Thematic

Thematic investing is a forward-looking investment approach that seeks to capitalise on megatrends and long-term structural changes.

We believe there are three overarching megatrends that are shaping the future:

• Demographic change
• Technological innovation
• Climate change

These are broad forces that reach into almost every part of our lives, and as they evolve – and interact – they create themes that have a radical, observable impact on the world. Thematic investing aims to identify these thematic opportunities, and make investments that potentially will benefit if they are realised.

As most investors know, generating good share market returns requires identifying companies likely to produce healthy earnings and dividends over time. Thematic investing is primarily about accessing the potential for significant growth. Most thematic investors are looking for opportunities to generate returns higher than those they would get from investing in the broader market.

Thematic investing focuses on structural, not cyclical themes. Where cyclical themes play out over the short and medium-term, structural themes – for example, the move towards clean energy – play out over a much longer term, and tend to be one-off shifts that irreversibly change the world.

Thematic investing is when an investor tries to identify long-term transformational trends, and the investments that are likely to benefit if those trends play out.

Thematic investing is explicitly forward-looking, often tapping into economic changes investors can see taking place around them, disruptive technologies, changing demographics and consumer behaviours.

The rise of cybersecurity is a good example, driven by rapidly increasing global spend by governments, corporations, and individuals to prevent cyber-attacks, data theft, industrial espionage, and other hacks.

The key benefits of thematic investing are:

• Growth potential: Exposure to transformative, long-term themes typically offers the potential for significant growth.
• Timing is less important: Because of the long-term nature of these themes, the timing of entry and exit points is less important than it is when investing based on economic cycles. Buying into the theme has the potential to be profitable whether the ‘wave’ is caught right at the start, or picked up a little later on.

Shown below, the rate of adoption of major technology changes over the past century – such as the telephone, electricity, cars and radio – has been measured in decades. The pace of technological innovation is unrelenting, with more recent changes such as the internet, smart phones and social media just as disruptive, and take-up more rapid.

Unconstrained

Thematic investing ignores geographical boundaries, sector classifications and style biases, meaning that investors are unconstrained in looking for investment opportunities, and can take a far more flexible approach in thinking how industries and companies work in a global universe.

Potential for alignment with an investor’s philosophy or values

Thematic investing can cater to an investor’s philosophy or values by tilting their portfolio towards a specific theme that resonates with them, such as environmental, social, or technology-focused themes.

Spreading portfolio risk

Thematic investing can help to spread portfolio risk as returns have tended to have low correlation to swings in major regional or sector investment benchmarks.

Suited to a passive investment approach

ETF thematic investing readily lends itself to a globally diversified passive approach – using rules to identify companies with revenue exposure to a secular trend, and then investing in a broad selection of the leading players from around the world.

Identifying a thematic opportunity you think provides significant long-term growth potential is an important part of thematic investing. The next step is deciding how to position yourself to benefit from it – who will the winners and losers be as the theme plays out?

A high-risk/high-reward strategy is to invest in one or several companies that you think will benefit from the trend. For every Amazon or Netflix, there may be hundreds, even thousands, of companies trying to exploit the same opportunities that fail, making the process of ‘picking winners’ extremely challenging.

An alternative is a thematic ETF, which provides exposure via a basket of securities rather than trying to pick a few ‘winners’.

This approach reflects the idea that in emerging industries undergoing structural growth, we may not know who the winners will be, but if you can hold all the stocks within that industry/thematic, and let the market decide the weighting of your portfolio by having a market capitalisation-weighted exposure, you can ensure you participate in the winners.

In other words, while you may not know who the next Amazon or Netflix will be, by investing in the industry/theme as a whole, you can ensure you have exposure to them.

Most thematic ETFs track indices that have been constructed to measure the performance of companies that participate in the particular trend.

We believe that thematic investing typically is suited to a market cap-weighted approach.

One of the benefits of a passive market cap-based indexing approach is that it tends to increase portfolio weightings to emerging ‘winners’ with rising market cap over time, while cutting exposure to ‘losers’ with declining market cap.

We believe there are three broad megatrends that drive thematic investment opportunities, structural changes that are creating permanent shifts to the way the world works:

• Technological innovation
• Demographic change
• Climate change

Each of these megatrends has implications for almost everything we do. We can see and experience their impacts in our lives today, and we also know they will have both predictable and unforeseen consequences for the remainder of the 21st century.

Technological change and the growing dominance of the digital economy is arguably the most significant megatrend in terms of creating thematic investment opportunities.

Demographic change includes trends such as:

• ageing populations
• slowing population growth rates
• the expanding middle class in emerging economies such as China and India.

As a megatrend, climate change encapsulates:

• the impacts and resource scarcity caused by climate change and environmental degradation
• policy initiatives designed to support decarbonisation and the climate transition
• consumer and investor preferences for sustainability.

An investor’s time horizon, tolerance for risk and overall investment goals are important considerations when deciding whether to buy into or sell out of any investment.

The main benefit of thematic ETFs lies in the possibility of gaining investment exposure to a specific theme.

While broader-based indices such as the Nasdaq-100 Index are often the focus of much of the discussion in investing communities, if an investor is seeking a specific type of technology exposure, such as robotics & A.I. or cybersecurity, a thematic ETF may be worth considering.

As another example, a broader-based index such as the S&P/ASX 200 provides access to the top 200 companies in Australia, but if an investor is seeking exposure to Australian technology companies specifically, they might consider a thematic ETF such as Betashares S&P/ASX Australian Technology ETF (ASX: ATEC).

Like all investment approaches, thematic investing is not without risk. Given the long-term nature of megatrends, there is the risk that the trend will take longer than expected to be established – or even that it does not materialise at all.

In saying that, we believe thematic exposures can provide strong potential for returns as part of a well-diversified portfolio, as well as exposure to markets that may have previously been difficult, or impossible, to access.

Investors typically use thematic investments to complement broad market core exposures, rather than to replace them.

For example, an investor might construct the core of their portfolio using ETFs that provide exposure to the broad Australian sharemarket, international shares, and fixed interest. They could then consider adding thematic investments as a smaller part of the portfolio, with the objective of seeking extra growth from exposure to themes in which they have conviction.

Investors can of course choose individual stocks that they hope will do well if a theme plays out. However, picking winners is notoriously difficult.

Another option is to gain exposure through a managed fund or ETF. Thematic ETFs typically invest in a portfolio of companies meaningfully exposed to a chosen theme, reducing stock-specific risk. They are necessarily exposed to theme-specific risk, so will typically trade with a higher level of volatility than a broad market core exposure. However, when blended with broad-based core holdings, a thematic ETF can add diversification benefits, as well as outperformance potential, to your portfolio.

As is the case with all investments, you should consider your time horizon, tolerance for risk and overall investment goals in deciding whether thematic ETFs are a suitable investment for you.

It’s important to assess the quality of exposure an ETF, and the index it tracks, provides to the chosen theme, which comes down largely to the index methodology.

Ideally, the index should provide a ‘pure-play’ exposure – the basket of securities in the index should represent the particular theme without its focus being diluted by exposure to other themes or sectors.

In analysing how ‘pure-play’ an exposure is, a couple of measures can be helpful.

The correlation with the broader market is one indicator – for example comparing the thematic index with an index like the NASDAQ 100 Index. A low correlation with the broad market can be indicative of a strong pure-play exposure, while a high correlation may suggest a lower pure-play thematic.

Looking at the overlap in holdings between the thematic index and the broad index can also be instructive, with a low overlap being preferable.

While there are no cast-iron rules around these two measures, a combination of low correlation and low overlap can be taken as an indicator that the theme has a reasonable divergence from the broad market.

It’s also important to keep an eye on costs. Index-tracking thematic ETFs tend to be more cost-effective than actively managed thematic funds.