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Thematic investing

  • Wiley Global Finance WILEY GLOBAL FINANCE
  • Exchange-Traded Funds
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Thematic investing is an interesting category of exchange-traded funds (ETFs). These ETFs represent unique, a little quirky, and sometimes expressive investment strategies. These funds make a statement. Some say “We are environmentally friendly”; others say “We can get you to a secure retirement”; and still others say “We know a new way to beat the market.”

Whatever the ETF’s message, it is sure to be different from that of ETFs that follow benchmark indexes. Every special equity ETF is based on a strategy index, and that alone makes a statement: higher fees. The expense ratios of special equity ETFs are about three times higher than the average ETF tracking a benchmark index. Although the costs are high compared to other types of ETFs, special equity ETFs are still only half the cost of comparable open-end mutual funds with similar investment strategies.

Overview

Thematic investing follows certain social, economic, corporate, demographic, or other themes that are popular in society. The opportunity comes when more people believe in the same themes and investment is driven in the direction of these companies. The shift of capital ultimately could drive superior performance in a thematic portfolio if the companies in the indexes benefit from the business.

Thematic investing is controversial. Its advocates say it is an effective strategy because it concentrates securities in an idea that is still misunderstood and underappreciated in the marketplace. Those companies involved in the theme will exhibit better-than-average returns as more investors realize their potential and money is moved into that sector. Critics see these types of strategies as marketing ploys designed to attract fast money from the public rather than as viable long-term investments. Those critics say the funds harm investors by encouraging them to chase the latest fad, usually too late.

We all remember the Internet stock bubble of the late 1990s. Dozens of newly hatched technology and aggressive growth funds pulled in billions of investor dollars. The inevitable bubble burst took down a huge number of individual investors. At the same time, mutual fund companies quietly closed their high-octane tech funds and went on to the next trend.

In my opinion, there is a little of both going on in thematic investing. There is no doubt that many performance-chasing funds are launched in the ETF industry solely for the purpose of gathering hot money. There are also some genuinely interesting ideas that may have long-term viability.

Environmental ETFs

Companies that clean the environment and those that are in environmentally clean businesses are very popular themes with investors. Several ETF companies offer interesting investment opportunities around that idea. Many indexes are focused on clean water, clean energy, clean air, and companies that are environmentally friendly. All the clean index providers approach the subject differently, and investors must takes work to figure out which indexes are the cleanest by their own standards.

Some of the indices around which ETFs are built, include: the WilderHill Clean Energy Index, which tracks the clean energy sector; the Light Green Eco Index, which is designed to identify companies with the best combination of environmental performance trends in their respective businesses; and the Ardour Global Index, which includes the stocks of 30 publicly traded companies engaged in the entire chain of alternative energy production, including alternative energy fuels and resources (solar, wind, biofuels, water, and geothermal), environmental technologies, energy efficiency, and enabling technologies.

Socially responsible ETFs

Some investors have a moral dilemma with the products some companies make or the businesses they are in. Rather than selecting companies to invest in, socially responsible indexes attempt to gain broad equity exposure while excluding companies that do not pass certain social criteria tests. Examples of screens include eliminating companies in the tobacco, alcoholic beverages, and pornography industries. In addition, socially responsible screens may extend into labor practices, human rights, and animal rights.

Different index providers have different views as to what they believe is socially responsible and those views are constantly changing. For more information on social indexes, including a list of filters used by each provider, visit www.ussif.org. Two examples are:

  • The KLD Select Social Index, which evaluates the social and environmental performance of companies in the universe by analyzing community relations, diversity, employee relations, human rights, product quality and safety, the environment, and corporate governance. Companies are scored based on these factors. An optimization process is used to determine index holdings and weights. Companies with high scores in the index have higher weights, and companies with low scores have lower weights.
  • The KLD Domini 400 Social index. The index methodology starts with the Standard & Poor’s (S&P) 500 Index as its core universe and adds to it 100 non-S&P companies chosen for sector diversification and market capitalization. An additional 50 companies are added that KLD believes exhibit exemplary social and environmental records. Companies involved in alcohol, tobacco, firearms, gambling, and nuclear power are excluded. Military contractors are also excluded. Companies that do not meet KLD’s financial screens (market capitalization, earnings, liquidity, stock price, and debt-to-equity ratio) are also ineligible for inclusion.

Corporate action ETFs

Corporate actions are the decisions made by the board of directors that affect the structure of a company. One company might go public in an initial public offering (IPO) while at the same time two other companies are merging and another is going private in a buyout. The dynamics of corporate actions make for some interesting indexes and ETFs. Examples include:

  • The U.S. IPOX-100 Index is a rules-based, value-weighted index measuring the average performance of U.S. IPOs during the first 1,000 trading days. Index constituents are selected on the basis of proprietary quantitative screens. The index is capitalization weighted, with a cap of 10 percent on any issue. Without the constraint, Google would have dominated that index.
  • The Share Buyback Achievers Index, which is designed to track the performance of companies that are incorporated in the United States, trade on a U.S. exchange, and must have repurchased at least 5 percent or more of its outstanding shares for the trailing 12 months. The portfolio is rebalanced quarterly and reconstituted annually.
  • The Sabrient Insider Sentiment Index. The objective of the index is to actively represent a group of stocks that reflect favorable corporate insider buying trends (determined through the public filings of such corporate insiders) or Wall Street analyst earnings estimate increases.

There are a variety of other specialized ETFs that track a particular theme, such as water resources or global infrastructure. Typically, thematic funds try to capture a social or economic dynamic that has garnered investor attention. The issue investors must decide is whether a particular theme is transitory or enduring.

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Article copyright 2011 by Richard A. Ferri. Reprinted and adapted from The ETF Book: All You Need to Know About Exchange-Traded Funds, Updated Edition with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint
The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

Exchange traded products (ETPs) are subject to market volatility and the risks of their underlying securities which may include the risks associated with investing in smaller companies, foreign securities, commodities and fixed income investments. Foreign securities are subject to interest rate, currency-exchange rate, economic and political risk all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector are generally subject to greater market volatility as well as the specific risks associated with that sector, region or other focus. ETPs which use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses and tracking error. An ETP may trade at a premium or discount to its Net Asset Value (NAV) (or indicative value in the case of ETNs). Each ETP has a unique risk profile which is detailed in its prospectus, offering circular or similar material, which should be considered carefully when making investment decisions.

Currency ETPs are generally more volatile than broad-based ETFs and can be affected by various factors which may include changes in national debt levels and trade deficits, domestic and foreign inflation rates, domestic and foreign interest rates, and global or regional political, regulatory, economic or financial events. ETPs that track a single currency or exchange rate may exhibit even greater volatility. Currency ETPs which use futures, options or other derivative instruments may involve still greater risk, and performance can deviate significantly from the performance of the referenced currency or exchange rate, particularly over longer holding periods.

Commodity ETPs are generally more volatile than broad-based ETFs and can be affected by increased volatility of commodities prices or indexes as well as changes in supply and demand relationships, interest rates, monetary and other governmental policies or factors affecting a particular sector or commodity. ETPs that track a single sector or commodity may exhibit even greater volatility. Commodity ETPs which use futures, options or other derivative instruments may involve still greater risk, and performance can deviate significantly from the spot price performance of the referenced commodity, particularly over longer holding periods.

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