Interactive Investor

Thematic funds and ETFs: how to spot a winning trend and avoid a dud

Making money from the next big thing is appealing, but there’s the risk of backing a passing fad.

17th February 2022 10:25

David Prosser from interactive investor

Making money from the next big thing is appealing, but there’s the risk of backing a passing fad. 

Thematic investment is booming. European exchange-traded funds (ETFs) with a thematic approach had amassed $41 billion in assets under management by the end of 2021, compared to less than $10 billion two years previously; actively managed thematic funds have attracted significant support too.

It is not difficult to see the allure. Thematic funds eschew the traditional approach to investment, which is typically based on investing across particular geographical markets, or in a certain size of company. Instead, they focus on big-picture themes – often, the powerful and disruptive trends that promise to change the world. And who doesn’t want to invest in the next big thing - whether it’s robotics or electric vehicles, clean water, or the post Covid-19 ‘new normal’?

Indeed, all those themes – and more - have seen interest from thematic investment in recent months. The trend towards investing this way seems to have been accelerated by the pandemic, says Richard Hunter, head of markets at interactive investor.

“The pandemic had a number of impacts on investing behaviour, from the rise of ‘meme’ stocks in the US to a change in behaviour feeding through to share prices – after the dust had settled from a global economy which all but came to a standstill,” Hunter says. “It accelerated the use of technology for older users, for example, with silver surfers becoming part of the Zoom and FaceTime generation, bringing forward widespread use of such channels by an estimated five years.”

However, there’s a problem. Making money from the next big thing turns out to be more difficult than you might expect. “It’s actually really hard to know whether a theme will endure or not,” warns Ruli Viljoen, head of manager selection at analyst Morningstar. “The danger is that investors are swayed by the fear of missing out.”

Good stories don’t always make for good investments

For one thing, while thematic investment has an intuitive appeal because it taps into the zeitgeist, focusing on ideas that we are hearing about all the time, good stories don’t always make for good investments. Indeed, some ideas turn out to be passing fads rather than genuine game changers.

Moreover, even if a theme does prove to be enduring, picking the winners often proves difficult; the very nature of disruptive change is that plenty of losers fall by the wayside. There’s also the problem of finding value: if you’re not the only investor out there who thinks, say, battery storage technology is going to be a real focus in an age of renewable energy; then the chances are that potential is already in the price.

Thematic funds are certainly not a sure thing. Just ask investors in Ark Innovation, the $13 billion poster child of the thematic investment industry. It fell 43% over the year to mid-January despite its exposure to supposed next big things in DNA technology, automation, robotics, energy storage, artificial intelligence and fintech. Or what about the video-gaming industry, ostensibly at the forefront of the trend to increased home entertainment? Its leading thematic funds fell by as much as 15% last year.

Thematic winners and losers

We have been here before, countless times. Investors of a certain age will remember how investment trusts raised more than £1 billion in the 1990s to back a spate of European privatisations that either never came or flopped horribly. The leading privatisation funds were shut within five years. As for the first boom, it triggered a catastrophic market crash between 2000 and 2003; recovery in most Western stock markets took at least five years.

Indeed, the crash is a good example of another common pitfall with the thematic approach. It often takes much longer than expected for a disruptive theme to prove both transformative and profitable. We can now see that there was nothing wrong with the theory, in the late 1990s, that an internet-enabled world would prove to be very different to what had gone before, but the business model required to benefit had yet to be developed.

Equally, however, it would be unfair to write off thematic investments simply because some funds have disappointed – or taken longer to deliver. After all, there are plenty of good examples of winners too. Research published by Morningstar last year found 70% of thematic ETFs had outperformed global equities over the previous 12 months. Invesco CoinShares Global Blockchain ETF (LSE:BCHN) and the L&G Battery Value-Chain ETF (LSE:BATT) had both more than doubled investors’ money. Clean energy, automation and mobility have both been rewarding themes in recent times, while funds invested specifically in semiconductors were top performers, too, over 2021.

How to spot a fad or game changer

All of which begs the obvious question: how do investors spot the difference between a passing fad and a genuine game changer? There is also the related issue of timing; after all, even investors who pick the right trends risk a long wait if they get in too early, or missing out if they get in too late.

Tom Bailey, head of ETF research at HANetf, suggests looking for an alignment of the stars as one way to decide whether a theme’s time has come. “One way for thematic investors to approach a theme and judge its long-term viability is to break the economy into three components: consumers, corporations and public policy,” he argues.

“When we see consumers and corporations pulling in the same direction, spending or investing on a theme, that’s encouraging. And when public policy joins them, setting performance thresholds or providing development incentives, all three are moving in the same direction, creating powerful thematic tailwinds.”

Sustainability and the broader movement towards environmental, social and governance (ESG) improvements might be a good example of that. Growing numbers of consumers have been focusing on ESG  issues for a number of years, but sustainability has become a mainstream issue for corporates more recently. And public policymakers are certainly now focusing on ESG with a new-found vigour.

ESG funds the hottest ticket in town

This may be one reason why ESG-focused funds have experienced a big pick-up in popularity over the past couple of years. In the UK, £16 billion was invested in responsible funds in 2021. This was £4.3 billion higher than in 2020. 

But here, too, some caution is required. Morningstar’s Viljoen points out: “The reality is that ESG funds tend to have a growth bias, and this is the investment style that has been in the ascendancy until recently.” She wonders whether demand for ESG products will wane if value-focused investment continues to find favour compared to growth styles, a shift that markets began to see evidence of last year.

With so much uncertainty, Viljoen’s advice to investors is not to put thematic investment funds at the core of their portfolios. “This is about being sensible,” she argues. “Think of these funds as satellite holdings – and in any case, if one of them performs really strongly, it will have a disproportionately positive impact on the value of your portfolio.”

It may also be a good idea to temper your expectations. Sometimes, the strongest themes may not be those world-changing next big things, but an idea that is more modest in scope.

Sometimes it pays to be counter-intuitive. “More recent market volatility has seen a resurgence of ‘sin stocks’,” points out interactive investor’s Hunter. “The rotation away from growth stocks into value has refocused attention on the likes of the oil and tobacco stocks: a 19% rise in the oil price so far this year has propelled the share prices of the BP and Shell, while British American Tobacco and Imperial Brands, with the attractions of strong cash generation, inelastic demand and generous dividend yields, are enjoying their own day in the sun.”

It's a reminder that fashions change – often overnight. Investment trends will come and go – and there is nothing wrong with looking for fundamental value – but the short term brings its own disruptions.

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