Does thematic investing work?

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?

Be focused

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.

Maintain standards

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.

Think laterally

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.)

Be prepared to drop a theme

Themes wax and wane. We have dropped a couple in recent years. One relied on the spending power of the ageing demographic in Western economies. The rationale was that in an ageing world the cohort of new pensioners was growing at a faster rate than GDP. However, there reached a point when the bulge of retiring baby boomers started to thin. As people move further into retirement they tend to spend less. It was time to move on. More recently we had a tourism theme, designed to benefit from the growth in international travel. Early last year we decided that the strengthening green agenda might act as a brake on air travel and exited in time to avoid the carnage caused by Covid.

Embrace sustainability

There is little point investing in any business if it is facing mounting environmental, social and governance issues. We monitor these continuously as they can change over time. For instance, we expect the new Democrat Congress to set higher regulatory standards for online media businesses. This could prove expensive for companies like Facebook (where we also have governance concerns). 

Watch valuations and vary the allocation

When a theme becomes popular valuations can soar. This may be good for a while, but what goes up too far always comes down. We can vary the amount invested in each theme as valuation dictates. The ability to increase or decrease capital in a theme helps in other ways too.

At the start of 2020, we expected a steadily growing world economy led by the US. This would have suited our automation theme, for instance. When the pandemic struck we reviewed our themes swiftly. It became clear there would be sharp economic contraction in the US and Europe so we reduced our exposure to the more cyclical elements in our portfolio, focusing more on holdings in “online services” that could help us work from home and our “scientific equipment” companies that lead the world in testing for Covid-19. With the arrival of vaccines suggesting more normal social conditions later this year, we have again reviewed our themes, taking some profits in our technology holdings. We have added to the more economically cyclical themes, like “automation”, which should see rising orders as economies recover and economic stimulus measures come through.

Diversification

As illustrated here, the benefit of a diversified portfolio built around themes is that we can switch emphasis between them when circumstances change or the market cycle turns. But that means we have to choose themes carefully, ensuring they are not too heavily correlated.

Thematic investing can work

Undiversified single-theme funds in segments the market has most favoured will often top the tables of annual performance. Holders of these funds will speak eloquently at drinks parties (remember those?). However, it is the average of fund performances which tells the whole story.

Last year six out of our nine themes delivered positive performance, showing we are fishing in the right places. The fact that many of our chosen themes overlap with ESG (environmental social & governance) trends helped. Our long-term performance over nearly a decade demonstrates that, with this sort of approach, thematic investing can be core to investors’ portfolios. It helps us identify strong companies in thriving parts of the market that are capable of compounding returns – a good starting point from which to grow real wealth and protect it.

Alex Illingworth co-manages the Artemis Global Select Fund and the Mid Wynd International Investment Trust. If you found this article interesting, we can email you when similar articles are published; simply register for 'My Artemis' and follow the funds and/or Alex.

FOR PROFESSIONAL INVESTORS ONLY. NOT FOR USE WITH OR BY PRIVATE INVESTORS.

Capital at risk. This content has been prepared for professional investors only. All financial investments involve taking risk which means investors may not get back the amount initially invested.Reference to specific stocks should not be taken as advice or a recommendation to invest in them.
Artemis Global Select FundThe fund is an authorised unit trust scheme. For further information, visit www.artemisfunds.com/unittrusts.
Mid Wynd International Investment Trust
This information does not constitute an offer, invitation or solicitation to deal in the securities of this fund.
Financial advisers and retail investors: The company currently conducts its affairs so that the shares in issue can be recommended by financial advisers to ordinary retail investors in accordance with the Financial Conduct Authority’s (FCA’s) rules in relation to non-mainstream investment products and intends to do so for the foreseeable future. The shares are excluded from the FCA’s restrictions which apply to non-mainstream investment products because they are shares in an investment trust.
Third parties (including FTSE and Morningstar) whose data may be included in this document do not accept any liability for errors or omissions. For information,visit www.artemisfunds.com/third-party-data.Any research and analysis in this communication has been obtained by Artemis for its own use. Although this communication is based on sources of information that Artemis believes to be reliable, no guarantee is given as to its accuracy or completeness.
Any forward-looking statements are based on Artemis’ current expectations and projections and are subject to change without notice.

Issued by Artemis Fund Managers Ltd which is authorised and regulated by the Financial Conduct Authority.