How to manage risks in thematic funds

Kenneth Lamont, manager research analyst for Morningstar UK, covers European passive funds. He cautions the reader about managing risks in thematic funds.
By Morningstar |  24-09-22 | 
 

Thematic funds have tempted investors with compelling narratives and periods of outsize returns.

The hype surrounding these funds led to the launch of 589 new thematic funds globally in 2021, more than twice the previous year’s record of 271. And assets under management in these funds grew to just over $800 billion by year-end 2021, a nearly threefold increase over just three years.

These funds cover a variety of themes, ranging from clean energy and water to technology trends such as artificial intelligence. But it’s crucial to look beyond an eye-catching story when evaluating their potential.

Since the onset of the global pandemic, flagship thematic funds like ARK Innovation ETF have seen a dramatic rise and fall, bringing renewed attention to the potential risks associated with investing in some thematic funds.

Are thematic funds risky?

By most measures, thematic funds can be considered risky investments. In fact, many thematic funds are risky by design.

Over the trailing five years, almost 9 out of 10 thematic funds in our database exhibited a higher standard deviation than the broad global equity market (as proxied by the Morningstar Global Markets Index).

This number falls to three in four when we look specifically at broad thematic funds, which track multiple themes and tend to have more-diversified portfolios.

Ultimately, this shows us that even the most broadly diversified thematic funds have exhibited a higher standard deviation than the broad global equity market.

However, risk should not be considered in isolation; it is also crucial to consider the potential trade-off between risk and return. While many funds have been more volatile than the broader market, many have also produced strong returns.

Exchange-traded funds, or ETFs, which tend to hold a narrower basket of stocks than their mutual fund peers, tend to be more volatile. Consider Canada-domiciled Horizons Marijuana Life Sciences ETF. The fund returned more than 100% in the four months between September 2017 and the end of that year—before shedding more than two thirds of its value in the year to the end of first-quarter 2020.

With such volatile returns, funds like this probably shouldn’t form any core allocation within a sensible investment portfolio. But could even the narrow thematic baskets have a place within a portfolio? The straightforward answer is yes.

Are thematic funds safer than a single stock bet?

How risky an investment is also depends on what we are comparing it with.

Take the example of a hypothetical investor seeking exposure to the cloud computing theme three years ago. This investor may have had the choice between a single stock and a cloud computing ETF that buys a basket of cloud computing stocks (including the single stock). Say the investor picked the single stock—enterprise software specialist Everbridge, which between the end of October 2021 and July 2022 lost more than 80% of its value following reported losses and the resignation of the CEO. Factoring earlier growth in, this investment would still be down by more than a third.

On the other hand, if the investor had chosen one of the largest cloud computing ETFs listed globally, returns would have been 7% over the same period. In this example, the ETF did hold Everbridge, but outperformance elsewhere in the portfolio helped offset the losses. Of course, if the investor picked a more successful cloud computing stock, returns could have been even higher.

Ultimately, even if investors get the theme right, unrelated company-specific problems such as fraud or bad management can derail a company’s chances of success. Buying a well-crafted thematic fund is still one of the more effective ways to diversify away some of that idiosyncratic or firm-specific risk while maintaining exposure to desirable theme-specific risk.

You may also want to compare your fund with Morningstar’s thematic indexes to see if it holds the kinds of stocks you want. For energy, for example, you might look at the Morningstar Developed Markets Renewable Energy Select 30, Morningstar Global Markets Renewable Energy, Morningstar North America Renewable Energy, and Morningstar Global Energy Transition indexes, among others.

How much of a risk is Crowding in thematic funds?

Crowding is when investors chase a specific stock or an investment idea at the same time. And this rush to buy or sell—particularly in smaller, less frequently traded stocks—can increase price volatility and increase the costs of trading.

Because thematic funds often invest in smaller companies that are frequently leaders in emerging technologies with high growth potential, liquidity is particularly important.

While active managers can choose which holdings to sell within a portfolio and avoid trading at the least opportune times, ETFs tend to have narrower exposures and (when passively managed) are compelled to buy and sell in line with index rules. This makes them particularly susceptible to liquidity squeezes that arise during mass exits. The impact on the underlying stock can be exacerbated when investors in many different thematic funds are selling simultaneously.

Liquidity headaches can also appear when the market is buying. For instance, the runaway success of some alternative energy ETFs caused growing pains in late 2020. The combined assets of iShares Europe- and U.S.-domiciled alternative energy ETFs catapulted to $10.7 billion by the end of first-quarter 2021 from $0.8 billion at the beginning of 2020. With so much money gushing into such a narrow portfolio of small- and mid-cap stocks and amid questions about liquidity, the S&P Global Clean Energy Index has been forcibly broadened twice. Any additional trading costs associated with the changes to new benchmarks were absorbed by fund investors.

What are the warning signs in thematic funds?

When evaluating the liquidity of a thematic fund, investors should look directly at the fund’s holdings (and, in the case of passive funds, the index methodology).

Metrics like market capitalization of the stocks and average daily traded volume can be used to estimate how difficult it would be to sell holdings at short notice. A fund with large exposure to small- and micro-cap stocks is worth further scrutiny.

Remember, a stock only has value if you can actually sell it. But while it is important to keep an eye on liquidity and avoid investments that are clearly waving red flags, only in the most extreme cases will it severely impact fund returns.

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