Thematic ETFs tend to launch just before a big drop in yields

Any investor short-selling shares of the most famous “theme” ETF – Cathie Wood’s flagship Ark Innovation ETF (ARKK) – will have had a killing in recent months.

By mid-February, the traded index fund had lost more than half its value since its peak the previous year. And there was no sign of the selloff ending, although Wood insisted the innovation stocks he owns were “well undervalued”.

But while those developments will have been disappointing for the legions of Wood fans, the sell-off will come as no surprise to a team of investment academics: their latest research suggests that investors in thematic ETFs are losing on average money.

According to the academics – Itzhak Ben-David, Rabih Moussawi, Francesco Franzoni and Byungwook Kim – the worst time to buy thematic ETFs, which hold stocks that follow a popular investment trend or theme, is when they launch.

This is primarily because funds tend to launch right after their theme peak and immediately before a sharp decline in returns.

The research focused on US equity ETFs, traded on the US stock market, between 1993 and 2019. She revealed that not only did thematic ETFs struggle, but sector ETFs performed almost as badly and represented a larger segment of the ETF market. Together, the two categories represented nearly 20% of assets under management and generated 36% of commissions.

According to Franzoni, thematic ETFs can be a losing proposition for several reasons: the theme is often overvalued; ETFs charge higher fees that eat away at returns; and thematic ETFs are less diversified and therefore more risky.

However, this does not mean that outsized returns cannot be made from it. For example, ARKK provided net annual returns in excess of 150% to investors who held the fund during the year through the end of 2020. As a result, those who have remained invested in ARKK since its inception in 2014 are still sitting on returns approaching 270%, against a rise of just under 150% in the S&P 500 over the same period.

Its sister fund, the Ark Genomic Revolution ETF (ARKG), was an even better bet in 2020, returning 180%.

But despite these examples of good performance, academics warn that it is impossible to draw any longer-term assumptions. For example, a common belief is that today’s investment themes are meant to “mature” across sectors. So even if you encounter early volatility, you are still bound to benefit if you buy early and stay long. This could be true, agrees Moussawi, for certain investment themes such as batteries. However, other themes may never mature, he says.

“I don’t think there will ever be an innovation industry,” he says. “Themes of innovation exist in multiple sectors,” he points out, adding that the same would apply to themes such as women’s empowerment, which is a factor in many sectors. This distribution of trends and themes across multiple sectors means that they could never “mature” into full-fledged sectors.

Even when it is possible to correctly identify an investment theme that will remain relevant in the future, thematic ETFs have dismal survival rates. Thus, an investor might choose the right long-term theme but find that the fund does not persist.

Kenneth Lamont, senior research analyst at Morningstar, the data provider, notes that many early internet fund investors 20 years ago failed to profit from the theme. As the dot-com bubble boosted tech stock prices, in the late 1990s a glut of internet-related funds was launched. However, only a handful survived – and most closed immediately after the bubble burst.

“Thematic fund launches are clearly a bull market phenomenon – this year we’ve seen a record number of launches,” Lamont said. “History tells us that the majority of these new backgrounds will not survive long enough to fully capture the chosen theme.”

Column chart of percentage indicating survival and success rate of global thematic funds

One of the reasons why investors may overlook or overlook these probabilities, says Abraham Lioui, professor of finance at Edhec Business School, is that there are other dynamics at work. “When people love something, they’re likely to be willing to sacrifice something,” he says.

Ben Johnson, director of research for global ETFs and passive strategies at Morningstar, agrees, pointing out that thematic ETFs tend to “catch investors’ appetite for storytelling, ownership and big-picture perspective. returns”.

However, by the time many thematic funds hit the market, the excitement has already been built in, he says.

Lioui and Lamont still believe that thematic ETFs belong in a portfolio.

“To defend thematic funds, choosing a basket of stocks following a theme reduces some of the idiosyncratic risk associated with buying a single stock,” says Lamont.

Lioui agrees that the ability of thematic ETFs to offer a narrow bet can bring rewards, but warns that investing still needs to be reviewed. “Of course, I would invest in the short term,” he says. “There is money to be made in the short term. But then, inertia sets in. People think if they are winners they will be forever.

Morningstar research published last year also showed the gap between a fund’s total returns and investor returns. This shortfall, which results from purchases and sales of fund shares at the wrong time, was particularly marked for the thematic sector funds.

“High valuations are rarely the starting point for successful long-term investing,” says Johnson. “Investors generally tend to buy thematic funds high and sell low – a trend that has recently manifested itself prominently in the case of ARKK.”

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