Chapter 1: The Allure of Thematic Investing

When it comes to investing, a sense of excitement can often cloud judgment. If you're particularly enthusiastic about your investment choices, it may signal a potential risk.

Investing merely to express personal beliefs can lead to financial losses. This is particularly true for investors who purchase thematic ETFs. The term "thematic investing" can be somewhat ambiguous; however, it typically refers to investment funds targeting companies believed to benefit from significant societal and technological changes. Environmental, social, and corporate governance (ESG) investing is a subset of this, but thematic ETFs encompass a wider array of interests, from cannabis stocks to blockchain and various "disruptive" technologies.

If a topic is trending on social media, chances are there's a fund ready to package it into an ETF for you. While thematic ETFs can be a lucrative model for fund providers, they often yield disappointing results for investors. To understand this phenomenon, it's vital to consider both the evidence and the inherent logic of thematic investing.

Thematic ETFs often thrive on passion over rational thought.

The typical pitch for these funds is compelling: "Care about a pressing social issue or an innovative technology? Invest with us, and we'll channel your funds into it." While this approach can seem appealing, it often leads to financial setbacks. The more emotionally invested you are, the less likely you are to scrutinize critical metrics like company earnings and debt levels.

Investors drawn to ESG funds often wish to feel good about their choices, aligning their money with values like renewable energy and social equity. However, this emotional drive can result in overpaying for investments that simply appeal to their beliefs.

The poor performance of thematic ETFs is notably illustrated in the 2021 research paper "Competition for Attention in the ETF Space" by Ben-David et al. The paper outlines a common scenario: a particular technology or social issue gains traction among the public, coinciding with the launch of a thematic ETF. As excitement peaks, so too do the valuations of the companies within the fund. This inflow of capital further inflates these valuations. Eventually, the hype subsides, leading to a stark drop in stock prices.

On average, specialized ETFs can lose 30% of their risk-adjusted value within five years of inception, not due to high fees but rather from inflated stock valuations. The authors note, "Overall, providers appear to cater to investors' extrapolative beliefs by issuing specialized ETFs that track attention-grabbing themes."

Section 1.1: The Case of Canadian Cannabis Stocks

The Canadian cannabis market exemplifies the risks associated with the excitement surrounding thematic ETFs. In 2017, the North American Marijuana Index was established, tracking publicly traded companies within the marijuana sector. With the legalization of recreational marijuana in Canada in 2018, investor enthusiasm surged, resulting in the creation of multiple thematic ETFs focused on legal cannabis.

Following legalization, the North American Marijuana Index skyrocketed by 150% within a few months, attracting many eager investors. Valuations of cannabis companies soared, as the sector was perceived as a "growth industry." However, this volatility culminated in a peak in late 2019, and as of fall 2023, the index has plummeted by 87% from its 2019 high, even dipping below pre-legalization levels.

Thematic ETF providers benefit from high management fees and capitalize on investors' irrational beliefs that excitement equates to sound investment opportunities. When things go awry, they simply pivot to the next trending issue, rinse, and repeat.

For investors, the fallout is compounded. Losing money is disheartening, but the emotional toll is even greater when it involves causes you genuinely care about. Instead of risking your capital in thematic ETFs, consider a straightforward portfolio of index funds. If you wish to support a cause, allocate time and resources directly to it.

Subsection 1.1.1: A Better Approach to Investing

As you invest in index funds and watch your wealth grow over time, you'll be in a better position to contribute to the causes that matter to you.

Chapter 2: Seeking Knowledge in Investing

To delve deeper into investment strategies, consider exploring educational resources like the MOAM crash course on passive investing.

The first video titled "Making the Bullish Case for Cannabis" discusses the potential of cannabis as an investment, while also addressing the associated risks.

The second video, "Cannabis Stocks Squeeze," explores the volatility and challenges within the cannabis stock market.

This article is intended for informational purposes only and should not be viewed as financial or legal advice. Always consult a financial professional prior to making significant financial decisions.