Here is the Problem with Thematic ETFs
And how not to construct a Luxury ETF
Exchange-traded funds (ETFs) come in all shapes and sizes. The traditional low-cost, broad-index ETF would be vanilla-flavoured if it were an ice cream. So-called “smart beta” ETFs employ rules-based systems, conceived to outperform traditional market-cap-weighted index funds. Industry and sectoral ETFs are like the little cousins of the broad-index ETF; still pretty vanilla but more niche in their selection. Equities, corporate bonds, government bonds, derivatives, commodities, macro data series, passive, active… There is an ETF for everything. In plain English, an ETF is set up to achieve a goal and that goal is typically exposure to a basket of securities that relate to a specific market, characteristic, strategy, asset class, or theme. In return for the construction of this ETF, issuers and/or managers are paid a small fee.
Thematic ETFs are one of the best demonstrations of the notion that financiers will literally build anything if they think investors are going to pay for it. Contrary to a mundane sectoral ETF which may cover everything that falls under the "energy” umbrella, a thematic ETF will invest in specific themes or prevailing trends. Themes like cloud computing, innovation, merger arbitrage, momentum, 3D printing, artificial intelligence, or luxury. Cathie Wood’s ARKK, a collection of “innovators” is a prominent example. Between 2020 and the fund’s peak AUM of $28.2 billion in February 2021, ARKK generated $15 billion in cumulative inflows. The fund is a little smaller these days.
There are inherent ironies in a thematic ETF. To capture the benefits of a rising trend, you need to get in at the ground floor; i.e., be early. By the time someone has constructed a financial instrument to express that theme, it’s likely already had its 15 minutes of fame. While the upside can be explosive when it works, the odds are usually stacked against the investor in a thematic ETF.
In essence, you are relying on; the theme being a winner, the fund being able to capture the benefits of that theme via its security selection, and the theme being nascent enough that it has not already been priced in amongst the representitive assets. It should come as no surprise that these ETFs typically miss the peak of their theme. Issuers tend to create thematic ETFs when the theme is at peak popularity. Investors, therefore, tend to buy thematic ETFs when they are at their peak and sell them at their trough. Usually, by the time it feels like a compelling enough opportunity to construct an ETF around a theme, it’s because it’s already popular. The chances of it being overvalued… is therefore higher.
“According to the academics Itzhak Ben-David, Rabih Moussawi, Francesco Franzoni and Byungwook Kim, the very worst time to buy thematic ETFs, which hold shares that follow a popular investment trend or theme, is when they launch. That is principally because the funds tend to launch just after the peak of their theme, and immediately before a steep fall in returns.
Emma Boyde, Financial Times, 20221
Kenneth Lamont, senior research analyst at Morningstar, suggests that “thematic fund launches are clearly a bull market phenomenon”, and remarks that “history tells us that the majority of those new funds won’t survive long enough to fully capture their chosen theme”. He is correct. Even if a fund identified a theme that would not fade into obscurity, one that would remain relevant, these ETFs have dreary survival rates. Morningstar shows that just 45% of funds launched before 2010 survived long enough to see 2020.
Even if you picked a fund with a winning theme, you could still fail to capture the returns if that fund is not well placed to harness that theme. More on that later, but the evidence shows these ETFs have grown in popularity over time.
Morningstar data indicates that the global AUM of thematic ETFs grew to ~$195 billion by the end of 2019. While this represented just 1% of total global equity fund assets, it’s up from 0.1% in 2009.
Not So Luxury
For the last few years, I’ve been studying luxury businesses. I have yet to pick up any material exposure in the space. There are a few names I am biding my time with but that’s another story. What caught my eye recently was Roundhill’s new Global Luxury ETF, LUXX. Having a look under the hood of their new thematic ETF was the impetus for this essay; because it’s so terrible.
The word “luxury” is defined as a state of great comfort or elegance, especially when involving significant expense. When “luxury” is used as an adjective, it implies that the noun it describes is luxurious by nature. In economics, a luxury good is one for which demand increases disproportionately as income rises; in other words, as prices rise, people desire it even more. In stock market terminology, the terms “luxury brand” or “luxury company” refer to companies that sell luxury goods. Genuine luxury businesses are sought after because they tend to be resistant to inflation and recessions due to their pricing power, fat margins, and affluent, price-insensitive, customers.
The problem is that “premium” and “luxury” are often used interchangeably. While I gather there is a level of subjectivity baked into these terms, products like Tesla, Lululemon, Ralph Lauren, and Nike, are not luxury. If your everyday Joe can afford one, it’s not a luxury good. Sleepwell Capital explains the levels of luxury well in this excerpt from his essay “All Hail King: How Rolex Exemplifies a True Luxury Brand Like No Other”2.