According to Bloomberg Business, thematic indices are proliferating 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 expert consultation to move from concept to rules-based index, with Bloomberg’s Global Defense Index currently allocating 77% to industrial companies and 18% to technology firms. Advanced tools like the TLTS function and ETF Strategy Optimizer help differentiate similar-sounding ETFs and manage trading efficiency, while European Council data confirms the dramatic defense spending increases driving these thematic opportunities. As thematic investing evolves, the industry faces both unprecedented opportunities and significant challenges.
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The Concentration Trap in Disguise
While thematic ETFs promise diversified exposure to emerging trends, many suffer from extreme concentration that investors often overlook. A theme like “European defense” might appear broad, but in practice, these indices frequently cluster around a handful of dominant players with overlapping revenue streams. The 77% allocation to industrial companies in Bloomberg’s defense index reveals how quickly thematic investing can become sector concentration in disguise. Investors chasing themes may unknowingly build portfolios with correlated risk exposures that amplify losses during sector-specific downturns, despite the appearance of diversification across a compelling narrative.
When Themes Fade Faster Than Forecasts
Thematic investing faces a fundamental timing problem: by the time a trend becomes identifiable enough to support an index, the most explosive growth phase may already have passed. Defense spending illustrates this perfectly—while current geopolitical tensions support the theme, defense budgets are notoriously cyclical and politically sensitive. The 37% spending increase since 2021 represents a response to specific events that may not sustain indefinitely. Historical precedent shows thematic funds often launch near peak hype cycles, leaving investors exposed when themes mature or get disrupted by unforeseen technological or regulatory changes.
The Stealth Costs of Complex Construction
Behind the sophisticated analytics and AI tools lies a costly infrastructure that ultimately gets passed to investors through higher expense ratios. The intensive research process described—consulting industry experts, analyzing private company investments, document searches across research and transcripts—creates ongoing operational expenses that traditional broad-market indices avoid. These costs compound with higher portfolio turnover as themes evolve, generating additional transaction costs and potential tax consequences. Investors pay premium fees for active management disguised as passive indexing, often without understanding the total cost impact on long-term returns.
Secondary Market Liquidity Challenges
As thematic ETFs proliferate, many struggle to achieve the trading volume needed for efficient execution, particularly in specialized niches. While Bloomberg’s tools help identify liquidity, they can’t create it where none exists. Smaller thematic funds often trade with wide bid-ask spreads that silently erode returns, especially during market stress when liquidity typically dries up first. The push into private markets introduces additional illiquidity risks, as thematic indices increasingly look beyond public equities to capture emerging trends—creating valuation uncertainties and redemption challenges during market downturns.
The Coming Regulatory Scrutiny
The rapid growth of thematic products hasn’t gone unnoticed by regulators concerned about product labeling and risk disclosure. As thematic indices become more complex—incorporating AI-driven company classification and private market exposure—regulators may question whether retail investors truly understand what they’re buying. The European defense theme specifically raises questions about ESG overlap, as many investors who previously excluded defense stocks now find them bundled into thematic products they perceive as growth opportunities. This regulatory uncertainty represents a potential headwind that could limit product innovation or increase compliance costs.
The Long-Term Viability Question
The fundamental challenge with thematic investing lies in its conflict with time-tested portfolio construction principles. While compelling narratives drive asset flows, academic research consistently shows that concentrated sector bets rarely deliver superior risk-adjusted returns over full market cycles. The defense theme exemplifies this—while current spending trends appear strong, defense contractors face unique risks including contract dependency, political budget cycles, and technological obsolescence that don’t affect broad market indices. Investors chasing themes may be building portfolios vulnerable to narrative shifts rather than fundamental value.
