Model Portfolios for the Modern Investor: Themed Investing, From AI to Rare Earth Metals

Content provided by Allan Lane PhD

How Themed Investing Using ETFs Became So Popular

The evolution of themed ETFs represents a nuanced narrative of financial innovation, market responsiveness, and the shifting preferences of contemporary investors. This re-alignment of investment funds emerged in the early 2000s, offering a distinct departure from traditional market-cap-weighted index funds. By focusing on broad sectors such as technology, healthcare, and energy, early thematic ETFs provided a platform for investors to strategically align their portfolios with specific industries and evolving economic trends.

As thematic investing gained traction, the breadth of these ETFs expanded significantly. By the mid-2000s, thematic ETFs began to reflect the transformative societal and technological developments reshaping the global economy. Early trailblazers in this space introduced funds targeting clean energy, biotechnology, and cybersecurity—sectors that addressed pressing global challenges, including environmental sustainability and technological innovation. These ETFs offered a compelling avenue for investors to capture the growth potential of emerging industries while aligning with ethical and forward-looking investment principles.

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The 2010s marked a pivotal era for thematic ETFs, characterized by rapid innovation and the proliferation of megatrends. Established issuers such as BlackRock (via its iShares product line) and State Street (through SPDR ETFs) capitalized on these trends by developing funds built around cutting-edge themes like artificial intelligence (AI), robotics, e-commerce, and renewable energy. Prominent examples include the Global X Artificial Intelligence & Technology ETF (AIQ) and the Global X Robotics & Artificial Intelligence UCITS ETF (BOTZ), issued by Mirae Asset’s Global X. These funds offered investors direct exposure to groundbreaking technologies poised to redefine industries and lifestyles, thereby transforming ETFs into instruments of participation in transformative global phenomena.

As the second phase of themed investing kicked, the range of niche exposures in turn went to the next level as typified by the launch of the VanEck Rare Earth and Strategic Metals UCITS ETF in 2021, and then by the WisdomTree Energy Transition Metals and Rare Earths Miners UCITS ETF launched in 2024.? These are not just esoteric investment plays, the commodities and the first mining for those assets represent the key components in many of today’s supply chains as shown in the table below.

Perhaps not surprisingly, the model portfolio industry adopted themed ETFs with enthusiasm, although it would be fair to say that not all fund selectors bought into the proposition, as some portfolio managers felt that themed investing was a passing fad that would ultimately lead to sub-par performance or that those exposures would be much better represented by an active fund manager.

As the products became less of a novelty, the geographic footprint of thematic ETFs expanded as providers introduced regionally domiciled funds to cater to diverse investor demographics. For instance, the WisdomTree Artificial Intelligence UCITS ETF and the Xtrackers Artificial Intelligence & Big Data UCITS ETF enabled European investors to access high-growth themes prevalent in both developed and emerging markets. This globalization of thematic investing underscored its universal appeal and democratized access to specialized growth opportunities.

Likewise, as the market evolved, thematic ETFs adopted increasingly sophisticated indexing strategies, incorporating Environmental, Social, and Governance (ESG) principles as a cornerstone. This integration enabled investors to align their thematic investments with broader ethical and sustainability considerations. However, the prominence of ESG has faced headwinds in recent years, with opposition from right-wing political movements influencing public discourse and regulatory landscapes. Despite this, sustainability-focused ETFs remain influential, particularly with younger investors.

Simultaneously, niche markets for highly specialized themed ETFs have emerged, spearheaded by issuers such as HANetf in the UK and various white-label providers in the United States. These entities have carved out a unique space by offering tailored investment solutions designed to meet the demands of specific investor segments and regional markets. This dynamic underscores the adaptability and creativity of the thematic ETF industry in responding to evolving market needs.

In today’s markets, the scope of thematic ETFs has broadened to encompass domains such as generative AI, climate change mitigation, and digital infrastructure development. While these funds highlight the industry’s capacity to innovate and capture opportunities in rapidly advancing sectors, they also pose challenges, including heightened concentration risks and increased volatility. Consequently, investors must adopt a measured and informed approach when incorporating these ETFs into their portfolios.

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Is Selecting a Themed ETF the Same as Stock Picking for a New Generation?

Investing in themed ETFs offers a unique approach that bridges the gap between traditional stock picking and broader market investing. Unlike selecting individual stocks, which requires detailed research and a focus on company-specific fundamentals, themed ETFs allow investors to target broader trends, such as artificial intelligence, clean energy, or robotics. These ETFs bundle multiple companies aligned with a specific theme, providing exposure to the trend while reducing the risks associated with investing in a single company. This diversity, combined with the pre-selected basket of companies, simplifies the investment process for those who want to align their portfolios with emerging trends without the complexity of granular analysis.

While themed ETFs mitigate some of the risks through diversification, they remain subject to the performance of the underlying theme, making them a strategic choice for investors with a strong belief in the long-term growth of these trends. By offering a balance of focus, simplicity, and diversification, themed ETFs present an attractive option for capturing the potential of transformative industries and ideas.

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A Framework for Incorporating Themed ETFs in a Target Risk Model Portfolio

Themed investing presents significant challenges for model portfolio managers, requiring a careful balance between opportunities and risks. One major difficulty is building portfolios that stay true to a theme while maintaining diversification. These investments often concentrate on specific sectors or trends, exposing portfolios to sector-specific or company-specific risks. It goes without saying that a decline in a key stock like NVIDIA in a technology-focused theme can disproportionately impact returns, highlighting the need for strategic diversification.

This is not unique to themed investing; it is typical of the challenges that all managers have to face head-on. Unlike decisions relating to strategic asset allocation, when an investor holds a view that a particular stock or sector looks like a promising investment, maybe they are wrong or too late! When exactly do you get in or out of the investment? Nobody knows, and it is probably not unreasonable to assume that it was only the elevated returns of those themed investments that got one’s attention in the first place. In a nutshell, unreliability of performance is the key challenge. Themed investments are often driven by market cycles and short-term hype rather than stable fundamentals, leading to inconsistent returns. For instance, renewable energy has seen sharp volatility due to regulatory changes, technological shifts, and energy price fluctuations. Additionally, the high correlation of thematic portfolios with specific sectors amplifies vulnerability to downturns.

Valuation adds complexity, as many theme-driven companies are growth-oriented and carry high valuations. Metrics like discounted cash flow (DCF) analysis or forward price-to-earnings (P/E) ratios help managers assess intrinsic value and potential returns. However, in emerging industries, traditional valuation tools often fall short, requiring speculative approaches.

The sustainability of themes is another concern. While some trends attract interest, their long-term viability may wane, risking obsolescence. Moreover, changing criteria for thematic definitions can dilute portfolio focus over time.

Liquidity and scalability issues also arise. Many thematic ETFs have low assets under management, leading to higher transaction costs and limited scalability for large portfolios. Regulatory and ethical considerations further complicate matters, especially in ESG investing, where greenwashing and regulatory uncertainties in sectors like AI or cannabis add idiosyncratic risks even at the sector level.

Benchmarking poses difficulties since traditional indices do not align well with thematic strategies, complicating performance evaluation. Communicating with stakeholders is equally challenging, as managers must educate clients on the risks and potential of thematic investments, while managing expectations for short-term returns.

Core/Satellite Investing

Over the years, several strategies have been refined, and refined again, to tackle the question of market timing, but don’t get fooled by overly complex solutions. Sizing the exposure to a particular theme is the only sound way to risk-manage the process. Estimate the annualized volatility of returns and then translate that into what a 2, 3, or even 4-sigma move in market prices amounts to. For example, if you are running a growth model portfolio where the annualized target risk is in the 12% to 14% range, are your clients ready for a 25% loss over a short period? Nothing new there, then. But what about if you inadvertently underestimate the risk impact of a large allocation to high-beta ETFs? It wouldn’t be unreasonable to find those drawdowns increasing by another 5% or more.

The idea of Core/Satellite investing was invented to precisely address the question of size, but don’t forget not all ETFs are created equal. When I last looked, those Bitcoin ETFs that were launched in 2018 are showing a realized annualized volatility of 50%+. Using our ‘back of the envelope’ approach, it suggests that one could witness a drawdown of 100%. Ok, let’s be modest and round that down to 90%, which history has shown us that losses this large can happen in the real world. That's why some managers suggest allocating no more than 2% to Bitcoin.

In summary, themed investing offers opportunities to capitalize on transformative trends but demands strategic foresight, risk management, and adaptability. By continuously monitoring themes and responding to market shifts, managers can align portfolios with objectives and deliver sustained value to stakeholders.

About Algo-Chain

Algo-Chain helps Wealth Managers & Financial Advisors who are looking to create their own Model Portfolios and increase their share of the value chain via their White Label Model Portfolio Service.

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Disclaimer

*The podcast provided by Allan Lane & Irene Bauer has been converted from their own original content, into a podcast using Generative AI tools and the voices used in the podcast are not their own.??All information provided has been fact checked.

The content referred to in this podcast is targeted at professional Wealth Managers & Financial Advisors and may not be suitable for all investors. Twenty20 Solutions Ltd does not provide, and nothing in this podcast should be construed as, investment or other advice. It is not intended that anything stated in this podcast should be construed as an offer, or invitation to treat, or inducement for you to engage in any investment activity. The information in this podcast relating to model portfolios & individual funds suggested by Algo-Chain is purely for research and educational purposes only.

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