Thematic ETFs plunge, taking down inexperienced investors

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In investing, a good story can be a dangerous thing.

Consider the rise and fall of thematic ETFs. These funds, which package an investable theme in a single tradable security, exploded in popularity through the pandemic bull market.

Hundreds of exchange-traded funds now cater to the trends of the moment, from working from home to decarbonization to the metaverse.

At the heart of each thematic ETF is a narrative that can be understood by even the most inexperienced investor.

“The problem with that notion is that just because you have a good story, it doesn’t mean that the pricing of the story is fair,” said Yves Rebetez, an ETF analyst at Credo Consulting in Oakville, Ont.

“The better the story is, the greater the likelihood that people will pile in at exactly the wrong time.”

The vast majority of thematic ETFs went on to suffer enormous losses as the bubble in risky assets popped last year. The average fund dropped by roughly 30 per cent in 2022, or nearly double the drawdown in the S&P 500 index.

Thematic ETFs have been around for more than 15 years, mostly to little fanfare, with early versions isolating agribusiness and water-based investments. A major flashpoint for thematics came after the federal legalization of cannabis in Canada in 2018. By September of that year, Horizons ETFs Management HXT-T had raised more than $1-billion in its marijuana-based ETF – the first such fund to hit the market. (Its shares are now trading nearly 90 per cent below the 2018 peak.)

But demand for thematic ETFs didn’t truly erupt until 2020 as the stock market was taking off. With interest rates at rock bottom and stimulus money flooding the financial system in the aftermath of the pandemic’s first wave, a trading frenzy took shape.

An army of retail investors flocked to discount brokerages and were quickly emboldened by astronomical gains in the market’s hottest themes. It started with pandemic beneficiaries and eventually spread to cryptocurrencies, financial technology and automation.

The colossus of thematic investing, however, was the ARK Innovation ETF ARKK-T, led by star stock picker Cathie Wood.

“She had a very well-articulated framework, identifying several megatrends and disruption waves that she saw as justifying leaving behind all of the old stock indices and going full tilt into actively managed themes,” Mr. Rebetez said.

ARK told a powerful story of disruptive technology that captivated investors. A 150-per-cent return posted by the flagship fund in 2020 bestowed Ms. Wood with a cultlike status. She became known in South Korean investment forums as “Money Tree.” ARK even launched a merchandise line, including a baby onesie that read “Invest in the Future.”

Then the paradigm shifted. Inflation and aggressive rate hikes pummelled growth stocks and speculative assets. ARK’s main fund is down by 73 per cent since its peak two years ago.

It’s been a similar story for several other major thematic funds. The WisdomTree Cloud Computing ETF is down by 54 per cent. The Global X Robotics & Artificial Intelligence ETF has lost 40 per cent. And the reckoning in the cryptocurrency space, including the collapse of now-bankrupt FTX exchange, has crushed the ProShares Bitcoin Strategy ETF to the tune of a 65-per-cent drawdown.

Thematic ETFs have fallen dramatically out of favour, with assets under management in the space totalling roughly US$85-billion as of the end of January, down from a peak of more than US$140-billion in late 2021, according to Global X.

That’s hardly a surprise given the experience of the average investor.

Purpose Investments took a look at the largest thematic ETFs that have been on the market for at least four years. The average price performance for the group isn’t bad at all – about 10 per cent a year. But when you factor in the timing of when investors piled into those funds, the return realized by the average investor is closer to 1 per cent.

Considering that roughly half of all flows have come into thematic ETFs when their prices are near peaks, it’s “not surprising the investor experience has not been ideal,” Craig Basinger, chief market strategist at Purpose Investments, wrote in a report.

The lesson: Pick your entry point, and know when a theme has become overhyped.

“Even if the thematic trend is a long-term secular change and you believe deeply in the theme, thematic ETFs should not be used with a ‘buy-and-hold-forever’ mentality,” Mr. Basinger said.