My view on thematic investments has always been clear: I think investors should avoid them unless necessary.
Before I explain why, let me clarify two things:
First, I am not against themes in general – identifying emerging trends and monetizing them is the essence of investing – I am more questioning how the financial industry turns them into pre-packaged investible products.
Second, thematic investing encompasses a large spectrum of products. My reservations mainly revolve around very niche sectors of the economy (for example “cannabis” or “autonomous cars”) or vague overarching investment themes that try to fit different economic trends under the same umbrella (‘smart cities’ or ‘megatrends’ for example). My comments don’t apply to products that provide broad exposures and that use more fundamental criteria to select investments (value, ESG, impact, etc.)
With this in mind, let me explain why I believe thematic funds and ETFs should be considered only on a case-by-case basis.
Less for more
There is a reason why asset managers propose thematic investments. It is a way to preserve margins in a competitive environment and keep clients engaged. Because you are providing something differentiating and in high demand, you can justify higher fees.
source: The Review of Financial Studies, Volume 36, Issue
And why wouldn’t you? I am not trying to argue against the law of supply in demand here, my point is more that investors often mistake differentiation for quality. Unfortunately the vast majority thematic products are built on weak investment processes : simplistic inclusion rules, basic screening filters, lack of fundamental research…And this results in questionable choices and imbalanced portfolios. To quote a Morningstar’s article (link):
“On average, thematic portfolios are far more concentrated than the global market portfolio (a proxy for the investment opportunity set), and they often levy considerable fees. The average thematic fund has almost half of its assets allocated to its 10 largest holdings while that figure is about 12% for the MSCI ACWI Investable Market Index”.
Selected popular thematic ETFs: beware of concentration
Also, if the holdings are selected on the basis of purity metrics (i.e. a stock is deemed relevant for a particular theme because of the sector it belongs to or its mix of products), as opposed to its potential to drive structural changes, this may impact the portfolio’s performance later on. Not to mention the fact that most companies selected tend have particular biases from a style point of view (a recent factor analysis link suggests that thematic indices have strong negative exposures towards the profitability and value factors, indicating that they hold growth stocks that invest now for future profitability).
Concentration and thematic purity can have unintended consequences especially if you combine thematic investments in your portfolio. Indeed more often than not, the overlap between thematic products is high. As an illustration, I compared the top ten holdings of various thematic funds offered by an established asset manager. If you believe you are diversifying your exposures by investing in Water, Security and Health, the reality is different. In that case, you are just placing a triple bet on one particular stock (Thermo Fisher).
Top 10 holdings for 9 thematic funds proposed by an established asset manager. The overlap is great.
So long story short, the value you get may not be worth the price. Worst, you could end up with a dangerous mix and pay a fortune for it.
A recipe for underperformance
Thematic investments (both funds and ETFs) tend to underperform. This has been documented in many studies. A recent research conducted on ETF (link), draws interesting conclusions:
“over their first 5 years, specialized ETFs lose about 30% (risk-adjusted). This underperformance cannot be explained by high fees or hedging demand. Rather, it is driven by the overvaluation of the underlying stocks at the time of the launch.”
Asset managers usually need a solid business case to launch new products. As a result, most of the information has already been extracted from markets when the product hits the market. They are born during the late stages of bull markets, when high prices often set them up for poor future performance.
source: The Review of Financial Studies, Volume 36, Issue 3, March 2023, Pages 987–1042,
An annoying distractor
Because of their attention-grabbing features thematic investments take a larger than necessary part of our focus. And for less sophisticated investors, this translates into larger than necessary allocations in portfolios and higher turnover because most themes are time-bound by nature. So not only do thematic investments distract us from what matters – core allocation – but they also induce bad investment practices: frequent trading, higher turnover, emotional decisions, lack of (true) diversification…
And the cherry on the cake: because themes receive high media exposure, investors pay less attention to fees charged on specialized investments and focus more on past performance (a behavior they don’t necessarily display for broad-based investment).
A source of misalignment of interests
Thematic investments are an easy sell. Thus, it is not a surprise if they generate a large portion of the asset managers’ revenue (as of December 2019, it is estimated that specialized ETFs managed 18% of the industry’s assets but generated about 35% of the fee revenue). Salespersons are incentivized to push these products and they are usually happy to do it because it is pleasant to position something brand new and differentiating (if you are not asked to do it too often). Managers participate in roadshows spending less time monitoring portfolios and their remuneration is often linked to asset growth. The issue is when the hype fades and/or performance disappoints. AUM vanish, information becomes scarce, the internal focus shift, fewer resources are allocated…and at some point the product becomes unprofitable for the asset manager and is shut down. This happens more often than we think. A study by Morningstar( link and link) reveals that only 1 thematic fund out of 2 make it through their first 5 years.
To conclude
For all these reasons, think twice before considering adding thematic investments to your strategy. If you have convictions in a particular theme there may be better alternatives to play it (do your own stock picking for example) and if you have no other choice, use them as satellite holdings or favor broader exposures. More importantly, take care of your core allocation. Otherwise you may condemn your portfolio to a slow death.