What is thematic investing?
Thematic investing isn’t about trying to predict which specific company or sector will have the most success in the years to come. Rather, thematic investing is an approach focused on predicting long-term trends that investors believe will alter the way we live and function as an economy. By investing in a theme rather than just one specific company or particular sector, investors are able to align their portfolio with their expectations for the future while reducing some of the risks that come with concentration in a single stock. Investing in certain trends allows people to invest across sectors that may be affiliated with one another through a common objective. An example of a thematic investment would be a mutual fund or ETF that invests in companies in the cybersecurity industry. If an investor believes that the “theme” of cybersecurity will continue to increase in importance as society continues to digitally evolve, they can buy into a fund that invests in companies engaged in the cybersecurity segment of the technology and industrials sectors.
Pros
- Easier exposure to numerous companies – Instead of having to research and thoroughly understand multiple companies/stocks that participate in a certain trend, an investor can delegate that task to a fund manager or ETF provider.
- Potential portfolio hedge – Since many thematic investments focus on potentially disruptive innovations, they may act as a hedge against some of the commonly owned companies that are often slower to adapt.
- Cost – As thematic investing has grown in popularity, so has the number of options people have for gaining exposure to the space. As competition increases among investment firms, they are becoming more incentivized to offer lower cost options for interested investors. There are a number of trend-based investments currently available with expense ratios less than 0.80%. Although the expense ratios for these funds are often higher than similar investments in the broader market, proponents believe the narrowness of the specific theme allows the investment manager the opportunity to add greater value.
Cons
- Overall Portfolio Diversification – Because the thematic style of investing provides targeted exposure to related stocks and sectors, investors need to make sure they are willing to accept the increased risk and volatility that is often associated with a less diversified fund compared to a more broadly diversified fund like an S&P 500 Index Fund.
- Potential for Underperformance – Academics have found that thematic ETFs, on average, underperform the overall stock market on a risk-adjusted basis by about 4 percentage points a year for at least five years following their launch1.
- Timing – When an investment company decides that it wants to offer a new fund to capitalize on a specific trend, it has to go through a regulatory and approval process before it can offer that fund to the general public. This process can pose a risk to investors if the trend changes or is shorter-lived than anticipated by the time they are able to invest their money.
Final Word
Just like any investment, you can see that there are both pros and cons associated with thematic investing. In December of 2019, thematic funds collectively had about $49 billion in assets under management. By the end of March of this year, that number had surged to more than $160 billion in assets under management2. The numbers suggest that a large number of investors are betting on the idea of thematic investing. These investors would be wise to remember that when they are making this bet, they are not just wagering that they will pick a winning theme, but also that they will select the right fund to take advantage of that theme. An investor can be rewarded with increased returns if they are right, but the longer-term underperformance of thematic investments (discussed earlier) suggests this isn’t always the case. Before considering thematic investments for your portfolio, it is important to first evaluate your appetite for risk as well as your individual investing goals. In my opinion, thematic investments should be viewed as a complement to your core portfolio holdings; rather than a replacement.
1. https://www.ft.com/content/7e16172e-ce51-4c41-a139-3a796790bbbe
2. https://www.morningstar.com/articles/1042268/are-thematic-funds-worthy-of-the-hype-or-a-risky-distraction