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Why Skepticism Is Important With Thematic Funds

Ben Johnson says that though they are growing in number and in assets, it's buyer beware on thematic funds.

Christine Benz: Hi, I'm Christine Benz for Morningstar. Thematic funds have been growing in number and in assets, but the data suggests that investors should approach them with skepticism. Joining me to share some research on this topic is Ben Johnson. He's Morningstar's director of global ETF research.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: So, Ben, let's first just define what is a thematic fund.

Johnson: Thematic funds, as the name would imply, try to capture, they try to harness, a theme that's trending out there in kind of the broader market environment and popular culture. As of today, that ranges anywhere from sort of cannabis--marijuana ...

Benz: Right. It's been a big one, right.

Johnson: ... which has been a big topic, to robotics. Going back a number of decades. all the rage was the Internet and dotcom stocks. So, these funds try to harness whatever the theme du jour might be, and investors, often wide-eyed, look to invest their monies in these funds looking to capitalize on that theme, looking to use it to their benefit within their portfolios.

Benz: So, let's talk about the growth. As we said at the outset, we're seeing an explosion of ETFs focused on various themes. We've also seen investors putting money into them. So, let's talk about the growth first.

Johnson: Well, we've seen tremendous growth over the course of the past five years in the U.S. market. Assets as of the end of 2019 stood just over $30 billion. That's nearly fourfold growth over that five-year span. And in that same period, we've seen a huge number of funds launch. So, there were 127 thematic ETFs and funds, both active and passive, in our universe as of the end of last year. Nearly three quarters of those funds were launched over the course of the past five years, which speaks to the fact that the ebb and flow of the thematic ETF menu tends to correlate pretty tightly with the movement in the broader market. The launch of new thematic funds tends to be a bull-market phenomenon.

Benz: Let's talk about that: Why thematic funds launch and what bets investors are making when they actually put money into such a fund?

Johnson: Well, I think it's important to think the bet that investors are making with thematic funds is a trifecta bet. I'm going to borrow from sort of a racetrack framework here. So, with a trifecta bet, you're betting on knowing which horse is going to win, which horse is going to place, and which horse is going to show in that order. Now, in the case of thematic funds, you're betting first that you're getting the theme right, that this theme is durable, that it has merit, that it's not going to flame out, that the growth of the cannabis sector, for example, in North America is something that's going to transpire over the course of the next few decades. Getting the theme right is one piece. Getting the fund to actually match the theme is another all-important piece. What we see oftentimes is that many of the businesses that are represented in these thematic funds' portfolios have only a sliver of their revenues that are generated from anything that has anything vaguely to do with the theme in question. 

Benz: Because there just aren't that many pure plays on some of these themes.

Johnson: Either there aren't enough pure plays--that's more often than not the case--or for diversification purposes, the portfolio has to be watered down with other, kind of, ancillary players or players who, again, generate just a small sliver of their revenues from whatever that particular theme might be.

Benz: OK.

Johnson: So, those two things are important to get right. And the third and maybe the most important thing to get right is valuations. So, how much of this anticipated growth is already priced into these stocks within the portfolio. If you're paying the wrong price if valuations are stretched, even if you get those first two things right, it's probably not going to matter over the long term.

Benz: In a recent paper, you looked at the fate of thematic funds. And it's not a pretty picture when you look at the data in terms of their ability to last and their ability to perform well. Let's talk about that.

Johnson: No. The majority of these funds die, especially over longer horizons, because those first two criteria aren't met. Either the theme isn't ultimately durable or the portfolio doesn't adequately capture and capitalize on that theme. So, dotcom stocks, I think, are the poster child for exactly this, and the dotcom funds--which we saw a raft of launches of those funds in the late '90s--there's only a small handful that have survived on to this day. So, even among those that have survived, what we see when we plot their risk and the return profile is that most of them have done no better than a broad market portfolio. So, investors are still left wanting even within those funds that have lived on to this day.

Benz: So, the takeaway for investors then is: Avoid these funds?

Johnson: It's buyer beware. The themes are always compelling. They always have an element of appeal, of curb appeal. But don't let all of the cocktail banter about whatever the theme du jour might be leave you blind to the real risks involved in investing in these funds. And the fact that you're making a trifecta bet, which by definition has small odds of paying out, but investors oftentimes look past the odds and at those prospective payouts, which can be large. They're just exceedingly rare.

Benz: Ben, always great to get your perspective. Thank you so much for being here.

Johnson: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.