Morningstar - Q1 2023 - 30

Spotlight: Thematic Investing
The Morningstar paper found that style factor
exposures evolve over the life of a theme.
In the early phases, portfolios tend to be tilted
toward smaller stocks with pronounced
growth features, which gradually taper off over
time as the theme matures. The paper's
findings support an early-adoption approach to
thematic investing in which investors buy a
fund tracking the theme early in its lifecycle and
realize the growth potential by holding until
the theme matures.
One concern with this approach is that it
can be tricky to gain access to a theme early
enough (at a low P/E ratio) to reap the
full rewards. Fund companies take time to spot
a theme, create a product, and start pushing
it to clients. By the time an investor has
heard of the theme and there are funds ready
to track it, the larger part of the growth
potential may already be priced into the portfolio
of companies. It seems realistic to expect
that, even in the best-case scenario,
investors are unlikely to capture a theme's full
growth potential.
$1,000B
250
500
750
EXHIBIT 2
Closure Concerns The number of internet-themed funds boomed in the late 1990s.
After the bubble burst, most of them shut down.
12/2012
12/2014
Launches and Closures of Internet-Themed Funds
60
Closures
Launches
40
Over the trailing 10 years to the end of May 2022,
URTH recorded less than half the standard
deviation of LIT. By this measure, LIT, which at the
time of writing holds 45 stocks versus the
more than 1,500 held by URTH, can be considered
a riskier investment.
20
-20
1996
2001
Source: Morningstar Direct. Data as of Sept. 30, 2022.
2006
2011
2016
2022
Ultimately, even if investors get the theme right,
unrelated company-specific problems, such as
30
Morningstar Q1 2023
However, LIT's 10-year standard deviation is
lower than any single one of its current
holdings over that period. This suggests
that the fund may be the less risky option when
used as a replacement for single-stock
investments.
12/2016
12/2018
12/2020 09/2022
Another concern with this investment approach
is the risk of closures-thematic funds have
a 33% closure rate over the trailing 10 years. The
tale of internet-themed funds in the early
2000s is illustrative of the problems this can cause
for investors ( EXHIBIT 2 ). As the dot-com bubble
inflated, the number of internet- and tech-related
thematic funds multiplied. By the turn of the
millennium, one in three thematic funds globally
was tracking a digital economy theme. However,
after the bubble burst, most of these funds
shuttered. Today, just 11 of the 66 digital-economythemed
funds launched in that period remain
open. In this case, an investor could have
picked the right theme-after all, the internet has
revolutionized our world-and even a solid
strategy but still ended up empty-handed because
the timing was wrong.
How Risky Are Thematic Funds?
Many thematic funds are risky by design. Over
the trailing five years, almost nine out of
10 thematic funds in our database exhibited a
higher standard deviation than the broad global
equity market (as proxied by the Morningstar
Global Markets Index). This number falls to
three in four when we look specifically at
broad thematic funds, which track multiple themes
and tend to have more-diversified portfolios.
Ultimately, this shows us that even the most
broadly diversified thematic funds have a
higher standard deviation than the broad global
equity market.
However, risk should not be considered in
isolation; it's also crucial to consider the potential
trade-off between risk and return. EXHIBIT 3
shows that while many funds have been
more volatile than the broader market, many have
also produced strong returns.
ETFs, which tend to hold a narrower basket of
stocks than their mutual fund peers, tend to
be more volatile, too. Consider Canada-domiciled
Horizons Marijuana Life Sciences ETF HMMJ.
The fund returned more than 100% in the four
months between September 2017 and the
end of that year-before shedding more than two
thirds of its value in the year to the end of
first-quarter 2020.
By most standards, this would classify as a risky
investment, but how risky an investment is
can also depend on what we are comparing it with.
To illustrate, we will contrast Global X Lithium
& Battery Tech ETF LIT with iShares MSCI
World ETF URTH, which approximates global
equity market exposure.
Number of Funds
Assets
https://www.morningstar.com/etfs/xtse/hmmj/quote https://www.morningstar.com/etfs/arcx/lit/quote https://www.morningstar.com/etfs/arcx/lit/quote https://www.morningstar.com/etfs/arcx/urth/quote https://www.morningstar.com/etfs/arcx/urth/quote
Morningstar - Q1 2023

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