Mark LaMonica - Thematic ETFs

Mark LaMonica has some robust views on thematic ETFs and what investors should look out for. Mark is a Product Manager at Morningstar and also the co-host of the Investing Compass Podcast. I love hearing strongly held opinions and it's worthwhile for beginners to understand that you are often being marketed to, rather than being shown how to make investment returns.

We spoke about:

• How the investment sets up and markets ETFs
• What a "Thematic ETF" actually is
• What railroads, the telegraph, and fibre optic cables have to do with thematic ETFs
• The durability of thematic ETFs
• Mark's least favourite thematic ETF

LISTEN TO MARK & SHANI'S EPISODE ABOUT THEMATIC ETFs

EPISODE TRANSCRIPT FOLLOWS BELOW

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EPISODE TRANSCRIPT

Chloe (2s):

Stocks for Beginners. 

Mark (7s):

Once a theme is widely accepted and an ETF company has launched an ETF off of that theme, the expectations are generally very, very positive. And what's going to drive those stock returns in the future is not how a company does absolutely, but how they do in comparison to those expectations. 

Phil (27s):

Hi and welcome back to Stocks for Beginners I'm Phil Muscatello. ETFs are a great way to access diversified portfolios of stocks across many asset classes. Beginners will often start with an S&P 500 or NASDAQ ETF. Or even an ETF that will let you buy in all of the major stock markets across the planet. However, there can be a dark side. Joining me today to explain this is Mark Lamonica from Morningstar. Hi there Mark. 

Mark (55s):

Hi, thanks for having me. 

Phil (56s):

Thank you very much for joining me for this. Now let's start by talking about the investment industry and how ETFs are really set up. What's it like in the sausage factory? 

Mark (1m 6s):

Yeah, yeah, absolutely. I mean, there is obviously a lot of minutiae and different service providers that you do need to deal with if you're setting up an ETF. But for an established financial services company that has existing ETFs, it's not that hard to set up a new one. So you already have relationships with all the different service providers, with authorized participants who really facilitate the creation of those ETF units. So all you really need to do is find an index that you want to track, if you have a passively managed ETF, and sign a contract with that index provider and away you go. 

Phil (1m 40s):

That's an interesting thing as well. I really like looking into all the nooks and crannies of the industry. And I actually spoke to someone from Singapore stock exchange, who that's all he does. He provides for S&P 500 he makes and creates indices and they actually get paid, don't they, buy the ETF providers so they actually have something solid to track. That's the way it works, isn't it? 

Mark (2m 4s):

Yeah, absolutely. And they actually, for some of those indexes, like the S&P 500, they get paid a lot. So it is a very lucrative business. I will say that Morningstar, we do have our own indexes. So kind of two different approaches. We have something called the open index products where we are actually giving away for free access to indexes, like an S&P 500, so sort of large scale indexes. And then we have our own proprietary indexes where we are taking different cuts of data, so whether it's using Morningstar ratings or motes, for example, and we're selling those. So Morningstar isn't in the business, but yeah, of course, all of these indexes need to be licensed by a product like an ETF. 

Phil (2m 43s):

And we might get back to that later in the interview. It'd be interesting to talk about some of those, is it indexes or indices? I never know what to say. 

Mark (2m 52s):

You know, I go back and forth, which isn't helpful to anybody. But yeah, I'll probably start talking about indices in a little bit. So, you know, just a little warning at the beginning, right? 

Phil (3m 1s):

Okay. So once an ETF is set up, really there's nothing else that needs to be done to keep it running. So it becomes more of a marketing exercise, doesn't it? 

Mark (3m 12s):

Yeah, no, absolutely. And I think with any product, and of course any financial product, you need to think a little bit about how the companies are actually making money. So with ETFs is pretty simple, right? They are charging a fee. That fee is on assets that are in the ETF. So you'll often see them quoted as a percentage fee. So what do they want? They want more money in that ETF. So they want investor inflows, they want to grow those assets under management and that's how they make more money. And, you know, a lot with ETFs there is really sort of a fixed cost. And so what you want to do is grow a big enough pool of money in that ETF to start making money yourself. So, yeah, it really is a marketing exercise. 

Mark (3m 53s):

And of course, marketing is really important. 

Phil (3m 56s):

And thematic ETFs are a big part of the marketing aren't they? 

Mark (3m 59s):

They are, they are. So, you know, a thematic ETF generally will cover a very narrow part of the market. And you know, what it's supposed to do is really take advantage of a narrative that's resonating with investors. And that of course is where the marketing comes in, right? If you have this narrative, it makes it a lot easier to go out there and sell. And that's nothing new, right? Sort of this notion of a compelling narrative has been around since, you know, the south sea bubble. Investors like stories. We all like stories with everything. And so if you have a story about something, it makes it much easier to market. So ETF companies really liked thematic ETFs. 

Phil (4m 35s):

One of the examples at the moment, of course, are ESG funds. They becoming so popular because it seemed to be something that young people are very interested in to be seen to be doing something valuable with their investing as well. 

Mark (4m 47s):

Oh yeah. No, absolutely. So any sort of theme. So there obviously is a wide variety of themes. Ethical investing is certainly a theme. Now, one of the interesting things about anything sort of ESG related is it comes in so many different flavors. So everything from, you know, funds that are really doing negative screening, that's what you hear about the most. So let's say you don't invest in coal or you don't invest in companies that are damaging the environment. But also ESG can take really a more holistic view of factors and really look at, okay, are these factors as investors we take on risk? Are the risks from things like climate change, are those being incorporated into the price? 

Mark (5m 30s):

So the one thing to be careful about with sort of ESG and ethical investing as it comes in lots of different flavors. 

Phil (5m 36s):

So I want to hear your story about the railroads, the telegraph and fiber optic cables. What have they got to do with thematic ETFs? 

Mark (5m 43s):

Yeah, yeah, no, absolutely. So, you know, once again, obviously there were not ETFs in what I'm about to talk about. They're not ETFs around at the time, but it is important to note, as I said a couple of minutes ago at the south sea bubble, that there are certainly these narratives that have always attracted investors. 

Phil (6m 0s):

And if ETFs had been around at that time, they would have been marketed as such. 

Mark (6m 4s):

Exactly, exactly. So, you know, I think if we look at railroads, telegraphs and fiber optic cables, the interesting lesson that this has for thematic ETF investors is all of them transformed the world. They had really profound impacts on the ways that we all, or people back when this happened, lived their lives. So let's take a look into some of those. So the telegraph, of course, really the first way that information was able to go quickly a long distance. And yeah, there was a huge bubble in the US around telegraphs. So between 1846 and 1852, the number of Telegraph miles in the US went up 10 times. 

Mark (6m 47s):

And basically, you know, these were startups. So a little different than what we think of at a startup these days. But these were companies that were, started to lay all these telegraph networks and they faced all the same problems that startups face now. So, you know, certainly there were issues with the quality as floods and weather and everything else knocked out these telegraphs. The other problem was there was a ton of competition. So this theme was something that was sort of universally accepted. So you had lots of companies competing over this. And basically what happened is there was a ton of capacity and ton of capacity led to bad business outcomes. So most of these startup telegraph companies went out of business and the ones that stayed around couldn't charge a lot because it turns out that one Telegraph is just as good as the other one. 

Mark (7m 33s):

So companies that were using telegraphs and people that were using telegraphs could shop around. So not a great situation for investors, very, very similar with railroads. Same thing 

Phil (7m 44s):

Just before we get onto the railroads. I just want to decide there is a book that came out, most probably a decade or so ago, called The Victorian Internet, which was the story of the telegraph industry. And there's parallels isn't there between the Telegraph industry and the early days of the internet? I mean, is AOL still around? 

Mark (8m 2s):

Yeah, yeah, exactly. Exactly. Oh, that's interesting. I'll have to, I'll have to pick up that book. 

Phil (8m 6s):

Anyway let's go on and we'll have a talk about the railroads now. 

Mark (8m 10s):

Yeah. I mean, railroads, pretty similar. So, you know, both in the US and the UK, the companies, or the countries took pretty similar approaches letting private companies fund these giant railroad networks. So once again, lots of, lots of investment, lots of different competition. And at the end of the day, the railroads didn't do very well. So in the us in 1894, there was a railroad crash where a quarter of railroad companies went out of business. But like the telegraph, the beneficiaries of this profound change in transportation, the beneficiaries were actually other companies. And so this was around the time that Sears Roebuck started, Montgomery Ward. 

Mark (8m 51s):

So all of a sudden these companies were shipping mail order products across the country. And the same time that Proctor and Gamble, Coca Cola companies that we still hear about today, they became national companies because they could take advantage of once again, these very, very cheap railroad rates to ship things all around the country. So it's just an example. And we'll do the last example. Something that actually occurred in more people's lifetime, like my own. The last example, if we look at fiber optic cables, so late nineties, right? The internet starting up, what do we need? What infrastructure do we need? We need to lay cable so that we can of course have all these high-speed networks that we all take for granted now. 

Mark (9m 31s):

So companies like Global Crossing, WorldCom they invested $30 billion. They built out 90 million miles of fiber optic cable. And in 2001, along with the dot com bubble bursting. This burst as well. And at the time, amazingly enough, 5% of everything, all these cables that they put all around the world were being used. So huge oversupply. And so these companies went out of business. But we're all seeing the benefit now, right? Google, YouTube, Facebook all of these business models that are reliant on the ability to deliver data around the world are based off of this. And, you know, I think the point and why this ties in with thematic ETFs is they're all examples where the theme was correct. 

Mark (10m 17s):

So the internet was going to change the world. Railroads were going to change transportation and shipping. But the question is who is the beneficiary? And we always get in these situations where we don't know. Is the beneficiary the company that is in this case, laying the fiber optic cable or the railroads? Or is the beneficiary consumers or other companies that use these networks to build out a business? So that's just something that's important to be mindful of with thematic ETFs is we don't really know who the beneficiary is going to be. 

Phil (10m 54s):

So what is it that really grinds your gears about thematic ETFs? 

Mark (10m 59s):

Yeah, I mean, listen, this is the whole thing that once a thematic ETF comes out, it is introduced by a company because this theme is quote unquote obvious and resonates with consumers. But if we put our investor hat on, we need to start thinking through, okay, how can I profit from a theme as an investor? So three things need to happen. So the theme needs to unfold as expected. So there are countless themes, right? That just don't actually play out. So the theme needs to unfold as expected. The companies that are actually in that ETF have to profit from this theme. Just like if there was a railroad ETF or an ETF that had WorldCom and Global Crossing in it, you would not have done well as an investor, even though, you know, the theme played out. 

Mark (11m 46s):

And then kind of the third thing is that, you know, these companies each of translate into attractive stock returns. And that's a huge problem because if we think about what are we doing as investors, we are looking at the future. So we benefit from what happens to a company in the future. The cash flows that that company generates. Now, the problem is that a lot of this has to do with valuation. So if the expectations of the market. So market prices, so whether we want to talk about the price of an individual company or the price of an index, those market prices are what investor expectations are in the future, right? It's basically the consensus of those investor expectations. 

Mark (12m 29s):

So once again, once a theme is widely accepted and an ETF company has launched at ETF off of that theme, the expectations are generally very, very positive. And what's going to drive those stock returns in the future is not how a company does absolutely, but how they do in comparison to those expectations. So a simple example is obviously in 2020 Tesla performed amazingly. So what matters to me, if I was a shareholder of Tesla right now, what would matter to me is not how they do on an absolute basis, but how they do versus those expectations. So let's say they sell twice as many cars next year. 

Mark (13m 11s):

That's great. Like if you were Ford, you would be over the moon if you could do that. But if the whole market thinks that they're going to sell three times as many cars, chances are that's going to be a pretty poor investment return. So I guess that's really my biggest problem. The whole thing that makes these great to market is the thing that also makes some potentially really poor investments, just because of those expectations. 

Phil (13m 34s):

But surely some companies will profit from the growth of a theme, doesn't a thematic ETF provide a convenient catch-all? And, you know, you might be able to snag at least one or two great companies in that overall ETF. 

Mark (13m 46s):

Yeah. I mean, hey maybe. Yeah, you're right. Somebody is probably going to profit from this theme. If it's a company that's directly involved in this theme, it would be captured in the thematic ETF. That could be a good thing. The problem is that in many and sort of how we've seen. If we look at the internet, for example, and this is a simplistic example, but if there was a social media ETF that had Myspace and Facebook in it, so things went pretty well for Facebook and I know Myspace was eventually purchased, but you know, basically it went away. So in that case, if we have more of a winner take all market, as an investor that's investing in this wide basket of related securities, you're going to have a lot of losers to capture that one winner. 

Phil (14m 30s):

There could also be problems with the durability of ETFs as well. What is the history of ETFs and how many have survived? 

Mark (14m 36s):

Yeah. Yeah. So we actually, Morningstar, did a thematic funds landscape report. And went back and of course examined this very question. And so basically, you know, if we go back and we looked over the past 30 years, so thematic ETFs are not new and sort of thematic based investments are not new, 30% of them went away. So they're no longer around. And you know, that's a pretty poor number at the end of the day. So why were they closed? Well, because either the theme failed, you know, from a business standpoint, the theme failed to attract capital, which generally means there were either poor returns or no inflows. 

Mark (15m 17s):

So all those things, you know, of course the theme going poorly or poor returns are going to drive investors away and they were closed. 

Phil (15m 25s):

So tell us about your least favorite thematic ETFs, Mark. 

Mark (15m 28s):

Okay. So one thing to remember, we talked about indexes or indices, whatever we decided to use at the beginning. So, you know, you use of course, a classic example, right? The S&P 500, which is the most invested and followed index in the world. Now that is the 500 largest stocks in the US. Well, there are different kinds of indexes that are created specifically for things like these thematic ETFs. And I think one of the most ridiculous ones is something called the Fang plus index. So the Fang plus index, I'll get into what it tracks in a second, but there is ETFs that are put out by micro sectors that track this index. 

Mark (16m 10s):

And interestingly enough, they have ETFs that track the index on sort of a one-to-one basis, so basically you are getting the return of the index, and then they've got leverage built into there to where you can get two or three times the index performance both up and down. So let's talk about what this index is because at the end of the day obviously that's what the ETF is. And, you know, I'll quote what they say "it is made up of Fang related securities". Like, I don't know what that means. They're obviously looking at companies like Facebook and Amazon and Netflix and Google, but I don't know what a Fang related security actually is probably neither do they. And they have a governance committee and the criteria they use to pick what goes into this ETF is, and I'll quote now "highly traded growth stocks of technology and tech enabled companies in the technology, media and communications and consumer discretionary sector". 

Mark (17m 5s):

So basically highly traded, that means popular. You know, if we translate that into English, so popular stocks in all sorts of different sectors that are popular with investors, right? So technology and tech enabled companies. Every company in the world is tech enabled right now, you know, every company uses computers. So I don't really know what that means. And yeah, so basically they're looking for expensive and popular stocks. I mean, at the end of the day. 

Phil (17m 31s):

And it's plus plus, so it must be really good then. 

Mark (17m 34s):

Oh yeah, yeah, exactly. Exactly. And the interesting thing is, you know, one of the reasons that we invest in ETFs and you said it at the beginning and ETF is a great way with one trade to get a diversified portfolio. Well, this ETF has 10 securities in it. So you're not getting a diversified portfolio, you're getting 10 popular securities. And one of the other things, and I know this is a little wonk-ish, but one of the other things is this ETF, so you put equal weight into each of these 10 securities and it rebalances quarterly. So what that basically means is they sell the winners and they buy the losers to get it balanced back so that they all have the same amount in there. Now, the problem with this is as an investor is I get those capital gains. 

Mark (18m 17s):

So I have to pay taxes on this. So this ETF had a huge distribution and, you know, I've read on different message boards that people are excited about this, oh, we've got this huge, people call them dividends, right? Got this huge dividend. That's really good, I'm making income. It's not income. It is capital gains that are being distributed to you. And the ETF is set up to do this. In an up market you're always going to get these huge quarterly distributions that are capital gains. So yeah, I would say this ETF is not exactly my favorite. 

Phil (18m 48s):

And it's got leverage involved in it as well. 

Mark (18m 50s):

Yeah. There is an option without leverage. 

Phil (18m 53s):

Oh ok. 

Mark (18m 53s):

But then of course you can go two or three times leverage getting two or three times the return. 

Phil (18m 60s):

Wow. And so people don't even understand what that means. They must probably looking at the plus plus thinking, oh, this is great. 

Mark (19m 5s):

Yeah, yeah, no, exactly. Yeah. 

Phil (19m 7s):

It's double thumbs up 

Mark (19m 8s):

And it's done very well. Like I will say that. It has very strong returns and of course, strong returns attract investor capital. You know, the problem is of course, you know, in my opinion is the stuff that's been going on in the market right now, the market's just gone straight up. And it has been performing very, very well. And that's when this stuff looks attractive. But you know, there's a price to earnings ratio of close to 48, which is very high for the securities in here. So yeah, I just worry that, you know, at the top of the market and you know, I'm certainly not smart enough to call a top of the market, but the same thing happens at the top of every market. All this investor money rushes in and generally gets burned when the market falls. 

Phil (19m 51s):

Just want to just to explore just that little point there that you made about the reweighting every quarter. Is that because the most successful companies in the portfolio are suddenly, maybe instead of being 10%, they're 12, 15, 18%. So you have to get rid of some of that to bring it back down to 10% and then buy more of the less successful companies? 

Mark (20m 13s):

Exactly. Exactly. 

Phil (20m 14s):

It doesn't sound good. 

Mark (20m 15s):

Yeah. Yeah. Generally the way an index works, so if we go back to the S&P 500, the S and P 500 is a market cap weighted index. So the weightings in that index are based on how big the company is and how big the company is measured by shares times the price. Now over time, if the same company is more and more successful, and we've seen this with a lot of tech companies, they will make up a bigger portion of the index. But there isn't any rebalancing that happens. So if a company drops out of the index, of course the index has to sell it and buy something else. But generally you're not going to have all that much activity around new companies coming in and going out. In this ETF it is an equal weighted ETF. 

Mark (20m 58s):

So just as you said, if one company does really, really well over the course of a quarter, and it's now 15% of the index, you have to sell it off to get that equal weighted again. And they almost have to do this because it's a 10 stock index. I mean, you know, they can't get to a point where if one company did really well, it makes up 60, 70% of the index so they're rebalancing. But the problem is as investors, that rebalancing is not free, right? We pay capital gains tax on that rebalancing. 

Phil (21m 32s):

So is there any place in an investor's portfolio for thematic ETFs? 

Mark (21m 36s):

Yeah. I mean, listen, our viewpoint at Morningstar is these should not be core parts of investors' portfolios. So yes, certainly if there is a little bit you want to dabble with on something more speculative, maybe this has a place depending upon of course your financial goals and what you're trying to accomplish. But I think taking a step back, investing is not supposed to be exciting. I know we're certainly on a podcast talking about investing, but yeah, it's just not supposed to be that exciting. It's generally safer for people to take a step back and watch these developments from the sidelines and buy something more diversified. So we use the example of the S&P 500. 

Mark (22m 17s):

That's an example of something, obviously a lot more diversified. So, you know, chasing around these new investment areas that are more speculative in nature hasn't generally worked out for most investors. So I think you should be very careful about these. 

Phil (22m 31s):

What products does Morningstar offer for new investors and especially in the ETF space and making sensible decisions about purchasing ETFs? 

Mark (22m 39s):

Yeah, absolutely. So the first thing I would say is you can go to morningstar.com. We have a lot of articles on there and they are free to access. So certainly you can read commentary from our editorial team talking about all types of investments, including ETFs. There's a good learn section on there. So you can go learn a little bit more about investing. We also have a subscription product called Morningstar premium. So basically you pay a annual subscription fee and you get access to our research. So Morningstar covers ETFs and funds as well as individual shares. So you can read what our analysts think about that and see the different ratings we have on different ETFs if that's what you're interested in. 

Phil (23m 23s):

Mark Lamonica, thank you so much for joining me today. 

Mark (23m 25s):

Great. Thank you very much.

Stocks for Beginners is for information and educational purposes only. It isn’t financial advice, and you shouldn’t buy or sell any investments based on what you’ve heard here. Any opinion or commentary is the view of the speaker only not Stocks for Beginners. This podcast doesn’t replace professional advice regarding your personal financial needs, circumstances or current situation.