Watch Out for These ETF Themes in 2022

Ruth Saldanha: 2022 could be a good year for fund investors in Canada as the Client Focused Reforms came into effect on the 1st of January of this year. Now, we think thematic funds might be the most impacted in that these products might be among the first to be reduced, closed, or even pared down. However, retail investors, especially newer investors, are very interested in thematic funds. So, what are some of the themes that you should consider for 2022? Mark Noble, Executive Vice President of ETF Strategy at Horizons ETFs, is here today to tell us what he thinks the year has in store.

Mark, thank you so much for being here today.

Mark Noble: Always a pleasure, Ruth.

Saldanha: So, first, what impact do you think the Client Focused Reforms might have on the Canadian thematic fund universe?

Noble: Well, I think, a lot of people view the client reforms as being focused on sort of the fiduciary obligation that dealers and by extension the advisors will have to have in finding suitable product for their clientele. There's a view that given that there's just so many ETFs in Canada, well over 1,000 products, there's a lot for anyone or any even brokerage to cover. So, there's probably going to be a rationalization of product shelves. And so, the area that would likely be impacted the most would be ETFs that have a low amount of assets as well as a high kind of standard deviation of risk. And so, of course, that would seem to be thematic ETFs which sort of hit a few of those buckets. I'm not sure if from a regulatory purpose you'll end up with ETF closures from thematics, but I could certainly see that being a concern if we go forward with those reforms. But I think well before those reforms are enacted, you'll see a lot of thematic ETFs close anyways, simply because they haven't attracted enough assets.

So, one of the things the ETF business does is, is it launches a lot of products and the goal for product providers, my firm included, is to come up with good product ideas. We're always trying to come up with good product ideas. But they're not always going to capture the imagination of investors. So, you put out a lot of schematic products, but you're hoping that the majority of that captures the imagination of investors. But we know they're not all going to. So, ideally, you will look at closing some of these ETFs probably in the next two to three years, and that may happen even before we may see these ETFs come under scrutiny for regulatory reasons

Saldanha: Let's talk about some themes overall. Now, some of the themes that have been in focus over the past year – cryptocurrencies, meme stocks, cannabis technology – all of these themes have been extremely volatile. So, how should newer investors consider thematic investing as a whole, especially since as the two of us have discussed before, it's very hard to get the theme right and the entry point and the exit point right all at the same time?

Noble: Well, I think, it's extremely important to understand why have we seen so much money come into these areas. And the reason is because we've seen a sort of once-in-a-generation move in terms of new retail investors in North America. The numbers are astounding. Pre-pandemic about 16% of the average daily trading volume in the markets was retail investors. That number is now over 30%. We've seen the amount of account openings in the United States exceed now 100 million. In Canada, we've added 3 million new self-directed investors. That's not retail investors. That's just investors doing it themselves. An astounding number given that we're a population of about 37 million. And this has added about 15% new AUM into the marketplace. That's an incredible amount of money. We're in excess of a $1 trillion, probably North America, of new monies come to the market.

What's happening is a lot of this money because it's generational in terms of being younger, so the average age of these clients is around 31 to 35, is they're buying newer and emerging themes. And therefore, that's what's creating a lot of this volatility because you've had this deluge of money go into themes that are popular like cryptocurrency, marijuana, clean technology. And now, the ability for us to add another 30 million, 40 million investors in North America over the next few years is highly unlikely. We simply don't have that population. And so, things have sort of hit a wall in terms of volatility in thematics.

What I'd like to say to thematic ETF investors is, this is not a tactical product class. This is a strategic product class where you need to have patience. So, if you're coming with the mindset of buying thematic ETFs to make a quick buck, that's the wrong mindset. And I know that there is a lot of fear of missing out with retail investors. But if we look at traditional sectors today, like communication services or information technology, the leading stocks in those areas are stocks that would have been thematic stocks 15 years ago in key themes like mobile technology, Internet, software companies. And some of those companies that were leaders back then don't exist today. So, we don't have PalmPilot, an early leader in mobile technology around, or Yahoo!, a leader in early Internet search, but the theme itself panned out, but that theme took 15 to 20 years to materialize. And so, that's the big thing here with thematic ETF investing is that some of these themes like cryptocurrency, there's probably real adoption for blockchain technology over the next decade; we look at electric vehicles, it's going to be a large part of the broader auto market. But in the meantime, because of this incredible deluge of money that's gone into there, the valuations could be extremely high, which results in higher volatility. So, the only way to really be able to effectively get in and out of these themes is to have a long-term time horizon to invest in them.

Saldanha: What do you see as being some of the key themes to watch for in 2022?

Noble: Well, we need to look at what's happening on a macroeconomic perspective. And the biggest concern outside of obviously COVID-19 being the pandemic that seems to never end is the inflationary concerns. So, the inflationary concerns, which have somewhat resulted from COVID-19 because of supply chain disruption, the inability to get things to market, greater demand for work-from-home technologies means that those types of commodity or inflationary asset classes that would typically do better with the rising interest rates seem to be what we think will attract assets in 2022.

The one area we think will probably be the most interesting to investors is robotics and automation for that reason. The biggest difference between the inflationary environment we see today and the last big inflationary spike we saw, which was four years ago, we have to go back four years to see the type of inflationary growth we've seen this year, was that we didn't have technology and automation playing such a large role. Like, the idea that technology could replace labor for a lot of usages in the industries and the larger economy didn't exist in the early 1980s where it does today. So, we think what's going to happen is, given the price surge that you've seen in commodities and labor costs, there's going to be a doubling down in investment in automation and robotics. So, robotics and automation ETFs which are focused in this area – we have an ETF, for example, under the ticker symbol RBOT – will likely be a key target.

The other areas of target will likely be commodities or derivatives of commodities. But they might be commodities that you don't think of from a thematic perspective. So, two commodities that seem to be very successful right now are lithium and uranium. Now, lithium and uranium are traditional commodities. They come out of the ground. But they're being used to power up clean energy or alternative energy technologies to carbon-based energy. So, we have this longer thematic trend in reducing carbon emissions and low carbon energy, but you likely have also this inflationary aspect in that the laws of inflation and cost of transporting goods and supply and demand still apply to things like lithium and uranium. And so, those are two asset classes that also likely see a kick-up and already have so far in 2022.

Saldanha: And on the flip side, what are some of the themes that you expect to take a back seat in this year?

Noble: Yeah. Well, our concern is in two key areas. We're concerned about the cryptocurrency trade, not because we're negative on cryptocurrency. Going back to my earlier comments, these are long-term technological innovations that's occurring in these areas. But our concern is just that the valuations and the speculation in this is ramped up so much, and especially with cryptocurrencies, because there's no fundamental underlying value with cryptocurrencies beyond what investors ascribe to them, you sort of need to keep on bringing on new investors. And the biggest deluge of investors were these retail investors over the last two years coming into cryptocurrencies. Now, you need institutions and larger capital market groups to be coming into these areas. And I don't know if that's going to occur to the degree that some of these investors would like in 2022, which means that I think this space ends up being highly volatile. It doesn't mean that the long-term view of something like Bitcoin replacing gold or blockchains impacting lending and traditional banking, (doesn't materially). Finding new investors this year to buy into that narrative and push these higher may be extremely difficult.

The other trend that also seems very impaired this year is marijuana. Marijuana or the cannabis investing market is really being based on legalization in the United States. It's unlikely that any movement in legalization occurs until post the 2022 midterm elections, which means that there's really no news to drive that forward. In the meantime, the Canadian cannabis companies are still not profitable. Their inability to enter the U.S. is really hurting their ability to grow the revenue stream. And the U.S. companies are hampered by the fact that they can't get large board listings until there's legalization in the United States. So, those are two, kind of, buyer beware categories. Long term, lots of opportunity for there to be real powerful businesses in those areas. But specifically, for the next 12 to 18 months, these could be volatile sectors.

Saldanha: Well, it's really interesting that you say that because the themes that you say that investors should probably buyer beware is cannabis, and the good ones are mostly lithium and uranium. But when you look at the valuations, both lithium and uranium are very overvalued at this point, whereas cannabis is quite undervalued. So, how should investors look at valuation when they consider themes, because if it's a long-term play, then perhaps it's the ones that are undervalued that you should consider. How should investors do that?

Noble: This is such a good question, Ruth, because that is a key point of investing is looking at valuations. But when you're looking at themes, it's a little bit different because what's driving the theme is generally not fundamental. So, if I look at a lot of companies, they have extremely high price to earnings, but they're still seeing momentum because they're capturing a long-term growth. So, if I look at lithium, for example, valuations of lithium companies are high, but most industry forecasts for lithium expect lithium usage to increase by 300% over the next decade. So, they're not trading at a 300% premium currently. They're trading at a significant premium, but a lot of that growth is built into that space.

Saldanha: Finally, as always, what risks should investors who want to invest in themes be aware?

Noble: There's three that I'd like thematic ETF investors to consider. The number one issue is to look at the uniqueness of the strategy. So, a lot of thematic ETFs are actually just closet versions of technology indices. And as your Morningstar viewers and audience are well aware, generally, getting lower-cost diversified exposure is usually the ammo for successful ETF investing. So, if I come by the NASDAQ 100 and get the same exposure as a thematic ETF, but I can get that for 20 basis points or 25 basis points, that's much better than paying 70, 80 basis points to get something that's basically the NASDAQ 100 in everything but name, or a sector ETF. So, really look at is this theme unique in terms of what I'm purchasing, or could I actually get a lot of these companies through a broader index strategy?

The second thing to look at is the underlying volatility of the asset classes. As I mentioned, some of these are extremely speculative. We've already touched upon the high valuations in some of these areas. You need to understand why am I investing in this, especially if it's highly volatile and doesn't have a lot of fundamental drivers of revenue currently, even though it may have long-term fundamental growth. And some themes may not have a lot of volatility. Like, if I look at like some of the infrastructure themes, they're actually fairly low vol. Or if I look at healthcare outside of biotech, it's fairly low volatility. But for the most part, a lot of these themes have a higher volatility. You need to make sure they fit with your risk controls.

And that fits into my third. Where does this fit in your portfolio? My third point is, these are speculative or what I call explore ETFs. So, generally speaking, if there's some guidance, most portfolios are going to use thematic should be designed to sort of a core and explore strategy, where you have a core portfolio that's built around well-established, diversified, broad ETF indices that are low-cost, diversified equities, fixed income. You are meeting all of the key criteria that's existed for the last 100 years on how to build a successful investment portfolio. If you have additional risk for what we call the explore portion, that's where these thematic ETFs would fit in. So, it's very tempting as a new investor to want to chase returns, but as we know, history shows us time and time again chasing returns and making that the core of your portfolio is usually a path to ruin. Where these thematic ETFs become extremely powerful is when they're additive to an already well-diversified and well-established portfolio.

Saldanha: Great. Thank you so much for being here today, Mark.

Noble: My pleasure.

Saldanha: For Morningstar, I'm Ruth Saldanha.