Thematic Investing: Skating to the Economic Puck

Thematic investing looks at equity markets in a different way — not according to the companies’ business activities (like sectors), nor according to fundamental, statistical, or macro metrics (like factors), but with an eye on how an economy may evolve in the future.
Since many themes involve portfolios of stocks that a well-diversified investor likely already holds, the financial merit of thematic investing is not in diversification, but in overweighting exposures in a sensible way to perceived alpha-generating companies.
Investors need to think carefully about where thematic investing sits within the tactical and strategic spectrum. Many themes will take time to play out, but they also can’t be expected to outperform forever. We argue themes sit somewhere in the middle.

Slicing and Dicing in the Securities Kitchen

There are many ways to categorize, and carve up, an equity market. Perhaps the one that investors are most familiar with is to allocate stocks into one of the 11 sectors of the Global Industry Classification Standards (or “GICS”) created by MSCI and S&P. These sectors examine a company’s principal business activity, and allocate it accordingly to one sector, which, when combined, revert to the market. In other words, the sectors are “mutually exclusive,” one company can’t be in more than one sector. Sectors are intuitive to understand, and the idea that their performance will differ according to where the economy is in the business cycle is a well-known feature, and investment strategy (“sector rotation”).

Another common way to split-up stocks is according to “style tilts,” with perhaps the most common delineation being between “value,” “growth,” and “blend”. Different firms will define these differently, but, often, value implies a stock that is cheap versus some accounting metric, and growth implies the opposite (with blend of course somewhere in the middle).

If it’s a question of just one moving scale (i.e. a higher or lower value metric) then companies are likely to only be able to sit within one of these categories, but, if value and growth are defined in different, but not opposite, ways, or, if more than one factor is introduced, then one company can find itself labelled in two or more ways (i.e. you might have one company that is in both value and growth segments, or exhibits both value and momentum characteristics). The point is that mutual exclusivity is now no longer a requirement, but the classification is no less valid as a result.

Our view is that thematic investing simply represents another interesting way in which to slice up equity markets. It has similarities to the sector approach in that, often, though not always, the companies are broadly involved in a similar economic activity, but it differs because, like the factor approach, one company can appear in more than one thematic idea (and many companies can appear in none).

In the sector case, delineation might be a question of both convenience (it helps to easily slot a company into a relevant sleeve), and/or a goal of outperformance (alpha may accrue to those best placed to both predict the business cycle, and to understand the sectors likely to thrive in that phase). In the factor case, the argument is somewhat similar, but longer run. Academics have argued, by citing empirical evidence, that persistent exposures to certain factors could lead to long-run outperformance, and, additionally, being able to categorize a company in terms of its value score (or according to some other statistical metric) is a useful tool for understanding a portfolio’s likely risk and return profile.