Are investors in thematic funds doing it wrong?

Trend-chasers' tendency to 'stay too long at a party' evident in dismal returns data, says chief market strategist

Are investors in thematic funds doing it wrong?

It’s a rule as universal as it is timeless: an effective strategy or business model, if allowed to go and grow long enough, is going to collapse in on itself. And that’s exactly what Craig Basinger saw in 2021 as meme stocks and investment themes ran wild across the markets.

“We were watching some of these thematic ETFs go crazy in the upward direction. … Having been around the block a few times, we knew investors were going to get hurt,” recalls Basinger, the chief market strategist at Purpose Investments.

“The one recurring thing about the investment world is that when there’s a good idea out there, it attracts so much capital so quickly that it goes way too far and itself becomes a bad idea.”

The high cost of thematic trend-chasing

That realization, followed by much additional thought and conversations, eventually led to the launch of the Purpose Tactical Thematic Fund two weeks ago. By actively investing in thematic ETFs – which one academic has uncharitably compared to “junk food” – it aims to solve what Basinger describes as a “lack of an investment process” in the thematic investment space.

“Investors tend to arrive at a party way too late and then they stay way too long … even when the price is yelling and screaming that they've made a bad investment and they’re now down 20%,” he says.

In an analysis of data from Bloomberg and other sources, Basinger showed how thematic ETFs have boomed in popularity over the past near-decade, going from around 200 million shares outstanding in 2015 to around 1.6 billion as of September 30.

Some deeper digging revealed pervasive performance-chasing in that trend-driven corner of the ETF space. In the past five years, Basinger found the vast majority of investor inflows into thematic ETFs occurred during periods when they were at their most expensive. Exacerbating the problem is a lack of discipline in thematic investing, evidenced by how rare it’s been for investors to sell out of thematic ETFs – even those whose share prices have dropped 80% over the past few years.

“So many times, I think [an investor’s] mind goes from thinking ‘There’s a really great performance growth trajectory here’ to ‘It doesn’t matter … this is a 10-year hold,’” he says. “When people change their minds like that, there’s something wrong.”

There’s merit in momentum

Staying with the same universe of thematics, he estimated the actual return experience of investors by looking at the dollar-weighted returns over the past five years – the returns adjusted for when investor dollars flowed in and when they flowed out.

That analysis indicated the typical investor experienced a mild loss of -2% on an annualized basis, compared to an 8% gain for a hypothetical someone who had bought and held from the very beginning.

While some investors might look to valuations to guide their buying and selling decisions, Basinger says the underlying companies in a thematic ETF are often expensive to begin with, and the hype train can drive their share prices even higher. The upshot is that even if a stock linked to a particular theme were to nosedive by 50%, it’s still typically priced too high to be considered an honest-to-goodness bargain.

“That's why we went with momentum to guide our fund’s investing process,” he says. “It doesn't ask why uranium started to go up earlier this year. … When it breaks down, it's not going to ask why it’s breaking down and try and put a story around it. It's just going to react to the fact that it's breaking down. And we think that's the safer process in these kinds of investments.”