How mutual funds are tapping into the bull market

In 2022 Itzhak Ben-David, Francesco Franzoni, Byungwook Kim and Rabih Moussawi, four academics, published research suggesting that thematic equity ETFs, which attempt to track a narrow industry or trend, underperform broader ETFs by about a third over the five years after their launch. That is because of a straightforward problem: when thematic ETFs get going, the buzz around the investment is already extensive and the underlying assets are already pricey.

Now, for those of us who have been around for some time, this research only confirms what we know for a fact i.e., thematic funds are a no-go for most investors.

But that does not stop the tens of thousands of experienced investors, let alone the new ones, from giving into their greed every time a thematic opportunity comes along.

In 1999, it was TMT – technology, media, and telecom.

In 2004-07, it was infrastructure and real estate.

Today, it is energy, PSUs, and Pharma. Earlier in 2023, it was all small caps and midcaps.

Why is this so?

Well, the promise of a theme to continue delivering stupendous returns is just too great to be diluted by historical facts. To an investor, it’s always different this time around. Unfortunately, the results are often the same i.e., underperformance.

So, while we can discuss endlessly about investor greed and fear, there’s another angle to this which needs to be explored. And that is…

Why do mutual funds, in general, cheer along investors as they are making this potentially grave investment mistake?

Take a look at these tables.

In this first table, I list out all the “equity” NFOs that have hit the market since the start of 2024:

Now, one thing is absolutely clear from this. The focus is on launching sectoral and thematic funds.

Yes, there’s a dedicated large cap fund in there, which one can say is a contrarian approach. Ditto for the focused fund.

And if you thought a few data points don’t a trend make, see this…

This is the list of all “equity” NFOs due to hit the market shortly:

Now, what do you have to say to that? The entire mutual fund industry is focused on tapping into this excitement. 

I hasten to add that among these is a technology focused NFOs, which could be considered a contrarian theme i.e., it has yet to become “popular.” 

Unfortunately, however, the overall trend is clear. The mutual funds are serving you what you are chasing. They are not doing what is “sahi.” 

Or perhaps they are. It’s “sahi” for them. 

Meanwhile, you need to decide how to approach investing on your own, or with the help of your investment advisor. Perhaps these guidelines will help:

First, shun all thematic/sectoral investing. As research as shown, by the time you start to invest in a popular theme, it’s already pricey. And hence, often such funds underperform in future (See the research quoted above). In any case, if the theme is good, and offers potential, your equity fund manager would already own it in the “diversified” fund.

Second, stick to one, perhaps two, diversified equity funds. I believe these are now called Flexicap / Focused funds. These give the fund manager, the expert, the flexibility to pick the best investment opportunity at any point in time. That way, you, who is probably not an expert, will not have to decide which sector to invest in every now and then. 

Third, spend a lot of time on deciding which fund management team to go with. Once you zero in on the team/s, then given them the money, and let them decide where to invest i.e., pick a diversified fund. 

Fourth, if you do not want to even select a fund management team, or believe you are unable to do so, simply stick to an extremely low-cost index fund. Avoid thematic index funds! 

Fifth, always remember to stick to your overall asset allocation, and also your portfolio allocation. If you do that, you have already won half the battle to create long term wealth. The added bonus is that a well thought through framework will also save you from all these NFOs that will continue to hit the market for ages to come. Sahi or not sahi. 

Happy “non-thematic” investing! 

Note: I am sure there will be that rare instance where thematic investing does make sense. Having said that, I am yet to come across any. 

Rahul Goel is the former CEO of Equitymaster. You can tweet him @rahulgoel477. 

You should always consult your personal investment advisor/wealth manager before making any decisions.