During the pandemic, there was a sudden surge of seemingly new ‘thematic’ investment funds that came to market worldwide (Morningstar’s data indicates that assets tripled in this space between 2019 and 2021 to roughly US$800B globally). Often structured as an ETF for ease-of-access to the DIY investor, an onslaught of new ideas flooded the market and captured the imaginations of many. These products launched on the notion that an everyday investor will profit off of a global theme that crosses traditional economic sectors, like “Big Data” or “Robotics & Automation", "Blockchain" or (unfortunately a bit close to home) "Cannabis." Although the themes might sound new, the concept of a thematic fund isn't. In fact, we can trace their roots back to the 1948, when Chicago-based
Television Shares Management Corp. launched The Television Fund.

Here's the thing though.

When we step back from the facade of storytelling and marketing around the 'next big trend' and think about what it is we're actually investing in, the odds are unfortunately stacked against the retail investor. When investing in a thematic fund or ETF, you are effectively placing three independent bets (full credit to this concept to my counterpart Ben Johnson, CFA):

  1. That you've somehow landed on the right theme, amongst hundreds of other other themes.
  2. That the theme you've picked is investable via a basket of public companies, and that those companies aren't already overvalued.
  3. You've picked the right manager or index provider to capture and exploit that theme.

When an investor gets all 3 correct, results are indeed phenomenal. Unfortunately, Morningstar's data shows historically that this is not often the case.

Source: Morningstar Global Thematic Funds Landscape Report 2022

The above chart maps the survivorship rate of thematic funds over last 15 years, ended 2021. It shows that over 5 years, only 39% of thematic funds survive and outperform a broad global equity benchmark (in this case the Morningstar Global Markets Index). Over 15 years, just one in 10 thematic funds survive and outperform.

When we throw in the behavioral biases that investors often succumb to, the picture gets worse. In Morningstar's 2023 "Mind the Gap" report, Morningstar's senior analysts Kenneth Lamont, CAIA and Matias Möttölä, CFA looked further into what is often called the "behavioral gap," or the difference between advertised fund returns, and what investors actually get. Through a decomposition of asset flow and performance data, the authors concluded that funds and ETFs identified as thematic (within Ireland, Luxembourg, United Kingdom, and the United States), posted on average, 5Y annualized total returns of 7.8% (ending June 2023), meanwhile investors in these funds earned 2.4% annualized over that same time period. That's a notable gap (4.9%), especially when compared against the broader equity fund universe across the same investment universe, which showed a gap of just 0.5% over the same period.

Source: The Big Shortfall: Understanding the gap in thematic funds

As experienced investors know, timing the market is next to impossible. It seems, though, because of the exciting and cyclical nature of thematic funds, that investors are more susceptible to buying too late (chasing trends) or selling too early (out of fear or panic).

Based on these stats, it might be worthwhile guiding investors to ensure their exposure to these types of funds or themes are a smaller portion of the broader asset allocation. This might even lead to fewer frantic phone calls.

Ian Tam, CFA is Director of Investment Research at Morningstar Canada, a member of the Ontario Securities Commission Investor Advisory Panel, and a member of the CFA Institute's ESG Technical Committee. The thoughts expressed in this article are his own and not necessarily reflective of Morningstar Research Inc. This article does not constitute financial advice. Readers are encouraged to conduct their own independent research before buying or selling any securities listed in this article.