Thematic and factor ETFs

Sector or theme?

An industry or sector ETF tracks one part of the economy: technology, healthcare, energy, financials. The boundaries are clear and well established.

A thematic ETF, on the other hand, is built around a phenomenon: artificial intelligence, clean energy, infrastructure, defense, water. A theme can cross industry lines, and the index definition is looser: two “AI ETFs” can hold very different companies.

Technology · Healthcare · Defense · Energy · Artificial intelligence · Infrastructure · Clean energy

Why diversification narrows

A broad market ETF can hold a thousand companies. A thematic ETF can hold thirty, and often the few largest make up a significant part of the fund. This means that the fate of individual companies shows up much more strongly in your portfolio.

At the same time, the companies are typically from the same industry, so they react to the same news in the same direction. That's why the diversification benefit is smaller than the number of companies would suggest.

When is a thematic ETF justified?

A thematic ETF works best as a considered addition, when you have a well-founded view and a time horizon for it to play out. It's a poor choice if the only reason is that the theme feels interesting right now.

• Check the contents: which companies, how many, and how large the weights are.
• Compare the costs with a broad market ETF: are you paying more for the benefit you get?
• The share is your own decision: thematic ETFs usually complement a portfolio rather than form its core.
• Check for overlap: your core portfolio may already own the same large companies.

Rules-based weighting

An ordinary index ETF weights companies by market cap: the largest company gets the largest weight. A factor ETF, also called smart beta, replaces this rule with another one.

It sits between passive and active: the selection isn't a portfolio manager's judgment, but it isn't just the market weight either. The rule is public and repeatable.

Multifactor is not a seventh factor

This often gets mixed up. A multifactor ETF is not a factor of its own but a combination of the ones above. It's an answer to the problem that a single factor can lag the broad market for years.

Historically, factors have had a weak correlation with each other: they work at different times. So combining them doesn't increase the expected return; it smooths out the risk of being in the wrong factor at the wrong time.

What an investor needs to understand

The idea of factors is based on long historical observations. What matters is that factors work unevenly: a single factor can lag the broad market for years before the difference turns around.

In practice, this requires patience and consistency. Switching factors after every weak period easily leads to being in the wrong factor at the wrong time.

This content is for information purposes only and should not be construed as investment advice or a recommendation. Investing always involves the risk of losing capital. The value of financial instruments and investments can go up or down, and past performance is no guarantee of future returns. The calculators and comparisons are illustrative.