The Explosion of Thematic ETFs

Everyone knows that ice hockey and poutine were both invented in Canada. What many people don’t know, is that the world’s first exchange-traded fund (ETF) was also launched in Canada in 1990. Called the Toronto 35 Index Participation Units (TIPS 35), it was created to passively track the performance of an index of Canada’s 35 largest stocks¹. Through the 1990s and early 2000s, exchange-traded funds were launched around the world to track the performance of just about every major index of stocks and bonds. And for the first 20 years of their existence, ETFs mostly remained synonymous with three key characteristics: passive management, broad diversification, and low fees.  

If the story had ended there, that may have been for the best.  

However, three fund providers emerged as the dominant players in the ETF space – Blackrock, Vanguard, and State Street. These providers offered ETFs tracking most of the world’s major indices, and quickly beat out their competition by achieving monumental scale.  

With an actively managed mutual fund, fund providers of any size can attract investors by advertising the skill of their portfolio managers. But for index ETFs, there is no active portfolio manager to advertise. Instead, the larger fund provider always has the advantage of scale, and can offer the same product at a lower cost than its competitors.  For example, State Street’s S&P 500 ETF (SPY) remains profitable despite its 0.03% management fees because it has $471B in assets under management².

By the end of 2022, ETFs held total net assets of $6.5 trillion while mutual funds held total net assets of $17.3 trillion³. And every year, assets continue to bleed from mutual funds into ETFs – benefitting the “big three” ETF providers and impacting the bottom line of smaller fund providers. Smaller providers have continued to lose market share on their mutual fund assets, and they have found themselves unable to compete in the ETF space with the scale of Blackrock, Vanguard, and State Street.  Instead, they had to search for their own path to profitability – enter thematic ETFs.  

As of the end of 2023, The MSCI World Index captured 85% of publicly listed developed world markets by market capitalization and contained just 1,408 stocks⁴. Yet in 2022 there were 8,754 ETFs listed on public exchanges, and as the below chart illustrates, that number continues to go up and up every single year⁵.  

Today, most new ETF listings are “thematic” ETFs – funds that aim to capitalize on recent trends in the financial markets.  Generally, these funds have higher fees, are narrowly focused, encourage investor speculation, and many use complicated strategies such as leverage and/or derivatives.  For example, here are some of the ETFs available in the Canadian marketplace today:

• Enhanced Equal Weight Canadian Bank Covered Call ETF (Management Expense Ratio: 0.84%)
• Psychedelic Stock Index ETF (Management Expense Ratio: 1.16%)
• Crude Oil Inverse Leveraged Daily Bear ETF (Management Expense Ratio: 1.43%)
• Inverse Bitcoin ETF (Management Expense Ratio: 1.90%)

Investors flock to these products for excitement and to capitalize on information they’ve seen in the headlines of the financial media.  And while these ETFs may serve a narrow purpose for some investors, they are not likely to help most people reach their-long term financial goals.  Recent research by Itzhak Ben-David and co-authors suggests that thematic ETFs tend to launch at the peak of asset class hype cycles, when media interest is highest and past performance looks strongest.  Subsequent returns for these funds do not create value for investors on average, and thematic ETFs tend to trail their broader index counterpart in the long term⁶.

From a fund provider’s perspective, offering these products still makes sense: when you advertise a thematic fund, you will attract attention based on media exposure and past performance.  As a provider, you can launch a fund and gather assets based on the hype surrounding an individual asset class or type of investment.  For as long as you retain assets in the newly launched fund, you can collect fees on them.  And if the fund’s performance is poor in subsequent years, you can always create another thematic ETF and start the cycle over again.

There is nothing inherently wrong with ETFs.  But it is important to recognize that the structure is no longer the guarantee of passive management, low fees, and diversification that it once was.  Instead, investors need to remain cautious when selecting ETFs for their portfolios, to ensure they do not miss the very benefits that made ETFs attractive when they first launched.

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¹ Canada: Birthplace of the ETF (James Comtios, ETF Trends, July 5, 2023)

² SPDR® S&P 500® ETF Trust Factsheet (February 1, 2024)

³ Frequently Asked Questions About How ETFs Compare with Other Investments (Investment Company Institute, April 10, 2023)

⁴ MSCI World Index (USD) Factsheet (December 31, 2023)

⁵ Number of exchange traded funds (ETFs) worldwide from 2003 to 2022 (Statista, February 2023)

⁶ Competition for Attention in the ETF Space (Itzhak Ben-David, Francesco A. Franzoni, Byungwook Kim, Rabih Moussawi; The Review of Financial Studies, March 2023)

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