Thematic investing may be growing in popularity, but investors also need to consider the risks of volatility.
As Schroders investment director Chloe Shea explains, thematic investing typically involves capitalising on hidden gems that are less well-known and therefore pose more of a risk.
She says: “Thematic investing is often associated with investing in an emerging idea or upcoming trend such as digitalisation and renewable energy.
"What we have noticed is that many of the companies that are involved in certain themes are considered hidden gems, which are relatively less well-known, smaller in size and are still in the growing stage.
"As they are not the typical mega-cap companies that we see in the headlines on a daily basis, the smaller size coupled with more uncertainties around profitability means that these companies may be subject to higher volatility.”
Thematic ideas can also be quite niche in nature, as there might only be a handful of companies that are purely involved in a certain theme.
Shea explains: “A good example of such would be cybersecurity, where compared to the broader technology sector, the number of companies that specialise in this field is relatively small and may be subject to more idiosyncratic risks, hence the volatility may also be higher.
"However, investors should also remember that while thematic investments may be subject to higher volatility, if investors choose to invest in the right theme over the long run, returns can also be rewarding.”
Thematic funds demonstrate a variety of volatility levels depending on the characteristics of the theme and the product provider’s approach to construction.
This is why Kenneth Lamont, senior manager research analyst at Morningstar, says volatility should not be viewed in isolation.
He says: “It is crucial to consider the potential trade-off between risk and return. Over the same trailing five-year period, while many funds have been more volatile than the broader market, many have also produced strong returns.”
He added that exchange-traded funds, which tend to hold a narrower basket of stocks than their mutual fund peers, tend to be more volatile too. This can result in big dipper-style performance.
Lamont adds: “How risky an investment is also depends on what we are comparing it to. To illustrate the point, if we look at the Global X Lithium & Battery Tech ETF, this fund’s 10-year standard deviation is lower than any single one of its current holdings over that period.
"This suggests that the fund, which has had a much higher volatility than the broad market, may be the less risky option when used as a replacement for single stocks investments.”
Rob Powell, head of thematic and sector product strategy at BlackRock, argues this is why it is important for investors to go through a thorough due diligence process.