Buy what you know: Fund edition
One of the most overused sayings in the investment world is to “buy what you know”, to which I often reply that this may be true in theory, but in practice, people often overestimate what they know or have an illusion of knowledge. Yet, when it comes to fund managers who are managing portfolios with a thematic expertise, one can show that they outperform when they buy what they really know.
More and more funds, even broad market funds increasingly show a thematic bias. Whether this is a bias towards technology stocks, healthcare/biotech, green technology or other themes. The chart below shows four thematic word clouds generated from the 10-K filings of US mutual funds. Clearly, these word clouds capture very different themes. John Bai from Northwestern University and his colleagues used word clouds like these to identify how close a mutual fund tracks a specific theme or a collection of themes to figure out if a narrow thematic focus provides a performance advantage.
Thematic word clouds of the 10-K filings of US mutual funds
Source: Bai et al. (2022)
As you might guess, fund managers that have a clear thematic focus tend to perform better than generalists. A fund that is in the top 10% of most thematically focused funds outperforms a fund in the bottom 10% by some 2.9% per year. Increasing the thematic focus of a portfolio can thus pay off handsomely and make all the difference between beating the market and not beating the market.
But not every thematically concentrated fund performs well, and one key insight from the research of Bai is that fund managers with specific expertise in their education tend to outperform when they manage funds with a thematic focus on their area of expertise.
You want to have a trained chemist or biologist run your healthcare or biotech fund. You want to have a computer scientist run a technology fund and you want to have an engineer run a fund that focuses on industrials or the future of mobility. Because of their education, they have deeper expertise in these themes and can better differentiate between the truly great investment opportunities and the ones that just look good on the surface.
Similarly, the reverse could be true (though that is not tested in the research cited above). If you have a fund with a broad mandate but a fund manager with specific expertise, give the fund manager leeway to emphasise the themes where she is an expert. This increased focus can improve the performance of funds even if they are broadly diversified overall.