A version of this article was published in the December 2018 issue of Morningstar ETFInvestor. Download a complimentary copy of Morningstar ETFInvestor by visiting the website.
Narratives have been used to lure investors for centuries. Simple, compelling stories tap into our emotions, hijack our ability to think rationally, and persuade us to pursue investments that are unlikely to perform well. Persuasive narratives are prevalent with thematic exchange-traded funds. These funds attempt to capitalize on the growth of popular trends like cybersecurity or the spending habits of millennials, but they face several obstacles that might prevent them from delivering attractive performance.
Compelling Stories Drive Speculation The South Sea Company of early 18th century England exemplifies how a well-spun narrative can cause investors to ignore facts and disrupt their ability to make sound investment decisions. The British government awarded the company exclusive trading rights with South America, a new land that was home to an abundance of gold, silver, and other exotic commodities. But its ability to capitalize on these rights faced a big hurdle. Many South American ports were controlled by Spain, which enforced quotas and taxes on the amount and value of goods that the British could import.
Despite this impediment, the company's directors engaged in a scheme intended to boost the stock's price and make them wealthy in the process. They championed the South Sea Company by emphasizing its trading rights and spread rumors that Spain might relax the import constraints. The tales the directors told were compelling. Promises of immense wealth drove speculators to buy the stock at a frenzied pace. New issues were filled within hours, and the company's stock price moved higher and higher.
But the stories spread by the directors were exaggerations at best. Spain never intended to relinquish its position, and it never did. Ultimately, imports from South America added little to the revenue of the South Sea Company. The excessive appreciation of its stock price far outpaced the tepid growth of its underlying business and proved unsustainable. Its share price collapsed, leaving speculators with a fraction of their original investment.
Why We Ignore Facts and Buy Stories Speculators in the South Sea Company were victims of an enticing story. Narratives like those used by the directors relied on simplicity, plausibility, and dramatic emotional connection to exert a powerful pull on the public, causing them to make decisions based on emotion and reaction rather than logic and reflection.
Plausibility is part of what makes a well-crafted narrative compelling and credible, even if the circumstances aren't factually true. The South Sea Company's potential to profit from its exclusive trading rights seemed reasonable, which was all that was required. When a story is plausible, the potential for truth bypasses logical thought processes, causing speculators to assume that the story is true rather than confirm the truth.
Stories build on their believability with simple emotional connections. I asked Sarah Newcomb, a senior behavioral scientist at Morningstar, to provide her insight as to why stories exert such a strong pull on our emotions. She responded that "stories are really powerful to us because they're easy to remember. They're small and easy for our minds to understand. A story is a self-contained thing that has meaning in our lives. Our brains love self-contained things that have meaning."
Stories can also exert their influence by accessing our emotions through excitement. "Generally, in a story we're able to make an emotional connection to what's happening. Emotions solidify memories and add salience to an experience," Newcomb added. "So, if something is emotionally charged, we're more likely to remember it and place higher importance on it."
Thematic ETFs Take Advantage of Stories Thematic ETFs are modern-day investment strategies that rely on simple, catchy stories to attract investors. They access our collective fascination with a wide range of niche topics, offering the potential to capitalize on the growth of something popular or trendy. Examples include ETFMG Prime Cyber Security ETF HACK, Global X Millennials Thematic ETF MILN, and Loncar Cancer Immunotherapy ETF CNCR.
The stories used to pitch these funds, and thematic ETFs broadly, are reminiscent of those used to sell the South Sea Company. The timeliness of these themes makes them relevant and familiar to people, instilling a sense of plausibility that tapping into them might lead to superior investment performance. Their stories are simple and easily remembered. Characteristics like these put them in a position to bypass our logical thought processes and provoke an emotional response.
But get past the story, and these funds lack some of the basic traits that are associated with great investments. Exhibit 1 lists the three thematic ETFs mentioned before, along with their expense ratios, diversification metrics, and price/book ratios. All of these funds charge considerably higher fees, are less diversified than Vanguard Total Stock Market ETF VTI, and trade at higher multiples, which increases risk and makes it harder for them to outperform.
Fees and diversification aside, thematic investments have another problem. The narratives used to pitch these funds imply that investors are making a single bet, one tied to the growth of a specified theme. But investors are actually making three bets. To capitalize on the success of a theme with one of these ETFs, investors first need to bet that their chosen theme will grow as expected. Second, they need to correctly bet that the companies held in the fund are positioned to profit from the growth of that theme. And third, they must bet that profit growth will translate into attractive stock returns.
The third bet is likely the most difficult. For high growth to translate into market-beating returns, it must exceed the expectations embedded in stock prices. The market's collective wisdom is pretty good at pricing expected growth. So while it is easy to find fast-growing companies, it is more difficult to identify stocks with undervalued growth. The fastest-growing companies tend to trade at higher valuations and don't typically offer the highest returns. And growth expectations aren't always realized. HACK's expected long-term earnings growth in November 2014 was 10%. But its actual earnings growth over the past few years was only 3.5%.
Growth aside, the problem with making multiple bets is that the overall probability of success is the product of the underlying probabilities associated with each bet. As an example, let's say the probabilities of an investor successfully choosing a theme, the stocks in a thematic ETF profiting from the growth of that theme, and those stocks actually providing a payout are each 75%. The investor's overall probability of success is then 0.75 x 0.75 x 0.75, or roughly 42%. So the investor's actual chances of winning in this scenario are much lower than the 75% success rate associated with the theme itself. Furthermore, the probability of being right says nothing about the size of the potential payout.
If You Must Given their higher fees, concentrated portfolios, and multiple bets, the simple recommendation is to avoid thematic funds. But given the power that narratives hold over us, it doesn't seem reasonable to expect that everyone will. Those unable to resist the siren song might want to check out a recent paper written by my European colleagues Kenneth Lamont and Hortense Bioy titled "Picking Your Dream Theme."
Their study looked at a wide selection of thematic ETFs listed in Europe and offered recommendations for investors that wish to venture into the thematic investing world. The study has not been replicated in the United States, but many of the takeaways also apply here. They suggest investors should take time to understand the risk/reward trade-offs. Some thematic ETFs are simply a play on a known factor or sector, so a cheaper alternative may be available. For example, MILN had almost 80% of its portfolio invested in technology and consumer cyclical stocks as of November 2018, which contributed to its strong growth orientation. Funds like these are best used as satellites because of their concentration.
 Mackay, C. 2003. "Extraordinary Popular Delusions." (New York: Dover), P. 46-88.
 Konnikova, M. 2016. "The Confidence Game." (New York: Viking), P. 101-102.
 Asness, C. 2015. "Don't Go for the Exacta." https://www.aqr.com/Insights/Perspectives/Do-Not-Go-for-the-Exacta.
 Bioy, H., & Lamont, K. 2018. "Picking Your Dream Theme." http://corporate1.morningstar.com/ResearchLibrary/DownloadRPSpdf.aspx?url=http://rps.morningstar.com/api/v2/654566632/documents/890113/file.
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