Thematic Funds Are Popular – But Their Performance Is Poor

One of the golden rules of investing online in company share or funds is to spot major economic and sector trends early, riding the wave to market-beating returns. Perhaps with that in mind, there is a particular breed of forward-looking investor that is attracted by thematic funds.

A thematic fund focuses on a particular trend or sector and selects companies that have exposure to it. Or if an index has already been created, a thematic fund might simply track that index.

Thematic funds might focus on low carbon energy, batteries, artificial intelligence, legalised cannabis, ageing populations or robotics. Their idea is to invest in a growing sector, where companies will grow along with their market. This kind of fund stands in contrast to broader actively managed funds that focus on income, growth, small, medium or large companies or geographies like Asia, Africa, Europe, China, Japan etc.

A specific example of a thematic fund would be Legal&General’s Battery Value-Chain fund, which invests in companies developing battery technology and miners of cobalt and lithium. Companies the fund is invested in include electric carmaker Tesla and Orobobre, the Australia-listed lithium miner. The fund does not actively pick these companies but tracks an index of companies exposed to the battery sector.

The amount of capital invested in thematic funds has, say financial markets and fund data analysts Morningstar, tripled over the past three years to $195 billion. Of the 923 thematic funds it tracks, 154 were launched in just the past 12 months. Robotics is currently the most popular theme among this category of funds with a total of $27 billion invested, followed by water scarcity, which has attracted $25 billion and IoT, which has pulled in $23 billion. An L&G fund focuses on cybersecurity manages $1.1 billion in capital, attracted over the 4 years since its launch.

The problem is, like actively managed funds more generally, thematic funds don’t have a particularly strong track record. Morningstar data shows only 41% have outperformed the MSCI World Index over 5 years. Over 10 years that drops to 26%. Thematic funds that track indices, which tend to be much smaller than benchmark indices and are of course only comprised of constituents that have a high level of exposure to the theme, don’t do any better.

And thematic funds also have a poor survival rate as they often struggle to attract enough capital to make it worthwhile for fund houses and managers to run them. Only 45% are still running after 10 years.

Like in the actively managed fund sectors, there are of course also winners among thematic funds. ARK Next Generation Internet, the $500 million fund that invests in cloud computing, ecommerce, artificial intelligence and social media has performed 3 times better than the MSCI World Index over the past five years. But on average, most thematic fund investors would have realised better returns by investing in broader indices such as the FTSE 100, FTSE All Share, S&P 500 or MSCI World Index.

There are some obvious reasons why thematic funds don’t tend to live up to the optimism of investors. Perhaps the biggest is that these funds ride investment fashions. That often means that by the time they have been set up, the sector they are tracking has already priced much of its future growth potential in. The funds then often only catch the last of the big growth phase in a theme. And also often a correction after a period of major gains.

Fees also tend to be high, at an average 1.25% for actively managed thematic funds. Even those that track an index tend to be much more expensive than funds that track a broad based index at an average of 0.52%. By contrast, the Fidelity Index UK Fund P costs 0.06% a year in fees. That means thematic funds have to do very well to beat standard broad index trackers after fees have been deducted.

And because institutional investors tend to have restrictions on how much money they can put into thematic funds, they tend to have trouble scaling up.

It’s easy to see why thematic funds are popular. They seem to make sense. Unfortunately, the evidence suggests that the reality is, on the whole, they perform more poorly than broader market benchmarks.