Morningstar recently published a study of the thematic fund universe, which showed that over the past five years assets had grown from $269bn to $562bn.[i] While through certain lenses this might be seen as a success story, it is bad news for investors. Over a 15-year period only 9% of funds in this space have survived and outperformed. Although that number may seem troublingly low, the reality is likely to be even worse.

Unfortunately a 91% failure rate is unlikely to dampen our enthusiasm for thematic funds because when presented with such information we will almost inevitably believe that we can be in the 9%.

If this overconfidence isn’t damaging enough, it is probable that the 9% number overstates our chances of a positive outcome from investing in a thematic fund. Another piece of Morningstar research from earlier this year compared time weighted and money weighted fund returns in order to observe the impact of the timing of investor cash flows – the so called ‘behaviour gap’.[ii] The two groups of funds that suffered the largest negative investor return gaps were ‘Non-Traditional Equity’ and ‘Sector Equity’ – the areas in which we would expect most thematic strategies to reside.  

This is unsurprising – thematic funds tend to exhibit high volatility and be more prone to bouts of exuberant speculation and painful comedowns – and it means that the 9% figure might be overly optimistic. Not only are there apparent structural issues with thematic funds, but they also seem to encourage some of our worst behaviours.

So, is there something inherently wrong with investing based on a particular theme or unified idea? Not necessarily, it is more that the majority of thematic funds tend to share a certain set of characteristics:

– Compelling, high growth narrative (most thematic funds are growth-biased).

– High fees.

– Unusually strong past performance from the area in focus. 

– Rich valuations of target stocks.

– Concentrated portfolio.

If I had to draw up a list of the top five things fund investors should avoid – this would pretty much cover it, and in thematic funds we often have them all wrapped up in one neat package for our delectation.

This is a classic case of the industry selling things that are good for them and bad for clients. Asset managers know that we are inextricably drawn towards powerful stories and strong past performance – thematic funds are designed to exploit this. They are funds with in-built marketing. It is easy for firms to launch lots (which they do) and hope that some stick; that most of them fail is of no great concern.

As thematic funds are typically launched in areas into which capital has flooded and driven up valuations, would it be possible to do the reverse – launch a strategy with a unified theme in an unloved area from which capital was being withdrawn? It would, and it may have a greater chance of success, but there is one small problem – nobody would buy it.

Investing in a thematic fund is an active investment decision – whether it is a pure active strategy or replicating a theme-driven index – it is also one with terribly poor odds of success. If we cannot resist the powerful urge to invest, we need to ensure that we size our position so that our portfolios can withstand the likely disappointment.

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[i] Navigating the Global Thematic Fund Landscape | Morningstar

[ii] Mind the Gap 2024: A Report on Investor Returns in the US | Morningstar

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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).

Back when I started my career in 2004, I remember that virtually every client account I looked at had tiny allocations to technology-oriented equity funds. I was initially puzzled by this before realising that these now inconsequential holdings were once significant but had been eviscerated in the denouement of the Dot-Com bubble. Looking back on such periods of exuberance and collapse it is easy to think that avoiding similar situations is straightforward. This could not be further from the truth – although the underlying stories may change the behaviours do not. Speculative bubbles are an inherent feature of financial markets. The key question is where are they most likely to occur?

Let’s start by defining terms. Robert Shiller – something of an expert in this field – defines a bubble as such:

“A situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors … despite doubts about the real value of an investment”.

I would add to this that bubbles typically involve some extreme dislocation between the pricing of an asset and any reasonable fundamental valuation of it. The only exception to this is where it is impossible to value the asset (more on this later).

There are four aspects that are key in the formation of a bubble: A compelling narrative, strong performance, powerful incentives and social proof. Narratives provide the foundation and ongoing support for a bubble, high returns corroborate the story, financial incentives are the reason why people become involved at all and social proof encourages action (we care deeply about what other people are doing.) These four elements create a virtuous (or vicious) circle as they feed upon each other, leading to dramatic price movements. 

Although predicting when a bubble may occur is likely a fool’s errand there are inevitably factors that increase the probability that a certain asset may be susceptible to such speculative activity. 

What are the features of an asset or the themes supporting it that increase the risk of a bubble?

1) True and simple stories: Although the underlying narrative supporting a bubble does not have to be true (sometimes they can be nonsense) the most dangerous are those which are supported by a valid and simple story. This allows investors in the bubble to answer easy questions such as (in the case of the Dot-Com bubble): Will the internet change our lives? Rather than more difficult ones such as: Which companies will benefit and what is already reflected in valuation? There is far more money to be lost when a story used to justify an investment bubble is true. 

2) Transformative stories: For bubbles to successfully emerge it needs to be easy for investors to disregard traditional approaches to fundamental investment valuation. It pays therefore for the narrative underpinning the bubble to be about a seismic change, which makes it easy to ignore the warnings of naysayers as their anachronistic methods simply do not incorporate the revolution that is taking place. 

3) Everyday impact: The most powerful bubbles draw in incredibly wide participation, even from individuals who would not normally make active investment decisions. The more that the story supporting a bubble in an asset relates to how we experience everyday life, the more people that are likely to become involved. If we can see and experience the story unfolding then we are more likely to buy into it.

4) Unquantifiable scale: Big bubbles need a big story. If there are obvious limits to growth then it puts a lid on speculation. A genuine bubble needs an asset where the transformation taking place means that it is difficult to limit the upside potential (in theory).

5) Difficult to value: Although most bubbles involve a yawning disconnect between the price of an asset and any prudent approach to valuation, the most significant bubbles can occur in assets that are either difficult or impossible to value. While equity market bubbles can be extreme at some point there will be a gravitational pull from fundamental realities of the asset class, but assets which are impossible to value because they have no cash flows – such as gold and cryptocurrencies – are perfect. If you cannot value an asset, who is to say what the upside could be?

This distinction leaves us with two types of assets: fundamental assets and belief assets. Fundamental assets have cash flows which means that (in theory at least) we can value it in some sensible fashion. By contrast, belief assets have no practical means of valuation, so they are priced based on what others are willing to pay. The easiest way to judge where an asset sits based on this delineation is to ask yourself – if an asset’s price was up 100% or down 50% tomorrow (other things equal) would that change my view? For fundamental assets this should dramatically alter its attractiveness, but for belief assets large price moves don’t really change anything apart from sentiment. This feature gives them a huge potential range of outcomes (from staggeringly good to disastrous) – ideal for bubble formation.

The more that an asset possesses these five features, the greater the propensity is for bubbles to develop. It is not simply about the asset, however. As Shiller’s quote highlighted, speculative bubbles are formed by people and their behaviour. The makeup of market participants matters, in the simplest of terms we can think of three groups involved in a bubble: Believers, Chasers and Luddites:

Believers: This group have fully adopted the story underpinning the bubble and approach it with almost religious fervour. Rather than being an investment view it often becomes part of their identity. They will never sell, never criticise and are able to justify any valuation. Their ardent belief either comes from developing a genuine confidence or faith in the asset and its supporting narrative, or because their financial incentives have become inextricably entwined with the continuation of the bubble. 

Chasers: This group are agnostic on the story and its validity – they just care about the price movements. They buy into a bubble because performance is strong. Like believers they have little regard for valuation, but are not wedded to the asset – they will own it while it is going up because it is in their financial interest to do so. A classic member of this group are asset managers launching products based around an emerging bubble asset, they don’t believe in it – they want to make money from it. Being a Chaser can be an explicit strategy but often it is simply the strength of performance from the bubble asset that draws them in for fear of missing out or maybe losing their job. Although this is the largest group, few will admit to being a member of it – momentum investing has a bad reputation, unless you are a quant.

Luddites: This group may believe in the story supporting the asset and almost certainly consider it to be grossly overvalued. They will inevitably endure poor performance as the bubble develops and be regarded as stubborn and out of touch. Professional investors in this group will risk dwindling assets and eventually their careers.

Both the relative size and movement of these groups will be crucial to bubble formation. While Believers are important in spreading the supporting stories they will be in the minority (although their flock will increase the more extreme the performance). The size of the Luddite group will shrink as the bubble grows as some capitulate to become Chasers and others give up.

It is the Chasers, however, that are most important. This will be the largest group and dictate both the size and persistence of the bubble. Their eventual exit from the asset will also precipitate its end.  

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Although difficult to validate, my base case would be that the potential for bubbles or prolonged periods of very extreme asset class performance is greater than ever before. Increasing connectedness through the rise of social media makes for easier amplification and transmission of stories, while I would also argue that investor time horizons are contracting – making us more prone to chase the performance of whatever is working. 

However we approach speculative investment bubbles – whether we choose to embrace them, chase them or ignore them – their emergence presents profound risks both in terms of the asset in question and our behavioural response to it. As a bubble inflates and the story becomes evermore persuasive, the increasing cost of missing out is likely to overwhelm the increasing risk of disastrous losses. 

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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). 

After reading my 641^st article confidently explaining ‘what Trump’s election victory means for markets’; I was reassured that there seemed to be a broad consensus on its implications. This allowed me to invoke one of Bob Farrell’s ten investing rules: “When all the experts and forecasts agree – something else is going to happen”. While the clarity provided by the election result may have provided some relief, it should not embolden us into believing we know what will occur next, because the truth is that we have no idea.

No matter how uncertain the outcome of a particular event is, what we know with absolute certainty is that when the results are in we will discuss them as if they were an inevitability. And so it is with the US election, where in reading the post-mortems of Trump’s victory we are led to wonder why the Democrats contended the election at all given how obvious its conclusion was.

From an investment perspective it is, however, critical to remember that the result was – for many – considered to be the flip of a coin with very few people willing to take a high conviction view on who the victor would be. This is important because it brings into sharp contrast an odd dynamic whereby most market participants were (rightly) unwilling to predict the outcome of a one-shot, binary election result around which there was a huge amount of data and information, but are now comfortable telling us what the longer term market and economic consequences of it will be. If we can’t answer the easier question with confidence, let’s not try answering the harder one that is immeasurably more complex.

Another favourite investor activity following an event such an election is to look at the immediate financial market reaction, hoping it will provide us with a sure guide as to what lies ahead in the coming months and years. It would be fantastic if this were the case, but it isn’t. When it became clear that Trump would regain the Presidency were investors hastily updating their inflation assumptions and quickly reworking their equity DCF models, or simply trading based on how they expected other investors to trade? Almost certainly the latter.

Market activity around such periods is both self-referential and self-reinforcing. Market participants decide how they will react prior to the event (in the most recent case the so-called ‘Trump trade’) and then react in that way immediately after. It doesn’t provide us with any longer-term fundamental insights, as much as we might want it to.

As markets were busy digesting the results of the 2024 election I looked back at the initial reaction to Trump’s 2016 win. In the two weeks that followed, the ten-year treasury yield rose, as did the dollar index, while in US equity markets financials, industrials and energy outperformed the wider market. And what happened over the full four-year term? Treasury yields fell, the dollar index weakened and all three of the aforementioned equity sectors underperformed the index.  

If the market was really telling us something immediately after that election, why was it wrong?

There are four critical reasons that make taking confident views about election results is so dangerous for investors:

– We don’t know what they will do: Although we can surmise and hypothesise, we have no certainty around what decisions a new administration might make.

– We don’t know what the consequences will be: Even if we did know what decisions would be taken, trying to understand the financial market consequences is close to impossible given its sheer complexity and deeply interwoven nature.

– We don’t know how much it will matter: Even if we knew what a new government would do and had some idea of the broader implications, it is still difficult to judge how to weight it relative to other factors. Is the occupant of the White House more important to equity market performance than how AI / tech develops from here? There are many, many variables that will matter and some will almost certainly be more consequential.  

– Other stuff will happen: Perhaps the most essential challenge for investors is that perennially frustrating problem of other things happening, things that we are not even considering today. These are likely to overwhelm whatever we are thinking about right now.  

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Investors abhor uncertainty and we are always looking for clues to how the future will unfold. Unfortunately, unpredictability is an ingrained feature of financial markets, not something that can be solved, and it is dangerous to believe it can be. More often than not admitting that we don’t know is the right answer and the one likely to lead to better investment outcomes over the long-run.   

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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). 

The week of the US election is the perfect environment for investors to make unfathomably difficult forecasts about financial markets with entirely unjustifiable levels of confidence. These could be about anything from identifying which equity market sectors might benefit from a particular outcome to forewarning a rout in US treasuries. Making decisions based on such prognostications is a wretched idea. This is not just because of the difficulty inherent in any given prediction, but because for it to be worthwhile investors have to keep getting such calls correct over and over again. The chances of this are slim and the downside severe.

When considering the type of investment decisions we want to make we need to ask ourselves not only about the likelihood of being right about a specific circumstance, but of being consistently more right than wrong in similar situations through time.

This is the challenge that resides at the heart of making bold macro calls or attempting to aggressively time financial market movements. While we might be fortunate with a view in a certain instance – how likely is it that we will overcome the odds and keep doing it?

No investment decision is ever made in isolation. We always have to consider: what comes next? Let’s imagine that we forecast a recession and an equity bear market – even if we are right, will we continue to be so? How deep will the downturn be? When will it end? What will the recovery be like? Each situation has its own unique set of complexities and uncertainties, which means that even if we strike it lucky once, we must repeatedly answer incredibly difficult questions. It is never one and done.

It is not even sufficient to be more right than wrong. We also need to understand the cost of being wrong, and our ability to recover from it. One mistaken call on an equity market downturn or a surge in inflation could prove irrecoverable. Investors making regular high consequence, high complexity decisions are playing Russian roulette.

This is exactly what we frequently experience with prominent hedge funds managers. They are given the limelight and earn astronomical performance fees (no clawbacks) for getting one big decision right. The problems then arise when they have to repeat the trick.  

If we are to consistently engage in low probability investment activities then we will either fail quickly or slowly. Slowly – if we are circumspect then over time the poor odds of what we are doing will catch-up with us. Quickly – if we take enough high consequence bets then one of them will end in disaster.

The interminable noise of weeks such as these gives entirely the wrong impression of what investing is and should be about for most people. Getting macro and market calls right is hard once, doing it repeatedly is close to impossible. Fortunately most of us don’t even need to try.

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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).