This article has been written by expert contributor, Tony Kaye, Senior Personal Finance Writer, Vanguard Australia.
Investing in trends is a relatively new phenomenon. But trends can often hide investment traps.
There’s a saying, that today’s newspaper is tomorrow’s fish wrap.
It’s an old saying, because most people don’t buy physical newspapers these days. But the meaning is still quite clear – what’s often leading the news one day will be gone, if not forgotten, by the next.
It’s a good lesson for investors in an era where investing in today’s trends, or the prospect that something may become a trend in the future, has become an accelerating trend in its own right.
Beyond investing in companies involved directly or indirectly in industries or markets that are currently booming, or are expected to boom, it has become easy to invest across a rapidly evolving universe of listed thematic investment products.
Think of a current trend, or a potential trend, and there’s bound to be at least one investment product that’s been designed around it. These “flavour of the month” products may invest in a grouping of stocks that are aligned to a specific investment theme (based on a current or emerging trend), or in some cases physical currencies or commodities.
Buyer beware
Choosing to invest in a trend, or a potential trend, is potentially a risky strategy.
Investment trends don’t necessary last, and future potential trends may never eventuate.
Australian Securities Exchange (ASX) monthly data on exchange traded products shows wide variations in the performance returns across different thematic ETF products. Some have produced double-digit positive returns over the short term, but have underperformed the broad share market when measured against the S&P/ASX 300 Index over the longer term.
One reason for this is that the fees on thematic ETFs are typically much higher than those of broad-based index funds,.
But it also directly reflects the performances of the underlying companies or other assets that the thematic products are investing in – which are either hand-selected or based on a niche market index. Some thematic products are comprised of just a handful of stocks, or one type of asset class.
Fundamental to the performance of trend-following products is investor demand to participate in a current hot trend, or a potential trend. Strong demand for a real or perceived trend can artificially inflate market prices.
A report published in March 2023 in the influential Review of Financial Studies academic journal found that specialised ETFs that focus on an investment thematic are generally launched when the hype around a specific thematic is increasing or peaking.
Fear of missing out (FOMO) on an investment opportunity is a key behavioural driver for many investors. Yet, trendy investments and products don’t necessarily have long-term staying power.
That’s because investment trend seekers often decide to take out their profits early and move on to something else, which can then trigger a significant downturn in the investments that they sell.
The Review of Financial Studies report authors found that the stocks packaged within the thematic products are often overvalued at the time of the product launch, and that ETFs focused on trends on average lose about 25% of their market value on a risk-adjusted basis over their first five years.
Diversification is key
Investing in a theme could deliver upside performance over a short period, but equally there could be significant downside exposure risks.
Last year the Securities and Exchange Commission (SEC) in the United States issued a warning to investors on the potential risks of a new breed of products known as single-stock ETFs.
Single-stock ETFs – as their names suggests – invest in just one company. Using complex financial instruments such as derivatives, single-stock ETFs enable investors to leverage their positions and take short-term bets on whether the company’s share price will rise or fall.
These high-risk products are not available on the Australian share market.
How you allocate your investment capital can be one of the most important, and often difficult, decisions.
Your asset allocation strategy should always be in tune with your investment goals and your tolerance for taking risk.
While some investment trends do offer clear upside potential, keep in mind that others may be high risk and very likely to result in a loss.
A key benefit of investing in broad index funds, through an ETF or an unlisted managed fund, is the in-built sector diversification that they provide in comparison with a narrowly focused thematic product.
If you invest in a single company, you’re basically only buying into that company’s operations and the particular sector in which it operates.
Investing in a few companies can provide you with some diversification, unless all of those companies are operating in the same market sector.
Alternatively, one investment in a broad index fund will provide exposure to many companies operating in many different sectors.
To get even greater diversification, you can consider repeating the process for other international markets to build a highly diversified global investment portfolio.
Tony Kaye is Senior Personal Finance Writer at Vanguard Australia. In his role, Tony regularly produces topical investment-related articles and educational content designed to help investors make well-informed decisions.
Tony is a former managing editor and financial journalist, and his articles are published in Vanguard’s weekly Smart Investing newsletter and elsewhere.
The above material has been republished with the permission of Vanguard Investments Australia Ltd.