Why Thematic Investing May Not Be the Best Way to Construct Portfolios

In recent years, much has been made of so-called Thematic Investing. Have you ever made a correct prediction about the implications of a particular new products that affects specific sectors? Have you ever wondered about the possibilities of creating wealth through such market analysis? It’s a fact that the world economy today is in a perpetual state of disruption and flux.

For sure, it can be difficult for investors to navigate such a volatile system. Within such a climate, investment strategies such as Thematic Investment can be seemingly appealing for asset managers and investors looking to construct their portfolios.

In this article, we aim to explore the logic behind this appealing investment strategy. Not only that, but we also hope to investigate its implications and why Thematic Investing may not be the best way to construct portfolios after all.

What do we mean by Thematic Investing?

As evident from its name, thematic investment refers to a type of strategy that aims to align asset selection primarily with certain sectors, but it also can relate to economic or political, or even themes in society. In this strategy, the investor identifies broad macro-level trends and the companies which stand to benefit from the materialization of those trends.

A portfolio can be created integrating the various companies and sectors that identify with the particular trend or theme. In general, thematic investing serves as a way to capitalize on anticipated changes in the world. Such strategies aim to produce long-term investment returns and are based on intense market research and theme analysis.

Thematic Investing versus Factor-Based Investing

Before we dive into the specifics of thematic investing, we want to emphasize one type of investing, factor-based investing, which is sometimes erroneously conflated with thematic investing.

Factor-based investing, simply defined, is an approach to investing which attempts to identifies characteristics of stocks which have shown to have excess risk-adjusted returns over very long periods of times, typically several or more decades. Examples of factors in the Equity universe can include stocks with smaller market capitalizations, lower Price-to-Earnings ratios, high-dividend payments, or those with strong momentum.

We at RVW Wealth have built our portfolios with the underlying belief that factor-based investing is the cornerstone of a strategic, disciplined approach that produces excellent results over long periods of time. As we will see, thematic investing, which focuses on tactical, short-term portfolio adjustments, is often at odds with a factor-based investing approach.

What are some examples of “Themes” in the contemporary age?

Let’s first explore the word “theme” from a semantics perspective, especially as applied to the world of modern finance. A theme implies ‘change’; whether it be through a potentially disruptive technology such as Artificial Intelligence, or something more periodic like currency volatility, the ability to identify and analyze these changes is what we can call a “Thematic Trend.”

Most of the investment firms globally, focus on five mega-trends that it believes constitute the base of social change: rapid urbanization, resource scarcity, shifting economic power, climate change, and demographic change.

The foundations of all these trends are the breakthroughs that drive these processes. By identifying and anticipating the sustainability and vitality of different trends, an investor can achieve long-term returns on investing in companies relevant to these themes.

How Does Thematic Investing Work?

With our now having defined Thematic Investing, how does it work? While the basics of it are quite simple, Thematic Investing can be a very demanding task. This sort of investment bets upon trends and anticipated changes. Thematic Investing involves pooling companies within the same sector or trend together in a portfolio and investing in them. This is done on the belief that these companies will generate out-sized returns in the long run.

A single theme can also involve multiple businesses across various sectors. For example, a health care fund may invest in hospital companies, health insurance companies, or pharmaceutical companies. There are several approaches investors can take regarding this strategy; one such approach is listed below.

A Systematic Approach towards Thematic Investing

Firstly, a correct theme needs to be identified. The theme chosen should be viable, i.e., structural with actual long-term implications for society. In investing, sustainability is of the utmost importance, and the investor must be alert as not to fall into what turns out to be a bubble or short-term fad.

Once a viable theme has been identified, the investor identifies the sectors that benefit from that trend. For example, if the trend identified is the increasing focus on Green Technology, sectors like electrical automobiles stand to benefit from it.

Once funds have been allocated for specific sectors, the investor analyzes companies that stand to benefit within those sectors. Since it can prove daunting to study and identify such businesses, Thematic Mutual Funds also exist to identify stocks associated with popular themes.

How does Thematic Investing differ from other investment strategies?

The uniqueness of Thematic Funds stems from the fact that they are based upon particular trends that can be multi-sector or multi-economic. In this way, they are different from Mutual Funds and quite different from Sectoral Funds. The latter are focused around specific sectors, while Thematic Funds can vary quite a lot in that regard if the Theme necessitates it.

Additionally, a major difference with Mutual Funds is that the latter has a diverse portfolio with numerous investments. On the other hand, A Thematic Fund is much more concentrated around key areas that affect the trend.

Is it worth it?

So far, this article has focused primarily on the conceptual mechanisms of Thematic Investing. The big question, however, remains: Is it worth it? The fact of the matter is that every investment strategy has its pros and cons. An investment managing firm will use the methods and strategies that fit its particular paradigms and philosophical values.

Not only that, but they will also use those strategies which tailor to the individuals they are mostly catering to. For example, for reasons we shall see below, private groups such as RVW Wealth do not necessarily see thematic strategies as optimal for portfolio construction.

On the other hand, other investment firms see these funds as a major aspect of modern financial planning. This is due to the exclusive nature of RVW Wealth, which prioritizes the needs of high net worth investors that require personalized investment opportunities. So, with this nuance in mind, we shall progress the article with the knowledge that various firms can see the same strategy through a diverse range of lenses.

For further clarity, we shall be using the example of the tour firm to demonstrate the drawbacks of this strategy that often makes it incompatible with our investment philosophy. As with every strategy, we must weigh the rewards of Thematic Investments with its associated risks before concluding:

Advantages of Thematic Investing

1) Business for the Future

The trademark of thematic investment lies in its promise of investing in “Business for the Future”. It allows investors to capitalize on anticipated market tends while also participating in causes that align with their personal views or philosophies. For instance, an investor can take a practical part in combating Climate Change by investing, and consequently promoting, Green Technology.

Additionally, such strategies are compatible with analysts and investment strategists who have a decisive understanding of trend developments across various sectors. Lastly, this type of strategy allows investors to take advantage of the disruptive circumstances within which the world economy finds itself. No longer are investors detached from the real world since they can make material advances through positive breakthroughs and changes in society.

2) Concentrated Portfolios

The concentrated nature of portfolios which use this investment strategy can allow for significant long-term returns. It is believed that the over-diversification that may occur with mutual fund strategies is not good for growth. On the other side, selecting a few stocks from several companies allows for huge results should those companies yield expected results.

Hence, this strategy has potential for long-term growth, which can be capitalized on if used efficiently. In addition to this, firms can still achieve diversification by building portfolios around different themes.

Disadvantages of Thematic Investing

1) More Theoretical Than Practical?

It is argued that the stated advantages of Thematic Investment strategies are more theoretical than practical. Moreover, some firms believe that these strategies are a form of market ploy which allows for a quick diversion of wealth from public hands. They completely ignore long-term growth and encourage investors to chase the latest fads rather than genuine economic developments.

These strategies are highly vulnerable to empty market narratives, which do extensive damage to portfolios. Alongside this, managers may also limit themselves to short-term advantages, ignoring the structural adaptability of the investor’s portfolio.

They also tend to ignore sustainability, putting investors at further risk by not diversifying the stocks and mismanaging portfolios. Hence, it becomes apparent that the practical implications of thematic investment strategies can be quite counter-productive.

For private investment groups such as RVW Wealth, such theoretical considerations can damage individual investors and be a breeding ground for dishonest practices. For them, individualized and personalized considerations are vital in ensuring that strategies adopted are adaptable and changeable, and customized in accordance with the necessities of the investor.

2) Risks of Concentrated Individual Stock Selection

Since the individual investor relies upon the success of a specific idea or trend, this strategy can be seen as putting all your eggs in one basket. Why? Because the impacts of unpredicted market cycles or fads can lead to huge financial fallouts. An example of this includes financial bubbles such as the tech bubble in the 2000s, which impacted investors who joined the fad too late.

That is why, concentrated portfolios are considered to be of greater downside risks, and changes in regulatory or tax policies exacerbate these. It can then be assumed that diversification in the portfolio should be preferred over a complete emphasis on Thematic strategies. Not only is there a great risk of fallout, but also a higher cost of said fallout as compared to traditional funds.

This is because the expense ratios of mutual funds and exchange-traded funds (ETFs) that employ thematic investment strategies is much higher in comparison to those of other investment vehicles, such as those that adhere to more “formulaic” approaches, such as index-based funds or factor-based funds. Hence, such strategies may not align with philosophies that prioritize client ease and adaptability. They are not, for instance, in line with the philosophy of RVW Wealth, which believes that risks must be made in a way tailored to the needs of individual investors.

3) Volatility

Another major concern with Thematic strategies is that thematic ETF’s are highly volatile. The argument here is that the narrower the concentration of investment is within the fund, the more volatile that fund is likely to be.

According to a report by Roger Nusbaum of Your Source Financial and Seeking Alpha, such volatility is inherent within the structures of thematic funds because of their lack of diversification and over-concentration. While they may not be as volatile as sectoral funds, the problem still remains and can be catastrophic for individual investors should things go south in the long run.

4) Market Timing

Like deciding when to buy or sell an individual stock, effective thematic investing requires identifying certain so-called “entry points” or “exit points.” Because thematic investment products are essentially trading vehicles, unless one can get lucky by buying low and selling high, thematic investing suffers from the same timing issues that individual stock selection does.

Contrast this with a factor-based approach which – by its very nature – emphasizes discipline and being fully invested at all times. This investment strategy reduces both the attention needed and the stress associated with market timing.

Thematic Investing: Less than Meets the Eye

Thematic investing has seen significant growth during the past several years. It is not hard to see why: many investors can easily identify with the underlying approaches that such thematic investments provide.

While thematic investing is appealing, in some sense, such a strategy is merely stock selection presented via window-dressing to look like proper diversification. In practice, thematic investing deviates from the tried-and-true approach of having a long-term focus using verifiable, academically determined approaches to investing, which have been demonstrated to be successful for the vast majority of investors.

For these reasons, we believe that thematic investing, while having some merits, is best avoided as the cons outweigh the pros.

Published on August 24, 2021
RVW Wealth