By Rahul Sen Sharma, Managing Partner at Indxx.

Rahul Sen Sharma, Managing Partner at Indxx.

Market downturns may cause the market capitalization and liquidity of thematic ETF constituents to fall below the thresholds mentioned in the index methodology. In such cases, rebalancing becomes imperative to ensure that the portfolio does not deviate from its objective.

Additionally, rebalancing also allows thematic ETF managers to maintain their strategic long-term allocations in the face of rapidly shifting markets.

The biggest risks facing thematic ETFs today in the current macroeconomic environment.

The current macroeconomic environment is marked by a slowdown in growth, high inflation, and interest rate hikes which have led to volatility in the equity market. In such scenarios, thematic ETFs, which are generally concentrated, growth-focused, and may not have fundamental screening, become highly vulnerable to momentum crashes.

Rising volatility in financial markets could mean fluctuations in the value of constituents of a thematic ETF which, in turn, increases risk as given by higher beta, correlation and volatility of the ETF. Additionally, the risk of a thematic ETF may increase if the theme is adversely affected by rising inflation or market downturns as thematic ETFs often do not focus on either fundamentals or diversification.

Rebalancing in a systematic, rules-based manner with buffer rules becomes more important to stop the portfolio from deviating too far from its methodology and objective.

Broad vs Niche: Are broad-based ETFs any “safer” than niche thematic ETFs during a prolonged bear market?

Broad-based ETFs provide exposure to a large subset of the market which helps with diversification. In a bear market, broad-based ETFs will have a mix of winners and losers which will help reduce the overall losses within the fund. Concentration risk is low as compared to niche ETFs.

The performance of niche thematic ETFs depends on their area of exposure. Industries such as consumer staples and utilities generally perform better during bear markets and any niche ETF with exposure to these segments of the market would also be expected to perform better under such conditions.

Also, in the short term, the performance of niche thematic ETFs may be better than that of broad-based ETFs. For instance, if an ETF only invests in technology companies, it will likely do well in a year that tech outperforms. But on the contrary, it might not do so well when the tech industry goes through a lull. Considering the onset of the Russia-Ukraine conflict, cybersecurity and aerospace & defence ETFs have performed considerably well year-to-date, whereas thematic tech ETFs have underperformed year-to-date under the current macroeconomic landscape.

To reap the maximum benefit from exposure to a niche theme, timing the market in the short term is essential as there is a potential for outsized returns but also outsized distress. However, as empirical research has shown, market timing is exceedingly difficult. From a long-term perspective, the feasibility and growth potential of the theme are important factors to consider.

Even though the duration of a bear market is unpredictable, there are some factors one can under such conditions:

• Having the right mix of stocks, cash, and bonds that suits their time horizon and risk tolerance to get through the bear market.
• Short-term bonds, commodities such as gold and silver.
• High-yield stocks or preferred shares are strategic ways to reduce volatility due to dividends and income generation. Real estate can also be an option, even when prices decrease, as the sector as a whole is generally less volatile.
• Identifying value stocks during the bear market.
• Investors can explore put options which can be used to speculate price action, and hedge against falling stock prices to protect long-only portfolios.
• Higher inflation can erode the purchasing power of a portfolio. During periods of high inflation, investors can focus on sectors such as energy, inflation-protected bonds (TIPS), and real estate (REITS), which have traditionally performed better amid high inflation.
• A diversified commodities fund can help mitigate inflationary risks while generating returns. For example, the Indxx Global Natural Resources Income Index has performed well in the current year with YTD returns of 463.64% (as of June 17th, 2022) despite the general market selloff in other sectors that are more prone to the negative externalities of high inflation.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)