Thematic tech investing is exploding in popularity. Everyone wants to invest in funds that own clean energy, cybersecurity, electric vehicles, e-sports, robotics, 3D printing and cloud computing.
But watch out, Morningstar warns: Most of these funds do not outperform the markets, have high fees, high failure rates, and run the risk of too much concentration that could cause stocks to tank should investors suddenly flee the funds.
Thematic tech is growing fast
A bull market and easy-to-understand themes have created an explosion of interest in thematic investing as people seek to put money into narrow areas of the investing universe, most of it technology themed.
In the U.S. alone, thematic funds have ballooned to more than $160 billion in assets by the end of March, from about $49 billion at the end of December 2019, according to Morningstar.
But a small group of funds is gathering the lion's share of the business. While 41 thematic funds now have assets over $1 billion, the top 10 largest account for just under half of all the assets.
While most thematic funds are tied to indexes, some are now actively managed. Cathie Wood's ARK funds, a series of actively managed funds with a small number of concentrated bets, has attracted massive inflows.
Thematic tech: A bull-market phenomenon
Not surprisingly, investors tend to rush into thematic funds, particularly thematic tech, during bull markets. Launches set records in 2016, 2018 and 2019, according to Morningstar. In 2019, a particularly strong year for stocks (the S&P 500 was up 29%), providers launched almost 40 new thematic ETFs. In 2020, also a strong year, a record 55 new thematic strategies came to market.
Does thematic investing outperform the market?
The answer, for the most part, is no.
While thematic tech investing did well during 2020, the record is much poorer over longer periods.
Thematic investing by its nature is prone to investors chasing hot themes: Clean energy, cloud computing, electric vehicles, battery technology, virtual reality, gaming, robotics, artificial intelligence, cybersecurity. These themes come in and out of popularity. Thematic investors are making a bet that they have picked a winning theme, but because thematic funds pick narrow, often volatile, parts of the market that fall in and out of favor, they suffer from high failure rates: Nearly one-third of all thematic funds have closed in the last 10 years and 34% have underperformed the broader equity market.
High fees are a problem
A major contributor of thematic investing underperformance has been high fees. Thematic funds, many of which are actively managed, charge much higher fees than broad funds and even most ETFs.
By comparison, the iShares S&P 500 ETF, a passively managed fund, charges an annual fee of only 0.03%.
"High fees charged by thematic funds have contributed to their relatively poor performance versus broad market indexes over longer periods," Morningstar said.
Too much concentration?
Morningstar also noted that a small number of actively managed funds have accumulated very large positions in many small-cap stocks, particularly Wood's Ark Innovation fund.
This concentrated ownership means that the stock prices may be subject to the whims of investors in the fund: "The liquidity promised by the ETF structure means investments can be pulled out on a whim," Morningstar noted.
What's it all mean?
Thematic investing is fun and easy to understand. I'm buying cybersecurity! I own fintech! I love clean energy!
If you like the theme but don't have the resources to investigate individual companies, thematic investing makes sense.
But Morningstar's report is a flag for investors: Don't kid yourself. You have not found the secret of stock market wealth.
"Some of the same individuals will likely get burnt when the fortunes of the more popular themes inevitably wane and investors swarm for the exits," Morningstar warns. "As timely as they may seem now, some themes will age poorly. Investors must ask themselves: Will that work-from-home ETF still be relevant in three years' time?"
What's the average investor to do? "Because of their narrower exposure and higher risk profile, thematic funds are best used to complement rather than replace existing core holdings," said Kenneth Lamont, senior research analyst at Morningstar and author of the report.