The Next Big Theme

“At the root of all financial bubbles is a good idea carried to excess.” – Seth Klarman

Great in theory, lousy in practice.

That about sums up the historical experience of investing in “thematic” mutual funds and ETFs.

For those unfamiliar with the concept, here’s a description of what thematic investing is.

Thematic investing is an investment approach that involves building a portfolio around a specific theme or trend. A theme can be defined as a broad concept or idea that captures a particular trend, such as renewable energy, artificial intelligence, or cybersecurity.

Thematic investing involves identifying companies or assets that are expected to benefit from the theme and investing in them. For example, if an investor believes that renewable energy is the future, they may invest in companies that develop solar panels, wind turbines, or other clean energy technologies.

Thematic investing can be seen as a way to capitalize on the growth potential of a specific trend or idea, while also providing diversification benefits to an investor’s portfolio. However, it is important to note that thematic investing carries risks, as the success of a theme is not guaranteed and can be affected by factors such as market volatility, regulatory changes, and technological advancements.

Ready to have your mind blown? Those three paragraphs were written by an AI chatbot – ChatGPT, to be specific. I simply prompted it by asking, “what is thematic investing?” and received that thorough response in about three seconds.

This tool, created by OpenAI, has burst into the mainstream like few technology applications in history. In January, ChatGPT reached 100 million active users – a mere two months after its launch. For context, here is how long it took for other major consumer tech apps to reach that same milestone, according to UBS:

• TikTok: 9 months
• Instagram: 30 months
• Spotify: 55 months
• Uber: 70 months

Artificial Intelligence is just the latest in a series of themes designed to capture the hearts and imaginations of investors everywhere. In addition to AI, we’ve seen:

Blockchain! Remote Work! Cannabis! Robotics! 3-D Printing! Telemedicine! Autonomous Vehicles! Cloud Computing! FinTech! Renewable Energy!

The list goes on and on and on. Each and every one of those has been slapped on the label of a mutual fund or ETF and packaged for easy consumption by investors who can’t resist the siren song of the next big thing.

While thematic funds have been around for quite some time, their growth truly exploded throughout the bull market rally of 2020-21.

And as their performance has waned over the last couple of years, so too have inflows into these products.

Easy come, easy go.

Despite there being myriad individual themes, all of them can be bundled under the broader umbrella of innovation.

Innovation in and of itself is a wonderful thing. There is no disputing that. But that does not automatically translate into outsized investment returns. As Kai Wu of Sparkline Capital so eloquently stated in a recent paper:

“We love innovation. Technology lifted the human species from millennia of subsistence to the dominant form of life on earth. And it is the principal driver of economic growth on a long timescale. That being said, investors in innovation do not have a god-given right to excess returns.”

So if innovation is so transformative, why haven’t investors in thematic products reaped excess rewards?

Let’s revisit our new friend, ChatGPT:

Once again, I am blown away by the detail and accuracy of this AI-generated response.

It’s nearly impossible to use a tool like ChatGPT and not be completely awestruck by the potential transformations that may arise in how we live, work, and behave.

The challenge of thematic investing, particularly in public markets, is that it charms you into imagining what’s possible at the expense of recognizing what’s probable. Its intentions are pure, but it’s the unintended consequences that inevitably lead to its demise.

Circling back to Kai Wu’s study of innovation investing, he regressed the returns of a hypothetical basket of “innovation” stocks and found some interesting results.

Although Kai’s innovation portfolio had meaningful exposure to technological themes, it also had negative exposure to the factors that have been the most likely to be rewarded over time – namely value and profitability. These unintended consequences create a massive uphill battle for investors.

Another study from academia, “Competition for Attention in the ETF Space,” found similar disappointing results for thematic investing. According to the authors:

“While early ETFs invested in broad-based indexes and therefore offered diversification at low cost, more recent products track niche portfolios and charge high fees. Strikingly, over their first 5 years, specialized ETFs lose about 30% (risk-adjusted). This underperformance cannot be explained by high fees or hedging demand. Rather, it is driven by the overvaluation of the underlying stocks at the time of the launch. Our results are consistent with providers catering to investors’ extrapolative beliefs by issuing specialized ETFs that track attention-grabbing themes.”

All things considered, we believe the data just doesn’t support any value creation stemming from thematic funds relative to less expensive and more conventional approaches. According to a Morningstar study, for the 15-year period ending December 2021, less than 10% of thematic funds that existed at the beginning of the period both survived and outperformed a global stock market benchmark.

Despite the evidence being stacked against thematic investing, I won’t hold my breath waiting for investors to eschew the category completely. The temptation is just too strong. And if it scratches someone’s speculative itch with their “fun money” account, who am I to judge?

But the odds point towards the movie ending the same way it always does – in tears.

The more obvious an innovative theme is, the more likely that Mr. Market has caught wind of the collective investor enthusiasm around it and incorporated it into prices.

Market commentator Josh Brown perfectly captures the current zeitgeist around AI in the context of market history:

“There’s always a kernel of truth around which the mania coalesces. This is what makes them so irresistible and frustrating to fight against. The crowd does have the facts on its side, at least in the early going. Everything they said the internet would be able to do 25 years ago came true. And then some. It’s actually been more world-changing than even the biggest bulls would have thought possible. And yet, almost none of the companies from the late 90s are still around. The Nasdaq had fallen by 90% from its peak despite the fact that, if anything, we had been underestimating the internet’s impact. Throw in wireless communications and throw in broadband technology – they all appeared at the same time. The bulls were right on the concept but wrong on the horses they’d bet on and way too early.”

It’s not enough to pick the right theme. You also need to pick the right companies (or funds) that will effectively capture that theme. Oh, and you also have to place those bets at a point in time when expectations are not completely untethered from reality.

It is perfectly acceptable to be mesmerized by the technology underlying many thematic products while also accepting that it is likely to be joined by unreasonable valuations and a future with a small handful of winners surrounded by a graveyard littered with losers.

It might not be the sexiest story, but we think an evidence-based investing philosophy is one that can still capture the benefits of innovation over time, without some of the drawbacks that accompany thematic-based approaches. Diversify broadly over a long enough period and you increase the likelihood of capturing the eventual winners. Tilt a little more towards cheap/profitable companies and away from expensive/junky ones and you’ll help mitigate the risk of being overexposed to the inevitable bubbles when they pop.

Resisting FOMO – the fear of missing out — is something we all battle as investors. But occasionally we get to experience JOMO – the joy of missing out – when the you-know-what hits the fan. And while evidence-based investing will at times be out of favor, it will never go out of style.

In closing, I asked ChatGPT to generate a poem about thematic investing. Enjoy!

This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from Savant.

Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results.