Why Thematic ETFs Make Me Nervous

When it comes to investing, exchange-traded funds (ETFs) are near the top of my list. That's why I'm surprised by how nervous thematic ETFs make me. While I'm all about broad-market ETFs, those tracking a single sector immediately raise caution flags.

I know how valuable ETFs can be for building a diversified portfolio. However, here are some red flags I need to come to terms with before investing in a thematic ETF. Here's where I get stuck.

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Peak of the hype

I've noticed that thematic ETFs typically launch when a specific trend has already captured public imagination. By the time an asset is considered a disruptive innovation (like cloud computing in 2011), institutional investors and early adopters have already driven up the underlying stocks. People like me -- who tend to scour the field before deciding what I want to add to my portfolio next -- buy in just as valuations hit the stratosphere.

When it comes to thematic ETFs, I have to ask myself whether I'm buying into the fund's underlying fundamentals or the hype.

Overconcentration

Let's say an ETF tracks cybersecurity or artificial intelligence (AI). I can have all the faith in the world in that sector's success, but the thought of diving in still makes me nervous. Here's why: Even if a cybersecurity ETF holds 50 stocks, all 50 could decline simultaneously if the sector falls out of favor.

On the other hand, if I own a broad-market ETF and cybersecurity represents only a part of the basket, the risk is greatly reduced. Even if cybersecurity stocks end up in the dumpster, other securities in the ETF can keep it (and my portfolio) afloat.

Hidden costs

Because of the specialized research and management required to keep thematic funds running, they tend to have higher expense ratios than broad-market ETFs. For example, a standard broad-market fund may have an expense ratio as low as 0.03%, while a thematic ETF typically has an expense ratio of 0.45% to 0.75%.

Increased complexity

I understand that this may be a "me problem," but thematic ETFs sometimes make knowing what I'm buying harder than it needs to be. Let's say I purchase a thematic AI ETF. Depending on its structure, an ETF may hold a hodgepodge of companies tangentially related to AI, such as data analytics, software development, financial services, and telecommunications firms.

While the onus is always on me to check under the hood long enough to understand an ETF's underlying holdings, I find it overwhelming to investigate each tangentially related company. It's particularly frustrating if I don't immediately understand why a particular company was included.

As I come to terms with my feelings toward thematic ETFs, I continue to invest in broad-market funds. One of my favorites tracks the S&P 500, and what I appreciate most about it is how it lets me buy stock in sectors that have entire thematic ETFs dedicated to them. However, since it covers the broader market, I'm not putting all my eggs in one basket.

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