A report published in 2023 by BNP Paribas showed that 70% of investors surveyed expected to increase their focus on thematic investing over the following three years. Clearly this is an area which is moving into the mainstream at pace but what exactly is thematic investing and how should investors think about getting involved?

In this article we’ll look to provide a broad-brush definition of thematic investing. Discuss why it can be an investment approach worth pursuing. Identify what the main themes are and explain how to achieve thematic exposure.

We’ll also round things off by discussing the core-satellite strategy and how you can avoid concentration and duplication risk.

WHAT IS THEMATIC INVESTING?

So, headline-view – what is thematic investing? It’s an approach based on identifying longer-term structural trends which will shape our world, our economy and influence which companies can dominate in the decades to come.

A good starting point is to consider what it is not – i.e. it’s not a cyclical disturbance which will tend to revert to its previous level over a cycle of a few years. A structural trend involves more permanent or long-lived change.

Or, to look at it another way, cyclical growth relates to where we are in the economic cycle. As an economy grows, wages, productivity and consumer spending all tend to rise, while the labour market tightens. The opposite occurs when the economy goes through a period of contraction, which can lead to recession.

Cyclical industries are sensitive to the business cycle, performing well as the economy grows but less so as it contracts.

Structural growth drivers are related to a shift in the inner workings of an economy itself – and sometimes this change can be dramatic – with the proliferation of the internet an obvious 21st century example.

WHY INVEST IN THEMES

In terms of why you might invest in themes – there are two key compelling reasons for doing so.

First of all, investing itself should be a long-term activity. Investing on less than a five-year horizon is more akin to speculation given how exposed you are to bouts of short-term volatility. In that sense looking at themes which might play out over decades chimes with genuine investing.

The other point is that themes can be a powerful driver of returns. A chart of the ISE Cybersecurity index makes this point – it has risen six-fold over the last 15 years.

What are the most popular themes. One is the ageing population with a big increase in the global cohort of over-65s expected in the coming decades.

Then there are areas like AI (artificial intelligence) automation and robotics. AI has clearly been the hot theme of the last year-and-a-bit.

You have cloud computing and cybersecurity – clearly hugely important in an increasingly digitised world. Then we have the energy transition.

There are a huge number of trends beyond the few highlighted here, some are more niche than others and some could be characterised as sub themes.

The key question facing investors is are you investing in a genuine structural trend or is this a short-term fad which has generated excitement but will fizzle out.

THEMES WON’T ALWAYS PLAY OUT AS YOU EXPECT

Even within this, the trajectory and pace at which a theme translates into investment returns can be highly unpredictable. The dotcom bubble and the crash that followed illustrate this neatly.

Clearly the internet has been transformative to so many aspects of our lives that it’s hard to keep track. However, while there was lots of excitement about the role the world wide web, to employ the vernacular of the time, there wasn’t a lot of discrimination going on in 1999 and 2000.

As a crude proxy for the dotcom bubble we can examine the performance of the Nasdaq Composite index which reached what was then an all-time high of 5,048.62 in March 2000 before falling to lows below 1,400 in 2002. It didn’t recover its March 2000 mantle until nearly 15 years later.

It has though come on leaps and bounds since and a business like Amazon (AMZN:NASDAQ), which was caught up in the dotcom boom and bust and didn’t enjoy its first profitable year until 2003, now bestrides the world as a tech colossus with dominant positions in e-commerce and cloud computing. So, some businesses got there eventually, but the road was pretty bumpy and at times circuitous.

HOW TO INVEST IN THEMES

That’s the what and the why of thematic investing covered – now we need to consider the important bit which is how.  

There are several key options. You can buy an individual stock which plays into the theme. Nvidia (NVDA:NASDAQ) is an obvious example of a stock which people have used to play the growth of AI. However, the danger here is a lack of diversification – which can leave you exposed if something goes wrong with the business itself or it proves not to be the right way to capture a trend.

With Nvidia – which is plainly at the leading edge of the sort of powerful microchip designs required to power AI – the case for it being a good play on the theme is pretty unanswerable. However, it’s not always so clear cut.

Grocery delivery service Webvan.com expanded rapidly in the late 1990s and in the summer of 1999 the company announced a $1 billion investment in warehouses to expand from a base of eight US cities to more than 26 by 2001.

It listed on the market at $30 with a $1.2 billion valuation in November 1999, raising $375 million. But in running before it could walk, with a customer base and margins which weren’t large enough to support the planned expansion, it burned out very quickly. By the time it announced it was shutting up shop in July 2001 its stock was worth just 6 cents.

This was clearly a business which was ahead of its time, with many of us now well used to doing the weekly shop over the internet, and yet it still failed.

A COLLECTIVE APPROACH

That provides an incentive to look at collective vehicles focused on different trends and themes in order to diversify your exposure. An obvious starting point for some would be exchange-traded funds where there has been a significant expansion in choice in recent times.

Advantages include transparency (you can see exactly what is in the portfolio), their low cost and the solution they provide to the diversification problem with most products encompassing upwards of 100 constituents.

However, there are some drawbacks. A criticism sometimes levelled at thematic products is that by the time they are created all of the easy money has been made. That’s because in order for an asset manager to decide its worthwhile launching a product they need to be confident that a theme has broad appeal with investors. Otherwise, it could fail to attract the required level of assets.

In addition, although the indices which these vehicles track are adjusted over time, they are highly unlikely to be as flexible as a portfolio which is being actively managed by a professional. A potential lack of discrimination might also mean you end up with a lot of dross which doesn’t effectively capture the theme and drags down the performance of those names in the portfolio which do.      

That brings us on to the other main option which is to entrust a fund manager to exploit a theme for you. The major downside – compared with an ETF – is you are more than likely to pay a price for this active management.

The upside is an active manager can react more sharply as a trend develops, potentially look to capture multiple themes and identify trends before they have peaked.

Sometimes you have to do a bit more homework to work out if you are backing a thematic fund – they may not have the obvious labels that an ETF would – but any technology-focused fund worth its stripes, for example, is very likely to be tapping into trends around cybersecurity, cloud computing and AI.

THE CORE-SATELLITE APPROACH AND AVOIDING DUPLICATION

It would be useful to talk about where thematic investments can fit within a broader investment portfolio. And that’s where the core-satellite strategy can come into play.

As the name suggests this involves having a core of long-term investments which provide exposure to a decent spread of the financial markets. Then on top of that you have satellite investments which are a bit more adventurous and concentrated – i.e. thematic stocks and funds. These might be more volatile than the steady eddies which account for your core holdings but also carry with them the possibility of greater reward.

There are no fixed rules with this but a decent pointer is somewhere around 60% to 80% would be in the core with the remainder allocated towards these satellite investments.

Its also worth providing a health warning about avoiding concentration and duplication risks associated with thematic investing.

Let’s deal with concentration first. We’ve already talked about these risks when buying individual stocks but sometimes even when buying a fund or ETF you will end up with your fortunes tied up with just a handful of stocks.

This risk is more acute with a more nascent or niche theme. Because either you end up with only a handful of relevant listed names or you dilute exposure by including stocks whose link to the trend is at best tangential. So, for example, the top 10 holdings in the L&G Hydrogen Economy ETF (HTWG) account for well in excess of 50% of the whole portfolio.

DOUBLE TROUBLE

Then you have to consider the duplication risks. If you compare the top three in the MSCI World index, for example, with the top three in most tech-specific indices they are the same – reflecting the fact that Apple (AAPL:NASDAQ), Nvidia and Microsoft (MSFT:NASDAQ) are the three largest companies in the world by some distance. So, in this scenario you would need to think carefully about whether it makes sense to hold products tracking both indices in the same portfolio.

The answer, and this is a wider principle, is to look carefully at what’s in the product or vehicle you are buying. This will not only answer questions about duplication risk but will also ensure you are getting exactly the sort of exposure you want. As ever with investing it always pays to do your homework.

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