Morningstar - Q3 2021 - 23

Thematic Funds:
Beware the Hype
Thematic funds have been one of the big winners
to emerge from the coronavirus pandemic,
with many posting eye-catching returns. These
funds attempt to harness secular growth themes
ranging from artificial intelligence to cannabis.
There has been a steady supply of new funds and
greater complexity from asset managers.
The growth of U.S. thematic funds in 2020 was
nothing short of remarkable. Strong performance,
persistently high inflows, and a bevy of
new launches combined to push the assets in
these funds to heights never seen before. All told,
more than $81 billion flowed into U.S. thematic
funds for the 12 months through March 2021.
The first quarter of 2021 was the strongest on
record, with more than $35 billion entering these
niche strategies.
Investors in thematic funds are making a trifecta
bet, to use a term from the racetrack. Specifically,
they are implicitly betting that they are:
gPicking a winning theme-one that is real
and durable.
gSelecting a fund that is well placed to harness
that theme-that owns stocks that are positioned
to capitalize on it in a meaningful way.
gMaking their wager when valuations show
that the market hasn't already priced in the
theme's potential.
The payouts can be meaningful, but the odds of
winning these bets are poor.
The long-term performance figures for thematic
funds suggest that investors have a slim
chance of selecting a fund that will survive and
outperform over the long run. Over the 10
years through March 2021, 23% of U.S. thematic
funds went on to outperform the Morningstar
Global Markets Index-but about 42%
were shuttered.
That said, the best themes are expected to
play out over many years, so they are most suitably
deployed over longer investment horizons.
Because of their narrow exposure and higher
risk profile, thematic funds are best used
to complement rather than replace existing
core holdings.
Most thematic funds will be used with the
hope of boosting returns over the investment
period, but some can be specifically used
to reduce portfolio risk. For example, alternative
energy funds can be substituted for core
energy holdings to reduce carbon risk. They fit
especially well with " ex-energy " exposures.
If a thematic fund has drivers of risk and return
that are distinct from other portfolio
holdings, adding it around the margins of a core
portfolio might yield diversification benefits.
But the risk and return drivers should be
well understood before any attempt is made
to blend them into a broader portfolio.
Liquidity risk is a notable one. In their search
of companies with the highest exposure to
emerging themes and those with the highest
growth potential, thematic funds often
invest in the smaller, less liquid stocks. They have
a higher average exposure to micro-cap stocks
than their nonthematic counterparts. The
average U.S. thematic fund has 6.65% in micro-cap
stocks compared with 4.22% for the typical
nonthematic fund.
Micro-cap stocks can offer large upside potential,
but a lack of liquidity means trading in and
out at short notice can be costly. The surge in
popularity of thematic funds-and thematic
exchange-traded funds, which tend to have
narrow exposures and (when passively managed)
are compelled to buy and sell in line with
index rules-has raised questions surrounding
stocks' liquidity. As thematic funds have
grown, the concentration of their holdings also
spiked. These funds tend to gravitate toward
similar names.
U.S. Thematic Fund Survival and Success Rates
Outperformers
5
28
Underperformers
12
34
Closed
100%
20
42
57
38
36
67
55
41
23
1 Year
3 Years
Source: Morningstar Research. Data as of 03/31/2021.
5 Years
10 Years
22
21
15 Years
20
40
60
80
For example, as of March 31, 28 thematic
funds globally combined to own one fourth of the
total shares outstanding of 3D printing firm
Stratasys SSYS. At one point, ARK Innovation ETF
ARKK alone held 22% of the stock's available
free float. Alternative energy funds' recent growth
spurt has also seen them build large stakes
in smaller firms. For example, Invesco WilderHill
Clean Energy ETF PBW recently held 18% of
the free float of the micro-cap Infrastructure and
Energy Alternatives IEA.
Like all investors, thematic investors are prone
to what George Soros calls " reflexivity trades " -
that is, they invest in themes because they have
been performing well and scramble to divest
when the tide turns. This strategy will have paid
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23
Morningstar - Q3 2021

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