Thematic investing: A different approach

By Jayson Forrest

There are a number of advantages to thematic investing, but also risks. Cameron Gleeson (BetaShares) explains how advisers can think about incorporating investment themes into a diversified portfolio.

Technological innovation, climate change, and demographic change. These are the three overarching mega-trends that BetaShares believes are shaping the future. These mega-trends represent broad forces that reach into almost every part of our lives, and as they evolve and interact, they create themes that have a radical, observable impact on the world.

Thematic investing seeks to benefit from these mega-trends and long-term structural changes, by identifying transformational trends and opportunities, and make investments that potentially will benefit if these trends are realised. The type of trends BetaShares is looking to capitalise on include: cybersecurity, cloud computing, crypto innovators, video gaming, decarbonisation, electric vehicles, critical minerals, robotics and artificial intelligence, solar power, Asia technology, and e-commerce.

“One of the reasons you look for thematic funds or investment themes is to add structural growth to your portfolios, and for investments that are outside of cyclical equities,” says Cameron Gleeson – Senior Investment Strategist at BetaShares.

“When you are accessing companies that are leveraging structural growth, their revenues (and ideally, their earnings) are less orientated to the business cycle, and that can be a powerful diversifier for an investor.”

Addressing investment professionals at the 2023 IMAP Portfolio Management Conference in Sydney, Cameron believes that by incorporating thematic investing into investor portfolios, advisers are able to offer potential benefits not found in more traditional investment approaches. These benefits include:

1. Access to long-term, above-market growth opportunities;

2. Replacing high-cost active managers for targeted alpha generation;

3. Mitigate the risks of the short-term business cycle;

4. Diversify the portfolio into areas that are under-represented in the core holdings; and

5. Increase client engagement.

“Thematic investing enables advisers to add investments into a portfolio that may not be well represented in the core,” says Cameron. “From both an advice and client perspective, we have found that over the last 18 months – particularly in the high-net-worth and private banking space – many advisers have replaced high cost active managers with a passive thematic exposure that is lower cost and diversified across the thematic, enabling them to take the investment decision in-house.”

Cameron says that across the advice spectrum, BetaShares has seen a steady increase in the number of advisers who have reported their clients wanting to gain exposure to a distinctive theme, such as cybersecurity or decarbonisation.

He believes one of the positives of clients seeing structural change happening in their everyday lives and then wanting to include that change in their portfolio, is that by doing so, they typically take a higher level of engagement with their portfolio.

Cameron says that when clients look at a longer term time horizon for their portfolio that are built on themes, this can improve the adviser/client relationship, by allowing advisers to have deeper and more insightful conversations with their clients.    

However, whilst Cameron acknowledges the advantages of thematic investing, he also cautions there are risks with this type of investing that need to be considered. These include:

1. Investment risk: Thematic ETF returns can be expected to be more volatile (i.e. vary up and down) than a broad global shares exposure, given their concentrated exposure. A thematic ETF should only be considered as a component of a diversified portfolio. Risks may include: market risk, index methodology risk, concentration risk, country risk, and currency risk.

2. No guarantees: Future outcomes are uncertain, so the desired return outcome may not be achieved.

3. Personal circumstances: Advisers need to take into account any client’s individual circumstances and objectives when developing a thematic investing strategy. This style of investing isn’t suited to every client.

4. Research: Advisers need to see the relevant PDS for more information about risks and other features of each fund, and the relevant TMD that sets out the class of consumers that comprise the target market for the relevant fund.

According to Cameron, a typical Australian diversified portfolio might have about 50 per cent of its equity holding in Australian equities, which reflects the strong home-country bias Australian investors have when it comes to investing.

“Why is the best risk-return portfolio in Australia going to be clearly weighted towards certain segments which are value-orientated versus a global portfolio which is very much growth-orientated?,” he asks. “While I’m not claiming that one approach is better than the other, or one sector tilt is better than another, if we want to add more growth exposure into a cyclical Australian exposure, then one way to do that is through thematic exposures.”  

Cameron says investing in investment themes is fundamentally different to traditional investing, where investors look at historical patterns, trends and cycles to decide what to invest in next. Instead, thematic investing seeks to leverage structural change and ride that change in a way that is somewhat disconnected in terms of the underlying business earnings to that cycle.

He cites a good example being Microsoft, which has been able to leverage into structural growth themes – like software development, cloud computing, and gaming. Cameron says the benefit you get from investing in a company which is able to do that is the compounding effect of revenue and earnings (over time) it provides the investor.

“This means the profitability of Microsoft’s earnings is far higher than that of a traditional oil and gas producer, like ExxonMobil, which is more cyclical in its earnings,” he says

When it comes to thematic investing, Cameron says it’s not only important to take a long-term view on investment themes but also to focus on the company’s earnings, and have conviction on the earnings of the underlying companies.

According to Cameron, BetaShares’ approach to building thematic exposures is to look for an area where it believes there is structural growth, which is driven by three key factors:

• Longevity: Propelled by multi-decade structural change;
• Investment universe: Ensure there are enough liquid companies to choose from that are adequately exposed to the investment theme; and
• Ability to monetise: The ability for the company to monetise the theme through a large, targeted market and through its pricing power.

“Our preference for constructing thematic ETFs is to take a passive view, but to look for companies that have a level of purity in terms of their exposure to the thematic,” says Cameron. “We do believe in diversifying across the theme by ensuring we do not have too much stock-specific risk.”

One of the reasons for that is due to the indices BetaShares typically tracks for a thematic ETF being passive and rules-based. As such, diversifying stock-specific risk is important, which also enables the investor to benefit from the ‘winner takes all’ dynamic (where the best performing stocks are able to capture a very large share of the available sector). That’s because when you look at long-term stock price returns and contribution to the overall index return, generally there’s only a handful of stocks that outperform the index.

“It’s that handful of winners you really want to make sure you hold. So, the approach to thematic investing that we take is to hold the theme in its entirety, because it’s very difficult to pick winners,” he says. “So, capturing the theme in its entirety is where you want to be. Riding market capitalisation and riding momentum is the way to profit from that theme, because it’s the ‘winners take all’ that dominate.”

And while there are a number of portfolio construction approaches an adviser can take when using thematics in a portfolio, BetaShares prefers to reserve the bulk of a core portfolio for low cost passive and, where available, low cost smart beta. This approach generally only requires minimum adjustment to the portfolio over the long-term.

However, in terms of portfolio construction, Cameron believes where thematics can really make sense is as a satellite exposure to the core portfolio.

“The good thing about thematics is generally they are lowly correlated to the core, but they have higher volatility as individual funds. So, when we look at blending thematic funds into a core, we can actually see beneficial outcomes in terms of risk-adjusted returns, provided we don’t make those thematic funds too big,” he says.

Cameron Gleeson is Senior Investment Strategist at BetaShares.

He spoke on the topic ‘How to incorporate investment themes into a diversified portfolio’ at the 2023 IMAP Portfolio Management Conference – Sydney.