The value of thematic investing

Why themes?

Thematic investing is often considered a mixed blessing because novice investors can fall prey to slick marketing and popular fads which prove anything but durable, and therefore turn out to be costly – often the ‘popularity’ is already reflected in share prices. Too often funds are launched which capture the mood of the moment, but which then wither on the vine. There can be no substitute for fundamental research as to the resilience of the trends in question, and there also needs to be a clear commitment to then stay the course given the path is rarely a smooth one.

Both the problem and perception have been compounded by the explosive growth in the number and scope of thematic ETFs, which can often be blunt instruments when seeking to capture certain themes. Often large companies are held because of their marketability given the liquidity requirements of ETFs. These companies can look to tick the box but which on closer examination, because of their other component businesses, are often far from being a pure play on the theme in question.

Meanwhile, other ETFs can distort markets by taking large stakes in smaller companies or by not accurately reflecting the chosen sector because of complexities – the myriad of crossholdings within the commodity sector, which are hard to replicate particularly when it comes to SMEs, being one example of where ETFs struggle. This is not to say thematic ETFs should be shunned completely but, as ever, careful selection remains of paramount importance.

However, such pitfalls should not blind investors to the generous returns to be harvested from pursuing the right themes. Portfolio returns by region or geography tend to be more correlated to the relationship between macroeconomic performance and market valuations. Such factors are less influential in deciding the returns from thematic investing and so can offer an element of diversification as well as better performance.

Despite the immediate outlook for globalisation, the world is becoming more transparent and connected despite some governments’ best efforts. Thematic investing allows investors to embrace a broader perspective given the investment opportunities across global equity markets – profitable opportunities which transcend portfolio allocations based purely on geography. And the importance of perspective to good fund management should not be underestimated – very often the big picture view aids stock selection.

Portfolio managers are recognising the potential. At an important seminar on thematic investing in 2019, BlackRock highlighted various long-term global trends which are encouraging structural shifts in many sectors and industries – and these, in turn, are influencing the trajectory of corporate earnings. As Alistair Bishop, managing director, put it: “These forces, which we call megatrends, are giving rise to a new set of powerful investment themes – the advent of disruptive technologies, radical shifts in consumer choices, greater regulatory intervention, and new opportunities for growth.”

BlackRock focused on five megatrends: rapid urbanisation, climate change and resource scarcity, demographics and social change, the changing economic power of the emerging markets, and disruptive technologies. The company believes the most powerful investment themes will be the result of a confluence of at least two of these megatrends. And because of their nature, long-term horizons will be required. Investors will need to be aware of the life cycles of themes and possess the patience to fully harness the returns.

Alistair continued: “Themes have longevity because the key megatrends that underpin them tend to persist for a long time. However, across this extended timespan, themes evolve and change shape. Themes overcome hurdles and gain momentum. Themes can be accelerated by innovation but constrained by consumer inertia. Themes can be reinforced by corporate investments but hindered by regulatory uncertainty. Thematic investing is non-linear.” It is the long-term compounding effect of share prices which really matters.

Favoured themes

Our favoured trends are smaller technology companies, and the full spectrum of opportunities within the healthcare, private equity and climate change spaces.

The very nature of the latest technology revolution – the internet and, with it, digital transformation and adoption of more technology-enhanced business models, means the sector will continue to benefit somewhat from its own multi-year cycle. Smaller companies are preferred in part because of the valuations of their larger brethren, despite their recent correction, and regulatory concerns.

Ageing demographics, a more favourable regulatory environment and the emergence of an affluent middle-class coupled with urbanisation in many emerging markets are some of the reasons to be positive about healthcare. Scientific innovation is a further factor – the DNA discoveries of Watson and Crick in 1953, the sequencing of the human genome, and the falling cost yet increased power of computer technology is continuing to transform the landscape.

Another prominent theme pursued is that of combatting climate change and protecting the environment. Holdings in this sector can be used to help diversify portfolios – these being typically infrastructure companies which provide exposure to a range of renewable energy sources, while providing handsome yields. The theme is also pursued via companies which invest in businesses with eco-friendly products and services.

The case for private equity is particularly attractive at present given the discounts on offer. The gradual de-equitization of markets, together with the quality and track record of the private equity managers, suggest good asset performance will continue. Some of these companies focus on the secular growth themes mentioned above, and more.

Some of the themes pursued do indeed represent a confluence of at least two of the megatrends highlighted by BlackRock. For example, the healthcare sector will continue to benefit at least in part from disruptive technologies, ageing demographics and social change, as well as perhaps from the changing economic power of the emerging markets.

Meanwhile, mention has been made of the importance of maintaining portfolio balance relative to remit. Thematic investing needs to be balanced against a portfolio’s regional and geographic exposure given the greater the weighting to growth themes within the equity exposure, the higher the risk and therefore scope for returns (and losses).

Future columns will examine these and other themes in more detail.

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