The potential for higher alpha or extra diversification are some of the reasons why investors should consider using thematic investments within their portfolios, according to Pictet Asset Management strategists. 
Investors have traditionally thought of stock markets in terms for their country or regional domicile but Pictet argued that defining companies in this way is becoming “tenuous”. It noted that many investors think of the FTSE 100 as being representative of the UK economy, but in reality more than half of its revenues are generated overseas.
“These anomalies help explain why allocating capital along other dimensions – including by investment theme – is growing in popularity,” they added.
“Thematic equities offer investors the opportunity to capture growth from areas of the economy that defy traditional classification. Investment themes, such as robotics and clean energy, straddle industries, countries and regions. They are also more tangible portfolio building blocks.”
Below, Pictet’s strategists highlight three ways that thematic funds can be used in an investor’s portfolio.
Thematic equities in a core-satellite portfolio
Pictet said that investors who build portfolios using a core-satellite strategy – or based on a core of traditional assets like equities or bonds with more unconventional satellite holdings on the side – should find it “relatively straightforward” to include thematic investing.
“Thematic equities make for effective satellite investments for several reasons. To begin with, thematic stocks are companies that don’t feature prominently in mainstream indices such as the MSCI World,” the firm’s strategists said.
Thematic equity in a core-satellite portfolio
Source: Pictet Asset Management
“The thematic investment universe contains a higher proportion of smaller-cap, specialist firms and emerging market stocks. What is more, the range of thematic investments is broad – there are almost as many thematic stocks as there are companies represented in traditional global stock indices.”
The firm also conducted research into the effect of adding thematic equities to a diversified portfolio – one whose assets are split, in varying proportions, between stocks and bonds (using the MSCI ACWI index and the BofA Merrill Lynch Global Government Bond index as respective proxies) – to determine the optimal size of a thematic equity allocation.
This suggested that an optimal core-satellite portfolio would have as much as 20 per cent allocated to thematic equities, depending on an investor’s return target.
Thematic equity allocation within a mixed bond and stock portfolio
Source: Pictet Asset Management
In addition, Pictet’s research found that a portfolio with 60/40 split between equities and bonds has made an annualised total return of 7.9 per cent with volatility of 9.8 per cent over the past decade.
If the allocation is changed to 41 per cent in bonds, 41 per cent in traditional equities and 18 per cent in thematic equity, then the annualised return rises to 8.1 per cent with the same volatility.
Thematic equities as a carve-out
While the core-satellite approach has a decent number of followers, most investors rely on geographical regions for their asset allocation decisions – thinking about their portfolio in terms of exposure to areas such as North America, western Europe and Asia-Pacific.
Pictet conceded that portfolios such as this do not appear to be natural homes for thematic investing, as the strategies that use this approach are global rather than regional in their nature. However, it added that there is “a strong case” for creating a ‘carve-out’ allocation to global equity strategies to allow thematic allocations to sit alongside larger regional ones.
“Regional investing aims to spread capital across assets that don’t fully move in lockstep with one another, but the approach isn’t failsafe. The last two decades have shown time and again that regional equity markets can move in tandem, particularly during periods of high volatility. This is why the addition of a differentiated global asset class such as thematic equity can help diversify sources of risk and return,” the group’s strategists explained.
“Some thematic equity strategies work more effectively than others as a complement to regional or country-based portfolios. Those that function best invest across multiple investment themes simultaneously and are therefore more broadly diversified, which can therefore account for a larger portion of a global equity allocation.”
Thematic equities as a portfolio diversification tool
The final approach to using thematic investments sees them used as a diversifier for global-biased portfolio. As noted above, allocating on a regional basis is one of the most common methods of portfolio construction but many are increasingly questioning this approach.
Pictet explained that the correlation of returns among regional and country stock markets since the financial crisis of 2008 has tended to spike whenever there is an equity sell-off. This essentially means that any benefits of international diversification disappear just when they are needed the most.
Because of this, global investing – or allocating capital across global industry sectors – has become more popular in recent years. Academic research appears to back the validity of this, with several studies showing that a company’s domicile can have less influence on investment returns than the industry it operates in.
Thematic allocation within a balanced portfolio
Source: Pictet Asset Management
“Thematic investing is designed to benefit from this trend. Not only is its approach country/region agnostic, but its investment universe is composed to a significant extent of companies that aren’t represented in mainstream global benchmarks,” Pictet said.
“This suggests that a global portfolio with investments across a diversified basket of complementary thematic equities offers a potentially more efficient allocation of capital than one constructed using traditional regional building blocks.”