A Thematic Approach with a Measured Risk Profile

Despite being a thematic fund, the VanEck Smart Home UCITS ETF (CAVE) is not as volatile as conventional thematic ETFs. Instead, its risk profile is more similar to a broader multi-theme fund, explains portfolio manager Seb de Feiter, offering investors a thematic bet with a measured risk profile.

Since the Covid-19 pandemic began to spread around the world at the beginning of 2020, financial markets have delivered a rollercoaster ride, shaken by a significant rise in inflation and interest rate volatility. Most funds have felt the impact: thematic funds in particular. That’s because thematic ETFs are often opportunity-driven, with portfolios mostly consisting of growth stocks (which are hit the hardest in a rising interest rate environment).

Looking forward, uncertainty about the direction of inflation, interest rates, economic growth and fiscal policies is causing a disconnect in financial markets. CAVE, however, is an actively-managed fund using a multi-layered thematic approach – as we explained in previous blogs – making it more mindful of the current uncertainty. This enables CAVE to benefit from the performance differences between factors such as value (versus growth) and size (large versus small caps) or industries (cyclicals vs defensive).

Since it is difficult to accurately time and predict the direction of macro-economic variables, and the fact that their influence on different parts of the equity markets is large, Seb makes sure that CAVE’s portfolio is well balanced and diversified across sectors and factors to reduce volatility. He monthly rebalances the portfolio, maintaining its diversification.

Layering Factors Within Themes

How does he do that? Well, Seb explains, the portfolio currently consists of a mix of cyclical sector exposures , such as consumer discretionary stocks like MercadoLibre, and more defensive sector exposures, such as consumer staples (e.g. Nestle) or healthcare (e.g. Option Care Health). Defensive sectors typically have lower volatility. Within those defensive sectors, however, we can also choose between growth and value stocks.

Healthcare, for instance, is an important subtheme within the smart home ETF. We believe that by bringing more technology-related care into our homes, it will be possible to keep costs in check and address the challenges of an ageing society suffering from chronic illnesses and diseases (see also this blog).

Two companies that fit the healthcare sub-theme are Dexcom and Option Care Health. Dexcom is a provider of glucose monitoring systems, whereas Option Care provides home infusion services. Both companies have defensive revenue streams (i.e., not cyclical). Dexcom, however, would have a stronger correlation with the growth factor compared to Option Care.

Seb also takes value and growth stocks into consideration at the overall portfolio level to make sure there is a mix of stocks with varying levels of sensitivity to changes in interest rates. For instance, cyber security growth stocks such as Crowdstrike and Zscaler have higher duration, meaning that a higher proportion of their cash flows lies in the more distant future. As a result, they are perceived to be more sensitive to interest rates. More value-like stocks such as Cisco Systems or gaming company Electronic Arts, have lower duration and are less sensitive to interest rate movements.

Size is a final factor to take into account. CAVE’s multi-layered thematic approach makes it possible to add companies beyond the usual suspects. Naturally, Seb also selects large companies such as Microsoft and Amazon, which both have important roles to play in the smart home. But he also adds smaller less obvious stocks, such as PowerSchool and Franklin Covey. Powerschool provides business software running core applications for educational institutions. Franklin Covey is a coaching company that provides training and assessment services in the areas of leadership, individual effectiveness and business execution for organizations and individuals.

Despite these advantages, Seb warns that thematic investing still comes with some risks that are less dominant in an index-tracking fund. Thematic funds will always be less diversified in most areas compared to a broad stock index with hundreds or thousands of stocks. Moreover, CAVE’s approach also requires the exclusion of sectors such as oil & gas, which can have a strong impact on the performance of a broader index. Additionally, a thematic view implies a longer-term perspective, which introduces some uncertainty. Finally, although we strive to balance relevant investment factors, the thematic angle means that growth plays a more dominant role relative to the broader equity market.

Reaping Results

Seb’s strategy is delivering the intended results. In the graph below, we compare the volatility of the Bloomberg thematic ETF database¹ to CAVE. It shows that CAVE clearly has a lower volatility than other thematic funds.

Based on Volatility, CAVE’s Risk Profile is Lower Than a Large Portion of Thematic ETFs

Smart Home vs. Bloomberg Thematic ETF database (YtD annualized 90-day volatility)

Source: Bloomberg – ETF database. (selected all ETFs in North America and Europe categorized as thematic, includes both single and multi-theme funds. Only ETFs with complete data for the selected YtD period are included. Excluding CAVE the selection contains 209 ETFs.)

Moreover, when we look at the ETFs with lower volatility than CAVE, it is noticeable that many of them are linked to infrastructure-related investments. Infrastructure is an asset class known for its relatively low volatility. This is due to the stable cash flow of the underlying assets, which are often contractually secured.

Dynamically diversifying the portfolio by investing across sub-themes, industries and factors has helped to reduce volatility in 2023 while safeguarding returns. Moreover, as the graph shows, CAVE has a lower volatility than other thematic ETFs, resulting in a more measured risk profile.