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.

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Important information and general advice warning

Vanguard Investments Australia Ltd (ABN 72 072 881 086 / AFS Licence 227263) is the product issuer and the Operator of Vanguard Personal Investor and the issuer of the Vanguard® Australian ETFs. We have not taken your objectives, financial situation or needs into account when preparing the above article so it may not be applicable to the particular situation you are considering. You should consider your objectives, financial situation or needs, and the disclosure documents for any relevant Vanguard product, before making any investment decision. Before you make any financial decision regarding Vanguard investment products, you should seek professional advice from a suitably qualified adviser. A copy of the Target Market Determinations (TMD) for Vanguard's financial products can be obtained at vanguard.com.au free of charge and include a description of who the financial product is appropriate for. You should refer to the relevant TMD before making any investment decisions. You can access our IDPS Guide, PDSs Prospectus and TMD at vanguard.com.au or by calling 1300 655 101. Vanguard ETFs will only be issued to Authorised Participants. That is, persons who have entered into an Authorised Participant Agreement with Vanguard (“Eligible Investors”). Retail investors can transact in Vanguard ETFs through Vanguard Personal Investor, a stockbroker or financial adviser on the secondary market. Retail investors can only use the Prospectus or PDS for informational purposes. Past performance information is given for illustrative purposes only and should not be relied upon as, and is not, an indication of future performance. This article was prepared in good faith and we accept no liability for any errors or omissions.

Smart Investing, Vanguard