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“Overhyped”? “Fad”? Why the critics are wrong about thematic investing

A difficult period for the performance of some thematic funds has given fuel to the naysayers’ arguments. But we believe thematic investing with an active approach is a powerful tool for investors now and in the years to come.

30/10/2023
thematic funds

Authors

David Docherty
Investment Director, Thematics

Thematic investing has taken off in recent years. Global thematic assets under management stood at $400 billion as of 1 July 2023, up 11% from the end of last year (according to data from Goldman Sachs).

But disappointing performance for some funds has led investors and commentators to ask whether investment themes are style over substance, or hype over returns.  

The charge sometimes levelled at thematic funds is that, by the time they’ve launched, the theme may have already played out. Sceptics of thematic investing argue variously that it mistakes short-term fashions or cycles for longer-term secular growth; that it encourages over-exuberant investors to overpay; and that investment universes are flawed both for portfolio managers and the end-investors in thematic strategies.

How do we answer the charges against thematic investing?

In our view, thematic investing requires discipline if we are successfully to identify powerful and long-term investment themes.

  • To avoid short-term fashions, themes need to have longevity. To achieve this we believe it is essential to work within an overarching framework. At the heart of which is our view that the most powerful themes are those where human ingenuity ignites innovation to address imbalances in the world. These imbalances can be between people and planet and between supply and demand in individual industries. We believe this approach is critical in prioritising the structural over the fashionable and the cyclical.
  • There must be share price upside in themes as a guard against overpaying. An obvious point perhaps, but thematic investors are ultimately investing in stocks and shares rather than in themes as abstractions. Once the fundamental attraction of a theme is discerned, the potential investee companies need to be identified and a judgment made on their prevailing prospects and valuations. This is critical to guard against the over-exuberance which some observers fear.
  • The creation of a thematic investment universe is critical. It must be broad enough to allow the portfolio manager to navigate an evolving theme, while being narrow enough to ensure the precise exposure to the theme which is being sought by the client. Striking this balance is important for the  investment strategy to have the authenticity required by portfolio managers and end-investors alike.

This is where active management becomes so crucial when investing in themes.

When it comes to thematics, active investing isn’t purely about stock selection for the portfolio. It’s also crucial to take an active approach in constructing the theme’s investment universe.

Building investment universes is a key part of thematic investing

As we have already said, investment universes must be neither too large nor too small. For example, we took the decision that robotics could not be a standalone theme. There is only a small handful of dedicated robot manufacturers and we believe this is insufficient to form a robotics universe, even if supplier companies are included.

We feel instead that automation is a powerful sub-theme within a broader smart manufacturing strategy and prefer this to a standalone robotics thematic.

A well-constructed investment universe enables portfolio managers to navigate around the theme within a variety of different subthemes. The investment attraction of these sub-themes may fluctuate as the wider theme plays out.

For example, the theme of energy transition spans a value chain extending from wind farms to smart meters with exposure to consumer, industrial and utility sectors. Meanwhile, the theme of sustainable food and water extends from field to fork, with opportunities at play in several sub-themes addressing the long-term imperative of providing food and water in an environmentally friendly way to a growing world population.

Stock selection remains essential

But even within a carefully constructed investment universe, an active approach to stockpicking is still essential. It can provide a meaningful above-index exposure to companies when a theme is developing and when we believe these businesses’ prospects are not reflected in prevailing share prices.

By following an active approach, portfolio managers can also avoid large index components which may well have become expensive and “oversized” as a theme matures.

An active approach is all the more important when a theme becomes “flavour of the month” and capital begins to pour in. Active investors have the flexibility to allocate that capital to the stocks they view as having the best prospects and the most share price upside. By contrast, passive investing is inflexible and much less capable of gaining adequate exposure to emerging investment opportunities in evolving themes.

An active approach also enables engagement with investee companies to identify and address potential sustainability risks.

The case for themes

In our view, it is wrong to write off thematic funds and that doing so means you risk missing out on the opportunities that change brings. We believe that themes are an important tool for investors, and that the growth in thematic investing will continue.

Investing in themes is all about gaining exposure to the forces that will shape the future. And the pace of change is accelerating. Powerful, long-term global trends are transforming the world.  They’re also creating a wealth of investment opportunities. Themes can help investors find the companies that will best shape or adapt to the new world with the aim of delivering positive returns over time.

We are therefore firm believers that a thematic approach can add considerable value. But it needs to be executed with discipline if we are successfully to identify, and profit from, powerful and long-term investment themes.

Authors

David Docherty
Investment Director, Thematics

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For illustrative purposes only and does not constitute a recommendation to invest in the above-mentioned security / sector / country.