One Chart One Idea - What is Thematic Investing?
How-to Guide, Pros and Cons
No doubt you have heard of AI in the past year and may have been looking for investment ideas to profit from the growth of the application of AI in various industries.
Investing in companies that use AI or are powered by AI is an example of thematic investing.
What is Thematic Investing?
Thematic investing is a top-down investment approach that relies on research to explore macroeconomic, geopolitical and technological trends. These trends encompass long-term, structural shifts arising from new business models, disruptive technologies and changing consumer tastes and behaviors — megatrends that have the potential to change whole industries and shape the way we will live, work, travel and treat disease in the future.
Thematic investing is intentionally future focused around specific emerging trends that are expected to evolve over time. The investment process aims to identify companies that may be well positioned to benefit from these trends and offers an alternative to analyzing companies beyond cycles, region, country or sector.
~MSCI
From the definition above, we can unpack what thematic investing entails:
It is a top-down approach to investing by looking at how macroeconomic factors and trends impact businesses and companies.
It mainly focuses on long-term investing as structural shifts take place over time, sometimes decades. However, short-term themes can also occur when policy shifts suddenly, or there are unforeseen developments in the economy like the Pandemic.
It consists of investing in a group of companies, which can cut across different regions, countries, sectors, and industries well-positioned to benefit from the materialization of these trends.
When investing in macro themes such as AI/Robotics, the aging population, and the electrification of vehicles, investors expect these investments will provide above-market returns over the long run.
While thematic investing is usually done through stocks, it can include other asset classes like bonds and real assets.
Thematic investing is dynamic as a broad range of structural and transitory themes can drive market returns. By leveraging Google trends and keywords that corporate officers mention (like AI) during earnings calls, we can understand how themes are developed.
Types of Thematic Investing
There are 4 major types of thematic investing, based on thematic funds that include mutual funds and exchange-traded funds (ETFs). These themes encompass more than transformative technologies.
Technological disruption
Megatrends
Environmental, Social, and Governance (ESG)
Outcome Orientation
For disruption, we think of cloud computing, artificial intelligence, autonomous driving, innovation from climate change, etc. Disruptive technologies can evolve over a long time. For example, music used to be mainly distributed by CDs in the 2000s. By 2018, only 7% of music revenues were from CDs, and the majority was from paid subscriptions (55%).
For megatrends, we think of demographic changes and resource scarcity. Research shows as the world population grows, an additional one billion people will live under high levels of water stress. Companies that supply technologies to upgrade water infrastructure will benefit.
For ESG, these can cover sustainable practices in businesses and companies with diverse and inclusive workplaces and best-in-class governance.
To invest with a portfolio outcome in mind means investing in companies that do well in the face of rising inflation or in those that have weathered market declines better.
The top themes over the last four years (2018–2021) capture nearly 25% of US equity market returns on average.
How Themes Shift
Goldman Sachs research analysts cover many companies. In their thematic research, the analysts identify a theme and then find the best companies that best fit the theme through rigorous fundamental research.
The bubble size in the graphs below represents the amount and prominence of research coverage on a particular theme.
From Chart 1, as of September 2022, the most important theme (the largest bubble) is “Recession Risk”. Its subthemes include inflation, central bank tightening, market volatility, etc. Digital transformation with subthemes of computing advances and cloud is the second largest bubble.
From Chart 2, as of August 2023, the size of the “Recession Risk” bubble has shrunk somewhat while the “Inflation”, “Hiking Cycle Endgame”, and “Market Volatility” bubbles have become bigger.
Research on “Digital Transformation” is dominant with “Cloud”, “AI”, “Computing Advances”, and “Entertainment Themes” being the popular areas of research coverage.
Where to Find Thematic Investing Ideas
First, research the macro trend(s) that APPEAL to you and not just what the market says is hot.
The best way to invest thematically is via exchange-traded funds (ETFs) (more about how ETFs are different than stocks herehttps://marianneo.substack.com/p/stocks-bonds-cds-etfs-or-mutual-funds).
There are 100+ themes out there. A good place to find ETFs that represent the themes you like is via ETF.com (free) or VettaFi (premium).
According to ETF.com, the largest Theme Investing ETF is the ARK Innovation ETF ARKK with USD 7.7 billion in assets as of July 2023.
Summary
Thematic ETFs have become popular as they allow investors to invest in specific areas where they see high growth and potentially high returns. As in any investment, there are both advantages and risks to note.
Advantages:
🌞 They reflect the longer-term growth and structural trends in the economy or represent a particular investor’s objective and can be potentially rewarding to invest in.
🌞 They cut across market capitalization size, regions, countries, sectors, and industries so investors can diversify across multiple areas.
🌞 They can better align with investors’ values (e.g., ESG ETFs) and their particular interests.
🌞 Investors do not have to spend time researching individual companies to invest in the themes they like as thematic ETFs and mutual funds are put together by research houses that perform rigorous investment research to identify the best companies within each theme.
Risks:
☁ Since thematic ETFs focus on one particular theme, investors are exposed to concentration risks. If the theme does not do well, the thematic ETF will not perform well (and vice versa).
☁ Given the concentration risk, thematic ETFs can be more volatile than a broad market index such as S&P500 (SPY). Thematic ETFs are not appropriate for short-term investing horizons.
☁ If a theme has done well, the valuation of the companies within the ETFs can be stretched (and vice versa).
You may like to check my other One Chart One Idea stories here. Please feel free to leave a comment if questions.
This article is for informational purposes only. It should not be considered financial or legal advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.