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Wanted: A better definition of thematic investing

Brian Garvey, Multi-Asset Portfolio Manager
Manny Hunjan, Associate Director of Multi-Asset Risk Oversight
2023-09-20
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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

With thematic investing gaining traction in the investment community in recent years, and with momentum in technological disruption also accelerating, we have observed a rise in the number of market indices available for investors to gain exposure to promising investment themes. The proliferation of such indices is not without a downside, however.

Most of these thematic indices focus narrowly on a singular innovative or disruptive trend with recent outperformance over broader global markets and the assumption of continued structural tailwinds. While this description loosely fits the definition of thematic investing, these indices are generally constructed after confirmation of strong performance from the underlying theme and with the benefit of hindsight into the previous cycle’s business environment. More concerning to us, though, is that “underneath the hood,” the majority of thematic indices are heavily levered to the same market factor that performed well over the last cycle — namely, growth.

What is thematic investing really about?

Thematic investing is about identifying and allocating capital to areas of the global financial markets that can potentially experience outsized returns from being well positioned to capture one or more structural trends. The underlying trends can be innovative and disruptive, such as the rapid technological growth of the past two decades, or focused on more value-oriented factors, such as supply/demand imbalances stemming from years of business consolidation and underinvestment. The main criterion, in our view, is that the theme in question should not be easily explainable or exploitable through traditional market factors (e.g., country, sector, style).

Two problems with passive thematic indices

In an archived June 2021 piece titled “A theme is not an index,” our colleague Andrew Sharp-Paul discussed the challenges associated with passive index implementations for allocators seeking true thematic exposure in their portfolios. Andrew aptly noted that investment themes cannot be predetermined or effectively pursued through so-called “rules-based” investing. Additionally, we believe passive thematic investing subjects allocators to undue portfolio risk from both a factor and an overall diversification perspective. Two key takeaways from our analysis on this topic included:

  1. Most of the currently available passive thematic indices tend to represent a single investment theme or trend, resulting in a concentrated (read: non-diversified) thematic portfolio allocation.
  2. Most of the existing passive thematic indices exhibit a built-in structural “tilt” or bias toward the commonly tracked growth factor — again, the one that fared well over the last cycle.

1. Most available passive thematic indices represent a single theme.

While we believe thematic investing can play a pivotal role in increasing a portfolio’s risk-adjusted total returns, it’s important to recognize that individual standalone investment themes will inherently reflect very specific, narrow drivers of return and risk. Much like broader portfolio diversification may help improve the portfolio’s expected risk-adjusted return profile, a select group of differentiated thematic “plays” — each benefitting from distinct and uncorrelated structural trends — should, at least in theory, provide that same advantage within the portfolio’s thematic allocation. (Of course, neither asset allocation nor diversification can guarantee a profit or protect against loss in declining markets. They are strategies used to help manage investment risk.)

But in reality, relying on the market’s overly narrow definition of thematic investing may ultimately undermine the intended diversification benefits. To help illustrate this point, we looked at the following MSCI “megatrend” indices, all of which are passive thematic benchmarks designed to provide equity exposure to a particular investment theme (see below for more detailed descriptions of each index):

  • MSCI Cybersecurity Index
  • MSCI Ageing Society Opportunities Index
  • MSCI Robotics Index
  • MSCI Efficient Energy Index
  • MSCI Digital Economy Index
  • MSCI Disruptive Technology Index
  • MSCI Future Mobility Index
  • MSCI Millennials Index
  • MSCI Smart Cities Index

Figure 1 shows the annualized returns, historical volatility, and risk-adjusted performance of these various indices since their inception a decade ago (June 2013 – May 2022, with the exception of the MSCI Cybersecurity Index, which launched in February 2019).

Figure 1
wanted-a-better-definition-of-thematic-investing-fig1

The first three columns are MSCI ACWI indices (Core, Growth, and Value), the following nine are the aforementioned passive thematic indices, and the last column represents the profile of an equal-weighted, hypothetical index composed of the nine thematic indices. While most of the themes delivered strong overall 10-year performance, the equal-weighted basket of themes outperformed global equities on both a total-return and a risk-adjusted basis. Additionally, the combined thematic index also outperformed the majority of the standalone themes on a risk-adjusted basis.

There were a few themes that outperformed the equal-weighted thematic basket, but much like “picking winners” in the broader stock market, choosing from a universe of possible thematic plays could be facilitated by utilizing a basket approach to construct a thematic portfolio allocation. As of this writing, however, the marketplace does not offer many diversified implementations of multi-theme indices, limiting the options available to allocators and hence their ability to diversify across a range of structural opportunities. Further, the results from several of these indices may reflect some hindsight bias, as returns for a passive thematic index are often “backfilled” rather than incorporating the true realized returns from a managed portfolio.

2. Most existing passive thematic indices are biased toward the growth factor.

To help understand the factor “footprint” of the return drivers of the passive thematic indices listed above, we employed a performance-based approach to estimate investment-style exposures. We used a three-factor model, similar to the Fama-French approach, to regress the returns of each thematic index to the returns of the MSCI ACWI Index, a “small-size” factor, and a “value” factor.

Figure 2 shows the style exposures of the thematic indices using the regression-based model described above. The equal-weighted index (top row) has a beta of 1.15 to the MSCI ACWI, along with a large and statistically significant (at a 95% confidence level) negative exposure (-0.22) to the value factor. The small-size exposure is positive, though small and insignificant. The equal-weighted index posted strong annualized alpha (2.6%), with its meaningful negative exposure to value providing a tailwind as growth equity leadership extended over the surveyed period: The MSCI ACWI Growth achieved a higher risk-adjusted return than the MSCI ACWI Value (Figure 1).

The remaining rows in Figure 2 show style exposures for each of the passive thematic indices. Interestingly, each of those thematic indices displayed a negative coefficient to the value factor, representing tilts toward the growth style, some of which were statistically significant (at a 95% confidence level). The exposures to the small-size factor were inconsistent and inconclusive, all with betas greater than 1.0.

Figure 2
wanted-a-better-definition-of-thematic-investing-fig2

The absence of passive thematic indices with a more balanced factor footprint could present a formidable challenge for allocators looking to gain exposure to more niche opportunities that could potentially benefit from shifts in factor performance leadership. And, returning to the point on diversification, we believe allocators would be hard pressed to create “factor-diversified” thematic portfolios by leveraging only existing passive thematic indices.

What are the investment takeaways?

The landscape of thematic investing gives allocators clearer access to market opportunities that are driving disruption across economies and sectors, but the presently available passive thematic options are limited to standalone indices that do not provide the same degree of portfolio diversification that a wider basket of themes should. Even if aggregated into such a basket of themes, the factor footprint of existing passive thematic indices is skewed toward those factors that have led the way amid the market regime of the past decade (but may not continue to do so).

If our investment team has a motto, it’s that “every decade is different.” Many investors are psychologically anchored to the past, often expecting recent market return patterns to predict future performance. But history suggests that one of the worst strategic asset allocation decisions is to extrapolate the dominant trends of the past decade into the next one. Our concern is that the success of many existing passive thematic indices is at least as much a function of the macroeconomic environment of the recent decade — one marked by secular stagnation — as it is of any particular fundamental insight. We believe that, over time, an optimal thematic portfolio should not have a persistent tilt to any single factor and should build from the structural investment opportunities that the market is failing to recognize.

Three characteristics of our approach

Our approach to identifying compelling investment themes seeks to accomplish this by targeting three desired characteristics:

  • A segment of the market that has suffered a prolonged period — perhaps 10 or even 20 years — of chronic, even dreadful, underperformance;
  • A “mental bias” that many investors have developed against the laggard space, making them hesitant or unwilling to commit capital to it; and 
  • A catalyst for structural change that may reverse the negative fundamentals and sentiment plaguing the “perpetually underperforming” area of the market.

Bottom line: Time for a better definition

We believe each economic business cycle has its own unique structural features that give rise to attractive, truly singular investment opportunities. The macro environment that has underpinned global markets over the past two decades is changing, and we suspect the market’s tired definition of thematic investing will have to evolve with it. We hope it does.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices does not account for any fees, commissions or other expenses that would be incurred.  Returns do not include reinvested dividends.

Index definitions

The MSCI ACWI Index is a free float‐adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets.  The MSCI ACWI consists of 46 country indexes comprising 23 developed and 23 emerging market country indexes.

The MSCI ACWI Growth Index captures large and midcap securities exhibiting overall growth style characteristics across 23 Developed Markets (DM) countries and 24 Emerging Markets (EM) countries*. The growth investment style characteristics for index construction are defined using five variables: long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate and long-term historical EPS growth trend and long-term historical sales per share growth trend.

The MSCI ACWI Value Index captures large and mid-cap securities exhibiting overall value style characteristics across 23 Developed Markets countries and 24 Emerging Markets (EM) countries*. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield.

The MSCI ACWI Small Cap Index captures small cap representation across 23 Developed Markets (DM) and 24 Emerging Markets (EM) countries. With 6,363 constituents, the index covers about 14% of the free float-adjusted market capitalization in each country.

The MSCI Cybersecurity Index aims to represent the performance of a set of companies that are associated with the development of new products and services focused on providing protection against cyber-attacks.

The MSCI Ageing Society Opportunities Index (the ‘Index’) aims to represent the performance of a set of companies that are associated with the development of new products and services focused on the health, recreation and lifestyle needs of the older population.

The MSCI Robotics Index aims to represent the performance of companies that potentially stand to benefit from increased adoption and utilization of robots and automation.

The MSCI Efficient Energy Index (the ‘Index’) aims to represent the performance of a set of companies that are associated with the development of new products and services focused on power generation using renewable sources.

The MSCI ACWI IMI Digital Economy Index is based on the MSCI ACWI IMI Index, its parent index, and includes large, mid and small-cap securities across 23 Developed Markets (DM) and 24 Emerging Markets (EM) countries*. The index aims to represent the performance of companies that are expected to derive significant revenues from the digital economy value chain.

The MSCI ACWI IMI Disruptive Technology Index aims to represent the performance of a set of companies aligned to themes commonly associated with or described as “disruptive technology.”

The MSCI ACWI IMI Future Mobility aims to represent the performance of a set of companies that are associated with the development of new products and services focused on energy storage technologies, autonomous vehicles, shared mobility and new transportation methods.

The MSCI ACWI IMI Millennials Index is based on the MSCI ACWI IMI Index, its parent index, and includes large, mid and small cap securities across 23 Developed Markets (DM) and 24 Emerging Markets (EM) countries. The index aims to represent the performance of companies that are expected to derive significant revenues from industries that target the preferences of the “millennial” generation.

The MSCI ACWI IMI Smart Cities Index is based on the MSCI ACWI IMI Index, its parent index, and includes large, mid and small cap securities across 23 Developed Markets (DM) and 24 Emerging Markets (EM) countries. The index aims to represent the performance of companies that are expected to derive significant revenues from smart solutions for urban infrastructure.

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