- Some investment themes are more exciting than others.
Recently, themes like crypto and blockchain,
marijuana psychedelics, cloud computing,
electric vehicles, clean energy,
robotics and artificial intelligence
have caught the imaginations of investors.
But this isn't the first time
that investors have clamored over exciting companies.
Electronics in the '60s,
the NIFTY 50 in the '70s,
biotech in the '80s
and the internet stocks in the '90s are good examples.
Similar examples go back hundreds of years.
The idea behind these eye-catching investment themes
is that investors can participate
in potentially disruptive trends
or innovations to earn excess returns.
As S&P describes their thematic indexes,
they offer access to a series
of technologically enabled, often disruptive industries,
generally referred to in aggregate
as the Fourth Industrial Revolution.
I'm Ben Felix, portfolio manager at PWL Capital.
I'm going to tell you why thematic investing
is like lighting your money on fire.
If you're excited about an investment,
it's probably not a good investment.
The collective excitement of investors
has a tendency to drive up stock prices.
Few things are as exciting
as new technologies or industries.
I used to read about hyped up investment crazes in books
but in my relatively short tenure
as a portfolio manager,
I have witnessed the phenomena first hand.
Do you remember marijuana stocks?
Everyone was going to be rich until they weren't.
One of the big challenges with exciting industries
is that they're exciting.
When people see a big potential market,
lots of businesses will form
to meet the potential demand.
The excitement about a big market stems
from profit opportunities for businesses
but however large the expected profits
from a new investment theme may be,
what matters to investors
is growth in earnings per share.
If lots of shares are issued by new
and existing companies pursuing profit opportunities related
to an investment theme,
it is possible that the investment theme
will end up underperforming in the market.
This idea was formalized
in a 2003 paper by William Bernstein
and Rob Arnott titled "Earning Growth:
The Two Percent Dilution."
Even if there is a huge pile of potential earnings
up for grabs based on a new technology,
the growth in earnings per share
of companies pursuing it may not be attractive.
Most entrepreneurs and investors
don't think like this though.
Entrepreneurs starting businesses in big markets expect
to be successful.
And investors selecting companies to invest in
in big markets expect to pick winners.
The combination can drive up the prices
of companies pursuing a hot investment theme.
Eventually, as investors learn more
about the market and the level of competition,
prices tend to fall
and they often fall dramatically.
This dynamic of big markets creating high prices
for companies despite limited opportunity
for investment returns,
followed by a drop in prices when reality sets in
was described in a 2020 article
by Brad Cornell and Awath Damodaran
titled "The Big Market Delusion:
Valuation and Investment Implications."
They explained that the extent
of overpricing in a market
will depend on the degree of overconfidence exhibited
by entrepreneurs and investors
where more overconfidence leads to higher prices.
The potential size of the market
where a larger potential market leads to higher prices.
The degree of uncertainty about the future profitability
of the market where greater uncertainty leads
to higher prices due to an amplification
of the overconfidence effect
and the perception of winner-take-all markets,
again amplifying the effect of overconfidence on prices.
Cornell and Damodaran offer empirical examples
of e-commerce in the 1990s,
the online advertising industry from 2015 to 2020
and cannabis stocks in 2018.
These were all big potential markets
with intense competition,
extremely high stock prices
and an eventual sobering drop in prices.
The effect of overconfidence on asset prices
is thoroughly documented in a 2003 paper
by Jose Scheinkman and Wei Xiong titled,
"Overconfidence and Speculative Bubbles."
The authors explain that due to the cost
of short selling, overconfident investors
will tend to have more of an impact on prices
than pessimistic ones.
And overconfident investors will be willing
to pay more than their own assessment
of a stock's fundamental value to acquire it
because it gives them the option
to sell to an even more overconfident investor later.
The result is bubble-like behavior in asset prices,
which doesn't tend to end well for investors.
This is a real problem,
especially for naive investors with limited knowledge
about asset pricing.
In a related 2013 lecture,
Scheinkman explains, "Experts that wish
to signal their familiarity with new technologies
have a tendency to exaggerate their value
and in this way generate over optimism
among naive investors."
That over optimism among naive investors
is something that financial product providers
are more than happy to cash in on.
A 2021 paper by Itzhak Ben-David and three co-authors,
titled "Competition for Attention in the ETF Space"
finds that specialized ETFs,
which are typically concentrated portfolios
with relatively high fees focused
on trendy themes are launched
just after the peak of excitement
and often the peak of returns related
to popular investment themes.
They find that specialized ETFs
do not create value for investors on average,
delivering a negative four factor annual alpha
of about 6% on average in the five years after inception
of the fund.
Before the fund inception,
the authors find that the indexes used
to create these specialized index funds tend
to have very positive performance.
This makes sense economically for the fund provider.
Create an index based on a popular theme
with recent high past returns,
build an ETF to track that index, profit.
Unfortunately for investors, these specialized funds tend
to hold securities with low expected returns.
Leading up to the thematic ETF launches,
the securities in the indexes tend
to have been increasing in relative price measured
by book-to-market and media sentiment.
But pre-launch, these indexes are not investible.
They are back tested conceptions
that index manufacturers think will sell.
After the ETF launches
and the index becomes investible,
the stock valuations tend to come back to Earth
and the media sentiment tends to decline.
Thematic indexes also tend to contain stocks
with more positive skewness,
which would be appealing for investors
who have a preference for lottery-like payoffs.
They find that within specialized ETFs,
the ones holding stocks
with the highest pre-launch returns
and media sentiment performed the worst post-launch,
further supporting the idea that the issuance
of specialized ETFs occurs near the peak
of valuation of the underlying securities.
Now, surely, investors in these funds
don't think they are going to lose money by investing.
The authors use analyst forecast as a proxy
for investor expectations.
They find that portfolios
of specialized stock display
significantly higher long-term growth forecasts
in the period leading up to the ETF launch.
After launch, the stocks experience a downward revision
in growth expectations.
The forecast errors, measured by the realized earnings
per share minus the analysts' long-term growth forecast
at the time of launch for specialized ETFs
becomes significantly negative and economically large.
This is consistent with strong over optimism in expectations
around the time of launch.
These data support the hypothesis
that the providers of thematic ETFs launch products
based on themes where investors hold optimistic beliefs.
Thematic indexes on which thematic ETFs are based consist
of high-priced stocks with strong media sentiment
and optimistic analysts' forecasts,
all of which tend to decline around the time
that the ETF tracking the index launches
and investors can actually start putting their money in.
A question worth exploring further
is what risk factors thematic ETFs offer exposure to?
There are well-documented risk factors
that explain the majority of differences in returns
between diversified portfolios.
How do thematic ETFs stack up?
In "Betting Against Quant:
Examining the Factor Exposures of Thematic Indexes,"
David Blitz digs into the question
using major index providers MSCI
and S&P's thematic indexes as a sample.
Blitz finds that thematic indexes tend
to have lots of idiosyncratic risks
measured by their volatility ratio.
That is risk that could be diversified away.
And they tend to be tilted toward small cap stocks
with high prices, weak profitability
and aggressive investment.
Empirically, this combination of risk factors
is terrible, delivering the worst risk-adjusted returns
of any factor-based portfolio sort.
Why would anyone invest in these funds?
Blitz offers some ideas.
Investors in these funds may simply not believe
in factor models for expected returns.
For example, any investor who believes
that value investing is old news
would have less of an issue holding small cap growth stocks.
In other words, these investors may not believe
in asset pricing models.
The other possibility
is that these relatively concentrated portfolios
are delivering positive risk-adjusted returns or alpha.
Despite their terrible expected return profiles,
thematic indexes may still be delivering positive returns
that are unexplained by a factor model.
In reality, while thematic indexes
do have positive alphas in back tests,
live funds, once launched,
tend to have negative alphas, as we saw earlier.
Another possibility is that some investors may want
the lottery-like payoff of specialized indexes
if they have high conviction in a given theme.
Who cares about expected returns
if you're just making a thematic bet
that the market has underpriced a certain theme?
As we would expect with lottery-like payoffs,
these will be losing bets on average
but winners could be big.
Or maybe investors are simply behaving irrationally,
chasing past returns in attention-grabbing investment themes
as they tend to do.
This behavior is well documented
in 2007 and 2020 papers by Brad Barber and Terrance Odean,
among many others.
A final possibility is there are non-financial benefits
to owning the stocks in thematic indexes.
Things like a need to belong,
feeling good about the investment
or satisfying a need for thrill seeking
are all documented reasons
that people choose to own assets separate
from their financial benefits.
I can definitely see this
for things like clean energy
or even ARKK where investors form a community
around their investment.
The title of this paper,
"Betting Against Quant:
Examining the Factor Exposures of Thematic Indexes"
is alluding to the fact
that quantitative investors
are often investing in stocks
with low prices, robust profitability
and conservative investment.
Investing this way can be done systematically
at a low cost and has theoretically sound
and empirically persistent positive expected returns
in excess of the market.
To build these portfolios,
quant investors need someone else
to overweight the small cap growth,
low profitability, high investment stocks
since all stocks in the market needs to be owned.
It seems like thematic investors
may be taking this junk off the hands
of quant investors.
Regardless of their financial performance,
another big hurdle for investors
is their own behavior.
In Morningstar's 2021 Mind the Gap report,
which compares the return of funds
to the return of the investors in those funds,
which are affected by the timing of their cash flows,
one of the biggest behavior gaps
is for sector funds.
Morningstar doesn't categorize thematic funds in this report
but I would be comfortable betting
that the behavior gap is even larger.
This was particularly problematic
for Cathie Wood's flagship ARKK ARKK fund
as documented by Morningstar.
At the end of November 2021,
ARKK Innovation had delivered
a staggering five-year compound return of 41.3%
but the average ARKK investor had earned only 9.9%,
not to mention the absolute collapse since then.
I tried to warn you guys.
Fund companies have a huge incentive
to create and market products
that cater to attention-grabbing investment themes.
The fees on thematic ETFs are a lot higher
than on broad market ETFs.
Take Cathie Wood's ARKK Innovation ETF,
which has a few of 0.75%
or the Horizons Marijuana Life Sciences Index ETF
with a management fee of 0.75%
and a management expense ratio,
including other costs of 0.85%.
This is way more expensive than a broad market ETF
or even a small cap value or value ETF.
It is good business for ETF providers
to ride these trends
but for investors, jumping on thematic bandwagons
is one of the worst approaches
to investing money, both in the short run,
unless you get lucky,
and definitely in the long run.
Thanks for watching.
I'm Ben Felix, portfolio manager at PWL Capital.
If you enjoyed this video,
please share it with someone
who you think it could benefit from the information.
We also discussed this topic in episode 185
of the Rational Reminder Podcast.
(upbeat music)