Who can deny the allure of a big market with a compelling narrative? Electric Vehicles, WFH, Clean Energy, and Biotech, to name a few. Public investments into these sectors have been proliferated through ‘thematic investing.’ Most commonly structured as an ETF, these funds raked in hundreds of billions of new investment dollars last year and were popularized by fund managers like Cathie Wood. This influx has resulted in Morningstar publishing a warning to investors: a good theme doesn’t always make a good investment (Morningstar).
The Big Market Delusion
Some of the potential downside to thematic investing can be attributed to what researchers have called the ‘Big Market Delusion.’ (Cornell & Damodaran 2020) This delusion becomes apparent when all companies in a particular industry rise in value, even though they are direct competitors, and eventually, some of those companies will fail. The sum of the parts cannot be greater than the whole. This phenomenon occurs most commonly across industries that are actively being disrupted or innovated. It typically begins in the private markets (VC and PE) and can continue into the public markets if the company can sustain itself long enough. The high valuations and hype continue. However, you can’t value a company simply on the size of the market it serves.
Buying thematic ETFs creates investor risk through potential market overvaluation and through an increase in unsystematic risk from holding individual positions. As the number of competitors enters the popular space, profits squeeze, market shares become further fragmented, and the more likely failure becomes in these winner-take-all markets.
The outcome for thematic funds is that over the last decade, they have underperformed the market on a risk-adjusted basis (Morningstar). Overconfidence and irrational exuberance can lead to sectoral bubbles. Investors jump at these “can’t miss” opportunities due to the perceived size market size and the company’s promise.