The rapid emergence of the ETF industry, marked by its AuM growth from $1 trillion to $10 trillion this past decade, was driven by passive indexed funds which thrived in a low-rates, low-volatility environment. These funds offered low cost, low differentiation solutions to retail investors.

As institutional investors overtake retail investors in ETF adoption, the landscape of the industry is set for a paradigm shift. The limitations of indexes are becoming increasingly apparent in a macro environment characterized by higher rates and higher volatility, which could stick around in the decade to come. The fundamental analysis and risk management that had been left behind by index funds are suddenly relevant again. Investors are consequently exploring alternative vehicles for their public equity exposures, namely active ETFs.

Tema is one of the first independent thematic active ETF asset managers, but unlike competitors, is concentrating on underpenetrated, generational thematic trends that were previously inaccessible to investors. These themes include reshoring, oncology, luxury goods, cardiology and metabolics (Obesity and diabetes), and monopolies and oligopolies.

The vulnerabilities of passive ETFs are becoming more apparent in the current environment

Limited by the rigid nature of their underlying indices, passive funds lack the ability to dynamically respond and adapt to increasingly rapid and sharp changes in environment. These limitations undermine risk management efficacy and can ultimately compound risks for their investors.

An example is the special premature rebalance the Nasdaq 100 index had to undergo this past summer. The disparity in performance within the index had over-concentrated its value, with the “Magnificent seven”, Alphabet (NASDAQ:GOOG), Amazon (NASDAQ:AMZN), Apple (NASDAQ:APPL), Meta (NASDAQ:META), Microsoft (NASDAQ:MSFT), Nvidia (NASDAQ:NVDA), and Tesla (NASDAQ:TSLA), reaching 55% of the index’s total value. The “special rebalance” not only revealed the concentration risks tied to indexation, but also exposed the arbitrage and front-running risks that passive vehicles can be exposed to, at the detriment of investors.

Active ETFs have enjoyed record growth in 2023

While passive ETF growth has started to slow, active ETF growth is now accelerating fast, with over 20% of year-to-date asset flows. Yet the active space is still young, with only 5% of total ETF assets. “Active” simply indicates that a fund does not track an index, which gives issuers greater flexibility and creativity to build their products. These products have the potential to create more dynamic and precise exposures, and offer greater efficacy for risk management.

The concerns with active management traditionally include higher fees, concentration risk, and ultimately disappointing performance. Tema believes a bottom-up approach to active management starting with risk management provides a proven and comprehensive solution to these latter concerns. Tema’s investment and risk management philosophy has an acute focus on mitigating downside risk. Previous academic studies have highlighted the underperformance of active management can largely be attributed to downside risk exposure.

Active ETFs can allow for better risk management

The discretion provided by active management allows Tema to proactively manage risk and capitalize on market dislocations in a disciplined way. For example, Tema’s risk management approach limits the size of any one company in a portfolio, thereby limiting concentration risk. Similarly, the flexibility of active management allows Tema to anticipate market events and position accordingly especially given the seasoned experience of Tema’s portfolio managers. This was evidenced most recently in the luxury space when Tema anticipated a Q3-2023 sell-off in luxury by increasing the cash position in the fund at the end of Q2-2023 to 20% temporarily.

Tema ETFs focuses on themes with inherent indexation limitations

Active management also provides the flexibility to access themes that are hard to index by nature of their constituents and underlying industries. Take for example Reshoring or Luxury, themes in which Tema launched the first US listed ETFs earlier this year.

Tema’s American Reshoring ETF (NYSE:RSHO), for example, seeks long-term growth by investing in companies that either enable the relocation of manufacturing and supply chains back to the United States or benefit from it. “Reshoring is a structural trend spurred by a confluence of factors including political and trade tensions, deglobalization and supported by unprecedented government spending. We think that reduced order cycles, lower inventories and more reliable supply chains should provide such companies with durable competitive advantages and higher sustainable growth outlooks,” said RSHO fund manager Chris Semenuk in a statement on the ETF’s launch. 

Reshoring companies are not clear-cut by nature of their industry classifications. As a result, reshoring beneficiaries and enablers are identified and analyzed based on bottom-up fundamental analysis that an index couldn’t replicate. Once the relevant securities have been selected, the portfolio construction follows a systematic approach which sizes positions based on conviction: highest, higher or foundational positions, depending on the manager’s relative confidence in that stock’s long-term potential.

A similar bottom-up, innovative approach underpins Tema’s Luxury ETF (NYSE:LUX) which invests in the global luxury industry. While luxury goods indexes exist, Tema saw a lack of precision in which companies are included in them. “We believe existing luxury investment indexes are undermined by construction issues and conflate bland consumer exposure with quality luxury exposure,” said Tema CEO Maurits Pot. “Furthermore, the luxury industry demonstrates high performance dispersion between longer-term outperforming and underperforming companies. While companies such as LVMH have generated consistent long-term returns for shareholders, companies such as Tods and Ferragamo have failed to generate shareholders for over ten years.”

Luxury indices include mass consumer goods companies such as Apple or Nike which are fundamentally different to pure luxury brands such as Hermes or Louis Vuitton. Luxury brands are underpinned by exclusivity, aspirational desires and craftsmanship while mass consumer companies serve more functional and less aspirational roles. As a result, luxury companies have superior profitability, pricing power and different growth drivers. The Tema luxury ETF aims to provide pure, undiluted exposure to the luxury market.

Tema’s other ETFs offer a similar level of expertise-driven thematic construction:

The Monopolies and Oligopolies ETF (CBOE: TOLL) comprises companies operating in a monopolistic or oligopolistic industry structure. Monopolistic structures are defined by sustainable competitive advantages and high barriers to entry, typically leading to high margins and profitability.
The Oncology ETF (NASDAQ:CANC) invests in oncology companies leading the fight against cancer. A revolution in biology and biotechnology is driving significant advances in diagnosing and treating cancer.
The Global Royalties ETF (CBOE: ROYA) is made up of companies across a range of industries that are all extracting consistent revenue streams from royalties collected on natural resources, music catalogs, or pharmaceuticals.

These unique and under-penetrated themes either cannot be accessed, or would have significant limitations if offered through an indexed vehicle. Access, precision, and risk management ae some of the clear benefits to Tema’s innovative approach.

Featured photo by Adam Smigielski on Unsplash.

This post contains sponsored content. This content is for informational purposes only and is not intended to be investing advice.

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