Issuers stuck between a rock and a difficult place when building thematic ETFs

“ There is a triangular compromise between the purity of a theme, its diversification and its liquidity ”

The proposed revamp of the clean energy index by the S&P Dow Jones Indices (SPDJI) has brought to the fore an uncomfortable discussion about thematic ETFs: should we be more worried about over-concentration or over-dilution when portfolio construction?

This dilemma has played out in the rebalancing of SPDJI’s Global Clean Energy index, which is expected to change the makeup of the prestigious iShares Global Clean Energy UCITS ETF (INRG) and iShares Global Clean Energy ETF (ICLN) after exponential inflows. last year.

Following consultations with investors on March 4 and 12, Société Générale declared SPDJI index is likely to expand from 30 to 77 constituents with inclusion criteria defined to allow companies with “significant” and even “certain” exposure to clean energy, compared to previous directives which only allowed pure clean energy games .

The choice to diversify outside of pure play was not made due to a lack of proposed clean energy players – Bloomberg Intelligence has identified a total of 255 renewable energy companies held by ETFs from clean energy in February. Rather, the decision was taken to comply with SPDJI rules on liquidity and market capitalization.

The result is that companies that are illiquid and in some cases overvalued 36 times (relative to earnings) will see their weight in the INRG and ICLN baskets reduced. For example, SocGen expects Meridian Energy, Verbund and Contact Energy to see their allocations reduced by 3.6%, 3.5% and 3.2%, respectively.

While the investment bank said the changes would help issuers avoid concentrating large sums of assets in a handful of small-cap stocks, it noted that using vague definitions for exposure to clean energy could result in subjective interpretation and play of diluted clean energy.

Offering a concise summary of this trade-off between over-concentration and low conviction, François Millet, head of index and product development at Lyxor, told ETF flows Big Call: thematic event on ETFs last week: “There is a triangular compromise between the purity of a theme, its diversification and its liquidity.”

In the context of BlackRock’s clean energy ETFs, the diversification proposals have watered down their basic sustainability talk. This, in turn, led Interactive Investor to review the status of the funds as members of its “ ACE 40 ” list ethical investment products rated.

While being covered as part of the rebalancing of the SPDJI, the underlying issue merits consideration for thematic investors in all categories. Should particularly popular themes diversify in order to reduce the risk of concentration? Or does the risk of over-dilution weaken the USP of thematic strategies relative to their broader index-tracked counterparts?

The answer to this question will vary from investor to investor depending on risk appetite, but the “triangular trade-off” is a crucial consideration for anyone interested in the world of thematic ETFs.

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