Globalisation, regulation and deregulation, digitalisation and innovation are playing an important role in reshaping economies, sectors and industries and these megatrends are creating thematic investment opportunities for investors. Koye Somefun, head of multi-asset solutions, sets out the characteristics of this approach and discusses the criteria investors should look at.
Listen to the podcast with Koye Somefun, watch our video (below) or read this article on the why and how of thematic investing
Thematic investing involves investing around a central idea, a powerful story that is expected to drive portfolio performance. At BNP Paribas Asset Management, we believe that investing in themes means focusing on structural trends that are expected to significantly affect economies and redefine business. Think of: demographic shifts, social or behavioural changes, preserving the environment, resource scarcity, economic imbalances, technological progress and regulatory or political changes.
We believe such megatrends can play a big role in the returns and risks of a wide range of investments. Contrary to some views, investing in themes is not limited to publicly listed equities or corporate bonds. Private equity or debt can also be a way to get exposure to a theme.
Nor does thematic investing need to be limited to a particular industry or sector, to well-established firms or just start-ups, or to companies of a certain size. Themes such as consumer innovation transcend sectors: it touches on healthcare, telecommunications and retailing, to name but a few. So it is clear that too narrow a view can cause an investor to miss opportunities. Themes can involve companies in all stages of their growth cycle (see Exhibit 1).
When looking for companies exposed to a theme, it is important that those selected have a significant part of their business dedicated to activities related to the theme. That means they generate a meaningful part of their revenues from selling products or services related to the theme.
Contrary to some perceptions, thematic investing is not just about investing in growth companies. A theme such as consumer innovation could encompass a fast-growing start-up delivering food to homes and offices, but equally an established supermarket chain reinventing itself or an online bookseller branching into cloud computing services. Any advantage that a group of companies has over their industry peers or any factor that disrupts entire industries can be useful when identifying a theme.
Finally, it is worth pointing out that in our view, themes are not restricted to countries or regions. We take a global perspective when investing in a theme.
What is the appeal of thematic investing?
We could rephrase the question and ask how returns from thematic investing compare to those of equity or bond portfolios. First, let’s set equity portfolios against bond portfolios and address the widely held perception that stocks typically outperform bonds over the long run.
Comparing the performance of US stocks and US Treasury bills between 1926 and 2016, it appears – perhaps surprisingly – that the returns of most buy-and-hold investments in individual US stocks fell short of those earned on one-month US Treasury bills over the same period. Yet it is well known that a broad stock market index greatly outperformed US Treasury bonds over this time.
The explanation for this paradox lies in the skewness of stock returns: This is in part because some companies are better positioned to take full advantage of transformative change in society. As a result, a small number of stocks typically generate most of the returns of a broad equity index.
That takes us back to thematic investing and its focus on investments in companies that are well positioned to profit from the transformative changes referred to above, in other words, on identifying the current and future champions for each trend. Those champions should have an outsized impact on value creation.
Watch our video on thematic investing
Allocating to thematic investing
Allocating to thematic investments requires a deep understanding of how they interact with other investments in the portfolio. The goal is to establish the extent to which thematic investments bring something new to the portfolio. This is important in order to know which positions in the portfolio should be reduced so that we can allocate thematic investments efficiently.
How does thematic investing in practice? A first step is to determine how a theme is represented. For the more common themes, this usually takes the form of an existing thematic benchmark index. Sometimes, such indices are replicated by exchange-traded funds (ETFs).
The caveat here is that there is not always a consensus on which assets should be part of an index portfolio representing the theme. One alternative is to use benchmarks from more than one index provider. Another is to rely on the return time series of the funds selected to invest in a given theme, combining them into a representative return series.
Finally, for themes that relate to specific sectors of the economy, it is not unusual to see thematic funds only benchmarked against a relevant sector index. In such cases, it is important to assess the expected benefit from biasing the selection towards the companies more exposed to the theme.
Thematic, ESG and long-term investing are sometimes confused
It is important to distinguish between thematic investing, an approach taking into account environmental, social and governance (ESG) considerations, and long-term investing.
While thematic investing generally involves trends that often materialise in the medium to longer term, this is not always so. Some themes may run their course faster and you may find that the market discounts them sooner than others. It is important to assess from time to time whether a theme remains a good investment.
Similarly, not all thematic investments are ESG compliant. There is a difference between companies pursing sustainable practices and those deriving a significant share of their revenues from services and products related to sustainable themes such as the energy transition or environmental sustainability.
It has to be said that for many investors, thematic investing is a way to have a sustainable impact and achieve their own sustainability goals. However, they also expect to achieve better returns when investing in themes and improve portfolio diversification.
Also read the article blog Assessing the added value of thematic investments and the white paper ALLOCATING TO THEMATIC INVESTMENTS An investment rationale for institutional investors
 See New survey confirms shift to thematic investing on our Investors’ Corner blog