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Morningstar’s wake-up call for theme-dreamers


Global research house, Morningstar, has prepped investors for disappointment amid a boom in thematic funds.

In a new report on the sector, the researcher notes that while thematic funds have experienced record growth in recent years as well as outperformance, history suggests the good times won’t last for long.

“Over the past 15 years, more than three fourths of thematic funds globally have shuttered and just one in 10 survived and outperformed,” the study says. “These figures paint a bleak picture for investors. They suggest that the odds of picking a thematic fund that survives and outperforms global equities over longer periods are firmly stacked against them.”

Despite the historical evidence, theme-based investments – often dressed-up in exchange-traded fund (ETF) clothes – have taken off in the last couple of years with both inflows and product-creation at record levels.

“Investor interest in thematic funds has increased dramatically in recent years, particularly since the beginning of the global coronavirus pandemic,” the report says. “In the trailing two years to the end of 2021, assets under management in these funds have grown nearly threefold to $806 billion worldwide. This represented 2.7 per cent of all assets invested in equity funds globally, up from 0.8 per cent 10 years ago.”

And during the three years to the end of 2021 thematic fund investors have also been rewarded in aggregate with outperformance given more than half of the strategies both survived and beat the Morningstar global equities index.

However, theme-based funds tended to underperform over the 12-month period while the long-term record for the style is woeful.

Morningstar counted about 2,000 thematic funds in action at the end of 2021, including 589 that “debuted globally in 2021, more than double the previous record of 271 new launches in 2020”.

“Historically, the number of thematic fund launches has been positively correlated with the performance of the broader equity markets,” the report says. “The number of new thematic launches rose in the run-up to, and peaked immediately prior to, both the dot-com bubble and the global financial crisis before trailing off in the years that followed.”

Long-term thematic fund underperformance is partly down to high fees, a phenomenon common to both active and passive strategies in the sector, according to Morningstar.

“The difference is particularly striking when we look at asset-weighted fees, especially as the most popular thematic funds charge fees many multiples higher than those of the most popular non-thematic funds,” the paper says.

Based on its own methodology, Morningstar lists about 200 sub-themes currently on offer to investors, grouped under four main categories – technology, physical world, social and broad. Kenneth Lamont, Morningstar manager research analyst, says that thematic fund “buyers should beware”.

“These funds are often designed more with saleability in mind than investment suitability. Many cross the border into gimmick territory. Examples abound. Whiskey ETF, The Kids Fund, and StockJungle.com Pure Play Internet are just a few that have come and gone over the years,” Lamont says.

“Investors have often piled into these funds at precisely the wrong time, only to be disappointed. Investors mulling thematic ETFs should think long and hard about whether a particular theme has long-term investment merit or if it is a mirage.”

The report follows Morningstar’s downgrade of the ARK Innovation ETF to “negative”, with process, people, and parent all “below average”. The ETF is one of several thematic ETFs provided by Cathie Wood’s (photo above) ARK, which saw significant inflows during the early days of 2020.

Morningstar strategist Robbie Greengold warned that ARK “shows few signs of improving its risk management or ability to successfully navigate the challenging territory it explores” and that “Wood’s reliance on her instincts to construct the portfolio is a liability.”

“Since its meteoric rise in 2020, the strategy has been one of the worst-performing U.S.-sold funds, as the aggressive-growth stocks it held fell back to earth,” Greengold wrote. “Its wretched 45.5 per cent loss over the trailing 12 months through February 2022 significantly lagged the 7.9 per cent decline of the average fund in the technology Morningstar Category and the Russell Midcap Growth Index’s 4.3 per cent loss.”

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