Stay informed with free updates
Simply sign up to the Exchange traded funds myFT Digest — delivered directly to your inbox.
The vast majority of thematic exchange traded funds, which have enjoyed a surge in popularity with investors this year, have underperformed broad market benchmarks, new research commissioned by the FT can reveal.
Only 20 per cent of thematic ETFs beat their index and on average they trailed the wider market by 8.5 percentage points over the past five years, according to data provider Morningstar, as investors tend to buy too late into overvalued, hyped markets.
ETFs are a basket of investments, usually made up of shares or bonds that track a particular index, such as the FTSE 100. Thematic ETFs, which have seen big inflows this year, are made up of stocks or bonds focused on a particular theme, such as defence, AI or cannabis.
Morningstar compared the performance of every thematic ETF against market benchmarks, such as the MSCI All Country World Index for global portfolios or the S&P 500 for more US-focused ones.
“The results are damning,” said Bryan Armour, director of passive strategies research, North America at Morningstar.
“The chasm between thematic ETF and market returns is in part due to performance chasing by asset managers. New products are often launched after the theme has started to take hold and the rosy outlook is already priced in,” he added.
Many thematic ETFs also have a short lifespan, closing down if assets dwindle once the bubble has burst. Morningstar’s data shows 138 closures in the past 18 months, outstripping the 88 launches.
The poor performance prompted Vanguard, the world’s second-largest asset manager and one of the biggest providers of ETFs, to warn that these thematic funds could hit the reputation of this rapidly growing market.
“We don’t want collateral damage to what has been an increasingly successful investment tool,” said Mark Fitzgerald, head of product specialism at Vanguard.
“ETFs have delivered hundreds of billions, if not trillions of dollars of benefits to investors globally. Let’s be very careful about what we put into these vehicles because we don’t really want anything that might tarnish the reputation of them.”
A key criticism of thematic funds is that they tend to launch to tap into excitement around a “hot” investment theme, such as the metaverse, cannabis, or beneficiaries from Covid lockdowns.
However, by the time they launch, this excitement may already be baked into share prices, meaning ETF investors are often buying overvalued stocks, increasing the risk of losses.
The cannabis theme was ignited by hopes of strong secular growth after it was legalised in Canada and some US states in 2018 and 2019.
But cannabis ETFs have underperformed the wider market by an average of 39 per cent a year over the past five years, Morningstar found, and 13 have closed since 2023.
A host of other themes have seen annualised underperformance of at least 10 per cent, including life sciences, wellness, food, nanotechnology, battery technology and cloud computing.
Defence ETFs have generated by far the best returns, with annualised outperformance of 12 per cent per year.
Fitzgerald was also critical of the poor survival rate of ETFs. “We want to build enduring products that will serve you for decades. When we look at thematics, the performance doesn’t seem to be particularly compelling and their ability to survive doesn’t seem to be particularly compelling, so basically what are they for?” he asked.
Armour said potential investors should ask themselves whether a theme is durable, if share prices are fair and whether or not a particular ETF is the best way of expressing that theme.
However, Todd Rosenbluth, head of research at TMX VettaFi, a consultancy, said he “strongly believed that thematic ETFs have a place in a portfolio”, although only as a small weighting.
“It’s an opportunity to target an investment idea and get amplified growth opportunities, but in a diversified format,” he said.
“Not all parts of your portfolio are going to perform in line at the same time. You want to have a truly diversified portfolio and multiple areas that can drive performance.”