFs.

Passive, core-index offerings will continue to have most of the assets, he says. Because it’s difficult to dislodge incumbents in that space, “any new fund provider is not going to bother trying and will instead come up with an original theme.”

Although the definition for thematic funds can vary, they typically focus on a subsector, such as cybersecurity, or multiple sectors, such as an infrastructure ETF holding everything from utilities to industrial and materials companies.

However, most of the recently launched thematic ETFs tend to have a technology or growth bent, while some older ones have concentrated on niches ranging from water infrastructure to shipping and airlines.

Investors typically own the ultra-cheap, passive, market-cap weighted ETFs for the core of their portfolio and add thematic ETFs for “the spicy sauce,” Mr. Straus says. “But thematic ETFs can be extraordinarily risky, so the position size is the important thing to monitor.”

For example, the high-profile U.S.-listed Ark Innovation ETF ARKK-A soared 157 per cent in 2020, but lost 23 per cent last year and is down 54 per cent so far this year. Technology-oriented stocks have been beaten-up amid rising interest rates.

The jury is still out as to whether the wild, roller-coaster returns in many thematic ETFs will make investors gun-shy, Mr. Straus says. “Longer term, I think that even as the markets go through a tough time, there will be some themes that will flourish.”

A potential new theme for ETFs could be energy storage, he says, because power from renewable resources such as wind and solar need to be harvested for use when needed. An agricultural technology ETF, which could invest in small-cap companies using drones or robots to assist in farming, could be another.

For investors spooked by volatile markets, themes benefiting from a recessionary environment and inflation could resonate, he says. That would include ETFs focused on natural resources, agriculture, as well as infrastructure, which could benefit from potential government spending to deal with a recession.

Themes that disrupt and lead to innovation

Steven Leong, director and head of iShares Canada product for BlackRock, stresses that the firm’s product launches are not driven as a “tactical answer to any particular set of market conditions.” However, there are already iShares ETFs focused on materials, agriculture, and infrastructure on its product shelf.

BlackRock’s recent thematic focus stems from a “megatrends framework,” Mr. Leong notes.

“There are five key foundational themes, which are long term and transformational in nature,” he says. “We are talking about themes that are potentially disruptive of business models … and can lead to important innovations.”

Those megatrends include technological breakthroughs, such as in cybersecurity and cloud computing; demographics and social change, which include areas like genomics because of longer lifespans, and rapid urbanization, particularly in developing countries, he says. Climate change and resource scarcity, as well as emerging global wealth, which is about the growing middle class in developing markets, are also themes.

Some of those trends are reflected in the recent Canadian launch of iShares Exponential Technologies ETF XEXP-T, iShares Global Clean Energy ETF XCLN-T, iShares Genomics Immunology and Healthcare ETF XDNA-T, and iShares Cybersecurity and Tech ETF XHAK-T.

These four ETF themes are not new for BlackRock as a firm, but are now being introduced to Canada because “we see that our clients are seeking these exposures,” Mr. Leong says.

Raj Lala, president and chief executive officer of Evolve Funds Group Inc., says the move by major firms to embrace thematic ETFs more enthusiastically is positive for the space.

“When advisors see the big, mainstream fund companies getting into the arena, they get a little bit more confident that these are solid, investible themes,” he says.

Evolve, which began offering ETFs in 2017, has more than one-third of its assets in thematic funds. The goal is to give pure-play exposure to long-term trends with the ETF holdings having little overlap with traditional indexes, he adds.

Mr. Lala says he sees thematic funds as a way for investors to express a view on a certain sector of the market, but he says he tends to use that term more with his firm’s disruptive innovation ETFs.

“I also think there is definitely a first-mover advantage,” he adds.

Evolve Cyber Security Index Fund CYBR-T, Evolve Automobile Innovation Index Fund CARS-T, Evolve Cloud Computing Index Fund DATA-T were the first ETFs launched in their niche in Canada, while Evolve Metaverse ETF MESH-T was tied for first mover.

Looking ahead to future opportunities

Given the market volatility, some advisors are thinking about buying the dip, but want to see more stability in the technology space, he says.

“I am not getting a ton of advisors asking about creating another disruptive technology-specific ETF,” he says.

Advisors who are dealing with risk in client portfolios are now expressing more interest in broad-based technology ideas with a covered-call strategy to generate income, he says.

“It’s something we are looking at. However, I am more focused on three years from now, and what will be the area or industries that will thrive … and create an investible opportunity,” he says.

“I am more than happy for us to launch products that may not be in favour today and that advisors may not be interested in looking at given the current market scenario, but where we see the strong growth.”

Mr. Lala adds that he is continuously looking at long-term themes such as 3D printing, geonomics and robotics.

“Those are interesting growth areas, as well as digital finance, that are going to reshape our world. That includes fintech, but also cryptocurrencies and the building blocks within the blockchain and non-fungible tokens – I put all of them into one category of digital finance,” he says.

“We haven’t fully decided where those big opportunities are just yet.”

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