In finance, a theme is an investing style or strategy in which an investor seeks to profit from companies benefiting from specific secular trends. Thematic investing is a popular and growing approach to active investing, as it allows investors to target investments based on their preferences and views about the future.
A thematic approach can help you identify companies well-positioned to capitalize on megatrends. For example, the Energy Select Sector SPDR Fund (XLE) tracks the 23 energy stocks in the S&P 500. XLE gained 64% in 2022 as high inflation, supply chain constraints, and the war in Ukraine caused commodity prices to soar.
Another ETF, Simplify Interest Rate Hedge ETF (PFIX), used creative OTC derivatives to benefit from rising interest rates. PFIX gained 94% returns in 2022 as the Fed turned off the printers and hiked rates. With generative AI and the metaverse well into the Gartner hype cycle, some investors are looking at the WisdomTree Artificial Intelligence and Innovation ETF (WTAI) and the Roundhill Ball Metaverse ETF (METV) to capitalize on these themes.
MSCI offers a large suite of thematic indexes across four categories: Environment and resources, transformative technologies, health and healthcare, and society and lifestyle. If you’re interested in thematic investing, here’s a guide to get you started.
What are the risks and returns associated with thematic investing?
On the risk side, portfolios focused on a few trends may be more volatile than traditional portfolios. We can see that, for instance, the ARK Innovation Fund had abysmal performance in 2022. And since these investments are based on long-term structural changes, they may take longer to play out, or they may not play out at all.
On the return side, well-chosen thematic investments can offer the potential for higher returns than traditional investments. They can also offer diversification benefits since they often have low correlations with other assets.
Research shows that from April 2018 to March 2022, eight of MSCI’s nine thematic indices outperformed the benchmark ACWI index. Cybersecurity was the top-performing index, with a 22% CAGR, or double the ACWI benchmark’s 11% return.
Thematic investing in private markets
The universe of available publicly-traded companies limits Thematic ETFs. Private companies are staying private for longer and are, therefore, off-limits to traditional ETFs. Even some publicly-traded companies are opting to return to private ownership.
This presents an opportunity for investors interested in thematic investing. Private companies often have a longer runway to execute their growth plans and may be less affected by short-term market volatility, quarterly earnings pressure, and other factors. They also provide an illiquidity premium or, more aptly, a complexity premium.
To access these opportunities, investors can consider private equity and venture capital funds, many of which have a thematic focus.
Private market investments have historically outperformed public markets in bull and bear markets. In fact, the average VC fund generates a 19% internal rate of return (IRR), compared to an 11% IRR for the S&P 500.
These differences become particularly pronounced in downturns. Ten years following the dot-com crash, private equity maintained a 7.5% average, compared to 0.08% for the PME index.
What are some considerations for investors looking to get started in thematic investing?
Not all themes are created equal. Some megatrends may be overhyped, while others may be under-the-radar. It’s important to conduct your own research and consult with experts before making any investment decisions.
In addition, it’s important to consider your risk tolerance and investment timeline. Thematic investing can be volatile, so it’s not for everyone. If you’re investing for the long term, though, a thematic approach can offer the potential for higher returns.
Diversification helps smooth out the ups and downs of individual investments, so it’s important to build a diversified portfolio. This can be done by investing in Gridline’s Thematic Portfolios, which allow investors to benefit from diversification across a mix of funds based on asset type, sector, stage, and geography. Gridline selects 5 to 10 underlying funds to build a diversified holding based on a specific investment thesis.