As interest in thematic exchange-traded funds (ETFs) surges, demand and supply continue to increase. By the end of April 2025, more than $300 billion had been invested in global thematic ETFs, according to Funds Europe, a digital magazine for the asset management industry. On the supply side, it reported 1,582 thematic ETF funds listed globally with over 3,000 individual listings across 53 exchanges and in 41 countries.
As a forward-looking advisor who cares about your clients’ goals and values, you should learn how to engage with them on this topic and provide proper guidance so that they can achieve their goals while managing all relevant risks.
Key Takeaways
- Thematic ETFs allow investors to commit funds to causes they care about—such as climate change, AI, or healthcare—offering a purpose-driven approach to investing.
- Their unique risk profile can reduce portfolio correlation and add a new layer of diversification, with the potential for long-term outperformance, as seen with past themes such as e-commerce.
- Thematic ETFs open doors for personalized, values-based conversations between advisors and clients.
- While thematic ETFs are promising, they also come with risks, including hype cycles, illiquidity, and thematic underperformance.
- Advisors must manage these risks by limiting exposure (5% to 20% of the portfolio), selecting well-managed ETFs with viable, growth-oriented themes, and educating clients on the dangers of chasing fads or entering too late.
What Are Thematic ETFs, and Why Do Clients Care?
Thematic ETFs are funds that seek exposure to a particular theme, trend, or niche instead of tracking a broad market index (like the S&P 500). Though they may sound like sector-focused and industry-focused ETFs, there is a difference between them:
- Thematic ETFs focus on forward-looking trends and themes that are transforming the world and are set to shape the future. These include artificial intelligence, climate change, digital health, sustainability, robotics, electric vehicles, etc.
- Thematic ETFs can include companies from different industries if they focus on the same theme.
Why Would Your Clients Care About Thematic ETFs?
There are at least four reasons:
- Investing with purpose: Thematic ETFs are another variation on the values-based approach to investing. Investors can use them to commit their funds to the values, passions, and beliefs that they care about the most.
- Participating in emerging trends: Investors also derive a sense of purpose in participating in trends that are shaping the future.
- Long-term growth: Some investors also believe that trends that will shape the future will also experience long-term growth.
- Generational appeal: Younger investors (Gen Z and Millennials) have a greater interest in sustainable investing, according to a Morgan Stanley survey.
For example, while 68% and 65% of Gen Z and Millennials, respectively, have more than 20% of their portfolios in companies or funds aimed at making a positive social and environmental impact, only 37% of Gen X and 22% of Baby Boomers do the same.
Since this generation is also more likely to invest than their older counterparts, according to a survey by YouGov, it makes sense that the demand for thematic ETFs is rising.
Using Thematic ETFs to Deepen Client Engagement
One advantage of thematic ETFs for advisors is that they open an opportunity to discuss the values that motivate your clients. This can happen in two ways:
- When you are dealing with a client interested in values-based investing, but doesn’t know how to turn that into actual investment decisions. With such an investor, you can have conversations about the values they care about, why they care about them, and how they focus on those values (when there are more than one). You can then introduce thematic ETFs as an appropriate way for them to invest in themes and trends that best align with their passions.
- When dealing with a client who specifically asks about thematic ETFs, after explaining what thematic ETFs are, you can deepen client engagement by seeking to understand the client’s values and connecting these to specific themes. For example, you can discuss climate change-themed ETFs with a client who is concerned about this issue.
Portfolio Integration Strategies
While investors seek to commit funds to themes that matter to them and will shape the future, they also have other goals they are pursuing, such as retirement and financial independence.
Additionally, every investor has a unique time horizon and risk tolerance, which influence their overall investment strategy. Before considering how to include thematic ETFs in a portfolio, let’s talk about three features of thematic ETFs that are relevant to portfolio management:
1. New Exposure
Thematic exposure results in a higher degree of unique risk than traditional equity exposures (by sector or style [value, growth, etc.]), according to BlackRock. Unique risk is risk that is specific to a given theme and can’t be explained by sector, geography, or investment style. A higher unique risk means thematic ETFs can better diversify the sources of potential risk and return.
In simpler terms, a thematic ETF is more likely to be less correlated to a market index than a sector-focused or style-focused ETF, and two thematic ETFs are likely to be less correlated to one another than two sector-focused or style-focused ETFs.
2. A New Layer of Diversification
One implication of the above is that thematic ETFs can add a new layer of diversification. As you know, the less correlated an asset is with other assets in a portfolio, the more likely it is to reduce portfolio risk when added to the portfolio.
3. The Potential for Higher Returns
BlackRock’s report also notes that past themes, such as smartphones and e-commerce, have outperformed the broader market during their adoption periods.
How can you adapt a portfolio to include thematic ETFs?
- Decide on the themes that are important to your clients: Some clients will have a single theme, while others will have multiple themes. For the latter, seek to understand the order of importance of these themes.
- Identify current exposure to the themes: If the current portfolio already reflects these themes, your client may be better off selling off those positions in exchange for thematic ETFs. As noted above, thematic ETFs provide more unique risk and are more likely to diversify the sources of risk and return.
- Choose how to gain exposure to thematic ETFs: You can gain exposure to thematic ETFs by reducing exposure to sector- and style-based ETFs or injecting new cash into the portfolio. BlackRock found that portfolio risk remained largely unchanged irrespective of the chosen option.
- Decide which portion of the portfolio to commit to thematic ETFs: You can use a core and satellite approach to incorporate all your client’s relevant goals. The core portfolio will include broad market equity ETFs, while the satellite portfolio will target thematic ETFs.
You can advise clients to allocate between 5% and 20% of their overall portfolio to thematic ETFs, depending on their risk tolerance and investment objectives.
Tip
The tax implications for thematic ETFs are no different from other ETFs.
Risk Management and Due Diligence
Despite their potential for diversification and returns, thematic ETFs are not without problems. Here are some of them:
- Hype: Some trends or themes may turn out to be mere fads that fade away after a few months or years. Many would argue that the metaverse and virtual reality are examples of this.
- Illiquidity: Given their narrow focus, they might not be as liquid as traditional sector, style, and geographic ETFs.
- Concentration and thematic underperformance: A thematic ETF may underperform because of risks specific to its theme. Since all the components of the ETF are affected by the theme, there is no internal diversification that can reduce losses.
While these risks are serious, they can be mitigated. By treating thematic ETFs as a satellite portfolio, you can limit the impact of concentration risk. Limiting your exposure to 5% to 20%, depending on their risk tolerance, will ensure that the core portfolio can weather any underperformance.
Most of these negatives can be navigated by learning how to select the right themes and ETFs. Here are three factors to discuss with your clients when they are choosing a theme:
- Viability: By viability, I mean the potential for the trend to have practical impacts—goods and services that people would be willing to pay for. The transformative potential of the theme is crucial.
- Growth: Given the possibility that a theme may be a fad, focus on themes with strong fundamentals and long-term value. In essence, do you see the theme becoming mainstream as economic agents continue to find it valuable?
- Time to maturity: What stage in the theme’s life cycle are we? If the theme is already in a high-growth or decline stage, your clients may be too late to the party.
Now to the ETFs themselves. You can minimize the negatives of thematic ETFs by choosing ETFs with the following characteristics:
- Holdings: An ETF’s holdings should reflect its theme. Compare the holdings of various ETFs under the same theme and choose the one with viable holdings that have long-term potential and are farther away from their high-growth and decline stages.
- Liquidity: Choose the ETF with higher trading volume. The more liquid an ETF, the easier it is to enter and exit.
- Management team: You may be better off staying with popular ETF creators that have built a reputation for quality and experience. Additionally, conduct a brief search on the management team to ensure they are the kind of people you can trust with your clients’ money.
- Historical performance: Though historical performance doesn’t guarantee future performance, it can be an indicator of the quality of decisions that fund managers have made in the past.
- Expense ratio: Choose the ETF that provides the best value for money, although it should be a deciding factor rather than a primary one. If three ETFs are tied or match closely based on other factors, you can use the expense ratio to choose one of them. This is better than simply opting for the ETF with the lowest expense ratio, even as it falls short in other areas.
What’s the Difference Between Thematic ETFs and Sector Funds?
Thematic ETFs focus on forward-looking trends (e.g., AI, clean energy, digital health) and can include companies across multiple sectors that align with a specific theme. Sector funds, meanwhile, include all companies within a specific industry (e.g., energy, healthcare) and are less focused on future trends.
How Can I Explain the Risk/Reward Trade-off of Thematic Investing to Clients?
Thematic investing offers the potential for high returns by tapping into transformative trends early (like e-commerce or AI). It can also provide diversification benefits because of its higher unique risk (compared with sector and style ETFs).
However, it also carries higher risks such as exposure to narrow themes that can underperform or become obsolete, illiquidity because of fewer holdings and less trading volume, and concentration risk, since all assets are tied to one theme.
What Are the Signs of A Well-Constructed Thematic ETF?
A high-quality thematic ETF should have the following:
- Holdings that reflect the theme, featuring companies with strong, long-term growth potential.
- High liquidity, indicated by solid trading volume.
- Experienced management, preferably from reputable ETF issuers.
- Strong historical performance, showing evidence of sound investment decisions.
- A reasonable expense ratio.
The Bottom Line
Thematic ETFs continue to become popular as a way for investors to invest in themes and trends they are passionate about.
Yet, there are risks associated with thematic investing—illiquidity, concentration, wrong timing, and hype. While acknowledging the passions of clients, advisors should guide them on how to align those passions with viable themes, select the right ETFs, and allocate their portfolios to thematic ETFs.