Erratic thematics: Why investors should treat thematic funds with caution

While thematic investment funds have become hugely popular in recent years, investors need to treat them with caution, according to Nick Wood, head of fund research at Quilter Cheviot.

Thematic funds are investments that allocate towards a specific theme or a number of themes, such as clean energy, the metaverse or electric vehicles. According to Global X, 2021 saw thematic exchange traded funds (ETFs) record $12.5bn of net inflows, while in the US this number was a staggering $44.3bn. The most popular themes with investors included climate change, big data and disruptive technologies.

However, while thematic investing has clearly become more popular in recent years, Wood believes investors should tread very carefully as it is an easy area to get things wrong, particularly in an environment where growth stocks are struggling.

“Many thematic funds will naturally be more growth biased and may have overlapping holdings,” Wood said. “With value having taken the lead from a style perspective, I suspect there are far fewer thematic funds performing well in that environment.”

Even with performance struggles, investors will have found it difficult, according to Wood, to catch the right long-term theme at the right time over the years.

Recent data from JP Morgan has shown that a basket of 1000 thematic funds has significantly underperformed the MSCI ACWI index over the last 16 years.

“Of course, within that set there would be some very strong performers no doubt. But it’s hard not to draw the conclusion that investing thematically is a tough job, in some ways as hard as a retail investor picking the right individual stock.

“The chances of investing in an individual theme early enough to make money, and likewise, exiting at the right moment is incredibly difficult. There is a significant risk that investors are more likely invest at the point where the theme has already gained ground and is in the wider domain, and naturally has already performed well.

“By the time they hear about it, the likelihood is that the ‘smart’ money has already made the best returns. Likewise, how do you know when to sell? Even if you have timed your entry well, if you don’t time your exit well you run the risk of losing those gains.

There are also many risks at the portfolio level for investors to be aware of too. “Passive options tend to differ quite significantly among providers, and often can exhibit high stock concentration. The more latent the theme, the more the underlying investments might be dominated by smaller, less liquid companies.

“Many active managers use a global index as a benchmark, which in no way reflects their universe, whilst a more specific index can often be dominated by a small number of stocks with large weights that make it uninvestable in practice and therefore not a great comparator. This makes it almost impossible to assess if performance is based on stock picking abilities over and above the style tailwind.

“Investors can also run the risk of being caught up in a gimmick investment. One ETF launched recently invests in breakfast commodities such as coffee, pork and orange juice. You have to wonder with a lot of these products if an eye-catching theme was more important than the investment principles in that case.

One final area Wood believes investors should be aware of is the amount of time it can take to see a return and urges patience.

“Investing in online retailers such as Amazon has been hugely profitable in recent years, but the hype around internet businesses first arose in the tech bubble in the late 90s,” he said. “Whilst we saw some extreme stock price moves, ultimately many of those businesses had relatively little substance at that stage.

“Likewise, sequencing DNA was a huge breakthrough for mankind, but it’s taken a number of years for scientists to speed up that process to the point where it’s really aided new drug discovery and ultimately allowed companies to profit from that breakthrough. New and emerging themes, such as the metaverse, could take equally as long to provide any sort of breakthrough.”

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