The problem with thematic investing

Thematic investing has been around for decades, but the market really exploded during the pandemic. Investors sought out ways to place focused bets on stocks that would benefit most from the trillions of dollars flowing into big ideas, and asset managers responded by launching hundreds of new funds in sectors such as artificial intelligence and green energy.

Between the beginning of 2020 and the end of 2021, total assets under management (AUM) in thematic active funds rose from around $290 billion to a peak of almost $900 billion, according to data from Morningstar – i.e., they tripled in two years. However, that turned out to be a short-lived high for many thematic-investing trends.

Since 2021, AUM in thematic funds has steadily declined. By mid-2024, assets had dropped to $562 billion, the lowest level since 2020. This is at least partly due to many funds not delivering what investors expected.

Why has thematic investing delivered underwhelming returns?

To say that performance has been a real issue would be unduly kind. This is especially true for funds focused on the energy transition. There are more than 400 funds in this category – with just shy of $70 billion in assets under management – but average returns in the category have been -7.5% over the past year. The worst sub-sector has been battery technology, which is down 13%. These funds are highly correlated with battery and battery-material prices – and the price of lithium has just hit a five-year low.

However, most specialist themes within tech have also struggled to beat the wider market, with just a handful of sectors outperforming the MSCI World index over the past year. In fact, the best-performing thematic fund sector was the space sector, where funds have made average returns of roughly 24% over the past year. Yet space is also a relatively small theme, with total assets in thematic funds of about $2.5 billion. It is also one that illustrates the challenges of scaling up some themes due to a shortage of suitable holdings to fill out portfolios.

For example, the handful of dedicated space exchange-traded funds (ETFs) have profited from the performance of Rocket Lab USA, which saw a share price increase of more than 400% for the 12-month period to the end of the first quarter.

This is one of the few pureplay space companies that’s big enough for large funds to acquire a substantial position, with a market value of $9 billion. Yet this is a business that lost $190 million on revenue of $436 million last year. It is also volatile – the stock is now down by 40% from its all-time high.

Are thematic funds worth it?

This hopefully makes it clear that investors should not fool themselves about what thematic funds can do. Yes, they can have a role in a portfolio, but they are not good at providing diversification. Thematic funds are highly concentrated plays on one particular idea and when the trend changes, performance can go bad very quickly.

On this point, note that a lack of diversification and crowding into popular stocks often leads to disappointment. Funds that crowd into the same stocks tend to gravitate towards more liquid stocks, according to a study of 17,364 funds by DIW Berlin, an economic research institute. These stocks may offer lower potential returns than less liquid, more overlooked ones. So it is no surprise that the most-crowded 10% of funds lagged benchmarks by 1.4 percentage points per year. Other studies show similar results.

Note, too, that once a thematic fund starts struggling, it may not be around for long enough to recover. At the start of this year, Fidelity shut a series of thematic ETFs launched in 2021 – including clean energy and digital health funds – after assets slumped. Other providers often do the same. Thematic investors may hope they are getting in early on a big opportunity. Maybe they are in the long term. But if there’s a downturn along the way, their fund may not exist by the time the profits come through.

This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.