Liquidity risks
Beyond market risk, thematic ETFs tend to be more exposed to liquidity risks than the average broad diversified equity fund.
In their search of companies with the highest exposure to emerging themes and those with the highest growth potential, thematic funds often invest in the smaller, less liquid stocks.
Thematic ETFs with the highest exposure to micro-cap stocks in Europe:
| Name | Ticker | Broad theme | Theme | Micro-cap exposure % | Fund size (€mn) |
| Rize Ucits ICAV - Rize Medical Cannabis and Life Sciences UCITS ETF | FLWR | Social | Cannabis | 53.8 | 35.0 |
| The Medical Cannabis and Wellness Ucits ETF | CBDX | Social | Cannabis | 45.5 | 28.5 |
| Global X Genomics & Biotechnology Ucits ETF | GNOM | Technology | Life Sciences | 32.0 | 3.7 |
| Cleaner Living ESG-S Ucits ETF | DTOX | Social | Wellness | 30.8 | 1.5 |
| ETC Group Digital Assets and Blockchain Equity Ucits ETF | KOIN | Technology | Fintech | 30.6 | 3.2 |
| Rize Education Tech and Digital Learning Ucits ETF | LERN | Social | Wellness | 27.5 | 10.9 |
| VanEck Digital Assets Equity Ucits ETF | DAPP | Technology | Fintech | 24.4 | 30.5 |
| Legal & General UCITS ETF Plc - L&G Digital Payments Ucits ETF | DPAY | Technology | Fintech | 24.0 | 13.5 |
| WisdomTree BioRevolution Ucits ETF | WDNA | Technology | Life Sciences | 22.2 | 1.2 |
| HAN-GINS Indxx Healthcare Megatrend Equal Weight Ucits ETF | WELL | Technology | Life Sciences | 20.6 | 11.5 |
Source: Morningstar
In the table, the thematic ETFs with the highest exposure to micro-cap stocks in Europe are listed. The Rize Medical Cannabis & Life Sciences ETF, for example, has more than half of fund assets invested in micro-cap stocks like Little Green Pharma Ltd, Australia's first locally-grown medical cannabis producer.
Micro-cap stocks can offer large upside potential, but a lack of liquidity means trading in and out at short notice may be costly.
The surge in popularity of thematic ETFs, which tend to have narrow exposures and are compelled to buy and sell in line with index rules, has raised questions surrounding stocks' liquidity.
In the case of ETFs, should the liquidity dry up in a portfolio stock, the increased trading costs will be passed on to the ETF investor through larger spreads, and tracking error versus the underlying benchmark will increase.
In fact, the runaway success of some alternative energy ETFs caused their own growing pains in late 2020.
The combined assets of iShares' Europe and US-domiciled alternative energy ETFs catapulted to $10.7bn (£8.21bn) by the end of first quarter 2021 from $0.8bn at the beginning of 2020.
With so much money gushing into such a narrow portfolio of small and mid-cap stocks, and amid questions about liquidity, the S&P Global Clean Energy Index has been forcibly broadened. Any additional trading costs associated with this switch were absorbed by fund investors.
When evaluating the liquidity of a thematic fund, investors should look directly at fund holdings.
Metrics like market capitalisation of the stocks and average daily traded volume can be used to estimate how difficult it would be to sell holdings at short notice. A fund with large exposure to small and micro-cap stocks is worth further scrutiny.
Kenneth Lamont is senior research analyst at Morningstar
