Why you should avoid investment themes

Investment themes are all the rage. Pick up any investment magazine or the money section of a Sunday newspaper and you’ll see what I mean. Robotics, artificial intelligence, infrastructure, healthcare and plant-based food are some of today’s “hot” themes. It’s anyone’s guess what subjects fund industry marketers will be writing about in a few years’ time.

The reason why investment themes, and thematic funds in particular, are so popular is that they come with a ready-made narrative. Investors love a good story and are far more likely to be swayed by a compelling narrative than by data and evidence. It’s for precisely the same reason of course that fund management companies keep launching new thematic funds and that financial journalists are usually only too happy to write about them.

Good stories don’t make good investments

Unfortunately, what makes for a good press release rarely makes for a good investment.

The main problem is this. Fund management companies know that, despite all the warnings that they shouldn’t, both retail and institutional investors (and indeed many financial advisers and investment consultants) tend to choose funds primarily on the basis of recent performance. So, naturally, most new product launches are in sectors that have seen strong returns in the last few years.

But when you take a longer-term view, the picture is very different. Recent research by Morningstar showed that thematic funds have trailed the overall equity market by about four percentage points per year over the trailing ten-year period[NHJ1] .

Higher risk, lower returns

Morningstar also revealed that thematic funds tend to come with higher risk. They typically invest in holdings that are significantly smaller, pricier, and less profitable than the average stock — all of which traits are associated with higher volatility.

Even for investors who can tolerate that extra volatility, however, Morningstar found the returns delivered by thematic funds over the past ten years have generally not been high enough to compensate for the additional risk.

But it gets worse. Survivorship rates for thematic funds are pretty dreadful. In the US, for example, Morningstar found that about 30% of thematic funds launched over the past 30 years are no longer around, and the mortality rate is even higher for funds in non-US markets. Because most funds that cease to exist had poor performance records, their demise artificially boosts the average performance of the funds that did survive.

A trifecta bet

Morningstar’s Ben Johnson summed it up by using a term familiar to those who bet on horse racing:

“Investors in thematic funds are making a trifecta bet,” he said. “Specifically, they are implicitly betting that they are picking a winning theme; selecting a fund that is well-placed to harness that theme; and making their wager when valuations show that the market hasn’t already priced in the theme’s potential.

“The long-term performance figures for thematic funds are not flattering. They suggest that investors’ odds of selecting a fund that will survive and outperform over the long run are slim.”

I mentioned earlier that, in my view, it’s the narrative aspect of thematic funds that makes them so popular. A second reason, I suspect, is overconfidence. Whether it’s you who’s picking the stocks or a fund manager you’re paying to pick them for you, successful active investing depends on predicting the future better than the market as a whole.

It’s all obvious in hindsight

Everything seems so obvious in hindsight, but predicting the future is actually far harder than we tend to assume. Think back to the early 1990s, for example, and the early days of the internet. It was clearly a technology that offered exciting potential, but it was by no means obvious then that it would revolutionise our lives in quite the way it has. It certainly wasn’t to me.

SOURCE - CFA Institute (https://blogs.cfainstitute.org/investor/2020/03/23/thematic-investing-thematically-wrong/)

But say you had foreseen the extraordinary growth of the internet. Could you have profited from that foresight as an investor? Well, you could have invested in one of the many technology funds that sprung up in the mid-to-late-‘90s, only to see its value crash when the dotcom bubble burst in the year 2000 (as I did). Or you could have bought individual technology stocks. But what then?

As financial historian Professor John Turner explains, identifying in advance the very few dotcom stocks that did succeed was a very tall order.

Would you have picked Amazon?

“Had you invested in Amazon’s IPO back in the 1990s and you held that stock today, you’d be a very wealthy individual,” says Professor Turner. “But had you invested in 20 other stocks, you probably would have lost all your money.

The same thing happened, he says, in the boom in British bicycle stocks in the mid-1980s: “There were more than 600 bicycle companies, and who knew that Raleigh was going to come out on top?”

Warren Buffett made a similar point at the recent Berkshire Hathaway annual meeting.

“There were at least 2000 companies that entered the auto business,” said Buffett. “In 2009, there were three left, two of which went bankrupt. So there was a lot more to picking stocks than figuring out what’s going to be a wonderful industry in the future.”

Consumers win, investors lose

And remember, all of these technologies — bicycles, cars and the internet — were ultimately very successful. But predicting that success was unlikely to make you rich. In each case, it was mainly consumers who benefited, while most investors had their fingers burned.

The moral of the tale for investors is to stop trying to predict the future. Investment themes will come and go, but those who invest in every major sector around the world, and focus on the long term, are likely to be richly rewarded.

Don’t fall for the latest story: stick to broadly diversified index funds.

ROBIN POWELL is Editor of The Evidence-Based Investor.

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