Show Me the Money?

BY SETH SOFFIAN

The upside sounds like an investor’s holy grail: huge returns and support for businesses or industries people often believe in, such as clean energy, artificial intelligence, or deglobalization.

It’s known as thematic investing, and it’s exploded in recent years as investors continue in their everlasting search for new ideas, new trends, and greater performance. But despite all the money pouring into various thematic funds globally—data shows recent increases as high as 300 percent—there’s considerable evidence that most results fall far short of expectations. In fact, many experts warn of thematic funds’ high volatility, failure rates, fees, and more.

“It’s not a particularly good style of investing,” says Nicolas Rabener, founder and CEO of London-based financial research and analysis firm Finominal. “The reason for that is behavioral. Most humans, as it applies to retail as well as professional investors, chase performance. The problem is a large part of investors enter when a theme is at the top and when valuations have been driven to extremes.”

According to a 2021 Morningstar report on U.S. thematic funds, 30 percent of such funds closed during the 10-year period observed. Another 34 percent underperformed against the broader equity market, leaving only slightly more than a third that delivered on their promise.

Similarly, university researchers in the United States and Switzerland recently found that thematic funds (often a subset of another increasingly popular investment vehicle known as exchange-traded funds, or ETFs) lost about 30 percent of their risk-adjusted value over their first five years. For this study, they looked at ETFs traded from 2019 all the way back to 1993. As they wrote in their 2021 report, Competition for Attention in the ETF Space, the authors determined that this underperformance “is driven by the overvaluation of the underlying stocks at the time of the launch. Our results are consistent with providers catering to investors’ extrapolative beliefs by issuing specialized ETFs that track attention-grabbing themes.”

Despite such dubious results, investments in thematic funds are only growing. Globally, total investments surged from about $251 billion in late 2019 to $718 billion two years later, according to Morningstar. In the United States, Morningstar reported thematic funding growth from about $49 billion in late 2019 to more than $160 billion 16 months later. Such is the allure of a popular theme mixed with potentially outsize returns.

Rabener, who likens thematic investing to venture capital for asset managers, pointed to the recent rise and fall of cannabis stocks. “Three or four years ago there was a lot of enthusiasm for it, and a lot of people jumped on the train,” he says. “Valuations got very expensive. Then when they started reporting their earnings, there was of course a big discrepancy between the multiples these companies were trading at and their earnings. At some point even the most irrational investor sees this is not a good bet, and the theme implodes.”

Perhaps no entity better exemplifies the volatility of thematic funds in recent years than high-profile fund manager Cathie Wood and her ARK Invest firm. A top executive at multiple Wall Street firms before venturing out on her own in 2014, Wood turned her aggressive beliefs in “disruptive technology” into about $60 billion in assets by early 2021.

But no sooner did ARK post whopping gains well above the market (such as nearly 150 percent in 2020 for her ARK Innovation Fund) than it grossly underperformed broader indices the last two years. Built on the likes of Tesla, Spotify, Zoom, Roku, Coinbase, and others, ARK’s flagship fund fell 23 percent in 2021, while the S&P 500 was up 27 percent. In 2022, the fund fell about 67 percent, more than triple the decline of the S&P 500.

And yet, 2023 has ARK back on the march. Its Innovation Fund had surged almost 22 percent at one point in late January, nearing the 26 and 24 percent monthly gains it posted in its banner year of 2020.

Such volatility only adds to the puzzle of thematic investing, which also includes plenty of competing opinions over what precisely defines a thematic investment. But given their popularity—and the higher-thannormal fees firms can command for them—thematic funds seem like a trend that’s hardly run its course. “From an industry perspective, it’s bound to grow,” Rabener says. “There’s no way around it.” «