Investing in the Winners of the Future? Here is Why Investors Should Think Twice About Thematic Investing
Just the other day, I was introduced to the world of thematic investing by my friend when we were discussing Telsa, the biggest component of the ARK Innovation Exchange Traded Fund (ETF).
According to ARK Invest, The ETF is a thematic investing ETF that focuses on:
‘disruptive innovation’ a companies that develop a technologically enabled new product or service that potentially changes the way the world works.
The ETF is a fund managed by ARK Investment Management who are known for their $7,000 price target set on Tesla stock.
We were having a heated discussion about why ARK Invest would sell off their stock in Tesla and reduce their stake by 17%. That was when I learnt more about managing a diversified portfolio and not letting one stock dominate the portfolio.
The ARK Innovation ETF is one of the many examples of the thematic investing strategy.
This strategy has been defined as an investment approach that centres around identifying future macro trends and investing in the underlying companies that will stand to benefit from the actualisation of this trend.
FYI: Macro trends refer to persistent and long-term trends affecting our world, like automation, shifting demographics and urbanization.
It is also a strategy that centres around diversifying your portfolio within a niche or industry. Recently, this distinctive and sometimes pricey investment strategy has been gaining traction.
According to Morningstar’s Global Thematic Funds Landscape Report, thematic funds have $296.2 billion in assets under management (AUM) as of end 2019.
This popularity has been expanding to Singapore as there have been many thematic funds rolling out here as well.
However, the report observed that only 45% of the thematic funds launched after 2010 are still around in 2020. Of the remaining funds, only about 25% performed better than the MSCI World Index over the 10 years.
TL;DR: Pros and Cons of Thematic Investing
The growing popularity of these thematic funds merits an in-depth discussion about this investment strategy’s pros and cons.
|High potential for growth
|Increased diversification risk
|More susceptible to regulatory changes and disruption
|Not as constrained by traditional investing biases
What is Thematic Investing?
As mentioned earlier, thematic investing is about identifying future trends and capitalising on it before it materialises.
In fact, some of you might already be applying the principles of thematic investing in your investment strategy. For example, you might already be identifying investments that could benefit from Government initiatives in the future.
At its core thematic investing looks to capitalise on future trends and adopts a future-focused investing perspective.
This strategy focuses on the structural changes in our society brought about by changes in our environment, technological innovations and demographic changes over an extended amount of time.
The funds can be broadly categorised under the broad themes of:
- Artificial intelligence
- Changing demographics and technology
- Environmentalism and environmental technology
- Healthcare and nutrition
- Luxury brands
- Marijuana production
- Robotics and automation
- Resource management
A Threefold Bet
Basically, investors of thematic investors are hoping that they can identify a winning theme and invest in the underlying companies that are well-positioned to benefit from this theme.
They are also hoping that they can invest early enough in a theme when the market has not fully priced in the potential of the companies under the theme.
Although the odds of being able to do this well are slim and the risks are high, winning these bets might result in great capital gains.
Growth Play and Long Term Investment Horizon
The investors who are putting their money into a thematic investment approach are focused on capital gains and exponential growth. They are often looking to beat the ETFs that track benchmark indexes (e.g. S&P 500 ETFs and STI ETFs) over the long term.
These robust themes are expected to come to fruition only after many years. This means that these thematic investing are more suited for investors with longer investment horizons.
Many institutional investors overseas also treat these thematic funds as a form of hedging risk. For example, they might balance out a retirement fund with high exposure to the traditional automobile industry with companies that are at the forefront of producing electric vehicles.
Pros of Thematic Investing
One of the pros of thematic investing is that even if you invest in an ETF, it is comparatively more concentrated than investing in regular ETFs that comprise of hundreds of companies in the fund.
There is beauty and less risk with a diversified portfolio, however, the potential for growth is not as high as a more concentrated portfolio.
Although concentrated portfolios are riskier, potential gains are also higher. Typically, the investment portfolios that produce the highest returns for investors are not broadly diversified.
Thematic investing focuses on a smaller pool of stocks to capitalise on macro-level trends based on a theme. This approach will usually feature companies that have innovative business models with the potential to grow their revenues at a faster rate than the broader market.
For example, if you are bullish about renewable energy you can invest in something like the Invesco WilderHill Clean Energy ETF (PBW) which holdings include Tesla, fuel cell company Ballard Power Systems, Inc, and Chinese electric vehicle manufacturer NIO, Inc.
If this industry were to take off as expected and that’s a big if, you could see huge gains in your investments.
Even though thematic investing can be rather concentrated, there is nothing stopping you from building portfolios of ETFs and stocks with more than one theme.
Thematic investing and the asset managers that manage these funds are not constrained by the traditional biases such as:
- Value vs growth vs income stocks
- Small-cap vs medium cap vs large-cap companies
- Geographical regions, sectors or markets.
Instead, they make investments based on a theme, which cuts across sectors, geography, types of stock and company size.
Cons of Thematic Investing
On the other hand, thematic investing has its fair share of risks and disadvantages.
However, as mentioned in the Morningstar report earlier, only 45% of the thematic funds launched after 2010 are still around in 2020. Of the remaining funds, only about 25% performed better than the MSCI World Index over the same 10-year timeframe.
Increased Diversification Risk
One of these risks that arise from this investment strategy is picking a theme that does fulfil its potential. Take the Human Genome Project for example which did not pan out as many leading geneticists found that the research was not very useful.
As a wise person once said past performance is not indicative of future returns. Investing in the future is complex and may not always result in good results.
There’s also the danger of ignoring signs and misunderstanding themes which will relegate a fund to obscurity and bad results.
Although this approach helps mitigate your risk slightly because your portfolio is not dependent on one single company, it is still less diversified than investment vehicles like index ETFs. If the theme does not pan out as expected, your investment will suffer too.
To mitigate this, you can achieve additional diversification by investing in more than one theme.
More Susceptible to Regulatory Changes and Disruptive Technology
This leads me on to the next point.
The thematic investing strategy selects companies that are at the forefront of technology and developments.
Generally, these businesses are more susceptible to regulatory changes and disruptive technology.
As these industries are very new, there is a lot of uncertainty which would invite more regulation. Also as the space is very new, and these companies are generally disruptors they are also vulnerable to be disrupted themselves, as it is hard to establish economic moats.
For example, if you were investing in the ETFMG Travel Tech ETF that is focused on next-generation travel, a new industry that is yet to be properly regulated.
Uber and Lyft that are the second and fifth biggest components in the fund and both these companies were affected by the legislation.
In Jan 2020, California enacted the California Assembly Bill 5, forcing Uber and Lyft to treat their drivers as employees and afford them more benefits and protections.
The regulatory trend is a wakeup call for the gig economy, a young industry powered by affordable, independent work. This legislation would affect the revenues of Uber and Lyft, companies that are also still burning through cash by the truckload.
According to Money Marketing a leading financial magazine in the UK, thematic ETFs, with an average expense ratio of 0.59% which is much higher than the average expense ratio for equity ETF at 0.38%.
Although this percentage might seem low, this expense ratio will compound over the long term and eat into your returns.
As discussed earlier, these thematic funds are less diversified, high-risk/high return investments with higher fees.
In addition, they are generally riskier as the data has shown that a good percentage of these funds have not survived since 2010.
Identifying the correct theme and the industries and companies that will benefit from this growth will be tricky as well.
However, if you would like to consider thematic investing, it would require you to conduct more in-depth research and learn more about systematic investing.
This would be beneficial as you would gain an in-depth understanding of the underlying factors that drive value creation and risk.
You can then utilise this knowledge for your other investments as well!
We cannot stress this enough, doing your due diligence is important as it will help you identify if this theme has durable investment merit or if it is just an illusion.
Finally, I would like to remind you to as much as possible to invest for the long run, invest in companies and causes that you believe in, and diversify your portfolio both among companies and market sectors.
Got Any Burning Questions about Thematic Investing?
Why not check out the SeedlyCommunity and ask your question there. Our open and friendly community is more than happy to help!
Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. Readers should always do their own due diligence and consider their financial goals before investing in any stock. The writer may have a vested interest in some of the companies mentioned.