Beware These Pitfalls When Investing in Thematic Funds
Morningstar analyst Daniel Sotiroff explains why so many have short lives and how best to use them in portfolios.
Thematic funds have been growing in popularity for several years, but they don’t make great investments, according to Daniel Sotiroff, a manager research analyst for Morningstar.
They tend to be highlight concentrated — the top 10 holdings account for about half of the assets of the average fund; they’re not cheap — 60 basis points for the typical fund; and most important, they tend to be launched late in bull markets when asset prices and investor speculation are often running high, leaving less room for price gains.
“Launching thematic funds in the final years of a bull market sets them up for poor performance,” writes Sotiroff. Their “sky-high prices” can translate into “low expected returns.”
The average thematic fund launched between January 1996 and July 2018 underperformed the MSCI ACWI Investable Market Index, a global index of large-, mid- and small-cap representation across 23 developed markets and 26 emerging markets, by 3.3 percentage points per year over the first two years of life.
In addition, many of the themes they focus on are trendy and lose their popularity over time, which can contribute to not only lower earnings over time but also the funds’ demise.
“Themes come and go, along with the funds that attempt to profit from them,” writes Sotiroff.
Roughly 94% of thematic funds survived their first year but less than 15% endured for 15 years or longer, according to Morningstar. Given their relatively short lives, thematic funds are “poor strategies for compounding wealth over the long run,” writes Sotiroff.
One way to help gauge whether a thematic fund will survive over time is to check its assets under management. A low AUM suggests a fund’s fee-based revenue may not be sufficient to offset portfolio management costs. The reverse is true over the medium term for higher AUM funds, with at least $50 million in assets, according to Morningstar.
The average AUM of thematic funds that liquidated or merged over the past 25 years was $25 million one year before the fund was shut down. Excluding a few large portfolios in the Morningstar sample, the median AUM for liquidated or merged funds was just $5 million.
As of June 30, 64 of 141 thematic funds included across all U.S. Morningstar categories, or 45%, had more than $50 million in assets.
“Given their concentrated portfolios, high fees and low survivorship rates, thematic funds should be used as satellite holdings, concludes Sotiroff. He recommends that investors choose thematic funds with at least $50 million in assets, recognizing that their odds of surviving long term and outperforming are small.
Among one of the largest thematic funds in the market currently is the Goldman Sachs Innovate Equity ETF (GINN), which was launched in early November from the merger of five separate ETFs and now has $348 million in assets and a net expense ratio of 0.50%.
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