Taking a Thematic Approach to Investing

The most heard investment advice nowadays is to invest your money in a combination of total stock and bond market ETFs. This passive investing approach allows you to get more bang for your buck than simply investing in mutual funds, and if professional investors can barely time and beat the market, then amateur investors shouldn’t even attempt to, right?

Others disagree with that premise and may suggest that if you put sufficient time and energy into it, it is entirely possible to beat the market through active investing, whether stock picking, FX trading or whatever. In recent years however, thematic investing has been on the rise as an alternative to both approaches. Before I explain what that exactly entails, let’s first see why neither active nor passive investing are ideal.

Active vs. Passive and why both approaches are imperfect

Let’s start with passive investing. This approach works well for the investor who puts their money away and glances at their accounts maybe once in a blue moon. It is low cost and makes for fairly well diversified portfolios. On top of that, the performance of such portfolios has been proving hard to beat over the longer run.

But it does raise questions. Why would I want to be invested heavily in equities at a time when an economy is showing the first signs of slowing down, and has already been gradually selling off? And why would I want to be invested in fixed income if we are obviously at the early stages of a multi year rate hiking cycle and will likely see several hundred bps increases in interest rates?

Why would I want to have the systematic risk at all if I know it’s very likely going to lose me money? And moreover, why should I allocate my investments to dying industries if I know some have a far better chance of outperforming others in the long run, or why would I invest in Europe if the expected stock return over 10 years is 4% while emerging markets probably offer 7%+? I’d prefer to position my portfolios in an intelligent and informed way, and not sail blindly.

Active investing on the other hand can work just fine for people who have the freedom to spend hours of their time on it every day. But even then, I work in the industry and even I only occasionally fully trust my market timing and stock picking sills (YMMV). Idiosyncratic risk can be a real killer. What’s more is that I may read the daily news and have ideas about what’s going on in the world without specifically doing any research, but to know what is going on inside companies and what drives their stock prices or credit spreads requires long and hard work that I neither have time for nor interest in.

Thematic investing is the answer

An alternative is the thematic investing approach. Theme investing goes beyond simple asset allocation, though can be a part of it. It entails looking at the world around us, and asking ourselves: what are the bigger structural trends in world society, politics the economy and financial markets, what themes are likely to drive markets over the next years and how can I best position myself for those today?

Theme investing is an investment approach where investors identify trends from a top-down angle, find themes that fit within that trend and then identify investments that will benefit. These themes can range from any of the following:

How can one actually invest in these themes?

Theme investing can be done using whatever instruments are most appropriate on a case by case basis, though increasingly niche ETFs fit the bill. Want to position for robotics and automation? There are ETFs for that (ROBO or RBOT). Want to position for water scarcity? There’s are ETFs for that (IH2O, PHO, CWW, etc.).

Less obvious are cases such as Brexit or rising interest rates, where some ingenuity is required to establish a portfolio. Yet it is easy to imagine that longer term rising interest rates should benefit the US dollar and US financials while you want to keep your duration levels low, or that Brexit will hurt UK companies whose revenue largely comes in in other currencies than GBP (on the assumption that GBP would weaken).

Theme investing does not only have to be done using ETFs. Sometimes equities, currency (cash) positions, bonds or even simple options may come into play.

Theme investing reduces both systematic and idiosyncratic risk

Theme investing reduces both systematic and idiosyncratic risk but doesn’t blindly take exposure to either one: you pick exposure to both intelligently based on the bigger trends in the world. Rather than going through company balance sheets and reading between the lines when a CEO is speaking, or even having a view of where the stock market is going, theme investing merely requires an understanding of and perspective on what drives the world around us. Ultimately, theme investing is about allocating your portfolio in an informed way.

What are some of the risks of theme investing?

While theme investing reduces idiosyncratic risk, it tilts your systematic risk away from traditional benchmarks. A theme investor will need to make sure to avoid fads (at times that can be hard to tell, for instance is crypto a theme or a fad? I don’t invest in it) and pick the themes that will offer value above traditional indices.

However if a portfolio is sufficiently diversified across different themes the impact of one individual theme not playing out is limited. At the same time, classical asset allocation considerations like risk, diversification and return need to be heeded. Theme investing does not replace that, it merely fits into it.

For instance, let’s say you allocate your portfolio across 10 themes. You can simultaneously track the risks and returns of those 10 different themes, but you can also occasionally take a helicopter approach and look at how you are actually allocated in terms of asset types (stocks vs bonds), geographically, sector-wise, and so on. That part of investing does not fall away when being a theme investor.

I prefer high-level, obvious and straightforward themes

In my personal Model Portfolio which I maintain on this blog, I show a clear preference for themes that are both obvious for all to see, straightforward and easy to understand. Examples of that can be urbanisation (who could deny that this is taking place?), global tourism (just look at tourist boom coming out of China), or automation.

These are all high-level themes that are certain to play out over the long run, and if they don’t beat the market I am fairly sure they will at least keep up with it. Meanwhile you may see me staying away from trends like blockchain, millennials or fintech as in my opinion they represent a lot of buzz but not always the substance to convince me to put my money into them.

Theme investing should be part of a broader asset allocation

Theme investing should be used as a building block in a traditional asset allocation. One can start with a traditional (yet informed) core bond and equity allocation of say 75% equity / 25% bonds if you’re a 35 year-old, then carefully replace part of that allocation with themes you have high conviction in. Instead of 75% in the core equity ETFs, you could invest 50% in it and 25% in specific themes like roboticswater scarcity or modern agriculture.

On this blog I will work my way through many of these themes and outline how to invest in them, as well as how to incorporate them in your standard asset allocation views, with a suggested allocation. I analyse each theme using a risk model and will give you a basic idea of the volatility of a proposed portfolio, the expected yield, performance in stress scenarios, etc. and use that as an input for my suggestions. You can also follow my model portfolio and its performance to see how such an approach works out in reality.

Categories: Explanations, General

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