This article on thematic ETFs is by The Lone Exchanger from Team Monevator. Come back every Monday for another fresh perspective.

Opening up his browser and heading to the ‘Funds’ page of his online broker, The Lone Exchanger felt like trying something new.

Navigating away from the relative safety of his All-World Tracker, he discovered a fresh and potentially exciting world…

Setting the stage

We know the drill by now for long-term financial independence. Budget effectively and put aside as much as you can in tax-efficient savings vehicles. Make a global index tracker fund the core of your strategy.

But where is the fun in that? In dutifully popping a portion of your hard-earned wedge into a slow and steady grower?

Surely the game played by these City types isn’t that complicated?

Well, flicking through the Monevator archives reminds us that over a ten-year period, more than 70% of professional fund managers failed to beat the market.

What chance do you or I have of doing better?

Not much.

But human nature is curious. Despite all the evidence that index funds are best for most – and that successful stockpicking is fiendishly difficult – there remains a temptation to try to beat the market to juice returns.

And as ever the financial world has stepped up to scratch that itch.

Theme-me-up, Scotty

While they’ve been around for well over a decade, ‘thematic’ ETFs have become much more popular in recent years.

The idea is that investors can easily put money into a fund which aims to track an index comprised of a subset of companies who share commonality around a certain theme.

As the name suggests, thematic ETFs offer investors the opportunity to actively invest in that specific field, or theme, without needing to buy lots of individual stocks themselves.

That makes thematic ETFs both similar to, and different from, so-called sector ETFs, which focus on a traditional industry sector, such as Banking, Retail, or Consumer Staples.

Companies held within thematic ETFs often track across different traditional sectors. For example, an ETF focusing on Robotics may contain one company focused on Artificial Intelligence (IT sector), another which manufactures industrial robots (Industrial sector), and one which provides automated surgical equipment (Healthcare sector).

Variations on a theme

There are at least a hundred such thematic ETFs now trading on European exchanges – and many more in the US.

Themes include ‘Ageing Populations’, ‘eSports & Gaming’, and ‘The Future of Food’. They are often focused on future perceived trends or fields.

In recent years, these thematic funds have become especially popular with younger investors who may have a higher risk tolerance – or a higher misunderstanding of risk.

The lowering (or elimination) of share dealing fees and the introduction of fractional share trading has also made it easier to allocate money towards such funds – and to trade in and out of them at will.

The following graph from Defiance ETFs shows the huge flow of funds into thematic ETFs since the start of 2020, compared to other ETF categories such as Financials and Energy:

Source: Defiance ETFs

Storming or performing?

Performance of thematic funds, as with any asset or sub-asset class, is difficult to gauge.

Picking different start dates can change the theoretical returns. And as most investors adjust their holdings over time – ‘dollar-cost averaging’ in at best or selling their winners at worst – the performance over fixed dates can be misleading.

The Accumulator was underwhelmed when he reviewed several popular thematic ETFs in his ten-year review in late 2019.

A deeper delve into thematic ETFs can also be found at The Evidence-Based Investor. Its conclusion was that thematic funds have put up market-beating returns on a 3-5 year timeframe. But they’ve done worse over ten years.

In addition, thematic ETFs were more volatile. That can impact returns over the longer term.

We also need to touch upon costs.

Many large passive ETFs that track broad stock indices have very low costs. Annual charges can be below 0.1%.

In contrast, thematic ETF providers may charge 0.4% or more. This sort of fee drag will dig into your returns over time.

Higher costs may be justified if the ETF is invested in tricky international stocks, or in small cap companies with limited liquidity. But often these ETFs buy large liquid companies listed on major exchanges.

In that case the higher fees charged will go straight into the pockets of the ETF’s management company and the associated index providers.

Risk or reward?

Many of the popular thematic ETFs are focused on the future, with funds often heavily exposed to growth-orientated technology companies.

In a world of relatively slow growth rates and low interest rates, these shares have done well recently due to their strong revenue growth figures and that ultra-low interest rate environment, which boosts the value of their future cash flows.

However if global interest rates start rising, it’s likely that there will be a hit to the valuations of such companies.

Furthermore, we need to be mindful of concentration risk.

If you purchase a broader ETF such as one tracking the S&P 500 in the USA, you have exposure to a mixture of sectors. This will include Financials, Energy, Retail, and Construction, as well as technology. If a particular sector struggles, others may pick up the slack.

In contrast, it’s likely most individual companies in a specific Thematic ETF will move in relative lockstep as there is little diversification. We saw that at the start of this year, when the iShares Clean Energy ETF plunged by around 30% in a couple of months as the sector fell out of favour.

Another consideration is that some companies included within a thematic ETF may have relatively small market capitalisations. This means they could end up being owned in large part by such ETFs.

Should investors’ preferences change and the ETFs get dumped, the funds in turn could be unloading shares in relatively illiquid companies. That could exacerbate share price movements to the downside, increasing volatility.

Holding on

It’s therefore important to look under the hood of a thematic ETF. At the least you should establish the number of individual holdings, and scan to see if anything interesting pops out.

You can do this by pasting the ETF name into a search engine and going to the provider’s website. There should be information on returns, any dividend yields, and exposures to regions and currencies.

As an example of what you might find, until recently the aforementioned iShares Clean Energy ETF only held around 30 companies. Compare that to a world tracker, which could hold more than 3,000. Clearly each individual company will have a far larger impact in the concentrated portfolio.

Furthermore, individual weightings matter. Do the companies held by the ETF have a fairly equal weighting? Or do just a handful make up a large proportion of the fund? In the latter case performance could again be driven by just a few giant positions.

Some holdings within an ETF may only be tangentially related to the theme in question, at least in your view. The index provider will determine how strict or loose its criteria is. Candidate holdings may only need a 25% revenue exposure to the theme to be eligible, for instance.

Consider too the overlap with any existing investments you may own.

Many specialist funds contain giants like Apple, Google, and Amazon – which you probably already hold in your passive global tracker. You’ll be paying a higher cost to hold more of them within a thematic ETF, and increasing your reliance on their performance, too.

High? Low? Silver?

Individual investors are unlikely to beat the market over a long time horizon if they deviate away from passive index trackers – and that includes making forays into thematic ETFs.

With such ETFs, costs – a key determinant of returns – are higher, returns more volatile, and some themes may be subject to boom and bust swings that gyrate with the economic cycle or investor sentiment.

Thematic ETFs do offer the more adventurous investor a glimpse of a more exotic investing world. But caution and due diligence are vital.

See more articles from The Lone Exchanger in their archive.

What caught my eye this week.

Hello! I’m half-on-holiday this week (and that’s without an NHS app ‘ping’ in earshot…)

My mini-break hasn’t stopped me reading the money and investing Internet. But it does limit my time to waffle on about it.

In other words, straight to the links this week.

Have a cool(er) weekend!

[continue reading…]

This is part two of a three-part series investigating whether Emerging Market bonds can enhance passive portfolios. Today we’ll consider Emerging Market bond risks.

In part one we looked at why you might be tempted to cast aside volatile Emerging Market equities in pursuit of the handsome risk-adjusted historic returns of Emerging Market US$ sovereign bonds.

But very few cases are one-sided in investing.

A big question mark still hangs over EM US$ sovereign debt.

Specifically, is its superior historic performance dependent on tailwinds that have mostly died down?

Emerging Market bond risks

The rise of Emerging Market bonds is partly a phoenix-from-the-flames success story.

Burned by crisis in the ’90s, developing world economies reformed their financial institutions. Their governments controlled spending and improved debt-to-GDP ratios. There was the helpful growth of China and globalisation, too.

Credit rating upgrades followed. Investors enjoyed high yields buoyed by outdated perceptions of Emerging Market bond risks.

Demand for EM debt got a further boost as Developed World yields shrunk. Many investors hunted further afield for income like truffle-loving pigs in a forest.

Fast-forward to 2021 and:

• Globalisation has stalled
• Chinese growth has slowed, even as Emerging Market economies are more reliant upon it. ¹
• Emerging Market bond yields have declined and credit spreads tightened.

Vanguard warns EM bond outperformance could be a historical artifact:

A number of trends – including falling interest rates, tightening spreads, and several equity bear markets – substantially explain what we expect was a historical anomaly.

Over longer periods, we believe investors can reasonably expect to be compensated for equity risk through realization of the equity risk premium.

Source: Vanguard. (“Emerging-market bonds: a fixed income asset with equity-like returns (and risks).” August 2018. Page 7.)

To put that quote in context, Vanguard’s researchers cautioned against expecting Emerging Market bonds to continue to beat Emerging Markets equities on an absolute return basis.

Reading between the lines

Indeed any bond-curious metric we check doesn’t augur well for a repeat of EM bonds’ Olympian performance of the past 20 years. 

Yields have waned on Emerging Market bonds to near historic lows:

Yield-to-maturity (YTM) peaked at 15.6% in August 1998 as financial shocks ripped through Emerging Markets. The YTM is now below 5%. ²

In other words, we’re being offered less reward for taking risk today than the bond investors of yesteryear.

Note, the bulk of long-term bond returns turn on the size of their coupons. ³ This is especially true at the intermediate durations that dominate EM US$ sovereigns. Today’s lower bond interest payments signal moderate rewards ahead.

Similarly, credit spreads (vs US Treasuries) have tightened:

The credit spread peaked at 1321 basis points – that’s 13.2% – in August 1998. The historic low was 1.6% in May 2007, just before the Great Recession convulsed the world. This spread is 3.3% at the time of writing. ⁴

The mountainous credit spreads and yields of the late ’90s and early ’00s indicate EM debt was consigned to basket-case status back then.

A fear of further defaults jacked up yields.

But Emerging Markets comfortably surpassed investor’s low expectations in subsequent years.

Which meant those elevated yields rewarded investors who took on risks that happily failed to materialise.

Default position

The subsiding credit spread indicates the perceived risk of default is lower today.

Comforting. But it also implies there’s less room for ‘equity-like’ upside.

Ultimately defaults will probably rise and fall in line with the global boom-bust cycle. An investor in Emerging Market bonds will lose when yields lag defaults. They’ll win when the market over-reacts and higher yields dominate even as defaults hold steady or decline.

As a passive investor I can no more time this default cycle in bonds than I can exploit stock market turbulence.

EM bond durations have also increased a touch over time. We’re taking on more ‘term risk’ today to bag our yield.

Finally, the EM debt market is much bigger than it was. It’s not a secret anymore.

Prediction time

So much for history’s rear-view mirror. How about forward expectations?

Fund manager Research Affiliates provides a brilliant range of tools, including expected return forecasts.

And these are pretty downbeat for Emerging Markets US$ sovereign bonds over the next ten years:

This expected returns chart shows annual GBP real returns (based on current valuations) of:

• 0.7% Emerging Markets US$ sovereign bonds (blue bar)
• 5.1% Emerging Market equities (red bar)

Note: Research Affiliates offers a range of returns along a probability distribution curve. I’ve stated the mean return.

Research Affiliates also offers an alternative forecast model that shows Emerging Market bonds in a better light. This uses yield and growth predictions instead of current valuations:

Here we see:

• 2.8% Emerging Markets US$ sovereign bonds (blue bar)
• 4.8% Emerging Market equities (red bar)

I don’t have an opinion about the efficacy of these different models. You can find Research Affiliate’s methodology on its website if you’d like to delve.

Will Emerging Market bonds yield for you?

One gauge of a bond fund’s annual expected return is its current yield-to-maturity. 

Current yield-to-maturity is a reasonable estimate of what you can expect to earn over the fund’s duration.

The following chart shows that current YTM is quite well-correlated to actual returns for EM US$ sovereigns:

A quick eyeball of accessible EM US$ sovereign bond funds gives us a starting yield of around 4%. The average duration is about 8.

That’s more encouraging. Although the one thing we can be sure of with any long-range forecast is that it will be wrong!

What should we do?

I don’t think anyone should oust Emerging Market equities from their portfolio expecting Emerging Market bonds to score higher returns.

That’s because it’s reasonable to assume the equity risk premium will reassert itself sooner or later.

Rather, the case turns on the chance of EM US$ sovereigns continuing to deliver superior risk-adjusted returns versus EM equities.

Any retreat from globalisation or a misfire from China’s growth engine will hurt EM equities. And rising EM bond defaults will probably correlate with such stock market drama.

The fates of the two sub-asset classes are therefore intertwined.

That said, Emerging Market governments can raise taxes, dip into currency reserves, and raise loans from the IMF and World Bank. That makes them less risky than EM equities, in my view.

Moreover, Monevator’s friendly quant, ZXSpectrum48k, has argued:

I also like the absence of EM FX exposure which I think you are simply not compensated for in EM equities. EM sovereign debt has produced the same returns as EM equities but with a fraction of the volatility. It also offers a somewhat lower correlation with broader equities.

UK investors are exposed to US$ currency risk via Emerging Markets US$ sovereign bonds, but not to Emerging Market currency risk.

There’s no need to hedge this US$ risk, as Emerging Market bonds should be allocated to the equity side of your portfolio. And currency risk can be seen as a diversifier, as long as it isn’t in your defensive asset allocation.

Same difference

Speaking of diversification, the geographic spread of Emerging Markets US$ sovereign bonds is quite different to Emerging Markets equity.

Take a look at the Regional Split rows below:

State Street. “Case for Allocating to Emerging Market Debt.” February 2021. Page 6.

• Latin America, Central and Eastern Europe, and the Middle East and Africa are much better represented in EM US$ sovereigns.

• In contrast, the Asia Pacific region dominates Emerging Market equities.

(Note: Emerging Market US$ sovereign bonds are labelled Hard Currency Sovereign EM Debt at the top of the left-hand column.)

You can also see that EM US$ sovereigns have decent yield, intermediate average duration, and a credit risk exposure that’s split across investment grade and sub-investment grade (junk) bonds.

Final asset allocation thoughts

Monevator contributor and former hedge fund manager Lars Kroijer made the case for diversifying into riskier EM government debt in his book Investing Demystified.

Lars suggested a 10% allocation to sub-AA government debt carved out of the equity side. He calculated this was roughly in line with the global split of risky assets between equities, corporate debt, and sub-AA goverment debt. (At the time he was writing).

Lars didn’t argue that Emerging Market bonds were vital or transformative.

Rather Lars was showing how to enhance diversification if you can live with the complexity.

Emerging Market bond risks may be worth taking for diversification

Personally, I haven’t yet been rewarded for increasing complexity in my own portfolio.

Despite this, I do still look for opportunities to diversify. The future often throws up surprises that backtests and forecasts gull us into believing we can factor out.

I have no actionable view on the future direction of US interest rates, the China-America trade relationship, or the fiscal positions of 74 Emerging Market countries.

Nonetheless I’m likely to soon split my EM equity allocation in half. This will enable me to allocate 5% to Emerging Markets US$ sovereign bonds.

Such a small allocation is unlikely to make a big difference one way or the other. But I think it’s appropriate to the merits of the case.

In part three I’ll look at the best Emerging Markets US$ sovereign bonds index trackers we can buy.

(Right after I’ve pulled these fence splinters out of my backside!)

Take it steady,

The Accumulator

P.S. Bond fund taxation is typically higher than with equities. This could be another black mark against Emerging Market bonds if you can’t fit them into your tax shelters.

1. See Vanguard. “Emerging-market bonds: a fixed income asset with equity-like returns (and risks).” August 2018. Page 7.[↩]
2. That’s according to the market-dominant JPM EMBIGD index of EM US$ sovereign bonds.[↩]
3. How much a bond pays in regular interest payments.[↩]
4. Again, according to the market-leading JPM EMBIGD index of EM US$ sovereign bonds.[↩]