How Not To Get Caught Out By Thematic Investing

How Not To Get Caught Out By Thematic Investing
Stéphane Renevier, CFA

over 2 years ago5 mins

  • We’ve seen three reasons thematic investing might not live up to its return potential: most funds are just good marketing, a good story doesn’t necessarily make a good investment, and a lot of good news might already be reflected in the price.

  • But there are things you can do to avoid those pitfalls: you can create your own thematic basket, and pay particular attention to valuations.

  • And if you really want to buy a thematic ETF, make sure you do your homework and understand what it’s investing in.

We’ve seen three reasons thematic investing might not live up to its return potential: most funds are just good marketing, a good story doesn’t necessarily make a good investment, and a lot of good news might already be reflected in the price.

But there are things you can do to avoid those pitfalls: you can create your own thematic basket, and pay particular attention to valuations.

And if you really want to buy a thematic ETF, make sure you do your homework and understand what it’s investing in.

Mentioned in story

Let’s face it, who doesn’t want to invest in the sorts of disruptive technologies – genomics, artificial intelligence, space exploration – that could change lives and make you money along the way? The prospect sounds too good to be true. And it might well be: most of these “thematic investments” end up underperforming the market in the long term. So before we look at how you can actually profit from investing in themes, here’s why they’re so problematic in the first place.

1. Most thematic funds are just good marketing

Whenever you see unconditional support for a product, it’s generally a good idea to understand where the incentives are. So let’s take a step back and look at who’s really pushing for thematic investing: asset managers and the financial media. Thematic funds provide asset managers with attractive fees and a new source of growth, while the media’s number one goal is to attract a reader’s attention. And when you combine a good story with the opportunity to make money, you certainly get that.

Now, I’m not saying you should dismiss thematic funds simply because some of its most vocal proponents have slightly misplaced incentives. Rather, you should be critical of what you read, and need to keep in mind that your long-term financial success is not their priority. If you think I’m exaggerating, look at the chart below: it shows that around 40% of all thematic funds are closed after 10 years, and more than half after 15 years.

Few funds even survive their investment horizons. Source: Morningstar
Few funds even survive their investment horizons. Source: Morningstar

2. A good story doesn’t always make a good investment

We all love a good story: the opportunity to invest in the newest technologies sounds much more exciting than buying a boring utility company. Combine a good story with an opportunity to make “no-brainer” money, and it’s no wonder the demand for thematic products has skyrocketed.

But as solar energy proves, being right on the theme – solar has become a significant industry – doesn’t always meant profits for the majority of investors.

Solar investment: a good but largely unprofitable story. Source: JP Morgan
Solar investment: a good but largely unprofitable story. Source: JP Morgan

And it’s not just solar, thematic funds have on average underperformed buying and holding the US market over a long-term horizon.

There are a few reasons why a good story may not make a good investment. First, it’s not easy to accurately forecast what will happen to a particular theme, particularly over a longer time horizon. Second, most themes narrowly focus on one driver and assume that others will remain constant, even though drivers never remain constant. Third, good stories tend to lead to one-way thinking. In other words, the more you believe in a story, the more likely you are to dismiss contradictory information and over-emphasize the importance of information you agree with.

3. Most good news is already reflected in the price

This third point might be the most important: if a theme is so widely accepted, are you sure it isn’t already largely reflected in a fund’s price? Becoming one of the first investors in a new theme will certainly lead to high rewards, but entering when valuations are already stretched makes it much less likely you’ll beat the market in the long term. Buying a theme that has already performed well might not be much more than performance-chasing with a narrative.

And always remember this old saying: “if you think you are getting a greater return without taking any greater risk, you probably don’t understand the actual risks you’re taking.” The majority of the most popular themes are in early-stage disruptive industries where failure rates are extremely high, meaning the downside for a theme that’s set up for success is extremely high too.

So what can you do to profit from a theme?

Create your own thematic basket

The majority of themes captured by thematic ETFs are too broad and often miss the actual return opportunity. If you’re serious about profiting from a theme, you first have to isolate as specifically as possible the structural change that will generate returns.

Next, you have to identify which stocks will benefit from it. In your analysis, you have to go beyond just looking at simple metrics – like most ETFs do – and carefully consider idiosyncratic risks, valuation, and any other important factor driving the stock.

Lastly, it’s important to reduce your risk by diversifying across four or five different themes. At the end of the day, it takes a venture capital approach to invest successfully in disruptive technologies: expect a few huge winners to more than compensate for the majority of failed opportunities.

Never underestimate the importance of valuation

As I mentioned, the theme’s potential for gains might already be embedded in the price, meaning your future returns might not be as attractive as you think. As a long-term investor, however, you have one key advantage: your investment is less driven by short-term price action and can take full advantage of the market’s mood swings. In other words, it might be a good idea to wait until the market corrects and valuations get more attractive before buying or adding to your positions. Your long-term returns might get a significant boost from a better entry point.

Valuation should be an important factor not just to decide your entry point but also your exit. If you’ve been benefiting from a theme but the market suddenly seems to be pricing it in fully, it might be time to exit and take your profits. How and when you sell might be the most underestimated part of successful investing, even for long-term investors.

Do your homework

If creating your own thematic basket is too time-consuming, you can buy into a fund – just make sure you do your homework before buying in. That means you need to understand not only the rationale for your theme, but also the implementation methodology. So look into the top holdings, make sure you read the fine print, and get to grips with the counter-arguments so you have strong reasons to believe.

It’s a lot of hard work, I know. But if investing was easy, there’d probably be far fewer influencers right now…

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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