May 29, 2024

Beware Thematic Funds’ Siren Song

Beware Thematic Funds’ Siren Song
A version of this article previously appeared in the May 2022 issue of Morningstar ETFInvestor. Click here to download a complimentary copy.

Thematic funds have a long history—some might say a checkered past. From the very beginning, they’ve been designed to capture investors’ imaginations and their assets, luring them with compelling narratives and the prospect of outsize returns. But most have done a much better job spinning stories than growing investors’ wealth. Investors in these funds are making a bet with long odds and a correspondingly large prospective payout; they would be wise to wager accordingly.

A Brief History Lesson

The history of thematic funds can be traced back to the end of World War II. In 1948, Chicago-based Television Shares Management Corp. launched The Television Fund, which sought to profit from the burgeoning television industry at a time when there were about 1 million television sets in the United States and color television was about to make its debut.

In 1950, that fund became the Television-Electronics Fund, a change that signaled an expanded investment scope. This on-the-fly tweaking of funds’ investment strategies as themes evolve has been a hallmark of thematic funds through the decades. Kemper acquired the fund in 1970. Its new owner expanded the fund’s remit further, rechristening it Kemper Technology. Thus, the fund was even further from its originally narrow thematic focus, a fate shared by many subse­quent thematic funds.

Thematic investing and growth investing are close cousins. The concept of growth investing gained steam in the 1950s. T. Rowe Price launched its Growth Stock mutual fund in 1950. The late Sir John Templeton founded Growth Companies Inc., ancestor of Templeton Growth, which launched in 1954. An early proponent of growth investing, Phillip Fisher, published the first edition of “Common Stocks and Uncommon Profits,” a core text for growth investors, in 1958.

By the mid-1950s, a string of future technology-focused thematic funds had debuted, including the Atomic Development Mutual Fund; the Science and Nuclear Fund; Nucleonics, Chemistry & Electronics Shares; and the Missiles-Rockets-Jets & Automation Fund.

By the 1960s, other futuristic thematic funds like the Steadman Oceanographic Fund, which invested in companies aiming to farm and build communities underwater, became popular as well. But much like “The Jetsons,” these funds had limited success in the 1960s.

One of the more memorable episodes in the long history of thematic funds was the rise and fall of internet funds. In 1995, Japanese asset manager Daiwa launched the first internet-themed fund: Daiwa U.S. Internet Open. As the dot-com bubble inflated, the number of internet- and tech-related thematic fund launches also ballooned. But after the bubble burst, the vast majority of these funds closed. Today, just five of the 50 internet-themed funds launched in that period remain.

The Modern Era of Thematic Funds

The thematic fund market has expanded in recent years. Today’s thematic funds attempt to harness secular growth themes ranging from artificial intelli­gence to Generation Z.

As of the end of December 2021, there were 1,952 surviving funds in Morningstar’s global database that fit our definition of thematic. Over the two years to the end of 2021, assets in these funds grew nearly threefold to $806 billion from $255 billion worldwide. As of the end of 2021, global thematic fund assets represented 2.7{18fa003f91e59da06650ea58ab756635467abbb80a253ef708fe12b10efb8add} of all assets invested in equity funds globally, up from 0.8{18fa003f91e59da06650ea58ab756635467abbb80a253ef708fe12b10efb8add} 10 years ago.

Assets have poured into thematic funds, and the menu has broadened. A record 589 new thematic funds debuted globally in 2021, more than double the previous record of 271 launches in 2020.

But it has been a pattern of feast or famine for this category of often faddish funds. As you can see in Exhibit 1, their recent popularity peaked in April 2021, when trailing 12-month flows into global thematic funds topped out at $241 billion. By the end of April 2022, this number had declined nearly 76{18fa003f91e59da06650ea58ab756635467abbb80a253ef708fe12b10efb8add} to $59 billion. Flows have fizzled, and poor recent perfor­mance is the chief culprit. After a few consecutive years of lights-out performance, many thematic funds have found they flew too close to the sun.

Performance pattern of global thematic funds

Exhibit 2 shows how quickly the tables have turned on thematic exchange-traded funds. The chart plots the distribution of thematic ETFs’ calendar 2021 returns as well as the distribution of their returns through the first four months of 2022. In 2021, 115 of the 164 (70{18fa003f91e59da06650ea58ab756635467abbb80a253ef708fe12b10efb8add}) thematic ETFs that existed from the beginning of the year to its end posted positive returns. For the year to date through April 2022, just 74 of the 309 (24{18fa003f91e59da06650ea58ab756635467abbb80a253ef708fe12b10efb8add}) thematic ETFs that existed at the beginning of the year had posted positive returns. This sharp turn for the worse in performance helps explain the steep decline in the amount of new money flowing into these funds seen in Exhibit 1.

Thematic ETFs' calendar 2021 and 2022 returns

The Trifecta Bet

Investors in thematic funds are making a trifecta bet (a term from the racetrack). Specifically, they are implicitly betting that they are:

1. Picking a winning theme—one that is real and durable.

2. Selecting a fund that is well-placed to harness that theme—one that owns stocks positioned to capitalize on it in a meaningful way.

3. Making their wagers when valuations show that the market hasn’t already priced in the theme’s potential.

The odds of winning these bets are low, but the payouts can be meaningful, as some thematic funds’ recent 100{18fa003f91e59da06650ea58ab756635467abbb80a253ef708fe12b10efb8add}-plus calendar-year returns show.

Picking winning themes is tough. To have lasting investment merit, themes have to be durable and they have to present an opportunity to profit. But often they are transitory and/or don’t result in spoils for public shareholders. Examples of ETFs designed to capitalize on themes with short shelf lives include the now-defunct Innovation Alpha Trade War ETF—launched at the height of U.S./China trade tensions in 2019—and ProShares Supply Chain Logistics ETF (SUPL), which debuted in April as reports of clogged supply chains and droves of ships floating outside major ports made headlines.

Selecting funds that are well-placed to capitalize on a particular theme can also be challenging. Many thematic funds’ portfolios match their themes about as well as paisley matches plaid. Take the example of a pair of vegan ETFs: U.S. Vegan Climate ETF (VEGN) and VegTech Plant-based Innovation & Climate ETF (EATV). As of May 9, 2022, VEGN’s top three hold­ings were Tesla (TSLA), Nvidia (NVDA), and United­Health Group (UNH). EATV’s top three holdings were food ingredients, flavor, fragrance, and food color manufacturers Ingredion (INGR), Givaudan SA (GVDNY), and Sensient Technologies (SXT). Clearly, one of these funds’ portfolios is a better match for its label. It’s not enough for investors to get the theme right—they need to make sure that thematic funds own the right stocks to capitalize on the trend.

By the time a theme has made headlines, odds are that the market has caught wind of it and priced its enthusiasm into the stocks best-positioned to harness it. By the time that one or more thematic funds have been launched to try to capitalize on the theme, there’s a good chance those stocks have been priced for perfection. If investors are late to the party, odds are that future returns will be disappointing. It is a familiar pattern in markets, and we’ve seen plenty of examples of it in recent years—from ARK Innovation ETF (ARKK) to Defiance Digital Revolution ETF (NFTZ). As its ticker implies, NFTZ is designed to offer exposure to stocks “with relevant thematic exposure to the nonfungible tokens, blockchain, and cryptocurrency ecosystems,” according to its sponsor. Since its Dec. 1, 2021, inception, the fund has lost just over 64{18fa003f91e59da06650ea58ab756635467abbb80a253ef708fe12b10efb8add} of its value. With the benefit of hindsight, NFTZ’s launch may have top-ticked the market’s short-lived love affair with these trends.

Long Odds

Exhibit 3 details the odds facing investors in selecting a thematic fund that will survive and outperform global equities. The long-term performance figures for thematic funds are not flattering. They suggest that investors’ chances of selecting a fund that will survive and outperform over the long run are slim. Over the 15 years through December 2021, 78{18fa003f91e59da06650ea58ab756635467abbb80a253ef708fe12b10efb8add} of all thematic funds worldwide were liquidated or merged, another 12{18fa003f91e59da06650ea58ab756635467abbb80a253ef708fe12b10efb8add} survived but lagged the Morningstar Global Markets Index, and just shy of 10{18fa003f91e59da06650ea58ab756635467abbb80a253ef708fe12b10efb8add} both survived and outperformed the global stock market benchmark.

Bar graph demonstrating the odds of thematic ETFs surviving and outperforming over the long term

Size Your Bets

Investors should approach thematic funds with caution. The stories used to sell these funds can be a siren song. Know that any wager you place faces long odds and size your bets accordingly.

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