Thematic investing takes sustainability a step further. Here's how
When investors follow global megatrends, they build sustainable and profitable portfolios
TLDR: Responding to global challenges, more and more businesses are making a profit from operations that benefit the planet and its people. Some, but not all, of these challenges are related to sustainability. Thematic investing aims to augment return on investment by capitalizing on such global challenges. Including sustainability-related methodologies in thematic investing can further enhance returns. In particular, materiality assessments are a promising way to analyse the risk and return of a thematic investment portfolio. Thematic investing, which is often coupled with sustainability-related criteria, can not only bring more financial value to investors, but also reflect who they are and which subjects they care about.
Many investors these days are mindful of the global trends and challenges ahead. These include parts of, but are not limited to, environmental, social, and governance-related issues (ESG). Trends that do not explicitly relate to ESG are artificial intelligence, the Internet of Things, and global trade, amongst others.
Some of these trends encompass many different sectors, span many countries, and have massive economic and financial potential. Such macroeconomic, geopolitical and technological tendencies are called themes or megatrends.
Structuring an investment portfolio so that it aligns with these trends helps maximize their long-term returns. In contrast, misinterpreting these trends can cause funds to miss out on key developments, and perpetually sail against the tides of the macroeconomic environment.
Thematic investments must not necessarily be sustainable. Because of their long-term orientation, many thematic funds nevertheless meet ESG criteria or even succeed them.
Spotting megatrends and constituting a portfolio which reflects their impact is not a trivial task. We explore this further below. Thematic funds are not subject to any specific regulation, but they fulfill certain criteria, which we shall explain. There is lots of common ground between thematic and sustainable investment; in fact, many methodologies from sustainability might prove useful for thematic investors.
How megatrends bring investment opportunities
Megatrends can be easy to spot using some gut feeling: artificial intelligence has been in media conversation for several years and is not stopping; renewable energies are a constant in public discourse. Quantifying the magnitude of these trends, and filtering out any trend that one might have missed otherwise is hard work. Keeping track of various developments and how they change over time is even harder.
BlackRock uses Natural Language Processing (NLP), a machine-learning technique to understand unstructured data like text, to scan news articles for such megatrends. The firm scans more than one million financial news articles each year to extract prominent keywords such as “cryptocurrencies” or “electric vehicles” which might qualify as megatrends. They then scan through information on various companies to identify those that are exposed to such megatrends in a direct or indirect way. For example, they might discover that a supermarket chain now accepts payment in cryptocurrencies, and therefore conclude that this chain is somewhat exposed to this theme.
Such themes or megatrends are then evaluated regarding their financial relevance. Some themes, like cryptocurrencies, might be built on an interesting set of ideas, but subject to massive volatility. This makes the theme less attractive for an average investor than electric vehicles, which are becoming increasingly cheap and are distributed with a well-established business model. This makes businesses that are exposed to electric vehicles on average more investable than businesses that are exposed to cryptocurrencies. As a result, an investor might prefer to set up or put more cash into a fund for electric vehicles.
One thing that all megatrends have in common is that they arise due to structural forces, such as ageing demographics, globalisation, or environmental changes. These forces create problems, which businesses then try to address. Environmental changes brought on electric vehicles in the sense that gasoline cars contribute too much to climate change, necessitating another transport solution. Cryptocurrencies arose after the financial crash of 2008, were made possible due to recent advances in cryptography, and quickly found enthusiasts around the world in parts because of the shakeout of the crisis, but also due to globalization and the existence of the internet.
Some of these forces are short-term, for example a financial crash. Others, like environmental changes, will likely accompany humanity for decades to come. Thematic investors not only study these long-term and short-term forces, but also how they interact and give rise to long-term and short-term themes.
Businesses addressing a large problem brought on by an external force might thrive and distribute outsized returns to investors. On the flip side, businesses that are serving a declining trend need to get creative to maintain investors’ faith. The tobacco industry, for example, is contracting due to stricter regulation and declining public sentiment around cigarettes and related products. Although the industry has managed to keep returns to its shareholders fairly consistent, it is poised to contract further in the next twenty years. This makes tobacco a bad candidate for a theme.
The seven golden rules of thematic investing
In 2022, Galilee Asset Management published a white paper in which it outlines the defining rules for thematic investing. These are not legally binding in any way, but serve to bring clarity to a vast and complex landscape of different funds. The rules are rather useful to understand thematic investing in further detail:
Thematic investing is not sectoral investing. By definition, themes arise from structural forces which can encompass many sectors. For example, consider a Swiss healthcare company and an American cruise company: The two belong to very different sectors, but their theme is the Silver Economy, i.e., the economy relating to the aging population.
Thematics are not market segments. The segment of French smallcaps might be interesting to study; however, all companies in this segment are not exposed to the same structural forces and thus the same themes. In fact, thematic investing breaks with traditional investing which often specializes on one segment at a time, opting instead for a broader approach.
Economic perspectives are not the same as financial market potential. Electric vehicles might be an economically strong theme; nevertheless it might have less financial potential than the stock market is suggesting due to hypecycles, bubbles, and similar effects. Promising economic perspectives of a theme are therefore not enough to justify a thematic fund; one needs to check for promising financials, too.
ESG is not a theme. ESG investing is a management technique for investing, and has not arised from long term forces per se (although some sub-topics of ESG do). The Pictet Water Fund, for example, focuses on the theme of water. It also has a purpose of reducing negative environmental externalities; this, however, is not part of the theme itself. It shows, however, that ESG criteria and thematic investments often go hand in hand.
A theme must stem from one or more megatrends. For a company to belong to a theme, it is not enough to be loosely connected to a set of ideas. A traditional locksmithery and a smart lock company might be solving the same problem. Only the smart lock company, however, is driven by two megatrends: digitalization and new modes of consumption.
A theme must be structural, international, and multi-sectoral. As a corollary of the rules above, a theme must span multiple sectors and nations. It must also structural in the sense that it is built on global structural shifts. As such, it must not be questioned for at least the next 20 years. The Silver Economy, for example, will be fueled by a doubling of the senior population from 1 billion today to 2.1 billion in 2050. There is no need to question this trend in the next couple decades.
Do not make a thematic allocation without specific metrics. For each theme, a fund manager needs to develop thematic indicators to accurately determine the valuation of theme-associated companies. In addition to financial metrics, this might include ESG ratings as well. This is is no different from what managers would do with any financial market before selecting a company from it.
In essence, thematic investing requires rigorous cross-sector research on long-term structural forces and on the business that are most exposed to said forces. This allows for the existence of high-quality thematic portfolios, which, according to BlackRock, have grown over 10x from $13bn in 2016 to $148bn in 2021.
How thematic investing ties in with sustainability
Megatrend funds focus on understanding long-term growth in profits of various companies, for example because of demographic shifts or resource scarcity. Sustainability is per definition long-term oriented, which leads to interesting consequences for the intersection between thematic and ESG investing.
The most basic way to use ESG for investing is with exclusionary criteria: Funds might choose not to invest in tobacco or gambling because of sustainability-related concerns. The next level of ESG investing is including ESG considerations within financial analysis and investment decisions. Fund managers might also consider how ESG issues impact a security’s risk and return profile. This process is guided by financial materiality at the sector- and at the industry level.
One can also take this a step further: Sustainable thematic investing means constituting a portfolio of companies that align to a sustainability-related theme such as climate or social issues. Such themes might be renewable energies or gender- and diversity issues. Just like in ESG investing, sustainable thematic investing requires dedicated methodologies to understand how the theme affects financial analysis and a security’s risk and return profile. Because it focuses on a sub-topic of ESG, sustainable thematic investing can be viewed as a special form of ESG investing.
How thematic investors can use materiality
ESG investors frequently use materiality assessments to understand which ESG criterion might impact financial and extra-financial performance. These, however, are somewhat more challenging to do for sustainable thematic portfolios than for regular ESG portfolios: Standards for materiality are industry-based, and thematic portfolios typically span many different industries.
One must therefore map out all exposed industries, and assess the materiality of each industry separately. Only then can one put all pieces together and create a materiality assessment of the entire portfolio.
Currently, this is hard manual work. Just like producing and tracking custom metrics for thematic portfolios, materiality might, however, become automated with the use of Wangari’s software once it is production-ready.
Every portfolio is a reflection of an investor’s values
Each investor has different values. Do they seek short-term profit or do they think more long-termist? Do they value rugged individualism, or social value creation? Which problems are dear to their heart, which do they care less about?
Such values are difficult to express in traditional portfolios of, say, French small-cap companies. By selecting thematic portfolios tailored to their values, investors can express what they care about most, and what they envision the world to be like in a couple of decades.
Thematic investing and ESG investing are two different topics with much common ground. What binds them together is a commitment to long-term thinking, and the use of rigorous analysis to spot value-adding companies that produce returns on investment that last decades.
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