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 Thematic investing. It’s one of the third rails of investment management.
For many investors, the whole idea of investing revolves around themes. Investors identify big-picture trends—the growing importance of clean energy, the rise of a middle class in the developing world, the baby boom—and invest in a portfolio of securities they feel will benefit from those trends. For proponents, themes represent top-down investing at its finest; perhaps even the only sensible way to invest—an index-driven evolution of Peter Lynch’s “invest in what you know” philosophy.
To others, theme-based investing is nothing but a gimmick. Detractors argue that most thematic investments are driven more by the marketing requirements of mutual fund companies than by any coherent, underlying investment thesis, and devolve into momentum-chasing with a fancy name.
The truth, of course, lies somewhere in the middle. For every legitimate, long-term investment theme like clean energy, there is a short-term fad created only to capitalize on a particular market bubble. The seemingly annual media headlines about “swine flu” or “mad cow” investment opportunities come to mind.
But the simmering debate points to a bigger question: What are investors trying to achieve when they take a focused approach to the market? And perhaps more importantly, does it work?
Consider the related issue of sector investing. Dividing up broad indexes such as the S&P 500 based on sectors has emerged over the past decade as an accepted investment methodology. What are investors trying to achieve when they invest in one sector or another?
The answer seems obvious: An investor who buys into the technology sector, for instance, believes that technology stocks as a whole will deliver a specific, unique and identifiable pattern of returns. That is, they believe that the technology segment of the market is driven by a unique set of factors that are powerful enough to make “technology investing”—long or short—something more than a random walk.
This paper will argue that, using this definition, “thematic” investments are equally effective tools as sectors for defining the market. The market segments that modern theme-based investments capture deliver unique and identifiable patterns of return, and represent a legitimate way to approach the market. They update the static, rigid sector breakdowns offered by the major sector classification standards and adapt them to a changing world. And they capture long-term macro developments that are having a sustained impact on the global economy.
Moreover, because many themes are, by definition, driven by extra-market phenomena such as demographic trends and/or public subsidy and investment, thematic investments can provide correlation benefits unavailable elsewhere when included in a portfolio.
In this way, the data suggest that thematic investments aren’t just a legitimate approach to the market; they may be, in some sense, better than sectors.
What Is Thematic Investing?
My favorite answer is one proposed by Deutsche Bank in 2006:
“Thematic investing involves identifying certain social, economic, industrial, and demographic trends, or ‘themes,’ that may ultimately drive the positive performance of a portfolio of securities benefiting from these trends.”
Thematic investing has also been described as a way of investing in change. Thematic investors evaluate the state of the world, identify the significant changes that are taking place and invest in securities that they believe will benefit from the continuation and resolution of those changes.
While active investors have been using these kinds of macro themes to drive security selection since the dawn of markets, the history of packaged thematic investments dates back to 1994, when Bank Sarasin in Switzerland launched the world’s first publicly available global “themed” fund, the Sarasin EquiSar Global Thematic Fund. The fund was (and is) designed to “capture the major trends driving economic and business prosperity,” according to its marketing literature, and invests in between four and six identified themes at any one time—in essence, a “theme rotation” strategy. Over the past five years, the fund has steadily outperformed its benchmark (the MSCI World Equity Index, Net USD), with the British share class capturing a 24.9% return against a 10.4% return in the benchmark.
Sarasin’s offering in Europe was quickly followed by the October 4, 1996, launch of the DWS Global Equity Thematic Fund. Both were followed by a number of other European banks, including Pictet Asset Management and BNP Paribas, as thematic investing became a major force in Europe.
In the U.S., the ability to invest easily in themes (particularly globally) has become possible only recently with the development of specific thematic indexes and associated exchange-traded funds. Although the first thematic ETF only launched in March 2005 (the PowerShares WilderHill Clean Energy ETF (NYSE Arca: PBW)), according to Exchange-Traded Funds Report by June 30, 2009, there were 51 theme-based ETFs on the market with more than $10 billion in accumulated assets.
Figure 1 showcases the list and types of themes that these funds aim to access.
The parade of new thematic investment products will undoubtedly continue, as new demographic, social, economic and political trends take hold. This is part and parcel of why some consider thematic investments gimmicky. Indeed, even inside the clearly successful Sarasin product, themes such as “strong get stronger” and “intellectual property and excellence” are as likely to raise eyebrows as generate knowing nods of agreement.
Looked at from a big-picture perspective, it is clear that “thematic investing” captures a diverse universe of ideas. Many of the themes investors focus on seem to be in place for the long haul—the development of cleaner, more renewable sources of energy is one commonly cited example. Others seem destined to come in and out of style. A few will see their relevance sunset as new trends take hold. As we’ll discuss, this dynamism is actually one of the key advantages that thematic investing has over, or perhaps alongside, traditional sector strategies.
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