digest
Short Summary
Main recommendation: Avoid thematic investing, meaning ETFs and index funds built around trendy, exciting themes such as crypto and blockchain, marijuana, psychedelics, cloud computing, electric vehicles, clean energy, robotics, and artificial intelligence, because they tend to underperform the market. Speaker Ben Felix argues that the excitement itself drives up prices, and that specialized thematic ETFs are typically launched near the peak of both hype and returns, leaving later investors with weak expected results.
Key Points
- Thematic ETFs are usually launched after an investment theme's peak excitement and returns, and the study cited (Ben-David and co-authors, 2021) found they delivered a negative four-factor annual alpha of about 6% on average over the five years after inception.
- Thematic indexes are back-tested before launch and tend to have rising prices, media sentiment, and analyst growth forecasts; after launch, valuations and sentiment tend to fall back.
- Overconfidence among entrepreneurs and investors inflates prices in big potential markets, and the 2020 Cornell and Damodaran paper cites e-commerce in the 1990s, online advertising from 2015 to 2020, and cannabis stocks in 2018 as examples.
- Growth in earnings per share matters more than market size, and heavy share issuance by new and existing companies chasing a theme can dilute returns, as formalized in Bernstein and Arnott's 2003 "Earning Growth: The Two Percent Dilution."
- Thematic indexes tend to be concentrated in small-cap, high-priced, weakly profitable, aggressively investing stocks, which Blitz's study found delivers the worst risk-adjusted returns of any factor-based portfolio sort.
- Investor behavior compounds the problem: Morningstar's 2021 report showed the largest behavior gap for sector funds, and ARKK Innovation's five-year return to November 2021 was 41.3% annualized while the average ARKK investor earned 9.9%.
Details Worth Noting
- Concrete instructions: The speaker gives no formal step-by-step method, but notes that excitement about an investment is a warning sign and that thematic ETFs carry much higher fees than broad market ETFs.
- Thematic ETFs often charge much higher fees than broad market ETFs; the speaker cites ARKK Innovation ETF at a 0.75% fee and the Horizons Marijuana Life Sciences Index ETF at a 0.75% management fee and 0.85% management expense ratio including other costs.
- Overconfident investors can push prices above their own fundamental value, because owning a stock gives them the option to sell to an even more overconfident buyer later, producing bubble-like behavior.
- Blitz's paper suggests possible reasons investors still buy these funds: they may not believe in factor models, they may want lottery-like payoffs, they may be chasing past returns, or they may gain non-financial benefits such as community or thrill.
- The speaker notes that quantitative investors may benefit from thematic investors taking on the small-cap growth, low profitability, high investment stocks they tend to avoid.
Bottom Line
Thematic investing is driven by hype that tends to inflate prices before launch and leave later investors with poor expected returns, so excitement about an investment is itself a warning sign.
