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Thematic Investing: Capturing the Big Changes

Thematic Investing: Capturing the Big Changes

Aug. 03, 2016

Aug. 03, 2016

Thematic investing is a relatively new development in modern portfolio management. It has gained momentum in recent years in line with the disruptive power of innovation and emerging macroeconomic trends that are shaping the world at a pace augmented by the mass economy, technology and globalization.

The identification of megatrends that may significantly outgrow the standard economic and business cycles is carving a place and setting new approaches in asset management, as investors seek superior returns. Thematic investing aims to capture those future trends at the earliest possible stage of development, and build a portfolio of securities and assets that can benefit the most from those success stories of the next few years.

Some trends that have been the subject of thematic investing include global warming, the emerging middle class, water scarcity and Internet penetration.

Thematic vs. traditional indexing

Through thematic investing, a portfolio is constructed by selecting themes, sectors, or regions across assets based on underlying market trends. This contrasts with the more traditional portfolio construction that selects asset classes based on economic cycles and market conditions. In traditional, benchmark-driven portfolio construction, primarily securities such as equities but also asset classes work as building blocks. In thematic investing, the building blocks are, for instance, the sector and country exposures.

Thematic investing is agnostic to traditional indexing parameters such as market capitalization and sector classification, as neither helps identify “winners” of the targeted megatrend. The result is a unique approach to asset allocation that incorporates a top-down view of a portfolio, combined with bottom-up stock selection of businesses best positioned to capitalize on the megatrend.

As a recent report1 from consultancy firm McKinsey notes, the generation of alpha switches from security selection in traditional index investing, to the selection of companies in certain sectors that will benefit from specific long-term structural trends. In other words, investment talent is defined by the right identification of themes rather than picking outperforming businesses or assets.

Some strategists note that exposure to one disruptive theme lowers the risk of a portfolio, as the targeted trend runs on its own structural underpinnings and, as such, is less affected by the ups and downs of the economy. Given the concentration of the investment exposure, a thematic portfolio is often measured against a pre-established absolute return target that is not linked to any market benchmark, as is the case with traditional index investing. This return is also usually considered in multi-year horizons.  

Thematic investing requires a keen understanding of structural changes to differentiate long-term trends from short-term fads. Elaborating an efficient exposure to a selected theme, and utilizing the right distinctive knowledge and existing investment capabilities are all challenges in a profitable thematic-investing strategy.

A recent study2 by RBC Global Asset Management showed that a portfolio which incorporates thematic investing outperformed the broader global equity market in 5-, 7- and 10-year periods.

Forward-looking

Thematic investing tries to be forward-looking and predictive. In fact, it lies on the premise that the best returns can be captured when the initial signs of a trend are manifested. Because themes tend to unfold and grow over multi-year periods, it can take a while for thematic investing to produce results.

It has been, until recently, best targeted through less liquid investments such as infrastructure, private equity, venture capital and listed small caps. To a large degree, this has hitherto limited thematic investing to the work of specialized asset owners and investors.  

However, institutional investors whose mandate is limited to traditional assets and defined by the focus of annual returns can target thematic investments via a portfolio of equities, mutual funds and exchange-traded funds. In these cases, thematic investing can be used as a complement or overlay to existing portfolios, an option that does not involve a complete overhaul or reconsideration of their investment structures. It is here where thematic investing may see the bulk of growth in coming years.  

Thematic investing raises the bar in asset allocation possibilities, particularly for institutions with long-term investment horizons. New offerings are likely to emerge in portfolio management as an increasing number of participants acknowledge the advantage of targeting enhanced returns from disruptive trends. This will undoubtedly be true in the world of index investing.

In an upcoming article, PULSE ONLINE will report on existing index offerings covering thematic investing.

 

1 From indexes to insights: The rise of thematic investing’, McKinsey, 2015.

2  ‘Global Megatrends: Capitalizing on Tomorrow’s Trends Today’, RBC Global Asset Management, 2014.

 

 

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