Concentration Risk in Thematic and Sector Funds: What Investors Need to Know

The asset management industry has discovered — or rather rediscovered with modern packaging — that investors are far more excited about investing in "the future of artificial intelligence" or "the clean energy transition" than in "a basket of large-cap global equities". Thematic exchange-traded funds (ETFs) and sector funds have proliferated rapidly, covering everything from genomic revolution funds to cybersecurity, plant-based food, and digital payment infrastructure.

The narrative appeal is real. The financial evidence on their actual performance for investors is considerably less flattering. This guide examines the structural risks in thematic investing, what the historical data shows about post-launch returns, and how to think about sizing any thematic position within a broader portfolio.

How Thematic ETFs Work

Thematic ETFs identify a broad investment thesis — the growth of artificial intelligence, demographic ageing, emerging market consumption — and construct a portfolio of companies they consider relevant to the theme. This typically involves a combination of screens: revenue exposure to the theme (often a minimum of 50% of revenue), market capitalisation thresholds to ensure liquidity, and occasionally fundamental screens for quality or growth characteristics.

The construction process immediately raises questions. What constitutes "AI exposure"? Does it include semiconductor manufacturers (certainly), cloud infrastructure providers (yes), enterprise software companies (arguably), and diversified conglomerates with one AI division (questionable)? Different index providers answer these questions differently, resulting in thematic ETFs covering nominally the same theme with wildly different holdings.

Concentration: The Top-10 Holding Problem

One of the most consistent structural characteristics of thematic funds is high concentration in the top holdings. Unlike a broad market index — where the top 10 holdings of the MSCI World represent approximately 20–25% of the portfolio — thematic ETFs frequently see their top 10 holdings constitute 40–60% of net assets.

This concentration creates several risks:

Idiosyncratic risk is not diversified away. Standard portfolio theory holds that diversification across many holdings reduces company-specific (idiosyncratic) risk, leaving only the systematic market risk that investors are compensated for. A 50-holding thematic ETF with high concentration in its top 10 names carries substantial company-specific risk that a broad index eliminates.

Sector and factor concentration. Thematic funds by definition concentrate in specific sectors. An AI thematic fund is essentially a technology sector fund with additional screens. Technology sector funds themselves often have high concentration within a small number of mega-cap names. Investors already holding a broad MSCI World index fund have approximately 20–25% in technology (as of 2025); adding a technology-adjacent thematic fund significantly increases the effective technology exposure beyond what the headline allocation implies.

Liquidity mismatch in smaller themes. The smallest thematic ETFs may hold positions in mid- and small-cap companies that are individually illiquid. Under normal conditions, the ETF maintains liquidity through the creation/redemption mechanism. Under stress conditions — where selling pressure in the theme is acute — the ETF may trade at a significant discount to its net asset value.

High Valuations at Launch: The Narrative Premium

The timing problem with thematic funds is perverse. Thematic ETFs typically launch when a theme is already generating significant investor enthusiasm — often after a period of strong price performance that has attracted media attention. The companies within the theme have frequently already re-rated to high valuations by the time the ETF reaches the market.

This is not coincidence. Asset managers launch products they believe investors will buy. Investors are most enthusiastic about narratives that recent price performance has validated. The result is that thematic funds are launched — and gather their largest inflows — at precisely the moment when the valuation premium for the theme is greatest and prospective returns are consequently lowest.

Research by Morningstar and academic studies examining thematic fund launches consistently find that the funds launched at the peak of a theme's narrative popularity tend to underperform the broad market by significant margins in the following 3–5 years. Survivorship bias compounds the problem: the thematic funds that performed poorly and were subsequently closed are absent from long-run performance databases.

Historical Evidence: Post-Launch Underperformance

Morningstar's research into thematic funds globally has consistently found that:

• Over a trailing 15-year period, more than three-quarters of the thematic funds available at the start of the period had closed by the end of it, primarily due to poor performance and resulting outflows.
• Only around one in ten thematic funds both survived and outperformed the broad global equity market over that 15-year horizon.
• Underperformance tends to be concentrated in the years immediately following launch, consistent with the valuation-at-launch thesis.

This does not mean every thematic fund fails. Clean energy funds launched in the early 2000s, when valuations were undemanding and the energy transition was genuinely underpriced by markets, delivered excellent long-run returns. But identifying the themes that are genuinely early-stage — and therefore attractively valued — rather than those that have already been priced by enthusiastic early movers is genuinely difficult and requires more than observing that a technology is important.

Survivorship Bias in Thematic Data

Any assessment of thematic fund historical performance must grapple with survivorship bias. Fund databases typically include only funds currently in existence. Funds closed due to poor performance — which are not randomly distributed but concentrated in the weakest performers — are absent. This creates the systematic illusion that the average thematic fund has done better than it actually has for the average investor who allocated capital at the peak of a theme.

Morningstar's forward returns analysis (which tracks prospective returns for funds from a given starting date, including all funds in existence at that date regardless of whether they subsequently close) typically shows thematic fund performance considerably weaker than backward-looking averages suggest.

When Themes Are Legitimate

Not all thematic investing is equivalent. There is a meaningful distinction between:

Genuine structural themes with long runways and reasonable valuations. The long-run case for renewable energy investment is grounded in policy mandates, cost curves (solar and wind have become the cheapest forms of new electricity generation in most markets), and physical necessity. If renewable energy stocks are not excessively valued relative to their growth prospects, this is a legitimate long-run theme with genuine earnings support.

Narrative-driven themes with uncertain revenue models and high valuations. Many blockchain, metaverse, and Web3 themed funds fall into this category: genuine technology innovation, uncertain monetisation paths, and valuations driven primarily by excitement rather than cash flow analysis.

The question to ask of any thematic investment is not "is this theme real?" (most are) but "are the companies in this theme priced to deliver competitive returns given the growth already expected by the market?"

Position Sizing: 5–10% Maximum

Given the risks outlined above — concentration, valuation at launch, survivorship bias, narrow exit opportunities in stress scenarios — thematic positions should be sized as satellites rather than core holdings. A maximum of 5–10% of the total equity portfolio in any single thematic strategy is a reasonable upper bound for most investors.

This sizing acknowledges that the theme might be right without betting the portfolio on being right about timing, valuation, and specific company selection within the theme.

Comparing the Major Providers

iShares (BlackRock), Invesco, and Global X are the largest providers of thematic ETFs in the UCITS market. Total expense ratios typically range from 0.40% to 0.65%, higher than broad market ETFs but lower than active funds. The ongoing charge does not capture the implicit cost of buying into premium valuations at launch.

When evaluating any thematic ETF, key questions include: How concentrated are the top holdings? What is the fund's age (younger funds have less performance history)? What is the underlying index's methodology? Are the constituent companies generating positive free cash flow, or are they pre-revenue?

Compliance and Regulatory Note

Thematic and sector funds are not diversified across the broad market and carry concentrated sector and stock-specific risks. High concentration in a small number of holdings increases the potential for significant capital loss. Past performance of thematic investments is not a reliable indicator of future returns. The themes or sectors in which thematic funds invest may experience rapid changes in competitive dynamics, regulation, and technology that can adversely affect fund performance. This article is for information only and does not constitute personal financial advice.

How Global Investments Can Help

Thematic investing is one of the areas where investor enthusiasm most frequently runs ahead of realistic expected returns. At Global Investments, we help clients evaluate thematic allocations on a rigorous financial basis — examining valuations, concentration, underlying earnings quality, and the implicit market expectations already embedded in fund prices. Where thematic allocations are appropriate within a client's portfolio, we implement them at sensible position sizes as part of a coherent overall strategy. Contact our team to discuss how thematic or sector-specific opportunities can be incorporated into your portfolio without inappropriate concentration risk.