The use of exchange-traded funds (ETFs) is increasingly popular and one of the fastest growing sub-sectors is thematic ETFs.

Globally, thematic ETFs increased by 80% in the last year from US$25Bn to just over US$45Bn.

One of the most written about thematic ETFs last year was the medical cannabis ETF, so perhaps thematic ETFs can be said to be growing like weeds.

However, investing for the long term is difficult enough as it stands and investors should not be distracted by thematic ETFs.  

Investors should stick the core building blocks of a diversified portfolio such as the FTSE 100, the S&P 500 and the main bond ETFs.

Get these elements right and you should not need to stray into thematic ETFs, which are expensive and represent unrewarded risk.

The reason so many thematic ETFs are coming to market is because they are highly profitable for the fund management company if they strike the right note. They typically cost around 0.5% compared to core ‘building block’ ETFs which can be bought for around 0.1% or less.

The thematic ETFs typically hold as many familiar stocks as the core building blocks and cost as much to run, but the fees are multiple of the core building block ETFs.

There is for instance a Vegan Climate ETF (NYSEARCA:VEGN) available, which sounds like it might be an interesting theme, but cut it open and inside the largest holdings include Tesla, Microsoft, Apple, Visa, and Alphabet (Google). Dig around in the entrails of the ETF and you will see by design this ETF looks like and tracks the S&P 500 very closely except the fee for being Vegan is 0.6%, about 10 times more expensive than a core S&P 500 ETF.

Similarly, many investors might be surprised to find that the largest stock in two medical cannabis ETFs is Scotts Miracle-Gro, best known for manufacturing Baby Bio, the plant food you may have at home. Dig a little deeper and the only profitable companies in these ETFs include a compost company and a property company. Many of them do not have much to do with medical discovery and treatment.

I do not want to pick on these thematic ETFs, but it is generally true that most thematic ETFs are made up of padding.

ETFs need to be easy to buy and sell and to do that ETFs need to hold large, liquid stocks.

Many of the new economy themes you might want to invest in are in their early stages and the stocks involved are frequently small, illiquid and far between.

The ETFs therefore need to pick up on areas only loosely related to the headline theme.

A lot of thematic ETFs are in exciting, fast growing areas like cyber security, battery technology or technologies of the future. Investors should be able to sense that they fast growing areas offer little in the way of diversification and will be risky and volatile.

There is a clean energy ETF that rose 140% last year which sounds great, although a check of transactions shows that most investors invested late last year or early this year as they chased this fashionable new area.

Unfortunately for those late investors the ETF has dropped 35% since its peak in January, illustrating the risk of being dedicated followers of fashion.

The issuers of thematic ETFs are aimed at small investors who want to add a little bit of value. Unfortunately, this is not always the case, investors often buy the same old stock just repackaged under a different name, priced at a higher fee.

I would argue that if you want to have a flutter on thematic ETFs do so with caution, but I would also say that when the lockdown ends, that if you want a flutter, you are probably better off going to Ascot or Cheltenham. You will be outdoors and I hope you have more fun.

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