The enduring appeal of thematic funds can seem somewhat puzzling given their track record of delivering disappointing returns to investors (and sometimes worse).[i][ii] Yet from a behavioural angle, there is no puzzle to solve. Their composition exploits some of our most damaging psychological traits. No matter how many flavour of the month funds fail, there will always be a new story to sell.   

Although we like to frame our investment decisions with rigorous analysis and metrics, more often than not it is the stories that really matter. Our desire to believe a compelling narrative that draws a comforting line between cause and effect is an inescapably human trait. Financial markets are noisy, capricious and uncomfortable, persuasive stories help to remove that nagging pain of uncertainty.

Thematic funds prey on our desire for clarity by making everything easy. Something significant is happening in the world (usually some seismic and profound change) and we can profit by investing in it.

The vital sleight of hand played by the purveyors of thematic funds is that a story being true means that we are going to make money from it. These are always framed as being one and the same question – if you believe, then you should invest – but in fact they are two entirely distinct issues. There have been countless cases of narratives, themes and stories being valid – the internet was transformative / emerging markets did grab a far larger share of global GDP – and investors still losing plenty of money.

Key to avoiding the allure of thematic funds is finding some way of living with this cognitive dissonance – if the story is true how, how can it not be a good idea to invest?

Thematic funds are built on three core components that form a (for a time) virtuous circle: strong performance, a convincing story and social proof. Each element feeds the next inflating a form of micro-bubble. High returns need an explanation, so a narrative is forged, more investors are drawn in boosting performance, which further bolsters the credibility of the story. And so on…

At some point this circle of virtue (or profit) will turn vicious when each element will damage rather than support the next as the hype fades or shatters. In most circumstances we can be confident that this will happen, we just don’t know when.

All investors are either valuation or momentum driven. We invest because we believe that an asset is undervalued or because we think the price will (continue to) go up. Thematic fund investors are almost always momentum investors – they just might not know it. Why can’t thematic investors be focused on valuation? Because it is tough to believe that an area of the market can be underappreciated / materially undervalued and have a specialist fund launched to exploit it.

Momentum investing is a perfectly robust and proven approach, so why can’t thematic fund investing work on this basis? Because too many thematic investors don’t realise they are chasing momentum, instead they rely on the fundamentals of the story. Momentum investing works because of the deliberate and dispassionate application of rules – it is following a system not chasing a story. Engaging in it without acknowledging it is a recipe for disaster.

While it may be difficult for investors to make money from thematic funds, it is easy for asset managers. Stories sell and thematic funds come with in-built marketing. The investment thesis and sales pitch are the same thing. Not only is the sales message readymade, but financial markets are narrative generating machines. There is always the next story to place on the shelf.

Given the evidence around the disappointing outcomes from thematic funds, what accounts for their ongoing popularity? It is a classic inside / outside view problem, where we focus on a specific issue and ignore the general lessons. When we are considering the latest area of thematic fervour (AI anyone?) our attention is trained on the strength of that particular story, so we ignore the litany of failures of other themes that have momentarily captured and overwhelmed investor attention. It is the base rate of success in thematic funds through history that matters. Although the stories are different, the behavioural drivers and lessons are the same.

Most thematic fund investing is founded upon ideas that are simply not credible:

– Buying expensive, in-vogue assets tends to end well.

– Unsustainably strong performance will in-fact be sustained.

– We can make accurate forecasts about fiendishly complex economic / technological developments.

– Being correct about economic / technological developments mean that we will outperform.

– Abandoning diversification for thematic concentration can be a smart idea.

These make for a toxic set of implicit and erroneous beliefs. Maybe we can strike lucky and succeed with thematic investing, but the odds are horrible.

The sad truth is that the type of thematic fund most likely to make money would be one that very few people would want to buy.

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[i] Ben-David, I., Franzoni, F., Kim, B., & Moussawi, R. (2023). Competition for Attention in the ETF Space. The Review of Financial Studies, 36(3), 987-1042.

[ii] https://www.morningstar.co.uk/uk/news/236136/comment-thematic-investing-appeals-to-our-worst-instincts.aspx

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

You are a goalkeeper about to face a penalty kick. You have three options to make the save. You can dive left, dive right or stay in the middle. Having looked at the stats you know the probabilities are most in your favour if you stand still.* So what do you do? You dive to the left or the right. Why? Because if you don’t and the penalty taker scores it will look like you didn’t even try. Not only will you feel worse, but the fans won’t be happy – the least you could have done is put some effort in. This bias towards action is not just an issue for goalkeepers, it is a major problem for most investors. We just cannot stop doing too much.

The penalty kick example was taken from a 2007 paper exploring the concept of action bias.[i] This idea is something of an oddity as it runs counter to a more common behavioural foible – omission bias, which is our tendency to view the harm from doing something as greater than the harm from not doing something. Whether we have a bias towards action over inaction will depend on the prevailing norms. If there is a strong expectation for action in a given situation (whether justified or not) then not doing anything will likely be viewed harshly.   

For investors it is undeniable that there is a powerful and inescapable assumption that we should be constantly active. Why is the idea so pervasive?

– Markets are changing, so must our portfolios: The relentless variability and noise of financial markets means that there is always a new theme, new story, new paradigm, which we must react to. We cannot stand still whilst everything seems to be shifting around us.

– Our behavioural biases lead us towards action: A range of behavioural traits provoke action and activity. We trade because we feel emotional (fear or greed), we trade because we overweight the importance of what is happening right now, we trade because someone is making more money than we are. The fluctuations of financial markets stimulate some of our worst behaviours.

– Underperformance is inevitable: All investors, no matter how seasoned or intelligent, will experience painful periods of underperformance whatever their approach. Even if we are adopting the right strategy, for prolonged spells it is likely to be perceived as naïve, anachronistic or just plain stupid. Our tolerance for such periods is much shorter than we think, and so we trade.

– Justifying our careers / fees / jobs:  It is really difficult to build a career by doing less than other people. How do we keep our clients if we are doing nothing when performance is poor and the returns of people doing everything are better than ours?  If we are the person in the room suggesting doing nothing, our promotion prospects are probably not looking too good. Action is a rational career choice and an institutional imperative, it’s just often not in the best interest of clients.   

– We need to tell stories: Everyone wants to hear stories. What did you do last quarter? How are you reacting to the emergence of AI? If we don’t do anything it is hard to spin a convincing narrative. We make changes so we can tell a story. (One of the strongest reasons for the pervasiveness of TAA / market timing is that it provides us with regular stories to tell).  

While there are factors that compel us towards action, there are several reasons why we should avoid it:

– Predictions are difficult: The more changes we make to our portfolios, the more we are likely to be engaging in short-term market predictions. It is reasonable to assume that the average (and above average) individual is not great at forecasting economic events nor the market’s reaction to them. We need to be right twice and most of us fall at the first hurdle.

– Whipsaw risk: It is not just that making forecasts about a complex adaptive system is a pretty difficult ask, it’s that we find ourselves reacting to each captivating narrative that the financial system spits out. Trading and tinkering incessantly. The notion that we will get this more right than wrong seems entirely fanciful.

– There is a reason for diversification: One of the primary reasons for diversification is that we do not know the future (if we did, we would only own one security). A sensible level of diversification creates a portfolio that survives different environments and where there is always something working and something lagging (this is a feature, not a bug). An appropriate level of diversity should allow us to do less.

– Negative compounding: Too much investment activity results in the incredibly powerful force of negative compounding, where the costs of our trading (a combination of fees and being wrong) act as a material long-term drag on our returns.

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The typical response to the idea of investors doing less is: “well, you can’t just do nothing”. Yet the point is not that there is never a reason to make changes – of course there are – but the default must be flipped from “what have you been doing?” to “why have you done anything?” The threshold for change must be higher.**

It seems ridiculous to suggest that thinking of ways to reduce our activity could be a route to better investment outcomes. Yet, as always, the things that seem unfeasibly simple in investing come with significant behavioural challenges. These are not impossible to overcome, we just need to find a way to do less in a system that incentivises and encourages us to do more.

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* There is a bit of a quirk here in that the best penalty taker may only strike the ball into the centre of the goal because they have already seen the goalkeeper dive. So, if the goalkeeper does stand still, the player may not kick the ball towards the centre of the goal. But let’s not let that spoil a good analogy.

** The underlying assumption here is that we have made sensible choices to start with. If we have made some terrible initial decisions, change is good!

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[i] Bar-Eli, M., Azar, O. H., Ritov, I., Keidar-Levin, Y., & Schein, G. (2007). Action bias among elite soccer goalkeepers: The case of penalty kicks. Journal of economic psychology, 28(5), 606-621.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

It is incredibly easy to be cynical when businesses talk about culture. It is more likely than not to mean another anodyne PowerPoint full of empty buzzwords quickly forgotten. Ask most businesses what they actually mean by culture and they would probably struggle to come up with a convincing answer.

The problem is we cannot just treat culture as another element of corporate BS to readily ignore. It really matters.

So what is culture? In simple terms, I see culture as the expected, encouraged and incentivised behaviours within an organisation. Individual decision making doesn’t occur in a vacuum, it is inescapably framed by the environment in which we operate.

Understanding what culture is and how to create the right culture is absolutely critical for any organisation or team. If you want to promote good behaviour and decision making, thinking about culture is essential. It’s just not that easy.

In this episode of Decision Nerds, Paul Richards and I tackle culture and decision-making with WCM Investment Management. They have some fascinating insights as the assessment of culture forms a key part of their company analysis. They have also thought exhaustively about how to structure their own culture to make better choices.

In this session, we cover a range of fascinating topics, including:

The need for alignment between culture and strategy

Is scale the enemy of culture?

Should culture evolve through different business/operating environments?

Where and how can culture go sour?

What does management often get wrong when talking about culture?

Companies – how often do stated cultural ambitions align with compensation structures?

What’s the most practical way to take the cultural temperature of a company?

You can listen on your favourite apps, or here.