Thematic funds are inherently risky due to their narrow focus and this makes the valuation of their relatively small stock portfolios even more crucial.
Take thematic ETFs focused on artificial intelligence stocks. AI stocks have posted huge gains over the past year, driven by Nvidia (NVDA), lifting valuations across the board. Does that mean that the biggest AI ETFs are all overvalued? Based on fair value estimates for the underlying holdings assigned by Morningstar analysts, the three largest ETFs show some difference in valuations.
As the chart below shows, stocks in the Gold-rated L&G Artificial Intelligence ETF (AIAI) are on average fairly valued, WisdomTree Artificial Intelligence ETF (WTAI), rated Bronze, is slightly undervalued and Xtrackers AI & Big Data ETF (XAIX), rated Silver, is slightly overvalued.
Looking at the top five holdings of each ETF, there is some overlap here, with both L&G Artificial Intelligence and Xtrackers AI weighting Nvidia [NVDA], Microsoft (MSFT) and Alphabet (GOOGL) heavily. The WisdomTree fund holds a completely different set of stocks, with Micron Technology (MU) the biggest weighting.
Are Thematic ETFs Overvalued or Undervalued?
More undervalued thematic ETFs can be found outside the AI space. Popular investment themes, such as those focused on the climate transition, have been victims of the hype cycle in recent years, posting periods of strong outperformance followed by underperformance - especially since central banks began to raise rates.
AI, automation and robotics are in the overvalued cohort, as well as defence, as geopolitical uncertainty is filling the order books of weapons makers and driving up valuations.
At the other end of the table, a China Internet ETF is the most undervalued among the largest ETFs after slower economic growth and regulatory crackdowns in China weighed on the sector. Funds exposed to EV batteries have struggled recently because of concerns about the speed of EV adoption in Europe, leaving L&G's Battery Value Chain ETF among the most undervalued.
Undervalued Stock ETFs
KraneShares CSI China Internet ETF
• Medalist Rating: Bronze
• Expense Ratio: 0.75%
• Theme: Internet
The €4.9 billion KraneShares CSI China Internet ETF (KWBP) fell 13.97% over the past year. The loss on the passively managed fund edged out the 17.99% loss on the average fund in the China region category. Year to date, the KraneShares fund is up 0.04%, while the average fund in its category is down 0.84%.
L&G Battery Value-Chain ETF
• Medalist Rating: None
• Expense Ratio: 0.49%
• Theme: Battery Technology
Over the past year, the passively managed L&G Battery Value-Chain ETF (BATT), which holds €645 million, fell 1.33%. It has climbed 4.5% year to date. The fund launched in January 2018.
iShares Electric Vehicles and Driving Technology ETF
• Medalist Rating: Gold
• Expense Ratio: 0.40%
• Theme: Next Gen Auto
The passively managed iShares Electric Vehicles and Driving Technology ETF (ECAR) ended the past year up 9.39%, underperforming the average fund in the equity technology category, which rose 29.16%. The €598 million fund has gained 5.48% year to date, while the average fund in its category is up 10.04%.
Overvalued Stock ETFs
VanEck Defense ETF
• Medalist Rating: Bronze
• Expense Ratio: 0.55%
• Theme: Security
Over the past year, the passively managed VanEck Defense ETF (DFNS) rose 52.97%, while the average equity industrial materials fund gained 16.75%. The €537.6 million fund has climbed 24.13% year to date, outperforming the average fund in its category, which rose 7.2%.
First Trust Cloud Computing ETF
• Medalist Rating: Bronze
• Expense Ratio: 0.60%
• Theme: Cloud Computing
The passively managed First Trust Cloud Computing UCITS ETF (SKYU) ended the past year up 43.7%, outperforming the average fund in the equity technology category, which rose 29.16%. The €323.7 million fund has gained 11.62% year to date, while the average fund in its category is up 10.04%.
Xtrackers AI & Big Data ETF
• Medalist Rating: Silver
• Expense Ratio: 0.35%
• Theme: Artificial Intelligence
Over the past year, the passively managed Xtrackers Artificial Intelligence & Big Data ETF (XAIX) rose 55.27%, while the average equity technology fund gained 29.16%. The €2.7 billion fund has climbed 15.78% year to date, outperforming the average fund in its category, which rose 10.04%
How Risky Are Thematic Funds?
Investing in a theme is an attempt to capitalise on short- or long-term trends by grouping investments around ideas. Whatever you think will be the "next big thing", from robotics to space travel, will be catered to by a thematic ETF. But the line between sectors and themes can be blurry, especially as sector definitions have drifted through time. This is especially true of "tech", which has splintered into many different sub-themes. A full analysis can be found in our article, "What is Thematic Investing?".
"Many, if not all, thematic funds are risky by design," Morningstar fund analyst Kenneth Lamont said. "They're designed to target very specific risk and return drivers. And that means they're often highly concentrated baskets of stocks and therefore highly volatile. And every investor in thematics must really understand that before they invest."
Methodology for Thematic ETFs
Using Morningstar Direct data, we've used the biggest ETFs in Europe by market capitalisation to represent their respective themes. We’ve looked at the ETFs’ underlying holdings and what the price/fair value of each is, using a weighted average of each stock.
Other ETFs in that particular theme may screen as undervalued, overvalued or fairly valued. Price data is at month-end. The screen includes a mixture of quantitative and qualitative ratings.
Fair value estimates inform investors of the long-term intrinsic value of a stock, helping them look beyond the current stock price. Morningstar calculates a company's price estimate based on the amount of cash it believes the company will generate in the future. In determining this estimate, Morningstar also takes into account the predictability of the company's future cash flows (uncertainty index).
The price/fair value does not take into account the cost of buying ETFs via an investment platform or ongoing charges.
As part of our mission to put more information into the hands of investors, this article was partially generated by Wordsmith, an automated smart-text platform, using Morningstar’s data. Written and edited by James Gard, Sunniva Kolostyak and Fernando Luque.
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