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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