Records suggest that thematic funds often struggle to perform consistently well. Yet, Alex Illingworth believes building equity portfolios around themes can yield consistent returns- if managed efficiently. He shares the seven factors he believes are key to successful thematic investing.
There is a powerful logic to building equity portfolios around themes – typically focused on companies in areas of the economy with a tailwind behind them.
Over £142bn worldwide is now managed in thematic funds and in the past six years asset managers have brought more than 140 to market. Themes pursued recently include artificial intelligence, cannabis and the digital economy.
The fashion for thematic investing is not confined to active managers. The number of thematic exchange-traded funds (ETFs) has ballooned to include clean energy, cloud computing, blockchain and even 3D printing.
Marketing managers clearly love launching thematic investment products. They are an easy story to sell because the rationale behind them is so intuitive. But the records suggest these funds struggle to perform consistently well.
New research on thematic ETFs trading in the US between 1993 and 2019 showed they underperformed the stock market by around 4 per cent for at least five years after their launch. Other research shows that fewer than 15 per cent of thematic funds survive beyond 15 years.
Investors tend to treat single-theme funds as satellite holdings – something on the edge to add spice to a portfolio. But is there a different way of incorporating themes within a core strategy? We build our portfolio around nine (sometimes 10) themes, including “online services”, “automation”, “low carbon world” and “emerging market consumer”. This year will be our 10th using this approach. So what have we learned?
Incorporating so many themes forces us to be focused – we hold up to 10 stocks in each theme, but sometimes as few as three. It can be tough being so selective, but it means these companies are the best we can find. Single-theme funds have to hold far more than that, even if some of the companies lack quality or benefit little from the named theme.
If we identify a theme but struggle to find companies of sufficient quality with which to populate it, we don’t let our standards slip – we wait. A couple of years ago we thought there might be a theme around the death of plastic, but we found it difficult to identify companies offering alternatives whose growth prospects were convincing. We are still looking. When we first started thinking about the “low carbon” world theme we also struggled. But the pandemic has accelerated many trends, including the transition to a carbon-neutral world. The theme now constitutes around 13 per cent of our portfolios.
The best investments are not necessarily the most obvious. For instance, within our “low carbon world” theme we recently invested in Trane and Daikin, which are both seeing increased orders for their modern air conditioning systems. A quarter of the world’s total carbon emissions come from heating and cooling buildings and transporting refrigerated goods. Trane aims to reduce one gigaton of carbon emissions from its customers’ footprint by 2030. (The fact that offices now need systems that clean the air more frequently is also driving growth.)