Thematic ETFs (are Terrible Investments)

TL;DR

Thematic investing, driven by exciting investment themes, often leads to overpriced stocks and underperformance due to excessive investor enthusiasm and competition.

Transcript

• Some investment themes are more exciting than others. Recently, themes like crypto and blockchain, marijuana psychedelics, cloud computing, electric vehicles, clean energy, robotics and artificial intelligence have caught the imaginations of investors. But this isn't the first time that investors have clamored over exciting companies. Electronics... Read More

Key Insights

• 🪛 Exciting investment themes attract investors, driving up stock prices and creating a potentially overpriced market.
• 💐 Thematic ETFs tend to launch after peak excitement, holding securities with low expected returns.
• 🫰 Thematic indexes often contain stocks with positive skewness, appealing to investors seeking lottery-like payoffs.
• ✳️ Thematic investing may lead to poor risk-adjusted returns, as these strategies tend to have idiosyncratic risks and overweight stocks with weak fundamentals.
• 🍝 Investor behavior, including timing and chasing past returns, can significantly impact the performance of thematic funds.
• 💐 Thematic ETFs offer higher fees compared to broad market ETFs, making them profitable for ETF providers but disadvantageous for investors.

Questions & Answers

Q: Why does the excitement surrounding big potential markets lead to overpriced stocks and underperformance?

The excitement about a big market creates profit opportunities for businesses, leading to the formation of numerous companies. If these companies issue lots of shares, it dilutes the growth in earnings per share, resulting in underperformance.

Q: Do thematic ETFs offer exposure to well-documented risk factors?

Thematic ETFs tend to have idiosyncratic risks that can be diversified away. They also tilt towards small-cap stocks with high prices, weak profitability, and aggressive investment, which historically deliver poor risk-adjusted returns.

Q: Why do investors still invest in thematic ETFs despite their poor expected return profiles?

Investors may not believe in asset pricing models or may seek lottery-like payoffs. Additionally, non-financial benefits, such as a sense of belonging or thrill-seeking, may drive investors to thematic investments.

Q: How does investor behavior affect the performance of thematic funds?

The behavior gap, which measures the difference between fund returns and investor returns, is often larger for sector funds and likely even larger for thematic funds. Poor timing and chasing past returns contribute to lower investor returns.

Summary & Key Takeaways

• Exciting investment themes, such as crypto, marijuana, and electric vehicles, often attract investors looking for potentially disruptive trends and excess returns.

• The collective excitement of investors can drive up stock prices, creating a bubble-like behavior in asset prices.

• Thematic ETFs, focused on trendy themes, tend to launch after the peak of excitement and returns, holding securities with low expected returns.