How Wall Street Exploits Social Movements for Profit
What you need to know about "thematic" ETFs
Don’t let your money die so you can express your beliefs.
That’s what most investors do when they buy so-called “thematic” ETFs.
Thematic investing is a bit of a squishy term but generally refers to a fund that invests in companies that some think will benefit from societal and technological shifts. Environmental, social, and corporate governance or “ESG” is one form of thematic investing, but there are many other thematic ETFs out there.
Weed stocks
Blockchain
“Disruptive” technologies
“social sentiment” aka meme stocks
If an issue is trending on Twitter, you can probably find a fund company willing to wrap that issue into an ETF and sell it to you.
Thematic ETFs are a great business model for fund companies but often lead to bad outcomes for investors. To find out why let’s examine the evidence and apply basic logic to thematic investing.
Thematic ETFs are popular because they appeal to passion rather than reason
Here’s the basic pitch of most thematic investment funds: “Hey, you know that societal issue you care deeply about or that technology you believe will change the world? Give us your money, and we’ll invest in it.”
To be honest, it’s a pretty genius sales pitch. Why wouldn’t you want to align your money with your values?
Here’s one reason why; you’ll likely lose money, which means you’ll have less resources to dedicate to that cause you care about in the future.
Excitement and investing make a dangerous cocktail
Here’s a rule of thumb you might find helpful.
If you’re excited about what you're investing in, odds are it’s a bad investment.
The more excited you are about the companies you are investing in, the less likely you are to care about things like the earnings and debt loads of those companies.
An investor who buys an ESG fund wants to “feel good” about aligning their money with issues they care about, like green energy and social equality. If that’s your primary motivation as an investor, you’re likely to overpay to buy assets that make you feel good.
The dreadful performance of thematic ETFs is captured perfectly in a 2021 paper titled “Competition for Attention in the ETF Space” written by Ben-David et al.1 In this paper, the researchers lay out the scenario in which most thematic ETFs are created.
A particular technology or societal issue gains momentum in the public consciousness.
Right around the time excitement for that issue peaks, a thematic ETF is launched.
Given the excitement for this new trend, valuations of the companies within the thematic fund often peak in a similar timeframe.
Money pours into the thematic funds, further driving up valuations.
Eventually, the excitement wears off, and stock prices come tumbling back to reality.
The researchers found on average specialized ETFs lose 30% of their risk-adjusted value within five years of the ETF launching. They found that this underperformance was not driven by fees (which are high) but by the overvaluation of the stocks within the fund.
Here’s the quote that brings it all together.
“Overall, providers appear to cater to investors’ extrapolative beliefs by issuing specialized ETFs that track attention-grabbing themes.”