Thematic ETFs have experienced a surge in popularity in recent years, with a growing number of investors turning to them as vehicles to access emerging and innovative sectors.
From clean energy and artificial intelligence to fintech and health innovations, these ETFs offer a way to tap into these forward-looking themes, providing greater accessibility and affordability to retail investors.
However, the rising popularity of thematic ETFs brings its own set of challenges. Emotional decision-making often comes into play, with many investors becoming entranced by the captivating narratives these ETFs present.
The result? Some end up buying at the height of enthusiasm, only to realize later that they entered the market at its peak, leading to potential underperformance or losses.
Recognizing this challenge, Purpose has introduced a new ETF to the Canadian market. The Purpose Tactical Thematic Fund (RTT), listed on Cboe Canada, seeks to sidestep these pitfalls.
By adopting a disciplined, rules-based approach to select its thematic exposures, this ETF aims to provide investors with a more calculated and strategic entry into the thematic space.
Let's examine the behavioural rationale behind why this fund may be effective and take a detailed look at its structure and strategy.
The pitfalls of emotional investing in thematic ETFs
Investing, at its core, is not just a numbers game. Behind every buy or sell decision, there's a human being with emotions, biases, and perceptions that can impact the choices they make.
With the rise of thematic investing, the intersection of emotion and investment decision-making has become even more pronounced.
Let's break down how behavioral biases can play out in the world of thematic investing, using the hypothetical example of an investor drawn to artificial intelligence, or an AI ETF.
Our investor first takes notice of the AI ETF due to its impressive recent outperformance. Recency bias, the tendency to weigh recent events more heavily than past events, comes into play here.
Instead of looking at the longer-term performance or understanding the fundamentals driving the returns, our investor becomes overly focused on the recent success.
They start to believe that the recent trend – in this case, the impressive gains of the AI ETF – is an indicator of future performance. The trap is set.
As the investor digs deeper, they notice that many others are talking about this AI ETF. Friends, colleagues, financial news outlets, and social media are abuzz with discussions about the fund's prospects. This creates a sense of FOMO (Fear of Missing Out).
Herding, the behavior of following the crowd, then amplifies this sentiment. The investor, driven by the desire not to miss out on perceived gains and the reassuring feeling that comes from being part of the majority, decides to invest in the AI ETF. They believe that with so many others doing the same, it must be the right choice.
Time passes, and as with many investment themes that experience rapid appreciation due to hype, the AI ETF begins to level off after reaching its peak. The initial fervor that drove its spectacular rise starts to wane and a downtrend starts.
Now, the investor faces the specter of loss aversion, the psychological phenomenon where the pain of losing is felt more intensely than the joy of gaining. As the ETF's performance begins to dip or even stagnate, the emotional impact of potential loss sets in.
Panic ensues. Instead of considering the long-term prospects or understanding the reason behind the ETF's performance fluctuation, the investor sells their position in a frantic bid to avoid further pain.
The culmination of these biases often results in a money-weighted return for the investor that lags the actual time-weighted return of the thematic ETF.
Essentially, the investor might end up buying high (due to recency bias and herding) and selling low (driven by loss aversion), the opposite of the age-old investing adage.
How the new RTT ETF from Purpose may mitigate this
Purpose's new RTT ETF takes a distinctive approach designed to combat the emotional pitfalls many investors face. As its name suggests, this ETF is able to tactically rotate between different investment themes via underlying ETFs based on a rules-based approach.
Rather than relying on subjective judgment or market hype, the fund utilizes a quantitative, rules-based approach centered on relative strength and momentum. In essence, it evaluates which thematic ETFs are showing strong performance trends and invests in them based on quantifiable indicators.
If there aren't clear buy signals within the thematic ETF universe, the fund has the flexibility to invest in broad market ETFs or even hold cash. This adaptability can provide a buffer during uncertain times or minimize tracking error when specific themes aren't showing strong positive momentum.
The ETF is all about trend-following – buying into thematic ETFs early in an uptrend and selling them early into a downtrend. This introduces a structured sell discipline, ensuring that the fund doesn't cling to underperforming assets out of sentiment or hope.
With the bulk of the portfolio decisions driven by a systematic, multi-factor model, emotions are largely kept out of the picture. This structured approach can be especially beneficial in the world of thematic investing, where compelling narratives can easily sway investor sentiment.
This content was originally published by our partners at the Canadian ETF Marketplace.