Specifically, in the case of thematic funds, investors are betting that they can get three things right:
1) They are picking the right theme
Is the narrative convincing? Is there a coherent and compelling growth story behind the strategy? Is there data to back it up? How is that work-from-home ETF going to look in five years’ time?
2) They are picking the right fund to track the right theme
Each thematic fund takes a different approach to selecting and weighting holdings, which can result in very different outcomes.
When evaluating investment merit, a strong narrative should not distract us from looking more closely at how exactly a fund tracks its theme.
Two ETFs tracking the same theme can be built very differently and result in distinct performance outcomes. To better understand the nuances, we must look more closely at how a fund chooses and weights its stocks.
After selecting stocks, an ETF must choose how to weight them. Given the narrow nature of most thematic funds’ selection universes, a standard market-cap-weighting approach will often result in large weightings in a small handful of stocks.
To correct this, most indexes have single stock, sector, or geographic weighting caps and/or floors. Another popular solution to this single-stock concentration problem is to equally weight constituents.
Both approaches balance the influence of larger companies and result in a small-cap bias.
Some funds implement more complex tiered or graded weighting approaches that prioritise businesses that offer greater exposure to the underlying theme.
For example, a specialised robotics company like US-based iRobot would be given a higher weighting than a huge conglomerate like Siemens, for which robotics forms a smaller part of overall operations.
3) They are picking the right fund to track the right theme at the right time
Has the growth potential of the theme already been priced into stock prices? If not, why not?
The tale of internet-themed funds in the early 2000s is illustrative. As the dot-com bubble inflated, the number of internet and tech-related thematic fund launches also multiplied.
By the turn of the millennium, one in three thematic funds globally was tracking a digital economy theme. However, after the bubble burst, the vast majority of these funds closed.
Today, just five of the 50 internet-themed funds launched in that period remain open, but each went on to register impressive returns in the preceding decades.
In this case, you could have picked the right theme – the internet did change the world – and even the right fund, but still ended up empty handed because the timing was wrong.
Our own research shows that investors are poor market timers, buying and selling at costly moments and ending up with lower returns than if they had simply left their money invested for the same period. This finding supports a long-term approach to thematic investing.