Performance Chasing with a Narrative?
Thematic investing is like venture capital for asset managers. For every 10 products launched, most fail to generate interest from investors, a couple break even from a cost perspective, and maybe one becomes the star fund that raises billions of assets under management and makes it all worthwhile.
Themes are typically about change: perhaps a country evolving from a frontier to an emerging market, a sector undergoing a dramatic transformation, or a new technology seeing widespread adoption. Of course, most investors are only interested in themes that generate enviable returns. Thematic investing isn’t just performance chasing, it’s performance chasing with a narrative. That can be a seductive combination.
So should investors consider thematic investing?
Selected Thematic Investments
Although there’s no standard definition, thematic investing tends to be about capturing the zeitgeist. Or trying to. The big themes of recent years have included factor investing; environmental, social, and governance (ESG) and low carbon investing; the rise of China; and new technologies like artificial intelligence (AI).
Although new themes appear all the time, many are quickly forgotten, especially those that disappointed investors.
Some themes have a near-universal appeal, while others are more eclectic. Internet stocks were all the rage in 2000, but far fewer investors got into bitcoin and other cryptocurrencies in 2017 or marijuana stocks in 2018. In hindsight, themes can often resemble financial bubbles.
Selected Thematic Investments
To evaluate thematic investing, we first have to figure out how to measure it. In the last 10 years, myriad large and small themes have come and gone, but deciding what is and isn’t one is highly subjective. Investing in tech stocks may have been a distinctive theme in 2000, but how about today?
Perhaps the only systematic way to identify themes is by performance. No matter how compelling the narrative around a frontier market or emerging technology, it won’t draw investor interest without a chart heralding great returns.
Replicating Thematic Investing
The Kenneth R. French Data Library has compiled daily returns for 49 industries in the United States going back to 1926. We used that data to replicate thematic investing systematically. We created one portfolio with a thematic allocation to the best-performing industry based on three-year performance, rebalancing annually, and another that allocates to the three best-performing sectors, which are equally weighted.
Both portfolios would have underperformed when benchmarked to an equal-weighted portfolio across all industries or the market-cap weighted stock market.
Once an industry outperforms, investors flock to it in a chase for performance, which often leads to expensive valuations. Eventually mean-reversion sets in, and with it less attractive subsequent returns.
Betting on the Best-Performing US Industries vs. Benchmarks
Although thematic investing’s relationship with performance chasing is intuitive, our approach — identifying themes based on three-year track records — is not without potential flaws. The lookback period may represent the industry standard for mutual fund and ETF performance evaluation, but maybe it is too short.
So let’s switch the perspective from returns to risk-adjusted returns: Allocations to the best-performing US industries, measured over three or five years, generated worse risk–return ratios from 1929 to 2019 than investing in the stock market. Performance chasing has not paid off.
Best-Performing US Industries vs. Benchmarks: Risk–Return Ratios, 1929 to 2019
So what sectors performed the best most often over the last 90 years? There’s a diverse array that reflects the US economy’s evolution. Electronic equipment and health care have outperformed in recent decades. But coal and tobacco have most frequently topped the leaderboard.
Of course, these two sectors have fallen out of favor with investors of late, but they’ve played a considerable role in US equity market returns. ESG investing could not match their track record.
Best-Performing US Industry, by Frequency, 1929 to 2019
To be sure, this analysis is largely theoretical and therefore easily dismissed by thematic investing proponents. And we already pointed out the challenge of defining and measuring themes. But what about the track records of investors that specialize in thematic investing? What do they have to say about the overall utility of such approaches?
Thematic macro hedge fund managers have highly flexible mandates and can build portfolios of uncorrelated themes. Such themes might be expressed through long and short positions in equities, bonds, currencies, and commodities, among other asset classes. If anyone can make money from thematic investing, these unconstrained managers with their incentivized performance fees ought to be prime candidates.
But according to our analysis, their returns were anything but stellar. These managers were thematically wrong during the global financial crisis (GFC), with a 20% maximum drawdown. Since then, their returns are comparable to US investment-grade bonds.
This hardly makes the case for thematic investing. After all, hedge fund managers have access to more financial instruments and thus more opportunity to exploit themes than the average investor. The lack of performance is even more glaring given the assumed reporting biases of hedge fund indices. The returns from thematic macro investing are probably even worse than they appear.
Thematic Hedge Funds
There is no denying thematic investing’s appeal. Most investors would love to benefit from the growth of certain emerging countries, amazing new technologies, or even marijuana legalization in Canada and the United States.
But for thematic investing to work for investors, the trends must continue. While momentum strategies over one-year periods and combined with frequent rebalancing are backed up by academic research, there is scant evidence that plain-vanilla performance chasing works.
ESG and similar themes are forms of investing based on personal preference. They may come at a cost, but they achieve some non-financial objectives.
These exceptions aside notwithstanding, thematic investing is likely a bad theme for investors.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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Professional Learning for CFA Institute Members
Nicolas Rabener is the managing director of FactorResearch, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focused on real estate across asset classes. He started his career working for Citigroup in investment banking in London and New York. Rabener holds an MS in management from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).