Introduction to Thematic Investing

Summary

• Thematic ETFs are ETFs that select underlying holdings based on their exposure to particular investment themes or ideas
• Thematic ETFs are typically agnostic to industry sectors and geographical boundaries
• While thematic ETFs differ from sector ETFs, the reason investors are attracted to them is typically the same – to gain exposure to a particular area of the market
• Typically, investors use thematic or sector ETFs to gain targeted or tactical exposure, and to complement their core or foundation portfolio allocations

What is thematic investing?

The goal of thematic investing is to identify megatrends and enduring structural forces that will affect the economy over time, and then position one’s portfolio to benefit from those forces, irrespective of the ups and downs of current or future economic cycles.

As most investors know, generating good share market returns requires identifying companies likely to produce healthy earnings and dividends over time.

In pursuing this quest, investors traditionally have had the choice of active managers attempting to pick winners, or passive managers taking a rules-based approach, such as investing in companies that meet criteria relating to price momentum, valuations or financial metrics.

The problem with many of these approaches is that the choice can be governed by short-run – or cyclical – dynamics.  Deciding which part of the cycle we’re in, and which companies will do well in that part of the cycle, is no easy task.

The table below summarises the differences between thematic investing and approaches relying on identifying and positioning for short-run economic cycles.

	Thematic or Secular Investing	Cyclical Investing
Investment Focus	Megatrends: Disruptive technologies, demographic changes	Geographic regions, sectors of the economy, factors such as momentum, value, quality, volatility
Type of change focused on	Structural	Cyclical
Investment horizon	Long Term	Short-Mid Term
Timing Considerations	Entry and exit timing less important	Entry and exit timing important
Illustrative size of portfolio	Smaller universe of securities	Larger universe of securities

Advantages of thematic investing

A primary benefit of longer-term investment approaches like thematic investing is that the timing of entry and exit points is typically less crucial than with more cyclically-sensitive investment strategies.

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.

Adoption of Technology in the US (1990 to 2020)

Source: Asymco, BlackRock

Thematic investing can also improve portfolio diversification, as returns are likely to have low correlation to swings in major regional or sector investment benchmarks.

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 anywhere in the world.

Of course, active managers are also able to take a thematic approach to investing. However, they are likely to face just as many challenges ‘picking winners’ from secular change as they currently do in picking winners from cyclical change.

One of the benefits of a passive market capitalisation 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.

In dynamic forward-looking markets of the type that lend themselves to thematic investing, the market, on average, has demonstrated a tendency to get it right over time with prices (or market capitalisation) leading fundamentals such as actual revenues and earnings.

Thematic investing is an approach that resonates with investors, as it taps into economic changes they can see and hear taking place around them every day.

What’s more, many of these megatrends – such as environmental, social, or technology-focused themes – tap into an increasing interest in socially responsible investing.

Megatrends likely to be sustained over coming decades

Other megatrends likely to be sustained over coming decades include:

• global population ageing
• climate change and the demand for clean energy
• Asia’s rising middle class
• adoption of robotics, and
• the increasing threat of cybercrime