Do thematic ETFs belong in your portfolio?

Christian Charest: For Morningstar, I'm Christian Charest. For investors who want to build a portfolio using ETFs, a common approach is to view individual funds as building blocks that complement each other. For example, by combining funds that target specific geographies or sectors in appropriate proportions. And since most ETFs do target regions or sectors, it's an approach that's easy enough to implement. But there's another type of ETFs that's growing in popularity: thematic funds, which are a bit harder to work into a portfolio. To talk about this, I'm here today with Mr. Alain Desbiens, director at BMO ETFs.

Alain, thank you very much for being with us today.

Alain Desbiens: Hello, Christian.

Charest: To start with, can you give us some examples of what we mean by thematic funds, including one that was recently launched by BMO.

Desbiens: The WOMN. This is an excellent question because I think people are looking at sector funds and thematic funds and they put them in the same basket. When you are looking at the Canadian ETF market, on the Canadian side, there's 26 sector funds. On the U.S. side, there are 17 ETFs. And on the global side, there's 24. Usually, what they tend to do on the sector base is replicate one of the GICS (Global Industry Classification System) of the TSX, one of the GICS of the S&P 500 or the MSCI. So, there's differences. We could speak about that, about what's popular in Canada, in the Canadian space, U.S. space and international space.

In terms of thematic, there's also different trends. A couple of the trends that we could see are that half of the assets of the 22 ETFs in the first quarter were in the marijuana space. Something also really interesting is the alternative, like, agriculture. In terms of trends also, you've got ESG -- women, WOMN for us, Women in Leadership, fits in that part. This is our first thematic fund in Canada, but we think it goes with ESG, which is, invest with conviction at low fees. So, this is for us what we are trying to bring there. And the other block on the thematic is more of the techno, the artificial intelligence, blockchain. So, basically, this is the theme into the thematic ETF space in Canada.

Charest: And how popular are these funds right now?

Desbiens: Well, there are different types of funds. Some of them are replicating indices, some of them are smart beta, some of them are active. But when you look at the space -- sectors and thematic -- there's basically 100 exchange-traded funds in the CAD, U.S. and global space, and there are $12 billion. On the thematic side specifically, there's 22 ETFs and $1.3 billion of assets under management.

All of those have some specificities. Like, if I look at the Canadian sector, it's mostly energy, banks, which is bizarre because these are the two places where Canada is known. But there's really people that sometimes want to overweight those two sectors and portfolio construction, professional investors, institutional, professional portfolio managers. So, they are looking at specifically replicating the indices or the equal weight approach that we have with ZEB.

On the U.S. side, they are really quite popular also. There's $2.3 billion and I think people are trying to grab what is not into the Canadian landscape which is healthcare, technology. And also, the biggest one is the U.S. bank, our ZBK and ZUB that are on an equal weight basis.

Global, it's really the infrastructure. It's really different what people are searching. So, as you could see, depending on what you are looking in terms of geography, people are going to pick different sectors, sometimes replicating the indices, sometimes going on an equal weight basis. But on the thematic so far right now, half of the assets of the 22 ETFs are more on the marijuana space.

What's interesting also in that space, the thematic one, you've got the alternative like COW on agriculture. Other trends there outside of marijuana, where there are five ETFs -- that's a lot out of 22 -- there's ESG and what I call the techno, artificial intelligence, blockchain. I think for some of the providers also in Canada -- because it's tough when you have 30 ETF providers to differentiate yourself -- some of them have targeted only either the sector or the thematic approach, sometimes providing active management in the sectors our active management with the thematic approach.

Charest: Now, from an investor's point of view, the attraction for marijuana funds is pretty obvious. It's a very high-growth, brand new sector. But for some of the broader themes, what are some of the reasons why someone would invest in a fund like that?

Desbiens: I think basically it's performance driven. I mean, sometimes you are receiving feedback from the industry, from analysts, from media that that sector could be a sector of growth, could be a sector of performance. So, sometimes people want to be in those sectors. Like any exchange-traded fund or mutual fund, Christian, I think there's a couple of rules. Like, is that thematic approach, is that sector approach, is that core approach, whether it's index, smart beta or managed, does it respond to a logic economically?

The second is, what's the risk profile? I mean, marijuana investing in an ETF is okay. Maybe in terms of risk versus buying one security, but it shouldn't be 20% of your portfolio. So, you need to look at the risk level. Something else also, when you invest in that trend, whether it's a sector or thematic approach, is that thematic approach or sector approach -- in Canada, U.S. or global -- fitting where we are now in terms of the economic cycle. We know that sometimes at the end of a cycle people are going to go more to commodities. So, are we seeing a trend emerging there?

And after that if I look at what the institutional and the portfolio manager does when they buy thematic, only half of them keep them for more than two years. So, this is in the ETF space where you see the most rotation. Sometimes people on a sector approach will go Junior Gold, ZJG or going to go Global Gold for example with the iShares XGD. So, they are going in, they are going out for a cycle. I think that's what also we are going to see in terms of the thematic. Sometimes depending on where we are in the cycle, we are going to be more popular and that's going to be also performance-driven.

Charest: Now, the main challenge for investors is that a lot of those thematic funds actually hold large blue-chip companies that a lot of investors probably already own if they already have a diversified portfolio either through an index fund like the S&P TSX Composite or the S&P 500. How can an investor integrate a thematic fund like this into an already diversified portfolio?

Desbiens: First, they need to understand what they have already in their portfolio. Do you understand what you have in terms of Canadian equity, U.S. equity, global equity? In terms of fixed income? This is basically the four sleeves that people have in their portfolio. And after that what you are buying as a sector fund or a thematic fund, is it overweighting one sector geographically or one sector in all of your portfolios?

And indeed, you could see if you are replicating. Sometimes though, what I see is, people on the thematic side using alternative funds like agriculture that you don't really find inside of the portfolios. Or like I was speaking to you about WOMN, investing with conviction. So, they want to have a tilt toward investing with conviction, but again, there they need to look at what we have already in their portfolio. And I think Morningstar is providing great tools for the professional investors to look at, to have an x-ray about what you have in your portfolio and when you add something, what are you overweighting and if you are going global, are you going hedged or unhedged?

So, you need to investigate, you need to know what you are buying, but also why you are buying that in your portfolio construction.

Charest: Now, I know you don't like to speak ill of your competitors, but don't some of these theme-based funds see more driven by marketing or the fashion of the day rather than a good investment case?

Desbiens: I think there's a differentiating point there. There's 30 ETF providers in Canada. Some of them, like in the mutual fund industry, are more niche. They are looking for a specific space where they think they can add value, they can add alpha. I think the real question is, there are 700 ETFs in Canada. The vast majority of the assets -- or 80% of the are with 20% of those ETFs. There's 30 providers, there's 20 providers that have less than half a billion dollars under management.

So, again, when you investigate why you are looking at a team, why you are looking at an ETF, what is going to make it into your portfolio construction, you've got to look at the AUM of the ETF you are buying. Because it's like in the mutual fund industry; in ETFs each year, all the providers on the fund side and on the ETF side, when there's no real sales success, could close the fund or amalgamate the fund. So, I would say, there is no risk of losing your money. There is the risk that you are investing in a team or in a sector and at one point the provider says there's not much appetite. So, we are going to close it at X date or we are going to amalgamate it to one of our other solution at X date.

Charest: Good advice to follow. Alain, always a pleasure having you with us.

Desbiens: Thank you, Christian.

Charest: For Morningstar, I'm Christian Charest. Thank you for watching.