Thematic investing: Bets on growth and innovation may fall short

Thematic investing is all the rage in investment circles. The theory behind it is simple: By adjusting your portfolio to take advantage of major trends, Structural change and disruptive technologiesInvestors should be able to achieve superior performance over the long term.

But so far, the results have been lackluster. Morning Star 2023 According to the report, the majority of investors Performance was poor If you are buying a thematic strategy.

The failure of these strategies to generate superior returns is often due to advisors and investors accepting the conventional wisdom that putting capital into the most innovative, fastest growing industries should lead to outperform the market. However, this is far from the truth.

Sun sign

Consider the solar power industry: In the early 2010s, the U.S. Energy Information Administration projected that installed solar capacity would grow about 12% per year over the next 25 years.

Solar energy has shattered even the most optimistic expectations and transformed the world’s energy mix faster than any technology before it. To date, installed capacity has increased more than 40-fold, and dramatic technological improvements have caused the price of solar panels to plummet.

Read or listen: Thematic ETFs and Wealth Transfer, Sylvia Jablonski of Defiance ETFs

Those who invested Solar stocks They’ve made huge amounts of money. But since 2010, solar stocks have underperformed global stock markets by more than 90%. The main reason is competition: no company has been able to capture the economic surplus that the sector generates. Lacking market power, solar companies have had to continually pump rising sales into capital expenditures to keep up with rivals, depriving shareholders of cash flow.

Smoke and mirrors

On the other hand, just as fast-growing industries do not necessarily guarantee high stock returns, industries with shrinking customer bases can present attractive investment opportunities.

Take tobacco, for example. In 1965, the U.S. Surgeon General published research showing that tobacco causes cancer. Five years later, the United States banned advertising of tobacco products on television and radio. Other countries around the world followed suit, and by the 1980s, tobacco consumption had peaked globally and begun an irreversible decline. In the United States alone, per capita tobacco consumption has fallen by 90% since the 1960s.

And yet tobacco companies were the best-performing industry on the U.S. stock market for the next 50 years. Again, the competitive environment of the industry was key: advertising bans and burdensome regulations dramatically raised the cost of entry, bankrupting smaller competitors and giving monopoly power to the large incumbents, which in turn allowed them to increase profit margins and pay out capital to shareholders that would have otherwise been spent on capital investments.

Thematic investment results

Advisors deploying thematic strategies in client portfolios must always remember that identifying which technologies and megatrends will change the world is only half the battle: good old-fashioned industry analysis is still required to determine whether these structural changes will lead to benefits and, ultimately, returns.

After all, investors get paid in dollars, not innovation or growth.