Thematic funds have tempted buyers with compelling narratives and outsized intervals of returns.
This hype round these funds has led to the launch of 589 new thematic funds worldwide in 2021, greater than double the file of 271 from the earlier yr. And belongings underneath administration in these funds has grown to only over $800 billion by the tip of 2021, practically tripling in simply three years.
These funds cowl a wide range of themes, from clear power and water to know-how traits similar to synthetic intelligence. But it surely’s essential to look past a catchy story when assessing their potential.
For the reason that onset of the worldwide pandemic, flagship thematic funds like ARK Innovation ETF ARKK skilled a spectacular rise and fall, drawing renewed consideration to the potential dangers related to investing in sure thematic funds.
Are thematic funds dangerous?
By most measures, theme funds might be thought of dangerous investments. In reality, many thematic funds are inherently dangerous.
Over the previous 5 years, practically 9 out of 10 thematic funds in our database have posted a better customary deviation than the broader world inventory market (as proxied by the Morningstar World Markets Index).
That quantity drops to a few out of 4 after we look particularly at broad theme funds, which monitor a number of themes and have a tendency to have extra diversified portfolios.
Finally, this exhibits us that even essentially the most diversified thematic funds posted a better customary deviation than the general world fairness market.
Nevertheless, danger shouldn’t be thought of in isolation; it is usually essential to think about the potential trade-off between danger and return. The chart above exhibits that whereas many funds have been extra risky than the broader market, many have additionally produced robust returns.
Alternate-traded funds, which have a tendency to carry a smaller basket of shares than their mutual fund counterparts, additionally are usually extra risky. Take into account Horizons Marijuana Life Sciences ETF domiciled in Canada HMMJ. The fund returned greater than 100% within the 4 months between September 2017 and the tip of this yr, earlier than dropping greater than two-thirds of its worth within the yr to the tip of the primary quarter of 2020.
With such risky returns, funds like this in all probability should not be a core allocation inside an affordable funding portfolio. However might even slender thematic baskets have a spot in a portfolio? The direct reply is sure.
Are thematic funds safer than a guess on a single inventory?
Most individuals would in all probability classify HMMJ as a dangerous funding, however how dangerous an funding is can even depend upon what we examine it to.
To get began, let’s examine World X Lithium & Battery Tech ETF BED with iShares MSCI World ETF URTHwhich approximates publicity to the worldwide inventory market.
Over the previous 10 years to the tip of Might 2022, URTH recorded lower than half of the usual deviation towards LIT. By this measure, LIT, which on the time of writing holds 45 shares in comparison with greater than 1,500 held by URTH, might be thought of a riskier funding. Nevertheless, LIT’s 10-year customary deviation remains to be decrease than that of any of its present holdings over this era.
You can too take the instance of a hypothetical investor in search of publicity to the cloud computing theme three years in the past. This investor could have had a alternative between a single inventory and a cloud ETF that buys a basket of cloud shares (together with the one inventory). Suppose the investor selected the one inventory: enterprise software program specialist Everbridge EVBG, which between the tip of October 2021 and July 2022 misplaced greater than 80% of its worth following reported losses and the resignation of the CEO. Considering earlier development, this funding would nonetheless be down by greater than a 3rd.
In distinction, if the investor had chosen one of many largest listed cloud computing ETFs on the planet, returns would have been 7% over the identical interval. On this instance, the ETF held Everbridge, however outperformance elsewhere within the portfolio helped offset losses. In fact, if the investor had chosen a greater performing cloud computing inventory, the returns might have been even larger.
Finally, even when buyers decide up the appropriate theme, non-company points, similar to fraud or mismanagement, can derail an organization’s possibilities of success. Shopping for a well-designed theme fund stays one of the vital efficient methods to diversify a few of this idiosyncratic or company-specific danger whereas sustaining a fascinating theme-specific danger publicity.
You can too benchmark your fund towards Morningstar’s thematic indices to see if it incorporates the varieties of shares you need. For power, for instance, you possibly can take a look at the Morningstar Developed Markets Renewable Power Choose 30, Morningstar World Markets Renewable Power, Morningstar North America Renewable Power, and Morningstar World Power Transition indices, amongst others.
How dangerous is the overcrowding of thematic funds?
Crowding is when buyers analysis a particular inventory or funding concept on the identical time. And this rush to purchase or promote, particularly for smaller, much less steadily traded shares, can improve worth volatility and improve buying and selling prices.
Since thematic funds typically put money into smaller corporations which are typically leaders in rising applied sciences with excessive development potential, liquidity is especially necessary.
Whereas energetic managers can select which securities to promote inside a portfolio and keep away from buying and selling in any case opportune instances, ETFs are likely to have narrower exposures and (when passively managed) are pressured to purchase and promote in accordance with the principles of the index. This makes them notably prone to liquidity squeezes that happen throughout huge outflows. The influence on the underlying inventory might be exacerbated when buyers in many alternative theme funds promote concurrently.
Liquidity complications can even seem when the market is shopping for. For instance, the runaway success of some various power ETFs triggered rising pains on the finish of 2020. The mixed belongings of other power ETFs domiciled in Europe and america catapulted to 10.7 billion on the finish of the primary quarter of 2021, in comparison with $0.8 billion in the beginning. of 2020. With a lot cash gushing into such a decent portfolio of small- and mid-cap shares and amid questions over liquidity, the S&P World Clear Power Index has been forcibly expanded twice. All further buying and selling prices related to modifications to new benchmarks have been absorbed by buyers within the fund.
What are the warning indicators of thematic funds?
When assessing a theme fund’s liquidity, buyers ought to look immediately on the fund’s holdings (and, within the case of passive funds, the index methodology).
Metrics similar to inventory market capitalization and common every day buying and selling quantity can be utilized to estimate how troublesome it will be to promote short-term holdings. A fund with important publicity to small and micro cap shares deserves nearer examination.
Do not forget that a inventory is simply helpful when you can promote it. However whereas it is necessary to control liquidity and keep away from investments that clearly wave pink flags, solely in essentially the most excessive circumstances will this have a huge impact on fund returns.
