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Are thematic funds mislabelled?

Understanding the portfolio behind a theme
Are thematic funds mislabelled?

Is Netflix (US:NFLX) a space exploration company? Investors could almost be forgiven for thinking so, given its inclusion in the recently launched Ark Space Exploration and Innovation ETF (US:ARKX).

Cathie Wood's (pictured) latest, hotly anticipated active ETF includes a number of names already associated in one way or other with space exploration, from Kratos Defense and Security Solutions (US:KTOS) to L3Harris Technologies (US:LHX), Virgin Galactic (US:SPCE) and Lockheed Martin (US:LMT). But Netflix is just one of the fund’s initial holdings to cause some head scratching: e-commerce and tech giants (HK:9618), Amazon (US:AMZN), Alphabet (US:GOOGL), Alibaba (HK:9988) and Tencent (HK:0700) all made the list, as did another Ark fund, The 3D Printing ETF (US:PRNT).

Some possible explanation has been provided, both by Wood and others. But the portfolio does raise broader questions about whether thematic funds are correctly labelled and the level of research required before buying in.

Why put in a space ETF?

To start with the Ark ETF, the unusual nature of some holdings can partly be explained by its relatively broad remit. The investment team has defined space exploration as “leading, enabling, or benefiting from technologically enabled products and/or services that occur beyond the surface of the earth”. The fund looks for orbital and suborbital aerospace companies but also targets those involved in “enabling technologies” such as robotics and 3D printing. It will also focus on businesses whose operations “stand to benefit from aerospace activities” in areas such as agriculture, internet access, imaging, drones and air taxis. Similarly, Wood recently told industry publication that had warranted a place in the fund because it has “one of the most sophisticated logistics companies using drones, especially to help with supply chain management”.

Nevertheless, the fund may seem less closely focused on the space theme than rivals such as the Procure Space ETF (US:UFO). It would likely not be the only thematic fund prompting raised eyebrows.

The issue of 'early' thematic funds

We have previously highlighted a concern that thematic ETFs can launch just as a trend and the factors driving it are peaking, setting investors up for disappointing returns. While some funds avoid this by focusing on nascent themes and industries, that can cause problems of its own which may explain the presence of the tech giants in Ark’s latest offering.

Putting it simply, funds can launch before the target industry is mature, meaning that while the investment case may be there, there are not yet enough companies in existence that fit directly enough into the relevant theme. On top of that, many of the most relevant companies may be small, creating concentration issues if the ETF itself attracts large sums of money and ends up having too big a stake.

Peter Sleep, senior portfolio manager at 7IM, notes that funds may seek “filler” in the portfolio to solve both problems. “The more specific the theme, the more likely the ETF is to have filler to bulk it out or companies that are only tangentially related to the theme,” he notes.

“To some extent this is necessary as many of the themes are targeting start-up industries with small companies and the ETF needs large, liquid names in the index so it can trade.”

This is a sensible approach, and means that investors may have to hold off or simply exercise patience until an investment manager or index provider can find more obvious holdings to fit a fund's themes. But it reminds us that the investment cliché of “looking under the bonnet” still holds weight.

Try before you buy

It’s not uncommon for ETFs to hold companies that may not correspond to an investor’s idea of a specific theme. As with Ark's new fund, HAN ETF co-chief executive Hector McNeil talks of blockchain ETFs that effectively act as “space holders” waiting for a nascent sector to grow. “Lots have held Mastercard (US:MA)Goldman Sachs (US:GS) and Microsoft (US:MSFT). They were possibly the only listed companies at that time [fitting the theme],” he says.

Thematic fund holdings may appear loosely related to the premise, or simply not meet investor expectations. Sleep has previously spoken of medical cannabis ETFs that hold some fertiliser company shares, while Nutmeg chief investment officer James McManus notes that the inclusion of “traditional” automakers like Ford Motors (US:F) among the iShares Electric Vehicles and Driving Technology UCITS ETF (ECAR) top 10 holdings “seems to surprise people”.

With thematic investing it can be especially important to consider your vision of how best to play the trend, and contrast this with the fund’s holdings. Even simple sector preferences may catch some investors out: one name, the iShares Ageing Population UCITS ETF (AGED) has a heavy focus on healthcare stocks, as some might expect, but it also has some 40 per cent of its assets in financials. Labels can be misleading.