According to Bloomberg Business, thematic indices have proliferated as asset managers identify new growth trends, with European defense spending surging to €343 billion ($398 billion) in 2024—a 19% increase from 2023 and 37% higher than 2021 levels. The construction process involves extensive data analysis and customization of existing indices, with Bloomberg’s Global Defense Index currently allocating 77% to industrial companies and 18% to technology firms. Industry experts emphasize the need to go beyond standard classifications and incorporate insights from sector specialists, while tools like document search and AI help identify emerging themes through executive commentary and media coverage. The analytical capabilities enable rapid index construction around fast-evolving opportunities, though the process requires sophisticated tools like Bloomberg’s TLTS function to differentiate between similarly named ETFs with significantly different holdings and characteristics.
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The Concentration Trap in Disguise
While thematic investing promises targeted exposure to growth trends, it often creates dangerous concentration risks that investors underestimate. Many thematic funds overlap significantly with existing sector ETFs or broad market indices, creating hidden correlations that undermine diversification benefits. The European defense example illustrates this perfectly—with 77% allocation to industrial companies, investors are essentially buying a concentrated industrial sector fund with a thematic label. This concentration becomes particularly problematic during market downturns when thematic funds often experience amplified losses compared to diversified portfolios.
The Inevitable Thematic Drift Problem
One of the least discussed challenges in thematic investing is thematic drift—the gradual evolution of company business models that renders initial index compositions obsolete. Companies classified as “AI plays” today might derive minimal revenue from AI in three years, while traditional industrial firms might pivot into high-growth thematic areas. This creates a fundamental measurement problem: how do you objectively quantify a company’s “exposure” to a theme when corporate strategies evolve faster than index methodologies can adapt? The reliance on media coverage and executive commentary for theme identification, as mentioned in the Bloomberg analysis, introduces significant subjectivity and potential for narrative-driven rather than fundamentals-driven investing.
Hidden Liquidity and Execution Costs
The proliferation of thematic ETFs creates fragmentation that impacts execution quality for investors. While tools like Bloomberg’s ETF Strategy Optimizer help institutions manage large trade lists, retail investors face hidden costs through wider bid-ask spreads and premium/discount volatility in less liquid thematic products. Many newer thematic funds trade with spreads exceeding 50 basis points, creating immediate drag on returns before considering management fees. The European defense spending surge might create compelling narratives, but the underlying securities in defense-themed ETFs often face regulatory restrictions and limited float that compound liquidity challenges.
The Coming Fee Compression Wave
Thematic investing currently commands premium fees—often 50-100% higher than broad market ETFs—but this pricing model faces inevitable pressure as competition intensifies. With multiple providers launching similar thematic products, we’re likely to see significant fee compression over the next 2-3 years, similar to what occurred in the smart beta space. Early adopters of thematic strategies may find themselves locked into expensive products that become commoditized, creating potential tax consequences if they need to switch to lower-cost alternatives later. The sophisticated analytics required for theme construction, while valuable for differentiation, don’t justify perpetual premium pricing in increasingly efficient markets.
The Private Market Blind Spot
The most significant limitation of current thematic approaches is their public market focus, which misses the innovation occurring in private markets. As the Bloomberg analysis notes, thematic indices currently track public equities primarily, but this creates a fundamental disconnect—many disruptive technologies mature in private markets for years before reaching public listings. By the time a theme becomes recognizable enough to support a public market ETF, the highest-growth phase may have already occurred in venture capital and private equity. Investors seeking true thematic exposure need complementary private market strategies, yet these remain inaccessible to most retail investors through traditional ETF structures.
The Uncharted Regulatory Landscape
Thematic investing operates in a regulatory gray area where classification standards remain inconsistent across providers. Unlike traditional sector classifications that follow established frameworks like GICS, thematic categories lack standardized definitions, creating potential for “greenwashing” and misleading marketing. Regulators have yet to establish clear guidelines for what constitutes adequate “exposure” to a theme or how providers should disclose their methodology limitations. This regulatory uncertainty creates compliance risks for providers and transparency challenges for investors trying to compare similar-sounding strategies with fundamentally different approaches and risk profiles.
