Morningstar - Q1 2023 - 8

Dispatches
Variations on a Theme
A tempered approach is
key to success.
PHILLIPS CURVE
Don Phillips
Thematic funds showcase the best and worst
aspects of asset management and hence present
a daunting challenge for investors.
On the positive side, thematic funds can highlight
an asset-management firm's skill in identifying
emerging investment opportunities and crafting
creative portfolios to harness them. Whereas
an individual trying to jump on a trend might take
a stab at a single stock, a professional investor
has the resources to assemble a portfolio of
securities representing multiple players riding the
trend, as well as ancillary plays on a theme,
such as suppliers or service providers or companies
that benefit from changes brought about by the
trend. Often, these peripheral bets provide a surer
return and help lessen the volatility of chasing
a hot theme. Broader diversification also improves
the odds that an investor holds one or more of
the trend's big winners, rather than just a bit
of the roadkill. A bet on an internet or technology
fund over the past 25 years-provided you
held on-would have fared far better than one
on Pets.com or most other dot-coms.
The dark side of asset management is its powerful
marketing apparatus, which poses a threat to
investor success when it comes to thematic funds.
Few asset managers launch funds to capture
unpopular or out-of-favor themes. Their incentive
is to create something that will have immediate
sales appeal. But by the time the theme is
identified, the funds organized and registered, and
the distribution established, the trend is
probably well underway and new investors are
buying into a surge of excitement.
Unfortunately, an investment's utility tends to
approach its nadir as its popularity nears its zenith,
8
Morningstar Q1 2023
as former Clipper Fund manager Jim Gipson has
noted. That means that most investors in
thematic funds buy near the peaks and then lose
faith and sell near the bottom. The carnage
created by internet funds during the tech bubble
or real estate ones during the financial crisis
was a calamity for millions of investors and
remains an indelible stain on the fund industry's
reputation. With thematic funds especially,
an asset manager's instinct for sales can easily
outweigh its obligation for stewardship.
A long tradition of the industry selling what's
easiest to sell and investors buying what's
most tempting to purchase is the assetmanagement
industry's unspoken shame. It has
also been a catalyst for the rise of indexing.
Knowing that fund firms too often play on
investors' worst instincts and amplify the fear
and greed cycle, many advisors now caution
their clients against wading into the dangerous
waters of theme investing. Instead, they
advocate simply buying the whole market at
a low cost and holding it. If new themes
develop and great companies emerge, the index
will participate. If the trend goes bust, there
will be other parts of the portfolio that absorb
the shock. Their logic is compelling, and
the wisdom is shown in the successful results
this approach has produced.
Still, hope springs eternal and every rule has
its exceptions. Only the most dogmatic of
investors will insist that there is only one approach.
Even some of indexing's pioneers have bent
the rules at times. Jack Bogle continued to hold
the actively managed Vanguard Windsor Fund
throughout his life. Burton Malkiel, who penned
the classic case for indexing, A Random Walk
Down Wall Street, concedes that he has regularly
bought individual stocks and even advocated
a thematic bet on China earlier this century.
Investing isn't a purity test. You're allowed to
take some chances and have some fun. But do so
within reason. It is essential to recognize
what's working against you in trying to play an
investment theme. What a fund firm is most
eager to sell is unlikely to be the best thing to buy.
If you are moving with a surging crowd, you
are apt to be crushed when it shifts direction. The
more narrow or short term the trend, the less
likely you are to ride it successfully.
Some rules that wise advisors use in counseling
clients on this issue resemble those given
to gamblers. Don't bet more than you can afford
to lose. Thematic funds are better placed
in the fun-money section, rather than the core,
of your portfolio. Look for surer bets, not just
the long shots. Identify trends that have staying
power, like the increased development of
technology, the rising demand for healthcare,
the move to more sustainable energy
sources. Look for safer, less volatile ways to
play your theme.
And perhaps most importantly, have a disciplined
approach. An investor who threw money at
a dot-com startup in 1999 probably had a rotten
experience, as did one who jumped on an
internet fund only to sell it in 2002 in the name
of tax-loss harvesting. But an investor who
bought a tech fund during those heady days and
continued to dollar-cost average has likely
done very well over the ensuing decades, as the
internet and technology have radically
altered our lives-just as many predicted, but
most misplayed.
Despite their rather checkered past, thematic
funds aren't going away. In the aggregate,
they will probably continue to do much damage,
but that doesn't mean that the thoughtful
investor can't find ways to successfully deploy
such funds or that responsible fund companies
can't explore ways to better package their
thematic prowess. An investment trend
in motion is a powerful force. Finding ways
to harness it is a key to the ultimate success of
both investors and the fund industry. K
Don Phillips is a managing director at Morningstar. He is a
member of the editorial board of Morningstar magazine.
https://www.morningstar.com/authors/286/don-phillips
Morningstar - Q1 2023

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