The exchange-traded fund (ETF) market, traditionally known for promoting diversified investing, is witnessing a rapid surge in the popularity of thematic ETFs. While these funds have expanded client options, they carry significant drawbacks: limited diversification, a heavy reliance on short-term gains, and an increased risk of exacerbating market volatility. Despite these growing concerns, finding an effective regulatory remedy remains a challenge as limiting product development is difficult.

According to a recent report titled "The Expansion and Tasks of Thematic ETFs" by Senior Research Fellow Kim Jae-chil at the Korea Capital Market Institute, the growth of thematic ETFs is one of the most prominent shifts in Korea's indirect investment market.

Explosive Growth and Concentrated Capital

In 2019, thematic ETFs accounted for a mere 5.1% of all passive equity ETFs. However, that figure climbed steeply starting in 2020, reaching approximately 33% by the end of June. Over the same period, total net assets in thematic ETFs skyrocketed from 1.8 trillion KRW to 96 trillion KRW. Meanwhile, market-representative index ETFs—which once drove the passive equity market's growth—saw their share drop from 81.9% to 53.6%.

The report highlights three major concerns regarding thematic ETFs:

   Limited Diversification: Unlike broad market index ETFs that offer robust diversification at a low cost, thematic ETFs typically hold a small number of stocks with heavily skewed weightings toward top holdings.
   Higher Turnover and Lower Returns: Investors frequently trade thematic funds to chase short-term trends, a behavior that historical research suggests rarely yields long-term success.
   Market Distortion via Capital Concentration: Funds tend to heavily concentrate on specific sectors. For instance, roughly 65% of all thematic ETF net assets as of June were tied to semiconductor and artificial intelligence (AI) themes.

The "Tail Wags the Dog" Phenomenon

Much like Financial Supervisory Service Governor Lee Chan-jin's warning that single-stock leverage and inverse products for companies like Samsung Electronics and SK Hynix risk letting "the tail wag the dog," thematic ETFs present similar market risks.

When multiple ETFs share the same theme, capital is funneled into overlapping core assets. Multiple funds channel money into the same small group of underlying companies, compounding concentration risk.

Kim pointed out that when trading across similar thematic ETFs moves in unison, ETF-driven supply-and-demand shocks can impact stock prices more heavily than the actual corporate earnings or growth outlooks of the underlying companies. Consequently, these artificial shocks widen tracking errors and introduce unnecessary volatility into the underlying asset prices.

The Search for Solutions

Addressing these structural concerns is difficult. Because thematic ETFs serve as legal investment options and drive healthy competition and innovation among asset managers, outright bans or strict supply caps are impractical.

The report concludes that the primary tasks moving forward are encouraging asset managers to pursue genuine differentiation and investor benefits, while simultaneously building better frameworks to support rational decision-making among everyday investors.

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