Thematic funds – fad or sustainable trend?

According to an analysis by Morningstar, asset managers have expanded the range of these niche strategies accordingly since the beginning of 2020. Investor demand for greater clarity about how these funds are constructed and how they fit (or not) into their portfolios has correspondingly increased.

Continuous growth in thematic funds

According to the BNP Paribas Thematics Barometer, dated April 2023 and prepared in collaboration with Coalition Greenwich, the share of thematic investments in Europe has increased by 20 per cent since 2020, with the highest demand coming from the wholesale channel sector. On average, according to this study, 70 per cent of investors plan to further increase their focus on thematic investing over the next three years, with 84 per cent of intermediaries and 56 per cent of institutional investors in favor of an increase.

These funds seek to exploit secular growth themes. Relevant themes are many, ranging from technology themes such as advancing digitisation, automation/robotics and artificial intelligence to generational trends, urbanisation, nutritional issues, demographic change and also physical issues such as renewable energy and climate change, which can offer great return opportunities for investors.

Investing with emotion

Thematic funds are attractive to investors because they are easy to understand - especially considering the amount of jargon in financial products. Thematic funds typically address meaningful themes that are often familiar to investors, such as f.e. the aging of the population or the transition to a digital economy. Stories such as the rise of electric vehicles, climate change and longevity have a strong pull on investor emotions. Behavioral science tells us that simple stories have a strong appeal to people because they are easy to remember. A story is a self-contained thing that has meaning in our lives - and our brains love those things.

Lessons learned

In the past, the launch of thematic funds tended to run in cycles. New strategies are often introduced during periods of strong performance. However, they tend to decrease during downturns. These trends suggest that investor interest in these strategies and providers' desire to offer them tend to align with the broader market.

The launch of thematic funds is a bull market phenomenon. The abundance of new thematic funds that have been launched in recent years underlines this connection. Experienced investors therefore often have bad memories of themed funds. In the past, such funds were often launched late in the cycle, after a theme had been generating above-average returns for a long time and the underlying stocks were highly valued.

What has changed?

In our view, the recent trend towards thematic and sector funds is much more sustainable than in the past. The following factors should be mentioned in this context:

1. Active asset management has been under massive pressure for a long time from cheap passive investment options such as ETFs and index funds. This means that smaller asset managers in particular have to specialise more and more in order to survive in the competition. If this specialisation can fill a niche with a credible investment approach and the corresponding core expertise, there is a high probability that investors can be enthusiastic about a corresponding product.
2. Asset managers and family offices must continually demonstrate where they create added value for their customers. The timely capture and successful mapping of future trends can be an effective means of asset allocation. In this context, the asset manager, if available, can also demonstrate its selection expertise when selecting products and score additional points.
3. Experienced fund initiators have learned from the mistakes of the past and very often continue to run their products even if they are temporarily exposed to larger returns of fund shares due to a cyclical correction. If we then manage to continue to achieve good performance, such products will immediately be on investors' purchase lists as soon as the topic in question picks up steam again.
4. It is likely that investors will continue to accentuate decided megatrends in their portfolios - and this despite the fact that investing in theme funds is particularly challenging. On the one hand, the right theme must first be identified, which, moreover, has not yet fully anticipated the positive long-term prospects from the valuation side and thus has further potential. Secondly, selection competence is needed to identify the right investment fund and the right manager.

Conclusions

In our view, thematic funds will remain highly in favour with investors and continue their growth trend. This applies to liquid investment strategies as well as strategies in the illiquid "private markets" area, such as CleanTech, mobility, longevity and others. Investors should be aware, however, that investing in thematic funds is particularly demanding and requires specific skills.

Nonetheless, there are a few important things to consider in conclusion, as finding the right theme is only part of the equation. Getting the fund to actually fit the theme is another important component. In concrete terms, this means: It is important to assess exactly how many of the companies represented in the portfolios of thematic funds have what proportion of their income from activities or products that have to do with the topic in question. Finally, it is important to question the evaluation. How much of the expected growth of a theme is already priced into these stocks in the portfolio?

Thematic funds have captured the imagination of investors. However, fund promoters should particularly check whether they are actually so convinced of a trend topic in the long term that they want and can continue to run the product even in cyclical weak phases. It is also essential to have special expertise and a credible and well-thought-out investment approach in the relevant topic. If these requirements are met, as is the case with some of the products from VP Fund Solutions clients, a good themed product can quickly become a success story.