Adding thematic equity investments to a multi-asset portfolio: An allocator’s handbook

We believe thematic investing can add a powerful return engine to portfolios, but we also recognize that it poses unique challenges for allocators used to assessing active managers relative to broad, market-cap-weighted benchmarks. This paper is intended to help allocators better understand thematic investing and its potential benefits, and to provide a framework for making and assessing allocations.

We begin by defining thematic equity investing and the hurdles allocators must overcome. We then test the often-stated arguments in favor of thematic allocations, including their ability to reduce the importance of the economic cycle to portfolio returns, to focus on forward-looking structural change rather than past winners, and to exploit idiosyncratic investment “blind spots” that fall between sector and style classifications.

Finally, we offer guidance on several key implementation questions, including how to size a thematic equity allocation, evaluate its performance, and assess prospective thematic strategies, including direct thematic investments and investments via a thematic manager.

Just what is thematic investing?

We define thematic investing as the identification and exploitation of a top-down, innovative, or disruptive trend that has a structural tailwind with the potential to drive above-average returns for companies participating in that trend. Returns to themes cannot be easily explained by traditional country, sector, or style factors.

While thematic investing can be applied to different asset classes, it is often expressed via equities, which is where we have focused our research in this paper. Examples of equity themes include fintech, the future of education, energy efficiency, and automation. By investing in companies within these themes, investors are assuming that their growth potential is not yet fully appreciated by the market but will be over time.

Importantly, thematic investing is different from sector investing, which involves allocating capital, either strategically or tactically, to market sectors like health care and financials. There are reasons investors might choose to allocate to specific sectors, but from a thematic investment standpoint, sectors will, at best, represent a diluted exposure to companies that stand to benefit from the theme. Moreover, the companies most exposed to a theme often come from across multiple sectors.

The challenge of adding themes to multi-asset portfolios

While interest in themes has increased in recent years, some allocators face a hurdle in that their investment framework is focused on market-cap-weighted benchmarks. These benchmarks typically allow for straightforward discussions around sizing (tracking error budgets), performance evaluation (return versus the benchmark) and manager selection (choosing a manager who can beat the benchmark).

However, thematic investing — especially at the individual theme level — bears little relation to broad, diversified equity benchmarks. This results in a different risk profile that can be hard to square with more traditional active equity approaches. The long time horizon of thematic investing also makes performance evaluation against market-cap benchmarks difficult and potentially less useful. For example, is a period of underperformance the result of poor thematic selection, poor implementation, or inappropriate benchmarking? And given that the goal is to exploit a structural theme, not to beat a specific benchmark, how do allocators evaluate and compare prospective thematic strategies? This paper seeks to answer these questions. But first we consider the case for thematic investments.

A few words on our data

Because themes are typically idiosyncratic in nature, it can be challenging to draw broad conclusions about thematic investing by looking at a small subset of themes. For this reason, our analysis for this paper is based on a large universe of single-theme managers divided into three broad groups: Economic, Social, and Sustainability. These groups are based on thematic mapping work by Broadridge, a data provider that collects and reports AUM and flow data on over $42 trillion in global fund assets. In tracking these funds, they have grouped thematic equity strategy into 13 categories based on fund objectives and investment policies. Broadridge regularly updates the database as funds and themes evolve, or as new themes emerge. In our analysis, we included monthly returns since January 2000 for single-theme active managers with a global equity focus and a track record of more than three years.

Why include thematic investments in a portfolio?

We evaluated three commonly cited benefits of thematic investing and found that they were supported by historical data.

1. Reducing the importance of the cycle — If thematic investments generate their returns by exploiting structural change, then including them in a portfolio could make the difficult task of timing the cycle less important, reducing the reliance on strong economic growth to drive strong returns. Thematic allocations could also help increase diversification given how much cyclical exposure is typically found in a portfolio.

To test this argument, we compared the cyclicality of global equity sectors and global equity themes (basing the themes on the Broadridge single-theme manager data noted earlier). We defined cyclicality based on the correlation with the OECD’s US Composite Leading Indicator (CLI). As indicated by the dotted lines in Figure 1, we found that themes were, on average, about half as sensitive to the cycle as sectors.

Figure 1

2. Investing in tomorrow’s beta — The inherent forward-looking nature of thematic investments, with their focus on structural change and future growth, may mean that they can potentially outperform market-cap benchmarks that are, by definition, backward-looking, with the weight of each company in the index determined by its historical performance.

Figure 2 shows the higher return and lower volatility that would have been achieved if an investor had perfect foresight about the sectors that would perform best over the next five years (light blue) compared with a typical market-cap-weighted strategy (dark blue). While this is admittedly a highly simplified example, we think it illustrates the potential benefit of seeking to invest in “tomorrow’s beta.”

Figure 2

3. Avoiding investment blind spots — Thematic investments may allow allocators to exploit perspectives that other investors either ignore or are not able to focus on because of, for example, prescriptive sector and style classifications. To test this idea, we looked at how much of the risk taken by thematic equity managers could be explained by their sector and style exposure. We found the answer was about 50%, with sectors having the largest impact (Figure 3). With non-thematic managers, sectors and styles explained a larger portion of the risk, on average.

Figure 3

While the sector exposure of thematic equity managers shown in the chart may seem high, we typically find that it is split across many sectors — as we would expect given…

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