Markets

What Thematic Investing Is, And Its Strengths and Risks

Over the past few years, disruptive ideas, innovations and economic forces have reshaped the way we invest. Investors are constantly researching new and promising ideas in order to capitalize on themes that will drive tomorrow’s markets. Broadly speaking, thematic investing is the approach of taking advantage of future trends while just as importantly avoiding fads. Investments take a top down approach providing investors an opportunity to generate alpha. Its forward-looking approach stands in contrast to a relative investing strategy which relies heavily on market capitalization to determine weights in a portfolio. Fundamentally, the objective of thematic investing is to not only generate superior returns, but evolve traditional index investing.

Consider the Trends

One of the key challenges of thematic investing is successfully identifying and capitalizing on themes. That being said, not all themes will necessarily lead to successful investments. History is littered with examples of prospering industries with no indication of which company will come to dominate the industry. This suggests that successful thematic investing is more about selecting baskets of investments rather than single securities.

A few factors should be considered when researching and prioritizing trends. First, an investor or fund manager should choose particular trends or themes that align with their values. Examples can include technology, clean energy, and advances in medicine to name a few. Second, it is important to determine whether the trend is structural, short term in nature or speculative. Structural changes, whether good or bad, have long term impacts on the way a market functions or operates. For every long term investment, there is a short-term or speculative fad creating a false signal to the market. Institutions use a range of approaches to develop thematic strategies, including developing views within the existing structure, placing a thematic overlay, or by creating a single or multi class thematic portfolio.

Portfolio Construction

Once a key trend has been selected, then investors must trace them to the themes they produce for a specific region or sector. Investors can then identify companies or ETFs that provide true exposure, both direct and indirect, to these budding industries. Thematic investments are chosen based on companies that will benefit from long term structural trends. Depending on the size of the portfolio, additional considerations might be given to the level of correlation between assets, key sensitivities and specific risk factors. By understanding sector exposures and then determining where and how to invest, institutional investors increase their odds of generating superior returns in an increasingly complex investment landscape.

Generate Alpha

In finance, alpha is a universal measure of a fund’s performance against a benchmark index. Alpha gauges the excess return relative to the return of a benchmark index. A positive alpha of 1 indicates the portfolio has outperformed the benchmark by 1 percent and negative alpha reflecting an underperforming investment. One major benefit to thematic investing is its potential to generate alpha at scale. By focusing on investment opportunities in hot spots, investors can deploy a sizeable amount of capital.

Flexibility and Technology

In the past, thematic investing detracted investors for its complexity, high costs, restrictive portfolio structures, risk limits and the challenge of putting together truly distinctive insights. Fortunately, investors have formulated a more creative and systematic approach to thematic investing. In recent years, financial technology has picked up on the growing trend of thematic investing and helping to democratize access for investors of all net worth’s. The fundamentals of financial technology startup, Motif Investing, is built on the premise of motifs, which features 30 stocks and ETFs that follow specific themes. Compared to traditional brokerages, online trading platforms leverage technology to democratize thematic investing in a low cost and efficient manner.

Risks

It is tempting to participate in thematic investing, especially when powerful technology trends are reshaping the world. While many of these trends turn out to be successful, there are an equal amount of companies that end up failing. Sometimes, investing themes will address macroeconomic turmoil, slowdowns or recessions. By jumping on a defensive position, investors are simply trading on speculation rather than investing in structural trends. To avoid investing in a fad, themes should be screened for staying power, earnings potential, and whether the company is liquid. Inherent in a thematic strategy is screening and researching stocks for risk and liquidity.

Final Take

The rise of thematic investing provides an alternative approach to a traditional index strategy. By understanding the implicit insights of growing trends and determining how to invest in them, institutions increase their chances of generating above average returns. While thematic investing warrants its own considerations, it is best used when complementing an already established portfolio.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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Trevir Nath

Trevir Nath graduated in 2011 from Rutgers University with a Bachelors in Economics & Psychology. His Psychology and Economics degrees increased his understanding of financial markets from a human behavior perspective. Looking to further his understanding of financial markets, he went on to obtain his Masters in Economics from the New School graduating in May 2014. He currently writes about personal finance, investing and its interaction with technology. His work also appears for numerous financial websites including Investopedia.

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