There seems to be a large quantity of ETFs being launched that are marketing themselves as “thematic” ETFs. It’s a moniker that is easily applied to any grouping of stocks that previously did not have their own ETF. However, one person’s theme can be another person’s niche industry.
What defines a theme-based ETF? There is no definitive answer, and they tend to fall into the “I’ll know it when I see it” category. Since I create and maintain my own database of ETFs, I tend to put a little more rigor into the process. Today, I will outline my thought process.
I start with the Global Industry Classification Standard (“GICS”), which classifies each stock into 11 major sectors, 24 industry groups, 68 industries, and 157 subindustries. If all of the stocks in an ETF fall into the same sector, then it is obvious it is a sector ETF. Likewise, if all (or more than 90%) fall into the same industry group, industry, or subindustry, then by definition they are also in the same sector. With 157 different subindustries classified in the GICS, some may sound obscure, and an ETF targeting one of these industry niches could easily be mislabeled a theme.
For me, a thematic ETF is one that targets an identifiable area of the market, and its holdings cross sector boundaries. Investment themes have been around as long as there have been investments. However, early ETFs were all based on established broad market, sector, and country indexes. The iShares North American Natural Resources ETF (IGE) was the first thematic ETF available to U.S. investors. Although its holdings are narrowly defined, they do not fit neatly into one sector. Instead, it and other natural-resource funds hold stocks that are classified as members of the Energy, Materials, Industrials, and Consumer Discretionary sectors.
Natural resources could probably be its own sector, but it’s not. Infrastructure and agriculture are two other themes that cross multiple sectors, and one could argue that perhaps they too deserve their own sector. Along those lines, I place these three well-established themes into their own pseudo-sectors.
Guggenheim Defensive Equity (DEF), launched in 2006, is a classic example of a thematic ETF. It holds a portfolio of stocks from sectors that have historically outperformed in down markets. Its largest sector weightings include Financials, Utilities, Consumer Staples, and Telecom. Other themes include private listed equity, “real” inflation-adjusted returns, rising interest rates, “wide moat” competitive advantages, and contrarian opportunities.
ETFs targeting merger and acquisition activity, spin-offs, stock splits, and insider buying might be classified as thematic ETFs by some investors, but I do not. Instead, I classify these corporation action groupings as event-driven ETFs. I’m not saying one is right and the other is wrong; it is just a different classification method.
This year has seen a surge of ETFs expressing new themes. Generational and demographic themes such as millennials and aging definitely cross sector boundaries. The names of many new offerings sound like they might belong to niche industries in the Health Care sector, but themes such as health and wellness, long-term care, and obesity can easily include stocks from the Real Estate, Consumer Discretionary, and Technology sectors.
Drones, 3-D printing, robotics, and the “Internet of Things” can encompass Industrials, Materials, and Technology stocks, making them thematic ETFs even if it sounds like they might belong to just the Technology sector. HealthTech and FinTech are two emerging areas of the economy. Their names suggest that they cross sector boundaries, which would imply that they cannot be classified as sectors, and are therefore themes by default. An analysis of their portfolio holdings shows this is in fact the case. However, Morningstar does not have a theme classification, so they usually force-fit them into one of their sector classifications.
The recently launched Spirited Funds/ETMFG Whiskey and Spirits ETF (WSKY) may sound like a thematic ETF, but distillers, vintners, brewers, and soft drinks are all subindustries within the beverages industry. The beverage industry is part of the food, beverage, and tobacco industry group of the Consumer Staples sector. You can call it whatever you want, but it seems clear this ETF fits neatly within the GICS sector and industry structure.
Don’t get hung up on ETF names and classifications. No two methodologies are the same, and they are just ways of helping you understand the exposure each product provides.
Health Care dropped three places to 10th on weakness in biotechnology, and Energy relinquished its top spot on selling in the exploration and production segment. Technology regained its status as the top-ranked sector, a position it has held for 10 of the past 11 weeks. However, it lost momentum in the process and will have to work to hold this position. Financials kept its third-place position, and it is one of only three sectors still in the green. Higher-yielding sectors were the only ones to improve their momentum scores this week. Telecom, Consumer Staples, and Utilities all climbed higher as a result. Real Estate was also a beneficiary of this shift to higher yield, but the gains were not enough to move it off the bottom of the rankings.
The style categories are mostly directionless at this time. None of them are more than seven points away from the zero line, and five are within a single point. Although the absolute moves were not large, five more categories flipped from green to red. The cartel of small-capitalization categories has split apart. The foursome dominated the style rankings for more than three months, but Small-Cap Growth broke ranks and fell to ninth this week. Moving up to third place, squeezed among the remaining three small-capitalization segments, is the unlikely intruder of Mega-Cap. However, given the tight compression of momentum scores and the market’s defensive shift over the past week, this is not too surprising.
Latin America did much more than just hold on to its top ranking; it also put a huge 28-point margin between itself and second-place China. The global rankings are displaying much more dispersion than either the sector or style rankings, which indicates global action is where the most opportunity for outperformance currently resides. China is no slouch in second place, but the race is tightening for the next four categories. Emerging Markets, Pacific ex-Japan, Canada, and Japan are within three points of each other and are the last of the six global categories still in the green. Canada surged from last week’s 10th-place position to join this group today, as currency gains worked in its favor. The Eurozone, World Equity, U.S., and EAFE all slipped slightly into negative momentum territory. A week ago, the U.K. was the only global category in the red. It is on the bottom again this week, and its downtrend has steepened.
The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.
“The thematic stuff is clogging the system. Are there too many thematic ETFs in the marketplace with low levels of assets, with very dim prospects of pickup? That’s the question the industry should ask.”
—Reggie Brown, senior managing director at Cantor Fitzgerald
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