Investment focused on defined themes, vulnerabilities, or industry sectors, and its associated complexities and potential pitfalls
In recent years, thematic investing has seen a meteoric rise, particularly during the pandemic, as investors sought out specialized stock options that stood to benefit most from the influx of trillions of dollars into innovative sectors. Asset managers eagerly responded, launching numerous funds focusing on sectors such as artificial intelligence and green energy.
However, the peak of thematic fund assets under management (AUM) turned out to be short-lived. Between January 2020 and the end of 2021, AUM in thematic active funds tripled, rising to nearly $900 billion, according to data from Morningstar. Yet, since 2021, these funds have experienced a steady decline, with AUM dropping to $562 billion by mid-2024—the lowest level since 2020. This downturn can be partly attributed to many funds failing to meet investor expectations.
One underperforming area has been the energy transition, with more than 400 funds in this category managing just shy of $70 billion in assets under management. The average annual return for these funds has been a dismal -7.5% over the past year, with battery technology being the worst sub-sector, posting a 13% decline. This poor performance is largely due to the high correlation between battery prices and the funds' returns - the price of lithium, a key battery material, recently hit a five-year low.
While most specialized tech themes have also struggled to surpass the wider market, with only a handful outperforming the MSCI World index, the space sector has been a notable exception. Funds in this domain made average returns of about 24% over the past year, despite total assets in these funds being relatively small - approximately $2.5 billion. The space sector exemplifies the challenges of scaling up some themes due to a dearth of suitable holdings for portfolio filling.
For example, the handful of dedicated space exchange-traded funds (ETFs) have profited from the performance of Rocket Lab USA. The company's share price increased by over 400% for the 12-month period ending in Q1 2022. However, this is a volatile business, losing $190 million on revenue of $436 million in the last fiscal year, and its stock is currently down by 40% from its all-time high.
Given the underwhelming returns from thematic funds, investors must be cautious about their expectations. While they can have a role in a portfolio, they are not effective at providing diversification. Thematic funds represent focused investments in a single idea, making them vulnerable during market shifts or when investor enthusiasm wanes, leading to rapid drops in performance.
Furthermore, the lack of diversification and the propensity for popular stocks to be overcrowded often results in disappointing results. A study of 17,364 funds by DIW Berlin found that the most-crowded 10% of funds trailed benchmarks by 1.4 percentage points per year. Moreover, once a thematic fund starts underperforming, it may not remain viable long enough to recover, as evidenced by Fidelity's decision to shut several thematic ETFs launched in 2021, including clean energy and digital health funds.
In conclusion, thematic funds have been underwhelming since 2021, primarily due to the combination of their concentration on specific sectors, vulnerability to market volatility, and the short-lived nature of popular trends. Investors would be wise to approach thematic investments cautiously, understanding the potential risks and focusing on broader diversification strategies.
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Investing in thematic funds that focus on technology, such as artificial intelligence, might not always guarantee superior returns, as these funds have experienced a steady decline since 2021, with the energy transition sector, in particular, failing to meet investor expectations, posting a dismal -7.5% return over the past year. Despite the potential benefits of thematic investing, it is crucial for investors to exercise caution, as these funds often lack diversification and are vulnerable to market volatility, making them prone to rapid drops in performance.
