Watch out for thematic funds’ risks – high closure rate and poor performance

THEMATIC funds exert a certain magnetism. Fund names alone – such as robotics, artificial intelligence and energy transition – immediately signal the exposures you will get.

They are also easy to market when market sentiment is bullish, as it is now.

But there are many reasons to be cautious. Sharply higher volatility is one. Other cautionary factors are less well known, however. Two stand out, and are highlighted in Morningstar’s report on the global thematic landscape in 2024.

One, the casualty rate among thematic funds is very high. Over a 15-year period to end-June 2024, more than 70 per cent of funds in the universe closed, Morningstar data indicated.

Two, thematic funds do not outperform global equities over longer periods. This is somewhat counter-intuitive since such funds have a growth bias. Higher fees may be a factor.

Singapore has had its own boom-and-bust cycle in thematic funds. Between end-1999 and mid-2000, managers rushed to roll out global technology funds as tech stocks were climbing. With 20-20 hindsight, the period marked the peak of the tech bubble – which burst around March 2000. Tech stocks subsequently fell by more than 50 per cent.

At that time, tech funds raised nearly S$2 billion, slicing the tech universe into narrow themes such as Internet and e-commerce. Many funds have since rationalised or closed. Some were merged into broader global tech funds.

Morningstar said: “Launches and closures of thematic funds have followed a highly cyclical pattern. New strategies peak during periods of strong performance, such as the early 2000s and mid-2000s, but tend to slow down during market downturns. Similarly, fund closures tend to spike during these downturns. The growing appeal of thematic investing is evident in the increasingly large launch cycles.”

Still, investor interest in thematic funds remains strong, Morningstar noted. In the five years to end-June, worldwide assets in thematic funds almost doubled to US$562 billion from US$269 billion. But this masked a sharp post-pandemic drop. Global thematic funds had actually surged threefold from 2020 to end-2021 to US$892 billion, before plunging by more than a third over the next nine months, during the so-called “tech reckoning” when Big Tech stocks dropped steeply in 2022.

The biggest rub is that thematic funds’ growth proposition – that most funds have a growth bias – is not borne out in returns against a global equities benchmark. Morningstar data over periods of up to 15 years shows that closures escalated alongside increasing underperformance. By the 15th year, nearly 73 per cent of funds had shut, and the proportion which outperformed dwindled to 6 per cent. This compared with closures of 6.4 per cent and outperformance of 28 per cent in the first year.

“These figures paint a bleak picture for investors. They suggest that the odds of picking a thematic fund that survives and outperforms global equities over longer periods are firmly stacked against them,” said Morningstar.

The experience in Europe largely mirrors the US in terms of closures and underperformance, even though the European thematic landscape is dominated by actively managed funds. In the US, 70 per cent of thematic funds are passive, although there is a growing number of active exchange traded funds.

In both the US and Europe, higher fees are a factor in underperformance. In terms of asset-weighted fees, popular thematic funds’ fees are “many multiples higher than those of the most popular non-thematic fund”, Morningstar noted. “High relative fees compounded over many years contribute to the low success ratios versus a costless index.”

Morningstar singled out European manager Pictet Asset Management’s success and longevity.

It is the largest thematic manager in Europe, and accounts for 55 per cent of thematic assets globally. Four of Pictet’s funds are among the largest 10 thematic funds in Europe.

“The firm’s success has been built over many years, and is founded on a measured approach to selecting and tracking long-term themes. In a market where fund launch and closure rates run high, Pictet has scored reassuringly low on both counts.” said Morningstar.

Freeman Tsang, Pictet Asset Management head of intermediaries (Asia ex-Japan), said Pictet’s choices of investable themes depend on some criteria, including a focus on megatrends as a driver. Megatrends are defined as “long-term structural forces of change such as technological, environmental and societal” trends, which are transformed into investment opportunities.

Pictet has also been early in the game, launching certain themes long before they inserted themselves into more common parlance. The Pictet Water fund, with US$9.4 billion in assets, was launched in 2000, for instance. Pictet Robotic with US$10 billion in assets, emerged in 2015. Pictet Clean Energy Transition with US$4 billion launched in 2007.

The artificial intelligence theme features in three funds – Pictet Digital (launched in 1997); Pictet Security (2006) and Pictet Robotic. The funds are available in Singapore for accredited investors.

Morningstar found that global thematic funds, which group various themes into a single fund, are the most popular with US$69 billion in assets globally.

Among these, the largest is Pictet Global Megatrends Select with US$12 billion in assets. “A multi-theme approach is attractive to those who prefer to spread their chips across multiple themes in the hopes of retaining thematic upside while smoothing the ride,” it noted.

In Singapore, Endowus also offers a Megatrends portfolio, to enable investors to participate in multiple themes.

The portfolio is actively monitored, and occasionally some funds may be replaced. The portfolio focuses on three themes – quality of health, life and environment.

Endowus advocates a core-satellite approach. The core allocation comprises a mix of diversified equities and fixed income assets and accounts for the bulk of a long-term portfolio. By definition, a satellite allocation is higher risk, and takes up a smaller allocation. Megatrends is a satellite allocation, alongside others, such as China, technology and real assets.

Hugh Chung, the platform’s chief investment advisory officer, said of the portfolio: “We not only do analysis and due diligence on the track record and portfolio management team of the funds but also whether they do what they set out to do and keep to their investment philosophy. We also make sure there is enough differentiation and diversification by looking at company/sector overlap as well as correlations with each other. We monitor the portfolio so that the funds in the portfolio are the best expression of the philosophy behind it.”

The underlying funds may change. Earlier this year, it dropped some of the underlying funds and introduced others. Investors may choose to pursue the new allocations or stick to the previous mix.

Over the 10 years to end-September, the portfolio would have generated 7.9 per cent in annualised returns, on an annual volatility of 13 per cent. The portfolio’s total expense ratio is 1.14 per cent.

Underperformance

In line with Morningstar’s research, the Megatrends portfolio also underperformed global equities over 15 years.

Chung said this could be due to two reasons. “One, a large part of the global equities index is large-cap US tech companies which have disproportionately contributed to index performance. Second, many thematic funds own companies that have long duration cycles. These funds underperformed a lot in 2022 when long-duration assets got punished by the rapidly rising interest rates.”