Once you’ve decided on an asset allocation strategy that suits your plans and expectations, it is time to get more granular within each asset class. There are a number of ways to do this, for example last week, we wrote an introductory piece on Growth versus Value style investing. Another way to mix up your portfolio is to invest in specialist funds to express a particular view on the future direction of markets.
Specialist funds come in all styles (active and passive), shapes, and sizes and allow an investor to focus their portfolio on specific areas of the market, be it specific industries, countries or investment themes. For example, sector funds invest in specific industries such as technology, healthcare or financials. Country-specific funds invest in a single country, such as China. Then there are specialist funds that invest in specific commodities such as gold, or in specific projects such as infrastructure. Specialist funds can be a way for an investor to either make long-term calls on specific structural growth areas such as tech and healthcare, or to make contrarian bets on unloved sectors.
Then there are thematic funds, which focus on specific investment themes and can be divided into broad or narrow. Narrow thematic funds tend to invest in assets connected to one theme – it can be anything from artificial intelligence to agriculture. These are pretty similar to sector specific funds mentioned earlier. Then there are even more focused funds investing in sub-themes, ranging from fishing to frontier tech to cannabis. Broad thematic funds, on the other hand, invest in multiple themes that are part of the same umbrella, such as global mega trends.
However, it is worth being aware that most thematic funds tend to invest in growth-style areas and as a result, may not perform as well in an environment that is more favourable towards value-style investing. Only 9% of all thematic equity funds had an explicit value tilt as of February 2020, according to Morningstar.
The rise of thematic funds
In recent years, the number of thematic funds listed in Europe has been growing and they have been attracting more money as investors become interested in specific market themes. At the end of 2019, there were a total of 293 thematic funds available for European investors, with 47 of these launched that year. The total assets have also tripled in size over the past three years, cumulating to more than £80bn (Source: Morningstar).
It is perhaps unsurprising that technology has been one of the most popular themes over the last three years, since funds investing in technology have performed strongly. Within this theme, robotics and automation is the most popular sub-theme globally. In Europe, the most popular theme is resource management as a result of the popularity of water funds.
However, the research shows that many thematic funds don’t see quite so much success. Just over two thirds (69%) of thematic funds launched in Europe prior to 2015 had survived by the end of December, and only half of these managed to beat the MSCI World index.
One of the reasons for this underperformance are higher fees. The average management fee across Europe on active thematic funds is 1.25% and 0.52% for passives, versus 1.02% and 0.32% for active and passive non-thematic funds, respectively (Source: Morningstar). And as you already know, fees detract from your returns over the long term, so make sure they are worth paying. It is always good to look at the long-term returns after fees, before making a decision.
It is also important to manage your expectations when it comes to volatility. Both thematic and sector funds tend to be more volatile than diversified equity funds, which is understandably given that they put all their proverbial eggs in one basket. If the sector or theme underperforms, there is no buffer to protect the fund from this.
Core vs satellite
This is why specialist funds tend to be used as satellite investments – smaller positions added to a core portfolio in an effort to create more diversification. This is especially true for narrow thematic funds, single sector funds and single-country funds.
However, some investors use broad thematic funds as a core portfolio holding as these can be fairly diversified. For example, funds offering exposure to global mega trends invest across the globe and in a wide variety of sectors.
Specialist funds can be a fitting addition to a diversified portfolio, as long as you know what you are trying to achieve – general diversification, to express a particular sector/thematic view, or both? Once you know what you are trying to achieve it is important to understand how it will affect your risk/return profile and the volatility of your overall portfolio. By adding a specialist fund to your overall asset allocation, it can either improve your diversification or make your overall exposure more concentrated, depending on your starting point.
So, whilst specialist funds are far from perfectly diversified, jack-of-all-trades funds, they are masters within their own areas. And that can make them quite special indeed.
The information in this post is not financial advice, it is provided solely to help you make your own investment decisions. If you are unsure about whether an investment is appropriate for you, please seek professional financial advice. You can find more information here.
When you invest you should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return.