Thematic and sector funds

Thematic funds are the fastest-growing category in retail investing and the one where investor outcomes have consistently been worst.

The launch pattern

Which is well documented.

Fund providers launch products for themes that have already performed strongly, because that is what attracts assets.

Which means the availability of a fund for a theme is weak evidence that the theme has already run.

Studies of thematic fund launches have found subsequent performance generally disappointing relative to broad markets, and a high rate of fund closures within a few years.

The closures matter: a fund closing forces a disposal at whatever price prevails, generally after poor performance.

The behaviour gap

Where it is largest.

Analyses of the difference between fund returns and investor returns consistently find the gap widest in the most volatile and most specialised products.

Which means thematic funds produce worse outcomes for their holders than their own published returns suggest, because money arrives after gains and leaves after losses.

And the more compelling the theme, the more this is the case.

The concentration problem

Structural.

A thematic fund by construction holds a narrow set of companies, frequently in a small number of countries and sectors.

Which means specific risk that is not compensated by additional expected return, since it could be diversified away.

Many themes are also expressed through companies at an early stage with limited profitability, which increases sensitivity to interest rates and sentiment.

And several themes overlap substantially with each other and with existing holdings, producing unintended concentration.

The theme being right

Which does not settle it.

Themes are frequently correct: technologies do transform industries, demographics do change, energy systems do transition.

The questions that determine investment outcome are different: whether the growth is already reflected in prices; whether the value accrues to the companies in the fund or to their customers and suppliers; whether the eventual winners are currently identifiable; and whether the fund's construction captures the theme at all.

Historical episodes consistently show transformative technologies producing poor returns for investors in the companies building them, because competition eliminated the profits.

Construction problems

Which are common.

Vague definitions, where the index provider's methodology determines what counts as exposure to a theme.

Companies with minority revenue exposure to the theme forming a large share of the fund.

Very small companies with limited liquidity.

High turnover as definitions change.

And costs substantially above broad index funds.

Reading the methodology and the actual holdings is essential, and frequently reveals a fund quite different from its name.

Sector funds

Similar issues, better defined.

Sector classifications are established and stable, which removes the definitional problem.

The concentration and behaviour problems remain.

Sector rotation strategies require correctly identifying which sector will outperform, which is forecasting.

And broad index funds already provide sector exposure at market weight, which requires no decision.

Where a small allocation is defensible

For balance.

An investor with a genuine long-term conviction, who accepts the concentration risk, who commits to a holding period through substantial underperformance, and who limits the allocation to an amount whose loss would not matter.

Which is a narrow set of conditions and is a legitimate position.

The failure mode is treating it as a core holding or adding it after strong performance.

Questions before buying one

A checklist.

How has this theme performed over the past three years, and would I be considering it if it had not?

What does the fund actually hold, and how concentrated is it?

How much overlap is there with my existing holdings?

What is the cost premium over a broad fund?

What would have to be true for this to underperform for a decade, and would I hold through that?

And how large is the fund, since small funds close?

The alternative

Worth stating.

A broad global index fund already holds every company in every theme, at market weight, at low cost, with no decision required.

Which means exposure to any genuine transformation is already present.

The thematic fund is a decision to hold more of it than the market does, which requires believing the market has it wrong.

And that belief should be stated explicitly before buying, since it is the actual proposition.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.