Thematic investing can seem to be an ideal way of capitalising on powerful trends, but is there a risk that investors become too blinkered by a compelling narrative and lose of the investment case of the underlying stocks?
Thematic investing is where a portfolio invests in a collection of companies which all relate to one area or idea, with well-known examples being robotics, technology or sustainability. This is usually seen as an example of top down investing, according to AJ Bell analyst Laith Khalaf.
While most managers employ a blend of top-down and bottom-up analysis, Khalaf added that taking a thematic approach will effectively link a fund’s performance to that of the overarching theme.
He said: “The performance of the fund will at least be partially dependent on the investment themes chosen, the extent to which they are actually manifested in the global economy, and, more importantly, the share prices of the companies operating in these areas.
“Thematic funds give active managers a place to look for investment ideas, but they still need to flesh that out with stock analysis to pick companies for their portfolio that they believe will outperform. Thematic investing shouldn’t therefore be viewed as precluding bottom-up company analysis, far from it.”
But it can become a problem when investors become too blinkered to the theme and any hype around it, thereby losing sight of the quality of the companies they’re actually investing in. A problem Primer Miton’s Duncan Goodwin said could happen.
Goodwin, manager of the Premier Miton Global Sustainable Growth fund, takes a self-proclaimed “unashamedly thematic” approach to his fund, focusing on environmental, social and governance (ESG) and sustainable stocks.
He said: “Running global thematic equity for a long time, the one thing you always want to be careful of is falling in love with a theme at any price, which we were not prepared to do.”
One way Goodwin avoids this is by making valuation the first step in his investment process.
He said: “That valuation focus allows us to focus on whether the opportunity is already in the price or not.
“And as I said before, we do think about the opportunity and how much we're prepared to pay for the opportunity, so that stops us falling in love with a particular theme.”
This has seen him alter Premier Miton Global Sustainable Growth’s position on some of companies invested in energy transition “materially based on that valuation rather than any change in thoughts about the theme [itself]”.
Disproportionately high stock valuations have been a criticism of several popular investment themes recently, most notably in US technology stocks.
There, several companies such as the FAAANMs (Facebook, Apple, Alphabet, Amazon, Netflix and Microsoft) have driven the majority of the S&P 500’s returns the past few years, but some argue that this has caused valuations to sky-rocket to unreasonable levels.
Just holding popular names to be part of the theme and not considering the investment risks is fundamentally the issue.
Valuation is one element to focus on when trying to anchor an investment case within a theme.
Jeremy Thomas, manager of the four FE fundinfo Crown rated Sarasin Responsible Global Equity fund, goes beyond this by writing a “pre-mortem” for every potential holding in order to avoid being caught up in the excitement and to rationalise the investment case.
He explained: “One member of a team or write what we call a ‘pre-mortem’, which is almost like a devil's advocate bear case or bullet points issue of the things that could go wrong.
“But it's much more than that. It's a narrative. And it's done to overcome some behavioural issues that make it easy to ignore just the downside risks or the bear case.
“We write it as a story assuming that we're sitting in 2024-2025 and this stock has gone wrong. We [say], let's just pretend we know Thermo Fisher has gone wrong [for example]. What is it that might have happened between now and that day that might explain that?
“So a post mortem of a body explains why someone dies, a premortem of a stock explains why a company has gone wrong in advance of it going wrong.”
Thomas continued that this reorients the team to focus on some of the risks, “instead just focusing on the excitement of this wonderful company”.
Thomas agreed that there was an issue within thematic investing of becoming too focused on the theme and losing site of the induvial investment case.
“I'm sure it's a problem,” he said. “It's definitely a problem in ETFs where it’s just a list of 100 or 50 companies which vaguely appear to be involved in robotics, chuck them in a basket, done, sell it to an investor or encourage an investor to buy it.”
ETFs are regularly used by investors to passively tap into one specific market theme. Green ETFs in particular have seen a significant rise in inflows over the past 12 months, though there are questions about how well they actually address the environmental, social and governance challenges trying to be tackled.
“We don't do that,” Thomas said. “If we found no ideas in automation there would be no automation stocks in the portfolio. Absolutely no simple route from our thematic automatic universe to the global buy list.”