Disrupting Sectors with Thematic ETFs July 3, 2019

Introduction to Traditional Sector Classifications

A sector refers to an area of an economy in which the businesses share the same operating characteristics, related products or services. Each sector may contain a subset of industries. For example, healthcare firms may include hospitals and medical equipment providers while consumer staples firms produce essential products like food, beverages and household items.

Each sector tends to perform differently during different market conditions because of the nature of the underlying industries and consumers’ demand for their products and services.

Examples of Sectors and Industries Composition

The classification of equities into different sectors enable investors to carry out their macro-level or sector rotation strategies. In addition, the low correlation between cyclical and defensive sectors allow investors to diversify their portfolios through different stages of the business cycle.

You may find more details regarding the classification of the different sectors by reading MSCI’s Report.

Sector Disruptors

From the Industrial Revolution in the 1800s to the Internet Boom in the 2000s, the economy is in a constant state of rejuvenation and renewal. Obsolete industries will be replaced by new enterprises and companies will be forced to adapt to the changing environment. This is part of natural economic Darwinism, where natural selection dictates that only the strongest survive.

Within each traditional equity sector, powerful structural trends are developing. The traditional sectors’ leaders of today are increasingly at risk of being replaced by companies, which are positioning themselves for the next socio-economic phenomenon.

Different industries within each sector have a differing vulnerability to being disrupted. We can use the Accenture Disruptability Index to gauge an industry’s state of disruption based on its current level of disruption and its susceptibility to future disruption.¹ There are four distinct states of disruption: durability, vulnerability, volatility and viability.

Description of the Four States of Disruption

Investors can utilise the Accenture Disruptability Index to evaluate the risk and return profiles of the respective sectors and industries. Armed with the knowledge, investors can then better allocate their resources into industries with lower volatility or participate in growth opportunities that the disruptors may have to offer.

Traditional Sector-Based Exchange Traded Funds

Traditional sector-based Exchange Traded Funds (ETFs) allow investors to gain exposure to select sectors without having to pick specific stocks. Inclusion criteria into these traditional sector-based ETFs are usually based on the market capitalisation (Share Price x Number of Outstanding Share Units) and the primary operating business of the companies.

During rebalancing, the composition stocks underlying these traditional sector-based ETFs may change because of various reasons; companies were liquidated or replaced by better performing companies. Moreover, new sectors and industries might emerge to reflect current economic trends.

Limitations of Traditional Sector-Based ETFs

The blistering pace of technological innovations, coupled with ever-changing consumers’ preferences, meant that sector-level disruptions are occurring on a more frequent basis and at a higher order of magnitude.²

Traditional sector-based ETFs may be ill equipped for investors who are looking to capitalise on the long-term growth potential of the sector disruptors. As traditional sector-based ETFs are market capitalisation weighted, they tend to favour large cap stocks. This tilts the ETFs’ exposure to companies that have already successfully capitalised on previous and current economic trends.

To illustrate, the Technology S-Curve shows that an innovation in its infancy stage provides higher growth potential, albeit with a higher risk of failure, than an ageing technology that is widely used by consumers.

Sector Disruptors: Thematic ETFs

When structural trends begin to materialise in the future, a new set of companies are likely to rise to replace the incumbent sector leaders. Instead of waiting for the traditional sector-based ETFs to filter out the old guards in favour of the new sector leaders, investors can potentially ride on the wave of new macro-level trends by targeting thematic ETFs.

Thematic ETFs may use alternative rules-based index construction strategies that adhere to specific thematic investment objectives to gain exposure to companies that develop revolutionary technologies or cater to rising consumer trends.

Traditional sector-based ETFs may not be able to offer investors such targeted investment strategies to express their views on changing socio-economic trends.

Sectors and the Potential Sector Disruptors

The bar chart by Statista shows the forecast of the economic impact of disruptive technologies in 2025. By 2025, the impact of the Internet of Things (IoT) industry is estimated to reach as much as US$11.1 trillion per year.³

Below are some examples of the potential sector disruptors and the thematic ETFs that provide exposure to these trends.

All ETF information is accurate as of 11 June 2019.

ETF Screener

You may search for ETFs with different thematic exposure by using our ETF Screener’s search box.

Conclusion

Technological advancement, demographic and social changes will be the driving forces in dictating the mercurial landscape of socio-economic trends. Old themes will wither away and be replaced by new megatrends. The displacement of obsolete themes represents possible thematic investing strategies for investors who are looking to capitalise on the growth potential that the sector disruptors may have to offer.

Thematic ETFs represent plausible investment vehicles for investors to gain access to their desired thematic investment strategies. Instead of waiting for traditional sector-based ETFs to sift out outdated themes, thematic ETFs help identify companies with exposure to up-and-coming trends and allow investors to time their entry early into the market before the trends become mainstream.

In essence, thematic ETFs provide investors with the shortest path possible to innovation that is shaping the future.

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