Being late to the party is the big risk buying this type of ETF

In the latest monthly column, a Morningstar analyst runs the rule over a passive strategy that has gained greater prominence with investors in recent years.

The global market for thematic funds has expanded rapidly in recent years. These funds attempt to harness secular growth themes ranging from demographic shifts to the rise of the metaverse. Some have delivered bursts of eye-catching performance, while others have failed to gain traction.

As assets have poured into these funds, asset managers around the globe have ramped up the supply of these niche and often gimmicky funds. Investor demand for clarity and guidance has increased proportionately.

It is only in the past five years that we have seen thematic funds seriously attract assets on a global level, with the growth registered during the pandemic being nothing short of spectacular. Thematic funds have tripled their share of global equity fund assets to 2.9% in the 10 years to mid-2022.

Four reasons why thematic ETFs have become more popular

First, companies with exposure to certain, potentially world-changing, winner-takes-all technologies have benefited from rapid growth and soaring stock prices. These have offered investors outsized returns, and this outperformance has attracted flows.

This was particularly obvious over the initial stages of the global pandemic when most thematic exchange-traded funds (ETFs) outperformed the broad market by a comfortable margin. For example, WisdomTree Cloud Computing ETF (LSE:WCLD) returned 109% in 2020, while Morningstar Global Markets Index returned a comparatively measly 16%.

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Second, some argue that fundamental changes in the way the global economy functions have supported the growth of thematic investing, suggesting that the "metabolic rate" of the economy is accelerating, with industry dynamics evolving faster than ever and profit pools shifting across value chains in many industries.

Growing irrelevance of geographic and sector groupings in a globalised world means where a stock is listed can have little bearing on where it sources its revenues. For example, London-listed BP (LSE:BP.) derives a fraction of its revenue from the UK. Equally, sprawling tech giants that operate in a kaleidoscope of emerging and existing industries are testing the traditional sector classification frameworks like never before.

Third, steady improvements in the quality and granularity of financial data mean that highly targeted indexes and investment strategies can now be constructed and maintained.

And lastly, the mega-trends of mass customisation and the democratisation of finance have also played a part. The highly targeted nature of some thematic funds allows investors to fine-tune their portfolios to match their investment preferences and to align with their beliefs.

Retail investors have historically been attracted to thematic investments by their strong narratives, which has contributed to the success of stocks and funds connected with themes.

How should thematic funds be assessed?

When running the rule over thematic funds, the fundamental fund characteristics that boost the chances of achieving long-term investment success, such as low fees, a seasoned management team, and a trusted parent organisation, still apply equally and should form the foundation of any evaluation. That said, the distinctive characteristics of thematic funds mean a more tailored approach to due diligence is required.

One of the common criticisms of thematic funds is that they are trendy. Fads come and go. Investors lose interest in old themes and chase new ones. This view is not unfounded. In fact, it would be fair to say that many thematic funds are trendy by design, and some even have the word ”trend” in their names.

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One way of assessing trendiness is to examine how frequently funds open and close. Global equity fund survival rates reveal that, on aggregate, thematic funds have been less likely to close than all equity funds over the one, three, five, 10, and 15 years to mid-2022.

This result may come as a surprise. However, the figures should be understood within the context of the booming thematic fund market. Most thematic funds have launched since 2017. The trailing five-year period has seen thematic funds register strong returns, which have contributed to these elevated survival rates.

We may get a fuller picture of thematic longevity once the market becomes fully saturated with thematic funds, and we enter a prolonged period of underperformance. It should be noted that outflows and closure rates remained low despite the poor thematic returns in the first half of 2022.

Danger of chasing past performance

To some degree, trendiness is a function of how a fund is used rather than something built into the fund itself. ETFs are traded throughout the day on an exchange, like stocks, making them a nimbler trading tool than traditional funds, which price once a day. This advantage means ETFs are favoured by investors with shorter investment horizons often making tactical allocations.

We see net flows and aggregate performance of thematic ETFs listed in developed countries over a period of the Covid-19 pandemic. Thematic funds posted eye-catching returns from the second quarter through to the end of 2020, before average performance started to slump.

Even as returns began to falter, investors were just beginning to ramp up their investments into thematic ETFs to record levels. This fits the timeworn pattern of investors “chasing past performance”.  

Unfortunately, it is also illustrative of how bad investors are at market timing. In this case, 44% of all global net inflows over the observation period into thematic ETFs occurred in the three months following peak returns.

Regardless of whether a fund is trendy "by nature", many thematic funds can be used to follow trends. This example supports the findings from our Mind the Gap research, which showed that fund investors who attempt to time the market more often than not find themselves worse off than those who bought and held over the same period.

Kenneth Lamont is a senior analyst focused on manager research and passive strategies at Morningstar.