What to know about thematic ETFs before adding them to your portfolio
Thematic ETFs (exchange-traded funds) have popped up from investment providers left and right in the past few years, launching products that mirror the headlines: a flurry of Defence ETFs after governments announced increased defence spending, and AI ETFs as ChatGPT excitement bubbled. But these products' strengths can just as quickly be their downfall when an investment fad goes out of fashion.
To understand if a thematic ETF could fit into your portfolio, it’s vital to understand what they really are. These are products that will track a particular sector or investment idea. This lets investors gain extra exposure to that area instead of having to select individual stocks or a broader fund. Thematic ETFs tend to be passive, meaning they track an investment index. But instead of a broad index, such as the MSCI World, it will focus on one area, such as the MSCI World Health Care index.
Confusingly, these are different from another type of fund that can also be referred to as thematic, where the investment strategy and holdings change based on what themes the managers identify as strongest at the time.
Why are there so many thematic ETFs?
Thematic ETFs can be a very beneficial product for their investment providers. They don’t cost much to launch and are easy to close if they don’t curry investor favour. If the theme does take off, being one of the first providers to offer it can mean a significant influx of assets, and a big payday for the company.
This means that many thematic ETF providers launch products as quickly as possible and aren’t necessarily trying to discern between themes that will be long-lasting or a shorter fad. When countries committed to increase defence spending within NATO in 2025, a flock of defence ETFs were launched within weeks. More recently, the listing of Space X led to an influx of space-focused ETFs.
It’s a low-risk approach for the companies creating the product, but it isn’t a low-risk approach for investors. The ETFs can often be feast or famine: the stocks held in the ETF could take off, leading to a period of high returns, or just as easily flop when the theme goes out of style.
Separating fads from transformations
Investors who do take on the thematic approach will need to be cautious of if a theme is here to stay, or if the ship has already sailed.
Some products are extremely niche, like Allianz’s Pet and Animal Wellbeing. Others invest in more familiar areas but are still prone to market cycles. Defence ETFs can fall into this category, as people would likely be less keen to invest in defence companies if conflicts started to end and countries were spending less on defence.
But some themes feel a bit more solid. Tech has experienced a long-term shift leading to years of strong returns for investors. Similarly, health care and energy are well-established sectors that have been able to attract investors over decades.
Still, none of these sectors are immune to market volatility, and they can experience serious downturns. Thematic exposure is typically better off being used as a satellite holding than a core part of the portfolio. This way, investors have the opportunity to benefit from fast-growing areas of the market, but don’t run the risk of running their portfolio into the ground if the investment isn’t all it’s cracked up to be.
Do AJ Bell funds use thematics?
We would not call any of the holdings in the AJ Bell funds ‘thematics’, but we do hold some sector-focused funds in the US part of the portfolio that centre on health care, utilities and energy.
The choice to invest in these areas wasn’t based on them rising as investment trends. Instead, it was based on investing in areas of the market we saw to be undervalued, or where we could add diversity. Some broader indices, like the S&P 500, can already have significant exposure to a single sector, like tech. Adding other individual sector exposures can even out that index weighting.
This isn’t a staple of the portfolio, and at many points the AJ Bell funds have not held any individual sector exposure. It can be a useful tool for diversification and market valuation when used sparingly, but investors will need to be prepared to make judgement calls on when it’s time to exit. If you’re seeing the theme everywhere, chances are the market has already priced it in.
Choosing a thematic ETF
Those interested in investing in a thematic ETF will need to determine how it fits in with the rest of their portfolio. AJ Bell customers can use the x-ray tool to see which sectors they feel they could add exposure to.
Like any other tracker fund, it’s important to understand what index the thematic ETF is tracking. They may hold companies across the globe, or only in the US. And some themes, like sustainability, can span across different sector allocations. You can use the Morningstar reports on the ETF Screener to get a feel for what is in the ETF you’re considering.
It’s also important to be aware that some thematic ETFs won't have many holdings and could have heavy weightings towards just a few companies. ETFs that track an index don’t have the same diversity standards, requiring a certain number of holdings and limits on weighting, that other funds often have.
Check to ensure the product you choose is also in the currency you want. Some ETFs will only be offered in terms of USD instead of GBP, meaning you take on currency risk on top of the market risk. Finally, watch out for high fees. While traditional ETFs have all gathered to a relatively low fee point, there’s still quite a bit of diversity on fees for thematic ETFs. Make sure you’re getting a good deal for the product you’re being offered by comparing it with similar options.
Thematic ETFs can play a helpful role in portfolios and have the opportunity for high growth if they are caught at the right time. But they require some savvy investing, and monitoring to ensure you've not found yourself hanging on to a theme that everyone else has moved on from.
Ryan Hughes: Managing Director of AJ Bell Investments
Ryan Hughes is AJ Bell's Managing Director of AJ Bell Investments. He joined AJ Bell in 2016 as Head of Fund Selection before moving on to become Head of Investment Partnerships and later, Investments Director...