The Case for Thematic ETFs: An Interview With SSGA's Michael Arone

The Case for Thematic ETFs: An Interview With Michael Arone

As investors face off against the challenging market of 2018, the question of how to generate strong returns in a volatile setting is top of mind. One solution investors are embracing is thematic ETFs. But is this a valid approach, or are investors just chasing past performance?

Inside ETFs Chairman Matt Hougan caught up recently with Michael Arone, Chief Investment Strategist for the US SPDR^® Business, to discuss the case for Thematic ETFs in 2018.

Matt Hougan, Chairman, Inside ETFs (Hougan): Let's start big picture: Are you bullish, bearish or neutral entering 2018?

Michael Arone, Chief Investment Strategist, US SPDR Business (Arone): Despite recent market turmoil, I'm bullish for 2018. We have better global growth supported by increasing corporate earnings; still easy monetary policy conditions; low rates; benign inflation; and, more recently, fiscal stimulus through both lower taxes and an easing of the regulatory burden. This should be a very constructive environment for risk assets in 2018, even if the returns are not as smooth as they were in 2017.

Hougan: Are high valuations a concern for investors? Should we be pulling back on our exposures?

Arone: The funny thing about valuation measures is that you can look at a variety of them and they’ll tell you different things. For example, I could calculate a few measures of valuation that will tell us that the market is expensive; CAPE, for example, or market cap relative to GDP. Many price measures these days are signaling that the market is expensive.

I could also calculate a few measures of valuation that would indicate the market is fairly valued; under the Fed model, for example.

I do think, however, that it’s getting more and more difficult to find measures of valuation that would describe the market as cheap right now. As a result, with markets at all-time highs and volatility near rising, I think it's a good time for investors to revisit investment strategies that might better help them weather the increase in volatility we’re seeing today.

Hougan: A big theme at Inside ETFs was the rise of thematic investing—robots, emerging market consumers, cybersecurity, etc. From a valuation perspective, are investors just chasing hot returns there? Do you worry about people buying the top?

Arone: Well, it's interesting. I think thematic ETFs are somewhat hard to define. Even the list that you gave—emerging market consumers, cybersecurity—there are so many different flavors, it's hard to lump them all together. In some instances, investors are chasing a hot theme or hot returns.

But if we take a step back, I think thematic ETFs can play an important role in portfolios. What we see are financial advisors using them in a variety of ways. For example, they might use them to complement an existing sector allocation, getting a bit more specific about an investment. Or they might use them for diversification relative to their more traditional stock and bond investments, or to manage risk.

Sometimes, for example, in the ESG space—whether we define that within thematic or a separate category—investors are investing based on their values or some other theme and not just returns.

So I think it's hard just to say that, in thematic ETFs, folks are simply chasing returns writ large. In some instances, that may be true, but more broadly, I think they’re after growth, diversification or managing risk.

Hougan: How do you separate a good thematic ETF from a bad one? And how do you ensure you get pure-play and near-pure-play exposure?

Arone: I would remove the word “thematic” before “ETF” in answering that question. I think what you have to do with these particular ETFs is think about how you determine a good ETF from a bad one.

When it comes to thematic ETFs, some of the very same metrics and due diligence processes that investors use to evaluate ETFs more broadly are applicable. You want to make sure that the exposure you're seeking matches up with the portfolio you’re getting.

One way to do this is looking at how different the return pattern is relative to that market. Another way to do it is by evaluating the holdings of the underlying ETF. It's always important to know what you own, and whether that represents what you're trying to achieve from a pure-play exposure.

Then, when it comes to ETFs—certainly the assets under management—the trading volume and the spreads are important.

So I think, all those components folks use to evaluate ETFs more broadly, they should use to evaluate their thematic ETFs as well.

Hougan: What are the most exciting themes for 2018? Where can investors get ahead of the curve?

Arone: At State Street Global Advisors and SPDRETFs, we're really excited. We just launched some new ETFs based on Kensho indexes. We're capturing some themes from what we're describing as the fourth industrial revolution. They're focusing on advances that, in our opinion, are reshaping our economy and our way of life. We think of them in three categories—how we live and work, how we travel, and how we protect ourselves. And so, we just launched three different Kensho ETFs under these themes.

One looks at intelligence structures, and it’s called the SPDR Kensho Intelligent Structure ETF (XKII). These are companies that are providing smart building infrastructure, smart power grids, intelligent transportation infrastructure, and intelligent water infrastructure.

It really is about providing an intelligent infrastructure component to how we live and work and how things are changing in that regard. As I was talking about before, if an investor has an existing position, for example, in the industrial sector, this may be a way to complement that with a more specific and longer-term theme.

The second theme we have is around how we travel, and it's called the SPDR Kensho Smart Mobility ETF (XKST). It tracks an index developed by Kensho that looks at autonomous vehicles, drones and drone technology for civilian and commercial applications, and advanced transport systems. It’s investing in companies that are on the cutting edge of that theme.

The third theme is around how we protect ourselves, and it’s called the SPDR Kensho Future Security ETF (XKFS). It tracks an index developed by Kensho that focuses on cybersecurity, advanced border security, robotics, drones, drone technology, space technology, wearable technologies, those types of things.

We think those are three important themes in 2018.

Hougan: What is the key message you think advisors should be focused on as we look toward the rest of 2018?

Arone: We’ve been in a long and deep bull market for risk assets—and I would include here stocks, bonds, private equity, and real estate as being part of that long and deep bull market. This has largely been supported by unprecedented and often experimental monetary policies, and this has brought forward a lot of really good returns. It’s been a real benefit for investors, and returns have been quite strong, certainly since 2009.

As a result of this experience, traditional diversified portfolios are now forecasted to have much lower returns in the next decade. Therefore, I think investors and financial advisors who serve them are going to have to get more creative in finding ways to access growth or higher returns in a diversified portfolio. The old 60/40 mix or the old equity/bond/liquid alternative asset allocation is likely to provide a much lower return in the future. This provides both business risk and investment risk to financial advisors, and likely provides a lower return profile for individual investors.

The key message that I want to provide investors is that there are lots of ways to think about adding returns in your portfolio while maintaining diversification benefits, and having an investment that's not as correlated to traditional stock and bond allocations. Thematic ETFs are a useful tool in accessing potentially higher returns and higher growth investments that still provide those diversification benefits relative to more traditional portfolio holdings.