Active thematic ETFs are more flexible

Whether investors choose passive or active thematic funds, it is crucial to understand the methodology used to construct the thematic ETF.

As befits their passive heritage, many thematic ETFs attempt to track specialist thematic indices. These indices are compiled using rules-based stock selection which aims to create some kind of economic linkage to the theme that investors want to gain exposure to. For example, the popular S&P Global Clean Energy and MSCI ACWI IMI New Energy indices provide exposure to the energy transition theme by selecting the companies with the largest overlap with the selected theme. The inclusion criteria are prescriptive, with potential constituents drawn mainly from companies that derive a particular amount of their revenues.

Because they are constructed based on prescriptive rules, thematic indices tend to focus on what are often referred to as pure-play stocks—these are companies whose activities predominantly lie within the scope of a particular theme. The result can be a narrow focus on just a small number of stocks. For example, in a clean energy index, only companies heavily involved in the generation of renewable energy may be included. They may exclude more diversified companies that also have a key role to play in the energy transition theme, such as companies providing software and infrastructure to enhance the electric grid or companies enabling electrification such as EV charging.

Thematic indices are also often weighted by market cap, or by a simple equal-weighting construction. Given the growing number of thematic ETFs and the relatively small number of pure-play stocks, these benchmarks can mean that many funds end up chasing the same stocks and investing in highly crowded positions. The table displays the heavy concentration that some leading thematic index providers have in their top ten holdings. This high concentration increases investment risk and fails to deliver the diversification benefits that investors may expect.

An integrated thematic view

Another advantage to active thematic managers is their ability to take a much more granular approach to portfolio construction and give more weight to companies that they believe can provide the most impactful and effective exposure to the selected theme, from across the market rather than limited to certain sectors or types of stock.

Gaining exposure to some of the largest structural themes, such as climate change for example, does not – in our view – require a targeted approach. The climate challenge is so huge that it touches almost all areas of the global economy. Greenhouse gases come from a wide variety of areas – energy in industry, buildings, transportation, and agriculture – with investable opportunities existing across the broad spectrum. If an investor wanted to get full exposure to the climate change investment theme, several different passive ETFs would have to be selected, e.g. Clean Energy, Water or Sustainable Food, putting the burden on theme selection and monitoring on the end client.

An active investor can apply a much broader approach to the theme and select companies from different sectors as long as these companies have a significant overlap with the selected theme. They can also position the portfolio towards different sub-themes and companies depending on the current market dynamics. However, given the breadth of the investment universe, it is important to select an active manager that has access to a network of global research analysts and the capabilities to support deep thematic research across markets and sectors.

At J.P. Morgan Asset Management, our active thematic ETFs use our proprietary Artificial Intelligence natural language processing tool Themebot. Themebot helps our portfolio managers cover more than 13,000 companies globally, at speed, generating a manageable list of opportunities from which to start.

Companies are rated for their exposure to the theme by both textual relevance and revenue. The use of this technology helps identify stocks that fit a particular theme, which may not have been initially covered by our analyst team, and also cover the breadth of a global opportunity set using one consistent framework.

Once a stock has been identified by Themebot, our analysts conduct fundamental research and management meetings to gain a fuller picture, only investing in our highest conviction investment ideas.