Against thematic funds

“Steve Jobs and I will always get more credit than we deserve, because otherwise the story gets too complicated,” Bill Gates once said.

Bill Gates understands the power of stories.

The success of large, complex companies like Apple and Microsoft can never have been entirely due to the actions of just their founders. Yet parsing their decisions to form a linear narrative of their actions causing their companies’ successes creates an easily digestible story.

Stories are more powerful than statistics because they make the complex simple. They remove uncertainty, creating a satisfying sequence of cause and effect. Because of their power, they’ve been used in all sorts of ways:

• Stories have been used to recite pi to over 111,000 digits.
• Stories shape our own identity. The stories we make about ourselves in our teenage years are held for the rest of our lives.
• Stories invented a new planet. The planet “Vulcan,” was believed to sit between Mercury and the Sun in the nineteenth century. Astronomers were so in love with the idea of the missing planet that many of them, bewitched by random shadows, insisted they’d seen it through their telescopes. Only in 1915, when Einstein came along and explained the shadows as space-time curvature, could astronomers stop “seeing” what wasn’t there.
• Stories help us persuade people. In a classic 1978 experiment, it was found that when someone was in the queue waiting for the photocopier, using the phrase “Excuse me, I have 5 pages. May I use the xerox machine?” resulted in 60% of people letting them skip the queue. But when they said, “Excuse me, I have 5 pages. May I use the Xerox machine, because I’m in a rush?”, it achieved 94% compliance. “Because” creates a story.
• Stories are the reason people buy lottery tickets and start businesses. If entrepreneurs were truly aware of the chances of their new business failing, nobody would ever start one. Only by telling ourselves stories can we convince ourselves that we’re the exception. It’s a necessary delusion, as those stories have been responsible for creating the likes of Apple, Google, and Microsoft.

In the world of investing, the power of stories is used to sell just about every strategy under the sun.

Whether it’s the simple story of a fund’s performance being a good predictor of its future returns, or the story of active management being able to save you in a crash, or the story of grey hairs and old age implying a more competent stewardship of your capital. These are some of the most common (and effective) stories under the sun.

But one area of investing which depends more heavily on stories than any other, is thematic funds.

Morningstar recently released their Global Thematic Fund Landscape Report, which contains some excellent analysis and data. I’ve relied extensively on it for this post, and definitely recommend reading the whole thing in full.

Contents

• What is a thematic fund?
• The problems with thematic funds – in theory
• The problems with thematic funds – the evidence
  • • • Performance
      • Fees
      • Valuation
      • Risk
      • Behaviour
      • Liquidity
• Why do thematic funds exist?
• Summary
• Conclusion

What is a thematic fund?

Thematic funds are, as the name implies, investment strategies which focus on a particular theme.

The theme can be anything – there are robotics ETFs, cannabis ETFs, artificial intelligence ETFs, clean energy ETFs, cloud computing ETFs, gaming ETFs, cyber security ETFs – there’s even an ETF focussing on “millennials”. If you think it could be an investment theme, there’s probably a thematic ETF for it.

These thematic funds harness the power of simple, catchy stories to bring in investors.

Because thematic ETFs tend to focus on topical, high growth areas, the stories used to sell them are able to convey a sense of plausibility that tapping into these funds might lead to superior investment performance. Just like how stories are used to bypass the logical part of our brain to persuade us to buy lottery tickets, they’re also used to make investors believe they can beat the odds by investing in a thematic ETF.

And these stories have been incredibly successful at capturing investors’ attention:

Source: Morningstar

But despite their meteoric growth rate, the odds are stacked against them.

The problems with thematic funds – in theory

In theory, if you invest in a thematic fund, you’re betting on getting three things right:

1. The theme needs to play out as you expect,
2. The companies in the fund you’ve selected need to be the ones which benefit most from the trend,
3. The prices of those stocks need to not already fully reflect the impact of the future growth.

Let’s take each of them in turn, and see how the odds of winning all three are low.

1. The theme must play out as expected.

In order for the theme to play out as expected, investors need to

a. Be correct about the long-term growth of the theme,

b. Be correct that the timing of the theme’s growth coincides with their investment horizon, and

c. Be able to withstand any drawdowns which may occur if the theme suffers from periods of disappointment on the way to mainstream adoption.

Point 1.a. is where many investors stop their due diligence.

It’s easy to think “clean energy is the future, so I’ll invest in a clean energy ETF”. But long-term trends rarely play out as expected.

In the late 1990s, investors were enamoured with Internet stocks, convinced they would fundamentally transform the economy and allow e-retailers to take market share away from brick-and-mortar stores. The story was right, but the timing was wrong. It took longer than many expected for that transition to happen, which prevented many from profiting from it.

Someone investing at the peak of the dot-com bubble would have been correct on 1.a. – the Internet was a long-term growth theme. But if their investment horizon was under 15 years (roughly the time it took for the tech sector to recover), they would’ve been wrong on 1.b. And if they weren’t able to withstand the drawdowns from the crash in 2000, they would’ve been wrong on 1.c.

American research and technology company Gartner produce an interesting graphic for thinking about the adoption of new technologies, called the ‘Gartner Hype Cycle’:

It’s easy to map the Internet boom, bust, and recovery onto something like this, and while it’s certainly oversimplified and un-scientific, it’s at least a good graphical representation to remind us that technologies are rarely adopted in a linear fashion.

Investors are going to have a bad time if they’re investing in a theme, but don’t have the time horizon to see it through to the Plateau of Productivity, or can’t stick with it through the Trough of Disillusionment.

And even if the investor is able to correctly predict the growth of a particular theme, has a long-term time horizon, and is able to stick with the theme through its ups and downs, that’s still no guarantee of success for a thematic fund.

We still have two further barriers to overcome.

2. The fund must have the right stocks to benefit from the theme.

Even funds which target the same theme often have hugely different portfolios.

For example, the iShares Robotics and Artificial Intelligence ETF (IRBO) and Global X’s Robotics & Artificial Intelligence ETF (ROBO) both attempt to target stocks which benefit from the growing adoption of robotics and AI.

But they’re very different funds.

IRBO has a much larger portfolio, with 109 holdings compared to BOTZ’s 32:

As a result, the exposures you’re getting are very different depending on which fund you choose.

BOTZ is concentrated, with the largest stocks at almost 10% of the portfolio. IRBO is more diversified, with no stock at more than 4%. BOTZ, by nature of its concentration, is also less diversified by geography, with over 90% of its companies being located in either the US, Japan, or Switzerland. Although IRBO has a larger allocation to the US, it does have smatterings of other country exposure in there, due it holding more stocks.

And this difference in portfolio construction is intentional from both parties.

BOTZ is designed as a purer play on robotics and AI, and targets companies which generate most of their revenue from AI, robotics, autonomous vehicles, or industrial automation (or that have a core competency in those areas).

In contrast, IRBO focuses on firms which generate most of their revenue from the industries which are considered to have significant exposure to robotics and AI. There aren’t many companies which offer pure exposure to robotics and AI, so this approach improves the fund’s diversification. According to Morningstar, “IRBO’s company revenues don’t have to come directly from robotics and AI. For example, it takes firms operating in the web search and software, hosting services, and smartphone manufacturing industries. As a result, it owns some firms that generate little direct revenue from robotics and AI.”

Even if you get the overall theme right, buying the right fund is another hurdle which prevents investors from capitalising on the theme’s growth. As we’ve seen, there can be significant divergence between funds which seemingly target the same theme.

But let’s say you’ve picked the right theme, and you’ve identified the fund you think offers the best chance of successfully capturing the theme’s growth. You still have one final hurdle preventing you from earning those outsized returns.

3. Has the theme’s growth already been priced in?

The key point here is that the market is forward-looking.

If you know about this theme, so does the market. And the market isn’t stupid.

If the market’s already anticipated the future growth of your fund, it will have already bid up the prices of the funds’ stocks to a point where the stocks are expected to provide the sorts of levels of growth you’re assuming. As a result, you can’t expect outperformance. The share prices have already been bid up to a point where the theme’s growth has been priced in.

By buying a thematic fund, you’re betting the market’s wrong.

In the words of Morningstar: “It is difficult to forecast the impact of a trend on businesses more accurately than the market. Doing so requires more than just an understanding of the macro story, but also understanding what the market is currently pricing in and how the competitive landscape might evolve. That’s a tall order.”

This is one of many reasons why I favour a passive approach to investing. It doesn’t require any of these sorts of decisions.

But anyway, that’s all in theory. It’s time to stop thinking about what should happen, and take a look at how thematic funds have fared in the past.

What does the evidence say?

The problems with thematic funds – the evidence

Performance

Let’s start with the thing everyone cares about. How have thematic funds performed?

Starting with data from the Swiss Finance Institute’s whitepaper, “Competition for Attention in the ETF Space”, we can see the average performance of thematic ETFs in red against broad-based ETFs in blue for the 5 years after the thematic ETFs’ launches:

Source: Competition for Attention in the ETF Space

Clearly, thematic ETFs have underperformed pretty hard.

For the investing nerds like myself, the authors include an interesting table breaking down the relative performance of thematic funds (“specialized ETFs”) against regular broad-based ETFs after adjusting for a bunch of different factor exposures.

Source: Competition for Attention in the ETF Space

The table shows that thematic ETFs persistently generate negative alphas of about -3.1% per year (i.e. -0.27% per month) for the Fama-French-Carhart four factors. In the first 5 years since the ETF’s launch (panel B), the underperformance is even larger, at -6.0% per year (-0.50% per month). Underperformance is smaller (but still negative) when using more elaborate factor models.

The authors conclude:

“Our results suggest that specialized ETFs fail to create value for investors. These ETFs tend to hold attention-grabbing and overvalued stocks and therefore underperform significantly: They deliver a negative alpha of about −3% a year. This underperformance is stronger right after launch, at about -6%, and persists for at least five years after their inception.”

Morningstar have also looked at thematic fund performance in detail as part of their Global Thematic Fund Landscape.

They come to similar findings, noting that the longer period you assess thematic fund performance over, the worse things look for them:

Source: Morningstar

Over a 1 year time horizon, you’d have a roughly 65% chance of outperforming the market with a thematic fund. Not bad! So should thematic funds be short-term plays?

I’d say no, for the following reasons:

1. As we saw in the first section, thematic funds require longer time horizons for the theme to fully come to fruition,
2. The year ending 31 March 2021 was an unusually strong year for thematic funds (we’d need rolling annual 1-year success rates to draw any meaningful conclusions),
3. Investors are particularly bad at timing the purchases and sales of thematic funds (which we’ll see in the ‘Behaviour’ section below), and
4. Nobody should be holding funds for 1 year – we’re supposed to be long-term investors!

For those with a longer time-frame (which should be all of us), the data looks much worse for thematic funds. Over 5 years, the percentage of outperforming funds drops significantly to about 43%, before settling at 22% when looking over 10-15 years. When looking at the long-term performance of thematic funds, almost 60% of thematic funds have closed.

Overall, thematic funds have underperformed broad-based passive index tracking funds heavily over the longer term.

Fees

One of the reasons thematic funds have underperformed is fees.

We’ve seen before how fees are the single best predictor of future performance, and here in the world of thematic funds it’s no different.

The chart below from Morningstar shows that, although thematic ETFs are much cheaper if you decide to go the passive route, they’re still more expensive than their passive counterparts. A passive thematic ETF at 0.60% or an active one of 0.96% are much more expensive than a global index tracker at roughly 0.20%.

Source: Morningstar

The Swiss Finance Institute’s whitepaper finds the same thing, with thematic ETFs having much higher expense ratios than smart beta ETFs, sector ETFs, or broad-market ETFs:

Source: Competition for Attention in the ETF Space

Although the direction of travel is downwards across the board, thematic ETFs are still considerably more expensive.

Another data-heavy table below shows the distribution of fees for thematic funds by percentile:

Source: Competition for Attention in the ETF Space

Most thematic ETFs fall somewhere between 0.39% (the 25^th percentile) and 0.70% (the 75^th percentile) with an average of 0.58%. That compares with an average of 0.35% for broad-market ETFs.

But the underperformance of thematic ETFs can’t be attributed to their high fees alone.

We’ve seen that fees usually fall somewhere between 0.55%-0.96% for thematic ETFs, yet they underperform by roughly 3% per year.

So why do they underperform by more than the fees they charge?

Valuations

I mentioned in the ‘theory’ section above that the third hurdle investors need to overcome to profit from thematic funds is valuation.

The market needs to have not already priced in the future growth in order for investors to benefit from outperformance. But the graph below shows that the opposite happens – thematic ETFs are usually launched right at the point where valuations are at their highest:

Source: Competition for Attention in the ETF Space

The graph on the left shows that thematic funds (red line) enjoy higher book-to-market valuations in the months leading up to their launch, followed by a significant drop-off in valuations post-launch.

Similarly, the graph on the right shows significant positive media sentiment in the months leading up to an ETF’s launch, again followed by a significant drop-off post-launch.

The authors conclude:

“The graphs suggest that thematic ETFs are launched in a late stage of the valuation cycle of the underlying portfolios. This pattern is consistent with the fact that it takes six months to a year to launch a new ETF. Thus, there is a substantial delay between the time ETF provider spots a hot trend and the time the ETF reaches the market. At that point, the valuation is likely to revert to more normal levels.”

In short: by the time you’re able to invest in a thematic ETF, the market has already priced the theme’s growth into the underlying stocks.

Investors are therefore investing at the point of peak enthusiasm, where media sentiment is strongest, the hype is at its maximum, and valuations are correspondingly at their peak. This is another reason behind thematic funds’ underperformance – especially in the periods following their launch.

Risk

So far we’ve only been looking at the returns of thematic funds. But what about risk? Are they riskier than regular funds and, if so, do their returns compensate investors for their extra risk?

The answer to the first question is, pretty unsurprisingly, yes. Thematic funds are riskier than the market.

Firstly, tend to have fewer holdings than their broad-based ETF counterparts:

Source: Competition for Attention in the ETF Space

The average (50^th percentile) number of holdings for a broad-based ETF is 247, compared to just 53 holdings for a thematic fund. Across the percentile spectrum, broad-based ETFs tend to hold anywhere between 2x to 5x the number of stocks compared to a thematic fund, which increases their risk.

Additionally, thematic funds typically invest in holdings which are significantly smaller, pricier, and less profitable than the average stock – all traits associated with higher volatility. This naturally results in thematic ETFs exhibiting higher levels of volatility compared to the market:

Source: Morningstar

But what about the second question – have these thematic funds compensated investors for their higher risk?

The answer to this one is, sadly, no.

Data from Morningstar shows that, although over shorter time frames thematic funds’ Sharpe ratios (a measure of risk-adjusted return) have been in line with the market, over longer 10-year periods their risk-adjusted returns have been well below the market:

Source: Morningstar

What’s more, these results capture risk and returns for surviving funds only – they don’t reflect performance for funds that have been killed off or merged out of existence. We saw in the ‘Performance’ section that roughly 40% of global thematic funds closed over the last 10 years. This means these risk-adjusted performance stats are inflated to present thematic funds in a better light – the truer picture is much worse for thematic investors.

Morningstar conclude by saying that, “In a nutshell, thematic fund shareholders have been subject to both lower returns and higher volatility over the past decade.”

Behaviour

Where the riskier nature of thematic funds is particularly dangerous is in encouraging bad behaviour.

Higher risk can have a significant impact on returns if investors are tempted to try and time the ups and downs in order to generate extra performance.

Investors often try and chase returns by piling into funds which have experienced strong recent performance, and sell after being hit by heavy losses. This is known as ‘performance chasing’.

Although it’s nice to think we’re immune to such poor behaviour, we all know that recent price explosions are hard to resist (think about the hype generated by cryptocurrencies in their most recent stratospheric rise). I know I’ve fallen victim to performance chasing on more than one occasion.

Interestingly, we can calculate the performance impact of our own bad behaviour.

When investors engage in performance chasing, the return they achieve will be lower than the total reported returns of the fund (which assume that investors buy and hold after investing a lump sum). If investors repeatedly buy a fund at its peak and sell it at its lows, their returns will lag someone whose bought and held. The difference between a fund’s total reported return and the returns achieved by the investor is a good barometer for how much the investor’s behaviour has hurt their returns.

According to Morningstar, over the past 10 years, investor returns for thematic funds have lagged total returns by about 4% per year on average. This average includes only results for the small number of thematic mutual funds that are still around (and it excludes ETFs), but the fact that investor return gaps for surviving funds are uniformly negative should give investors pause.

Thematic funds are especially prone to performance chasing from investors, as they have a higher percentage of retail investors than broad-based ETFs:

The table on the right shows that investors into thematic ETFs are more likely to be retail investors, who are typically considered less sophisticated and are more prone to performance-chasing behaviour. Perniciously, this performance-chasing behaviour can become self-reinforcing, and result in positive feedback trading which magnifies the performance on the upside, but also magnifies the selloff when the bubble pops. We’ve seen good examples of this recently with the Gamestop and AMC dramas, where Robinhood was a key facilitator in the frenzy.

So not only do thematic funds underperform the market due to the combination of higher fees and higher valuations, the investors using these funds add an additional layer of underperformance on top, through attempting to time the market and chase performance.

Liquidity

A further risk to thematic funds – which doesn’t always show up in historic performance data – is liquidity risk.

In their search of companies with the highest exposure to emerging themes and those with the highest growth potential, thematic funds often invest in the smaller, less liquid stocks. The chart below shows that thematic funds have a higher average exposure to micro-cap stocks than their nonthematic counterparts. Micro-cap stocks can offer large upside potential, but a lack of liquidity can cause problems:

Source: Morningstar

We saw right at the start of this article how quickly thematic funds have grown. And as these funds have grown, the concentration of their holdings also spiked, as these funds tend to gravitate toward similar names.

For example, 28 thematic funds globally combine to own one quarter of the total shares outstanding of 3D printing firm Stratasys:

Source: Morningstar

Morningstar also note how the growth of thematic funds in certain sectors can result in suboptimal outcomes for investors:

“In fact, the runaway success of some alternative energy ETFs caused their own growing pains in late 2020. The combined assets of the iShares Global Clean Energy ETFs (ICLN and INRG) catapulted to USD $10.7 billion by the end of first-quarter 2021 from $0.8 billion at the beginning of 2020. With so much money gushing into such a narrow portfolio of small- and mid-cap stocks and amid questions about liquidity, the S&P Global Clean Energy Index was forcibly broadened. Any additional trading costs associated with this switch were absorbed by fund investors.”

So a lack of liquidity meant that not only were investors forced to invest in a broader set of stocks – which were selected primarily for their larger size and therefore their ability to absorb higher flows rather than their adherence to the investment theme – but they had to pay for it through higher trading fees!

In the case of ETFs, should the liquidity dry up in a portfolio stock, the increased trading costs will be passed on to the ETF investor through larger spreads, and tracking error versus the underlying benchmark will increase. But active managers can choose which holdings to sell first. This in itself may result in suboptimal outcomes, but consequences may be greater if, faced with prolonged selling, the fund is forced to divest to meet redemptions. Us UK investors know all too well the fate of Neil Woodford, whose lack of liquidity in underlying stocks caused his fund to implode and lost investors millions of pounds.

Overall, a thematic fund investing in less-liquid stocks may result in:

• A broadening of the investment criteria to absorb additional inflows, resulting in less ‘pure’ thematic exposure and higher trading costs to reposition the portfolio,
• Higher trading costs in the form of wider spreads,
• Higher tracking error versus the underlying index,
• Liquidity crunches resulting in forced sales if having to meet prolonged redemptions.

Why do thematic funds exist?

We’ve seen that thematic funds look like a pretty bad deal for investors. So why has their popularity continued to explode?

Firstly, because they’re profitable for asset managers.

These funds come with great marketing stories which bypass most investors’ critical faculties, and are a great draw for AUM. Alongside their ability to raise cash from investors, they’re also able to charge more, so are a lucrative opportunity for fund providers.

If a fund doesn’t gain traction, providers can close it and move on. If the theme resonates with investors, these products can be quite profitable. So it makes sense for fund providers to pump out as many thematic funds as possible, as the chances are at least some of them will do well.

Secondly, they appeal to investors’ desire to beat the market.

Here we are again with the power of stories. Thematic funds give investors an alluring opportunity to invest in a segment of the market which has a compelling growth story behind it, and which doesn’t require the time, tools, and effort involved in picking individual stocks.

As long as investors continue to listen to the siren-song of thematic growth stories, and remain unaware of just how heavily the odds are stacked against them, then the demand should remain intact for thematic funds.

Summary

In theory, if you invest in a thematic fund, you’re betting on getting three things right:

1. The theme needs to play out as expected,
2. The companies in the fund you’ve selected need to be the ones which benefit most from the trend,
3. The prices of those stocks need to not already fully reflect the impact of the future growth.

These are high barriers to overcome.

And the evidence confirms the odds are stacked against the thematic investor.

Performance:

• Thematic funds deliver a negative alpha of about −3% a year. This underperformance is stronger right after launch, at about -6%, and persists for at least five years after their inception.
• According to Morningstar, over 10-15 years, the percentage of outperforming thematic funds is around 20% – almost 60% of them closed.

Fees:

• Thematic ETFs are significantly more expensive than broad-based passive ETFs.
• Their fees tend to fall somewhere between 0.55%-0.96%, yet they underperform by roughly 3% per year – meaning not all of their underperformance can ben explained by fees alone.
• A further reason for underperformance is…

Valuations:

• By the time you’re able to invest in a thematic ETF, the market has likely already priced the theme’s growth into the underlying stocks.
• Thematic ETFs launch at the point of peak enthusiasm, where media sentiment is strongest, the hype is at its maximum, and valuations are correspondingly at their peak.
• This is a significant headwind for thematic fund performance.

Risk:

• Thematic funds take more risk than the market, but this is not compensated for in the form of higher returns.

Behaviour:

• This higher risk leads to bad behaviour.
• Over the past 10 years, investor returns for thematic funds have lagged total returns by about 4% per year on average due to investors mis-timing their purchases and sales of thematic funds.

Liquidity:

• Thematic funds are more likely to invest in less-liquid stocks than market-tracking funds.
• A thematic fund investing in less-liquid stocks may result in:
  • • A broadening of the investment criteria to absorb additional inflows, resulting in less ‘pure’ thematic exposure and higher trading costs to reposition the portfolio,
    • Higher trading costs in the form of wider spreads,
    • Higher tracking error versus the underlying index,
    • Liquidity crunches resulting in forced sales if having to meet prolonged redemptions.

Conclusion

Overall, thematic funds look like a bad bet for investors.

They perform worse than the market, thanks to a combination of higher fees and higher valuations. They’re also riskier than the market, but don’t provide high enough returns to compensate for the extra risk. On top of that, thematic funds’ returns are even worse than their time-weighted returns would imply, due to the temptation to engage in performance-chasing.

But despite all that, I can still see the appeal.

They’re a quick and easy way of expressing a view on a particular theme for those who don’t want to spend time conducting due diligence on individual companies. They’re likely to be more diversified than investors punting on one or two favoured thematic stocks, and will incur less in transaction charges than pound-cost averaging into several direct stocks.

So as long as investors approach these funds fully informed, with a realistic expectation that they’re likely to have the unattractive characteristics of higher risk and lower return, then I don’t mind them in a portfolio – for the same reason I don’t mind holding individual stocks.

Regular readers will know I’m a fan of carving out a small portion of your portfolio for speculative positions. In my own portfolio, I have a limit of 10%, and it contains a combination of stocks and funds. I did laughably little due diligence on any of them.

Really, for someone who spends their weekdays investing as a day-job, then their weekends writing an investing blog, I should have proper investment cases for all of them. But in reality, they’re little more than hopeful gambles. I love a good story, too.

Allocating a 10% maximum for my speculative positions limits my inevitably terrible decision-making to only 10% of the portfolio, but means I’m able to scratch the active itch we all get. Importantly, it means I’m stopping myself from messing around with the other 90%, which my rational brain knows is going to be the long-term wealth-building driver for the portfolio.

And I think this is the right bucket for thematic funds – I wouldn’t recommend them forming a core part of a portfolio. They look like poor long-term investments.

But I can understand taking a small speculative position. As long as you’re fully aware of the evidence against them, and it stops you from tampering with the rest of your low-cost, transparent, liquid, and diversified portfolio, then I don’t think there’s anything wrong with that.