This article examines the topic of thematic investing, an approach portfolio managers use for choosing assets with certain shared characteristics that drive returns.

While these may be dark days for the financial markets, the popularity of thematic investing strategies and funds continues to soar.

According to Morningstar, more than $700 billion is now invested in over 1,200 thematic funds, nearly triple the amount invested in 2019. The US research firm Broadridge estimates that assets allocated to thematic investments will grow markedly in the next few years.

And thematic investing, which emphasizes identifying a selective group of securities that are poised to benefit from emerging long-term themes or trends, such as climate change, water scarcity or aging populations, is being heavily promoted by major financial institutions.

Just last month UBS held a webinar and issued a “Thematic Guide” white paper and Envestnet moderated a thematic investing webinar featuring prominent fund and asset managers. Earlier in the year BlackRock released an extensive research report on The Great Acceleration, to boost its iShares Megatrend ETFs and Bank of America issued a thematic white paper entitled Planet, Prosperity, People and Policy.

Wealth managers react
Wealth managers have also been employing thematic investing strategies – but with caution and caveats.

Summit Financial expects continued interested in thematic investing because it’s a “compelling investment story,” said the firm’s CIO, Kevin Barry. But thematic investing in publicly traded equities “has proved too volatile,” Barry said, noting the nearly 60 per cent decline in Cathie Woods’ ARKK Innovation fund since the end of 2021.

As an alternative, Summit is recommending thematic investing via private equity. The current market environment favors thematic investing in the private markets with drawdown structures, said Stuart Katz, CIO at Robertson Stephens. “The general partner has the structural flexibility to deploy capital in a disciplined way, add operational value [through] a control investor and thoughtfully decide to monetize the investments over time,” Katz explained.

Bel Air Investment Advisors also advocates a private market approach. “The lack of liquidity [in private markets] may actually be an advantage in reinforcing long-term investing disciple,” said Carl Ludwigson, Bel Air’s managing director.

While Andrew Stewart, CIO at Exchange Capital Management, is wary of “hyper-focused themes,” he also believes that “some themes can work as long-term strategies” and looks for companies that invest in R&D of “drugs, treatments and devices that improve human life.”

The Atlanta-based wealth management firm Balentine is focusing on decarbonization as a thematic investment strategy, said David Damiani, the firm’s CIO. “We believe this theme will be measured in the trillions of dollars over the coming decades, offering attractive returns for those willing to invest,” Damiani said.

Caveats
One advantage of thematic investing, according to Damiani, is that “getting the idea correct is more critical than the specific investment because a rising tide lifts all boats.” But he cautions that if investments are made “late in the life cycle of the theme as the trade becomes crowded,” investors have to “identify the sustainable winners rather than simply ride the wave.” 

That critique was harshly amplified by Morningstar this summer in an article titled “Chasing Thematic ETFs’ Returns Has Set Investors Up to Fail.”  According to Morningstar, many investors have bought thematic funds near the top and the performance of the funds over the last three years “is a damning indictment of investors’ tendency to chase performance.”

Above average earnings growth?
But advocates of thematic investing point to the strategy’s potential to generate alpha at scale, capture growth opportunities created by long-term structural trends and its ability to allow investors to align their personal values with their portfolio.

UBS identifies population growth, aging and urbanization in emerging markets as secular trends that will “endure over the coming decade [and] will likely be resilient to economic downturns and political uncertainty.” These themes also “aim to deliver above-average earnings growth over a full economic cycle,” according to UBS.

What’s more, the Swiss bank’s Thematic Guide white paper claims that those three “pillar” trends are unlikely to be influenced negatively “by the disruptive forces of technological advancement, societal changes and resources constraints.” 

Because humans are “pre-wired to think linearly, [investors] often fail to recognize exponential growth opportunities in early and even mid-life stages,” according to BlackRock’s “The Great Acceleration” study. This tendency, the asset management giant maintains, “presents opportunities for investors to capture associated mispricing.”

Perhaps. But thematic investing “still requires the right research capabilities and a disciplined investment process,” according to the US management consulting firm McKinsey & Company.

“The search for thematic tailwinds such as renewables and growing Asian middle class consumer may be durable long term, but subject to near term unrelated hurricanes that can blow the thesis off course,” cautioned Robertson Stephens’ CIO Katz. “In other words, thematic investing requires patience and resilience.”