The pace of economic and technological change is accelerating at the fastest pace in human history. Consider this: There have been only 24 transformative general purpose technologies (GPT)* (e.g., steam engine, electricity, computer) introduced in all of human history. Seven of the 24 were developed in the 20th Century. In the first 20 years of this new century, already three new GPTs have emerged—business virtualization, nanotechnology and artificial intelligence—positioning our current century to double the pace of the most innovative 100 years in human history. For much of human civilization, about 6,000 years, generations of humans may have lived without ever seeing any real change. For instance, from start of the 17th Century to the late 18th Century, there were zero GPTs introduced. Today, at the current pace, we’ll see a new GPT emerge every seven years.
The significance of this rapidly-changing landscape is as obvious as it is profound. From an investment perspective, the accelerating pace of change forces investors, advisors and money managers to consider whether a relative investment framework tied to an index largely comprised of old-economy stalwarts will remain relevant amid successive waves of economic and technological revolution.
Recognizing the quickening velocity of change, market participants will increasingly reorient their drive for alpha by relying on insights rather than scratching out alpha by managing around the margins of some static index. In this white paper we define thematic investing, discuss the two different approaches in thematic investing, explore the varied ways to execute on a thematic thesis, and identify the advantages and disadvantages inherent in thematic investing.
Rather than attempting to generate alpha through the overweighting or underweighting of individual securities relative to an index, thematic investing looks to generate alpha by using a top-down investment approach that identify broad and technological trends that are expected to drive above-market growth in the stocks that profit from the trend.
The Two Approaches in Thematic Investing:
Cyclical themes, occur at short or medium term intervals, based on changes in the business cycle. Outperformance is unlikely to be sustained over longer periods of time since its cyclical nature tends to make such investments mean-reverting. Structural themes are singular, permanent shifts in the existing landscape. These themes are driven by powerful forces such as disruptive technology, changing demographics and consumer behavior. They have the potential to provide much longer and more profound outperformance.
These approaches are not necessarily mutually exclusive, but exploiting them will likely entail different investment strategies. For instance, investing in cyclical themes often involves basing buy-and-sell decisions on stock price momentum and shorter holding periods, while structural themes often require a longer-term view that demands patience until these themes permeate more broadly through the economy.
In 2022, you can contribute up to $20,500 to your 401(k) account. If you are age 50 or older, you can contribute up to $6,500 more. Constructing a thematic investment portfolio differs from building a traditional portfolio in a number of important ways. For instance:
It should be clarified that there is no fundamental conflict in the traditional investment approach and thematic investing. In fact, for most individual investors, the thematic and traditional strategies easily and comfortably exist side-by-side, with a traditionally-managed portfolio acting as a core holding and a thematic investment portfolio as a satellite holding that seeks to generate incrementally higher returns.
Crafting a thematic investment strategy is a multi-step process that begins with developing a thematic thesis and setting the appropriate portfolio risk parameters, and ends with constructing the portfolio. In between these two points lie many questions that investors and money managers need to ask themselves: Is the trend cyclical or structural? What is the economic size of the opportunity? Is the theme investable? Are the available investments in highly liquid public companies or confined to less liquid companies or companies with diluted exposure to the theme? What is the risk to an investment should a theme not materialize? Is the theme’s value chain fully understood? What is the conviction level for a particular theme, i.e., is it based on observable data or an individual hunch?
Investors can pursue thematic investments in one of two ways: either through individual securities or via thematic ETFs. Going the route of individual securities requires, of course, the research and analysis normally attendant with stock investing. However, this analysis presents an additional layer of challenge since it involves novel technologies and nascent macro social and economic trends that require an understanding that goes beyond company financials. As with all individual stock investing, diversification is also a challenge for investors with limited funds to devote to such a strategy.
Thematic ETFs are an ideal alternative to individual securities since they take care of security selection and offer greater diversification within a theme than an individual investor is likely to achieve on his or her own. Another attraction of thematic ETFs is that they have high active share and high beta, distinguishing those portfolios markedly from broad-based indices and providing investors with the potential for higher returns and increasing their overall portfolio diversification.
In implementing a thematic strategy, it is important not to confuse sector investing with thematic investing. For example, a technology sector ETF may be chock full of companies with disruptive technologies, but they may include technologies that are not part of an individual’s thematic thesis, thus diluting an investor’s exposure to a desired theme. Since both of the themes, cyclical and structural, are subject to highs and lows in investor popularity, and a theme’s adoption curve and stock prices rarely operate in tandem, a momentum investment strategy may be a particularly valuable approach for executing on a thematic investing strategy since it has a defined entry and exit discipline.
Since it's initial discovery, momentum investing has established a reputation as a reliable and successful investment strategy, supported by a large body of academic research, including the pioneering 1993 research paper, Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, and the 2014 study, Fact, Fiction and Momentum Investing, authored by Clifford S. Asness and members of his AQR Capital Management team.
One of the easiest ways to implement a thematic investing strategy is through ETFs, and the growth in thematic ETFs evidences growing public awareness and participation.
At the end of Q1 2021, there were 163 thematic ETFs with an aggregate of $133.1 billion in AUM, up by 28 percent from Q4 2020. In 2015, there was just over $10 billion in thematic ETF assets.
The most popular theme with $18.0 billion in AUM is disruptive technologies. Themes revolving around people and demographics (e.g., health, new consumer) had $6.1 billion in AUM, while ETFs associated with the physical environment (e.g., climate change, infrastructure) have $4.9 billion in AUM.
On a year-over-year basis, Thematic ETF AUM increased 430% from $25.1 billion at the end of Q1 2020
Healthcare Innovation remains the largest theme by AUM, followed by CleanTech and Cloud Computing.
As with any investment style or discipline, thematic investing comes with a number of potential benefits and risks.
Benefits
With expectations of modest capital market returns in the next decade, thematic investing may be one of the few ways to generate above-market returns.
Thematic investments may act as a portfolio hedge since it constantly focuses on trends and disruptive changes in the world. For example, if a retiree is investing in carbon-era companies (e.g., oil) for dividends, a clean energy ETF may hedge the stranded asset risk of oil investments.
A forward-looking discipline is more likely to profit from future progress than indices that reflect the old economy. For instance, the leading manufacturer of electric cars, which is not in the S&P 500, has a larger market capita-lization than all the auto companies in the S&P 500.
Low correlation to traditional equity indices could translate to higher returns in a thematic portfolio.
Risks
High volatility due to high portfolio concentration and uncertain future prospects. This is equivalent to putting all your eggs in one basket.
Identifying the wrong theme or a theme that takes too long to blossom may mean sub-par returns for an extended period of time or outright capital losses. For example, robotics—a hot theme in the 1980s—may be finally beginning to realize the future many expected for it 40 years ago.
A thematic thesis may be potentially upended by a change in tax policy, regulatory changes or disruptive technologies. Even a worldwide pandemic may undermine an investment thesis. For instance, one money manager has touted a trend toward urbanization, which the pandemic and work-from-home puts into serious doubt.
Thematic investing requires being right three times: on the theme, the fund or company selection, and the entry point.
Advisor interest in thematic investing has grown sharply, perhaps in part driven by client interest. As advisors develop an approach to thematic investing that fits the needs of their clients and practices, our investment experts at The Retirement Group can help.
The rise of thematic investing provides an alternative approach to a traditional index strategy. By understanding the implicit insights of growing trends and determining how to invest in them, institutions increase their chances of generating above average returns. Successfully identifying and capitalizing on themes is one of the key challenges, meet with a financial advisor today.
The Retirement Group is a nation-wide group of financial advisors who work together as a team.
We focus entirely on retirement planning and the design of retirement portfolios for transitioning corporate employees. Each representative of the group has been hand selected by The Retirement Group in select cities of the United States. Each advisor was selected based on their pension expertise, experience in financial planning, and portfolio construction knowledge.
TRG takes a teamwork approach in providing the best possible solutions for our clients’ concerns. The Team has a conservative investment philosophy and diversifies client portfolios with laddered bonds, CDs, mutual funds, ETFs, Annuities, Stocks and other investments to help achieve their goals. The team addresses Retirement, Pension, Tax, Asset Allocation, Estate, and Elder Care issues. This document utilizes various research tools and techniques. A variety of assumptions and judgmental elements are inevitably inherent in any attempt to estimate future results and, consequently, such results should be viewed as tentative estimations. Changes in the law, investment climate, interest rates, and personal circumstances will have profound effects on both the accuracy of our estimations and the suitability of our recommendations. The need for ongoing sensitivity to change and for constant re-examination and alteration of the plan is thus apparent.
Therefore, we encourage you to have your plan updated a few months before your potential retirement date as well as an annual review. It should be emphasized that neither The Retirement Group, LLC nor any of its employees can engage in the practice of law or accounting and that nothing in this document should be taken as an effort to do so. We look forward to working with tax and/or legal professionals you may select to discuss the relevant ramifications of our recommendations.
Throughout your retirement years we will continue to update you on issues affecting your retirement through our complimentary and proprietary newsletters, workshops and regular updates. You may always reach us at (800) 900-5867.
Palandrani, Pedro. "Thematic ETF Report: Q1 2021." GlobalXEtfs, April 7, 2021
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