In the world of exchange-traded funds (ETFs), thematic investing has taken on new significance as market participants seek to align future expectations with their portfolios. This unique and sometimes expensive investment strategy merits a proper discussion of its pros and cons.

As the name implies, thematic investing is a strategy that seeks to align asset selection with certain social, economic or corporate themes prevalent in society. Some of today’s common investment themes focus on environmental sustainability, social security or technological progress. Investors following a thematic approach would select funds that mirror these themes.

Although thematic funds can differ greatly from one another, they all differ from standard ETFs that track benchmark indexes such as the S&P 500 or Nasdaq Composite. In this sense, thematic funds are considered special equity ETFs that are based on a specific strategy index. From the perspective of cost, this also translates into higher fees. As Fidelity notes, the expense ratios of special equity funds are roughly three times higher than the average ETF that follows a benchmark index.

To get a sense of some of the more popular investment themes of the past few years, check out: 2018 Investing Themes and 2017 Investing Themes.

Thematic investing has grown in popularity in recent years thanks in part to the growth of smart beta ETFs and so-called factor-based research. According to Global X Funds, these strategies have placed a greater emphasis on analyzing the past. Thematic investing serves as a forward-looking approach that seeks to capitalize on anticipated changes in our world. Whether social, economic or demographic, these strategies are intended to produce market-beating gains over the long term.

Many of these thematic approaches converge on information technology, social media and health. New paradigms in financial technology, robotics and artificial intelligence, Internet of Things and renewable energy are set to transform our world for the foreseeable future. Therefore, it only makes sense that investment themes mirror these anticipated changes.

Global X Funds has developed several ETFs that capitalize on these trends, including FinTech ETF (FINX n/a), Internet of Things ETF (SNSR n/a), Lithium & Battery Tech ETF (LIT B-) and U.S. Infrastructure Development ETF (PAVE n/a).

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Like any investment approach, thematic funds offer their fair share of risks and rewards. Below is a high-level breakdown of each.

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One of the key strengths of thematic investing is that it is far more concentrated when compared with regular or passive fund strategies. Case in point: mutual funds are usually comprised of 40-80 stocks in a portfolio. The emphasis (perhaps over-emphasis) on diversification means that returns are more likely to be much lower than potential. After all, spreading out your stock selection across multiple sectors is not always an optimal strategy for growth.

Thematic investing, on the other hand, focuses on a much smaller selection of stocks to capitalize on a future growth trend. Selecting a few companies involved in Internet of Things, blockchain or renewable energy, for example, could yield huge results should those industries develop as expected. The legalization of recreational cannabis in Canada and several U.S. states has also put marijuana ETFs on the fast-track to exponential growth. Despite their recent struggles, FAANG ETFs that track shares of Facebook, Apple (AAPL), Amazon (AMZN), Netflix (NFLX) and Google parent Alphabet (GOOG) are still destined to lead the technology sector for many years to come. These are just some notable examples of thematic investing strategies with significant long-term growth potential.

Thematic investing strategies are also highly customizable and can vary significantly based on an investor’s preferences. This feature is less prevalent in other fund strategies, especially those that follow an index. And while thematic funds are highly concentrated (see above), investors can still achieve diversification by building portfolios based on more than one theme.

On the opposite side of the ledger, one of the most common risks associated with this strategy is selecting a theme that doesn’t quite pan out as expected (remember the human genome project?). Investing for the future, based on past information, doesn’t always yield positive results.

For this reason, concentrated portfolios assume greater downside risks that are compounded by regulatory changes, shifts in tax policy or new disruptions in technology. All these factors present drawbacks to thematic investing strategies. A recent example is the impact of the 2016 presidential election on Big Pharma. U.S. President Donald Trump’s vow to lower drug prices has significantly impacted the industry’s guidance.

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As the age of technological progress intensifies, and as factor-based research continues to proliferate, investors will be placing more emphasis on thematic approaches. You now have a better idea of whether such strategies are worth pursuing based on your underlying objectives.

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