Thematic investing is a popular strategy that allows investors to capitalize on macro level trends resulting from social disruption, economic developments, or technological advances. They look for opportunities that arise due to a major shift in a society’s or an industry’s behavior and select funds targeted to a specific area of interest with potential upside. Rather than searching for individual stocks, thematic investing offers an investor a fund that is dedicated to one particular theme that may be unfolding in any given industry. Both mutual fund companies and ETFs offer exposure to this targeted style of investing.

These funds have surged recently with new themes rapidly being introduced over the past five years. Autonomous vehicles, medical advancements, technological innovations - such as cloud-based services, and ESG (environmental, social, governance) or sustainable investing are all examples of thematic fund types popular today. According to Morningstar, the market has quadrupled to over $30 billion with 72% of funds available being launched in the last five years.  Despite their popularity, success has been mixed.  Investors need to be diligent in researching ideas and maintain a long-term perspective.

Funds are trying to capture investor interest in the latest hot topic such as electronic payment services or cannabis. It is easy to get drawn into the excitement and prospect of future growth.  Yet this enthusiasm and investor support can quickly fizzle out; that is why many funds close down.  It’s not to say that the theme itself has gone away, but rather it falls out of favor.  Perhaps investors feel a material shift will be too far in the future, or that companies may have a difficult time turning a profit in the near term.

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The idea of aligning their investments with themes that investors believe in, such as clean energy or the prospect of an exciting new technology, makes perfect sense.  However, executing that plan and delivering strong investment performance can be challenging. The sector on the whole does not have the best track record for a number of good reasons.

Bull market trend: Thematic funds and the introduction of new themes are much more prevalent in strong markets. Investors are feeling confident and therefore may be open to more risk.  In a market downturn, investors are more likely to exit, searching for safer, more diversified investments.  Buying in during a bull market can lead to a greater likelihood that investors are piling on when stock valuations are already inflated.

Missed the boat: Chances are when an idea catches the attention of the average investor, companies focusing on this theme have been way overbought.  Often by the time a thematic funds is launched to capture a trend, the stocks have already skyrocketed.

Even if valuations for a fund are reasonable, investors are often buying the “expectation” of the success a trend may create, but actual profits and a true shift could be many years out. Investors are excited about the future of a new technology like 3D printing, electric vehicles, or clean energy, but when it comes to finding a stock with good value it becomes much more difficult to select the right company with the scale to maintain success over the long term in the face of setbacks.  Regulatory setbacks are one example of an obstacle that some of these companies may face.

Furthermore, the fund you chose must do a good job of selecting the underlying investments. Take an example of an advancement in a medical technology.  An investor may have identified that advancement as a promising opportunity and may have invested when valuations were attractive.  Even if the technology was a success, the investor still may not see a profit if the thematic fund invested in the wrong companies within that space.

Long term support: The market has grown quite rapidly in terms of number of funds offered; however a small group of funds control a large portion of the market.  This means that smaller funds may have a hard time staying active and could potentially liquidate.

Diversification: There are two levels of diversification to consider.  The first is the percentage of the individual investor’s overall portfolio dedicated to thematic funds.  Due to the fund’s concentration on one particular trend it should not represent more than 10% of a portfolio.  The second level is within the fund itself.  Some funds are narrowly focused 100% on the theme, while others have broad exposure.  Broader funds invest in larger companies with some exposure to the theme, but also have other business lines.  This is better from a diversity standpoint, but then there are many other factors, outside of the intended theme, that will impact fund performance. Are you really getting the intended exposure?  Selection involves research.  Often it may make more sense to buy a group of individual companies that are the largest players in the field while making sure that together they don’t represent more than 10% of a portfolio’s overall holdings.

Volatility: Due to their narrow focus and the unpredictability that comes with new ideas or technologies, these funds tend to experience more volatility than the broad market.  Investors need to be prepared for these moves and also look to hold for the long-term.  Many of these global trends take years to take hold fully.

Fees: As one would expect thematic mutual funds charge higher fees.  Even passive style funds are still more expensive than similar non-thematic funds.  

Payoff can be great if you select the right investment, but for the average investor there is some element that these funds are more similar to betting than investing.  There can be huge upside but in the near term you are often betting on a company’s future profitability with no proven track record.

With Trust and Integrity, Peapack Private provides comprehensive financial, tax, fiduciary and investment advice to individuals, families, privately-held businesses, family offices, and not-for-profit organizations. We help our clients set and achieve their goals by developing solutions specifically designed and implemented for them.

Contact us at 908-598-1717 or for more information and or to arrange a complimentary consultation.

Peapack Private Wealth Management is located at 382 Springfield Avenue, Suite 208, in Summit.

IMPORTANT: This information should not be construed as tax or legal advice. Please consult your attorney or tax professional before pursuing any of the strategies described above. 

Nondeposit investment products are not insured by the FDIC; are not deposits or other obligations of, or guaranteed by, Peapack-Gladstone Bank; and are subject to investment risks, including possible loss of the principal amount invested.