ETFs: The merits of thematic investing in an uncertain world

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After a year of populist electoral uprisings around the world, it is clear that the catatonic global economy continues to damage and divide. Regardless of political persuasion, there is a unanimous wish that unconventional monetary measures such as QE, and the related era of ultra-low or negative interest rates, could be consigned to the past.

These measures were initially heralded for keeping the world economy back from the abyss when the world’s financial infrastructure threatened to collapse. But they have now contributed to a profound sense of inequality and made finding sources of return almost impossible for investors. After nearly a decade of this low-return environment, many investors have begun to question their traditional asset allocation framework and started to look at thematic inv-estment strategies as part of their approach.

Thematic investing is built on the idea of capturing returns through exposure to assets linked to long-term structural trends. A thematic approach requires a fundamental understanding of the impact of long-term economic, political and social trends on regions and sectors, which in turn reveal investable opportunities.

Such an approach can be delivered through allocations to appropriate ETFs but it does carry risks. The first risk is easy to conceptualise but harder to spot. With so many thematic app-roaches now on offer, including demographics, technology and agriculture, how can investors be clear whether the theme is built on a real, sustainable trend rather than marketing spin? Is a theme backed by rigorous res-earch and analysis or do investors risk falling for what behavioural finance terms “the narrative fallacy” – the appeal of an investment theme because it has a nice story behind it?

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Before undertaking any kind of thematic approach, investors should hold broad internal dialogues to make sure all relevant trends are considered, investment objectives are clear, and they should gain agreement on the rationale that will be used to prioritise and ultimately select some themes for more research. They should be asking whether the trend is really structural or merely conjectural or short-term in nature. For example, we offer thematic equity products with exposure to robotics and automation technology because it’s our view that the world we live in is being transformed. Tech-led innovation is shaking up the status quo. Companies which contribute to the robotics and automation megatrend are likely to
outperform major equity benchmarks over time.

But investors need to accept this investment hypothesis over and beyond being simply attracted by the raciness of the theme. Investors who are merely excited by the idea of robots should watch a sci-fi movie instead.

A related risk is that the portfolio’s exposure to the thematic trend may be illusory. The index methodology must be particularly rigorous because it is not just identifying particular stocks, for example, energy companies, or US mid-caps, as would be the case in a conventional index.

In a thematic index or stra-tegy, the construction needs to (i) define the subsectors that represent the key drivers within the ecosystem, (ii) apply a rules-based selection and appropriate weighting methodology that captures the growth of companies contributing to each of the subsectors and (iii) offer an exposure to the entire value chain using a globally diversified basket of stocks. For this reason, in thematic investments, index choice and rigour through specialist research is far more critical than for exposure to more mainstream areas such as the S&P500 or FTSE 100.

Investment decisions must not be considered lightly. While two products may be similar at face value, closer investigation may reveal important elements which are crucial to the decision-making process. Grea-ter choice must therefore go hand in hand with greater scrutiny.

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