Thematic investing is hugely popular – here’s how it works

Data by Morningstar, a US financial services firm, show the total amount invested in thematic funds grew to $718bn in the fourth quarter of 2021, from $251bn two years earlier. There are now 1,276 themed funds available, covering myriad growth trends from marijuana to artificial intelligence and cybercurrencies.

Thematic investing allows you to back your convictions, but the narrower the niche, the higher the risk. So the best place to start is with established, long-term global trends, such as urbanization, ageing populations and environmental, social and governance (ESG).

A closer look at these topics reveals some reasons for the popularity of thematic investing.

Urbanization

According to the World Bank, the urban population will more than double by 2050, with more than 70% of people living in cities. This will support housing, public service suppliers, infrastructure, smart city technology and many others.

Ageing populations

The UN expects the number of people aged over 65 to double by 2050, and make up 16% of the world’s population. This will provide long-term benefits to sectors catering to their needs, such as holiday cruises, golf and health and long-term care providers.

ESG

One of the biggest areas driving growth in thematic investing is ESG, with global assets on track to exceed $50 trillion by 2025, according to Bloomberg Intelligence.

There are many important themes within ESG, but the most popular is renewable energy.

Climate change is predicted to cause trillions of dollars’ worth of damage to economies. The earth’s natural resources also cannot keep pace with its growing human population and will eventually run out.

The switch from fossil fuel to renewable energy must keep accelerating, and funds that track it are the most popular themed investments.

Mixed performance

In the latest Morningstar analysis, more than two-thirds of thematic funds globally survived and outperformed global equity markets in the year ended March 2021.

Morningstar warned investors in thematic funds they are relying on three things to happen. First, they need to pick a winning theme; second their chosen fund needs to be well-placed to survive and harness it; and third, the market must not have already priced in the theme’s potential.

However, it said if you can make the right choices, the prospective payouts can be large.

Meeting the challenges

To limit the potential downside of thematic investing, avoid investing large portions of your portfolio in it. Keep most in the broader market and do not rely on one idea but diversify across several themes.

Read as much research and analysis as you can. Does the data suggest this is a strong historical trend? Or is it based on only a short period of data?

Always look for businesses with a solid balance sheet, good cash flows, manageable debt levels and strong profit growth potential.

Is there real long-term potential or could it just be a compelling story with no substance? Could any positive movement just be a bubble caused by other investors chasing the same speculative narrative?

Consider whether the theme will be resilient in a downturn or bear market. It might do well during a period of broader market growth, but could it fall faster than the broader market during a correction? So is it really a sustainable long-term theme, or simply a theme with a higher market beta?

Speak to your financial adviser about your investment plan and whether the themes you are interested in fit with it.

Much depends on your timeline. Though the Nasdaq technology index gained 200%, then rapidly lost all those gains during the 2000 dot-com bubble, the index is now worth seven times what it was then. So if you’re investing for 20 years or more, you could potentially take more risks in such volatile sectors.

Make sure the theme also matches your attitude and tolerance to risk. If you have a low-risk tolerance and shorter time horizon, avoid more volatile sectors, no matter how tempting they seem. Look instead for longer-term trends such as urbanization or renewables, that gather momentum slowly.

Investing in diversified thematic funds, rather than individual stocks, allows you to access themes while diversifying risk and accessing the manager’s specialist knowledge and experience.

And remember, investment fads will always come and go, but a disciplined, long-term approach based on solid research and analysis is what matters.

Potential challenges

One potential pitfall to avoid in thematic investing is investing narrowly in only one theme, which would mean you are poorly diversified. For example, investing only in a few pharmaceuticals stocks, to profit from an ageing population, means you could outperform handsomely while this sector is in vogue.

But you are also exposed to a sharp downside if the pharma market suffers a correction, say due to tighter regulation.

The way to avoid this is to use thematic funds, which enable you to invest in a theme in a much more diversified way. These funds achieve this by buying many different stocks across the sector globally, which is a much better way to access the trend as it carries less risk.

Robert Johnson, professor of finance at Creighton University, believes another problem is that many investors are irrationally swayed by stories and ignore fundamentals, and this is driving much of the growth in thematic investing.

“Nobel laureate Robert Shiller showed how popular narratives can drive individual’s decisions and create market inefficiencies,” said Johnson. “Look at the recent bubble in cryptocurrencies or the housing bubble that precipitated the 2008 financial crisis to see how narratives can drive behavior and economic crises.”

“Recently, some fund managers have accumulated massive assets through the narrative of investing in innovation. But such a narrow focus leaves them exposed if the market turns against disruptive tech, as happened in the last few months.While some tech companies will post spectacular growth, many more won’t and it is hard for individual investors to identify winners and losers.”

However, Johnson is in favour of thematic investing provided you choose themes with strong supporting evidence.

For example, academic research over 30 years shows smaller-cap stocks and value stocks tend to perform better in periods of expansive monetary policy – for example, when interest rates are lower – said Johnson. Firms with larger cash holdings tend to perform better when monetary policy is tighter.

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