How to use ETFs to get exposure to thematic investing

  • Identify what thematic investing is and why it has been associated with active management.
  • Describe why it is important to understand the aim of the index methodology and how they are constructed.
  • List why it is important to ensure investors have a meaningful exposure to a trend.
How to use ETFs to get exposure to thematic investing

Venture into any modern big city and you will see the signals of a rapidly changing society. 

Millennials messaging on social media, electric cars silently cruising along the road, retirees, of which there are increasing numbers, utilising their leisure time – or those past retirement age working on.

Ten or 20 years from now the scene will be different again, as new technologies, new trends – a new normal – emerges.

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Evolving societies pose a challenge for investors, with the threat always there of being on the wrong side of changes – of becoming the victim of capitalism’s creative destruction rather than riding the wave of new innovations.

Step in the concept of thematic investing.

Thematic investing focuses on picking companies that are capitalising on future trends and macroeconomic themes. The majority of thematic equity strategies focus on technology, demography and environmental challenges.

Technological themes include digitalisation, automation and robotics, artificial intelligence (AI), social media, blockchain, and cloud computing.

Demographic trends focus on the challenges of growing and ageing populations, lifestyle, wealth increases, medical progress, and generational spending patterns.

In the environmental category we have climate change, renewables, waste management, agribusiness, and water, while infrastructure and urbanisation are also relevant. 

The idea with thematic investing is that by focusing on stocks with high exposure to major trends, superior risk-weighted returns can be achieved in comparison with traditional investment approaches. 

There is an estimated €460bn invested in thematic equities globally, according to data from Morningstar, February 2018.

Thematic investing has in the past invariably been tied to active management, with a fund manager making an active bet on stocks they consider to have high exposure to a specific theme, or set of themes.

However, a multitude of thematic exchange-traded funds (ETFs) have launched in recent years that aim to provide thematic exposure but with the benefits of passive index investing – i.e low management fees, greater methodological transparency etc. 

Index methodology

When grappling with the rudiments of index-based thematic investing it is important to understand what the aim of the index methodology should be, and how a robust index can be created. 

The first point to note is that the constituent selection approach obviously has to be different to the standard method of weighting stocks according to their market capitalisation.

The method of attributing the highest weightings in a portfolio to the biggest companies is based on the premise that stocks that outperformed in the past merit the highest weighting in the index.

Thematic ETFs, on the other hand, focus on companies that are judged to be well placed to be the success stories of tomorrow. As the index has to be forward looking it cannot therefore be selected, and weighted, by market capitalisation.