The Risks and Rewards of Thematic Investing

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In Part 1, we explained what is meant by thematic investing, and how to get started investing in a theme, either as a self-directed investor, or by buying a mutual fund or exchange-traded fund.

To review: Thematic investing is a fancy way of saying that you want a long-term investment based on a theme (i.e., an idea or trend) that you believe will play a significant role in a changing society, the economy, or advancing technology.

Theme examples include solar energy, innovative or “disruptive” technologies, clean energy, renewable energy, clean water, scarce natural resources, to name only a few. Interest in thematic investments has exploded in recent years.

As we discussed in Part 1, it’s less time-consuming and usually less risky to buy thematic ETFs and mutual funds because you are letting a professional money manager do the research and select the stocks.

Here are a few of the rewards when following this path:

The rewards of thematic investing

  • The potential for higher returns: As with any investment, thematic investments can become wildly popular among individual investors, with the potential for the stock price to skyrocket. That is what happened with AI and bitcoin. No one could have predicted the success of these two technologies, but those who bought early are ecstatic they did. In the future, there will be other themes that will capture the public’s imagination, but it takes a visionary to predict which ones will make it to the winner’s circle.

  • Diversification: Owning a thematic ETF or mutual fund is a double-edged sword. On one hand, it is more diversified than owning only one or two stocks because you own a “basket” or portfolio of thematic stocks. Therefore, if a few stocks in the portfolio fail to deliver, it’s not a big deal. On the other hand, it is less diversified, and riskier, than investing in a broad-based index fund. To reduce risk, and have a more diversified portfolio, it makes sense to spread the risk by having other investments besides thematic stocks.

  • Professionally-managed investments: One of the advantages of owning a professionally-managed ETF or mutual fund is that an experienced professional chooses which stocks are in the portfolio. Theoretically, they will do the research, find potential winners and avoid the losers. Most people don’t have the time or knowledge to pick potential winners. This is especially true for thematic stocks, which may not fit neatly into a specific sector or industry.

  • Invest in your values and beliefs: Thematic investing allows investors the opportunity to support the issues they are passionate about. Perhaps they are concerned about renewable energy, ethical business practices or clean water. Investing in these themes, or many others, is not only morally and ethically satisfying, but offers an opportunity to earn profits.

The risks of thematic investing

  • Not all thematic investments succeed: Although some themes have done spectacularly well, many have not. Because thematic investments are based on long-term ideas and trends, many of the themes will take years, even decades, before making a profit (with no guarantees they will ever profit). Therefore, as with any investment, there is the chance of losing money when investing in a thematic stock or fund, especially in the short term. Kenneth Lamont, a senior manager research analyst for Morningstar, made this observation: “I would suggest that in five or 10 years, the big thematic winners won’t be the companies you think they’ll be. Basically, you are making a bet that a certain theme will play out and pay off.”

  • Incomplete track record: Many thematic ETFs and mutual funds have limited track records, making it difficult to evaluate their long-term performance. For example, the first artificial intelligence ETF, Amplify AI Powered Equity AIEQ - $35.88  0.959 (2.879%) , was created in October, 2017, only seven years ago. Even worse, some thematic investments may turn out to be short-lived fads that won’t last the summer. It’s not easy to separate the hype from the facts, especially when they have a short history.

  • Increased volatility: Some concentrated or “niche” thematic ETFs or mutual funds will be volatile (such as what recently happened with AI and cryptocurrency stocks). If investing in a thematic fund, you must be prepared for a roller coaster ride during some weeks or months. Increased volatility to the upside can bring fantastic returns when correct about a theme. Increased volatility to the downside occurs when the market recognizes that the theme has no real future, or when you picked the wrong stocks or fund. Sometimes there is a stock market correction, and nearly all stocks get punished. That appears to be occurring right now. Lamont confirms: “You are investing in a highly-concentrated basket of stocks which can be very volatile.”

  • High expense ratios and fees: While some thematic ETFs and funds have “reasonable” expense ratios, some charge high fees and expenses (e.g., expense ratios over 1.5 percent is considered high). To avoid this drawback, stick with thematic funds with expense ratios that are below 1 percent.

  • Market timing is nearly impossible: Unless the fund manager is a fortune teller, knowing when a specific theme or idea will succeed is a nearly impossible feat. For example, clean energy has been a hot topic that has been discussed for years. While some clean energy ETFs and mutual funds did well, many did not. Fund managers must have the skill to identify which themes have the potential to succeed in the future. Thematic investors must be patient and committed as the theme plays out.

Choosing the right themes

Understanding the risks and rewards of thematic investing is a good start, but to be successful you must periodically monitor your investment while also patiently giving the investment time to grow. Perhaps most important, choose themes that have the potential to outperform over time. No one said this was easy.

Morningstar research analyst Lamont summed it up this way: “Thematic investing has a place in your portfolio, but there are definite risks. They should never take up a large portion of your portfolio, and should not act as a replacement for a broad-based index fund.”