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Thematic investing: Independent sources of excess growth
THEMATIC opportunities transcend typical market boundaries and categorisations, and often have multi-year return profiles not fully exploited by traditional country, industry, or style factors.
In recent years, thematic investing has attracted significant interest worldwide. The uninspiring performance of some traditional active strategies is prompting asset owners to seek alternative return sources and new ways that outperform market benchmarks.
Expanding interest in sustainability and socially responsible investing has been a tailwind for thematic approaches as well.
Investors concerned about lofty broad-market valuations are looking to diversify into areas with better long-term growth potential.
For example, the increase in carbon-emission caps and limitations on the urban use of internal combustion engine vehicles are supporting the global adoption of electric vehicles.
Changing consumer preferences are leading to an explosion of e-commerce and demand for experiences over objects.
Technological innovation is creating new industries and investment opportunities in everything from gene therapies to artificial intelligence.
Themes can represent exponential growth opportunities, but they often go underappreciated for extended periods, largely because of the difficulty in comprehending and discounting the changes they can usher in over time.
For instance, 25 years ago, few would have imagined the ubiquitous reach of mobile phones - a market that expanded 55 per cent annually from 1995 to 2008, which now has over a 100 per cent global penetration rate.
There are three potential benefits to a thematic approach. The first is additional returns. Thematic investments often feature business models with the potential to grow earnings and revenue faster than the overall market.
Enterprises whose earnings derive from the adoption of renewable energy or expanding connectivity, for example, will likely see demand that outpaces the market.
The second is diversification. Many thematic stocks have low long-term correlations to traditional indices, with revenue sources independent of country or global economic cycles.
Existential disruptions like mobile technology or immuno-oncology, and demographic shifts such as aging populations or growing emerging markets' middle classes are broad-based, with value chains that span multiple sectors and are country agnostic.
Furthermore, because indices reflect historical market constructs, they often typically under-represent future growth areas.
Lastly, long-term growth. Investment horizons and holding periods have been in structural decline amid higher-frequency trading, growth in passive instruments and exchange-traded funds (ETFs), and increased access to real-time market data.
Thematic investors have an opportunity to gain early exposure to secular outperformers with long runways for growth.
Despite these benefits, challenges nonetheless exist. Heuristics and biases can create inaccurate assessments about a theme's timing or scope. Accurately identifying investments in a bona fide high-return-potential theme which will benefit from that theme is also troublesome.
Investors must verify the secular opportunity through dedicated multi-disciplinary research. It is critical to establish whether or not a theme represents a legitimate secular opportunity with the potential to generate above-average returns not reflected in current market valuations.
Thematic research must also be pragmatic. Often, a thematic idea is too early or lacks necessary market engagement, weakening the investment thesis for the time being.
To determine if and when a trend will gain market traction and affect profit pools of certain companies, teams need to construct practical, research-based frameworks.
We believe understanding a theme requires a mosaic of multi-disciplinary top-down and bottom-up insights.
Investors must also take an active approach that focuses on thematic pure plays. Active strategies focused on pure-play investments that are primarily leveraged to a theme are particularly effective.
Enthusiasm for passive approaches has led to a proliferation of thematic ETFs, which establish their opportunity sets from a broadly defined thematic "beta".
By casting such a wide net, passive vehicles potentially expose investors to companies with diluted or secondary exposure to a theme.
Extraneous aspects of the business may dominate the investment case and have a greater impact on stock price performance than the theme itself.
Another potential edge for active management arises from stock-level dispersion within themes.
Because themes often span multiple sectors and regions, individual stock performance with a theme can vary widely, suggesting that blunt exposure via passive allocations is suboptimal.
Investors can improve on thematic beta exposures by applying active fundamental insights, which seek to distinguish between potential long-run "winners" and "losers" within a theme.
In addition, investors must maintain a long-term perspective and watch fundamentals.
We determine milestones that gauge a theme's development, using metrics like adoption rates, market share, or government policy targets, which can subsequently be monitored.
Investors should also want to have a view on a theme's maturity to avoid staying too long or rationalising investments in a theme that fails to develop as expected.
Finally, to avoid overpaying, there is a need to set valuation expectations to identify the point at which we feel a theme's excess-growth expectations are discounted in market valuations.
We appreciate that historical valuations are a poor tool for forecasting the trajectory of a thematic idea that is in the early stages of structural - and usually nonlinear - development.
Marrying the art and science of investing is crucial, especially as it relates to ground-breaking business models or disruptive technologies.
- The writer is managing director and portfolio manager at Wellington Management. He leads the firm's multi-asset and themative investment efforts for the Asia-Pacific region.