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Why thematic investing is becoming more popular

11 October 2017

Dan Smith, investment analyst at Thomas Miller Investment, explores thematic investing and how the strategy fits into investors' portfolios.

By Dan Smith,

Thomas Miller Investment

One investment approach growing in popularity is thematic investing. Thematic investing uses a top-down approach, seeking to identify long-term secular trends that are likely to shape the world we live in and be key driving forces behind financial markets in the future.

Thematic strategies are designed to invest in assets where returns are influenced more by structural forces of change and the success of a theme is often independent of the economic cycle.

Themes can originate from a variety of sources, but are typically centred on social, political, demographic or technological change.

Thematic strategies share resemblances to “smart beta” strategies, in that they materially alter the return profile of a traditional market cap weighted index, which is often criticised for being overly exposed to the largest companies and for backing previous winners.

While smart beta funds seek to alter the return profile of a market cap index by tilting an index to a particular investment style, such as value or growth, thematic funds seek to alter the return profile of an index by tilting its exposure to a particular theme or concept.

Having an investment strategy that provides a unique or alternative source of return for an investor is an attractive quality.

Adding a thematic fund not only offers the opportunity of an additional source of alpha, but also has diversification benefits, which can enhance a portfolio’s risk-adjusted return.

However, thematic investing does not come without risks. By their very nature, thematic funds are designed to take advantage of long-term investment themes, which means they are likely to take a long-time to come to fruition, if at all.

This can mean thematic funds could underperform a global equity benchmark for an extended period of time, which could prove challenging for those investors with a short investment time horizon.


 

Arguably, the biggest challenge for thematic investing is the successful identification of the key trends of the future and more importantly whether these trends will turn into profitable investment opportunities. History, after all, is littered with trends that have failed to take off.

When we look to determine the merits of an investment in a thematic fund, we look for two key factors in assessing their strength– visibility and persistence.

Visibility may seem counterintuitive, as once investors see evidence of a theme playing-out, most of its enthusiasm and future returns will be reflected in the assets price.

While we sympathise with this view, we believe it disregards one key behaviour bias amongst investors - that they tend to overreact to short-term trends but underact to longer-term trends, thus a trend can still offer an attractive return even if not invested in at its earliest stage of development. Persistence is about establishing whether a trend is short-term in nature or whether there is a long-term structural force behind it.

Two particular structural themes which we believe possess both visibility and persistence characteristics are those focused on demographics and technological changes.

From a demographic perspective, we already know that aging baby boomers will markedly affect the demographic profile of developed nations, which gives us visibility of a trend.

While the persistence is supported by recent reports from the UN World Population Prospects, which estimate the number of older persons – those aged 60 years or over – is expected to more than double by 2050 and triple by 2100.

One way of capturing these demographic changes is through an investment in the iShares Ageing Population ETF which is focused on the growing needs of the world’s ageing population. The passive fund is diversified across sectors and countries and focuses on biopharmaceuticals, life and health insurance, biotechnology, hospital facilities and travel.


 

In regards to technological change, the visibility of the trend is clear and we have already seen evidence of the disruption Amazon has had on the traditional bricks and mortar retailers, while Netflix has changed the way households watch their favourite television series.

The persistence, whilst more subjective, appears to show the trend is accelerating in pace – a case in point being the number of car manufacturers investing huge sums into electric vehicles.

The breadth and depth of technological change is disrupting almost every industry, leading some commentators to refer to the current technological advancement as the Third Industrial Revolution.

A technology fund offers a good way for investors to profit from technological advancements and improvements and one with a strong, consistent track record of performance is the Fidelity Global Technology fund.

One key consideration for an investment in a thematic fund is how it fits within a portfolio. We believe that while thematic funds offer the opportunity of superior long-term investment returns, they also possess a higher level of risk, as the drivers of their returns are often more concentrated than in a more typical active equity fund and are also likely to be correlated. We therefore believe that thematic funds are best utilised as a complement to a well-diversified portfolio, rather than a standalone investment.

To conclude, thematic funds offer the potential for investors to capitalise on long-term secular investment trends, and in the process offer the opportunity of superior investment returns over the longer term.

While thematic funds can represent an alternative source of return, they also supply an additional layer of risk as their returns are often dependent on a smaller number of factors. As a result, we believe they have use as part of an overall diversified investment portfolio.

Dan Smith is an investment analyst at Thomas Miller Investment. The views expressed above are his own and should not be taken as investment advice.

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