What is Thematic Investing? How it Works, Pros and Cons

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For many such as myself, whenever I come across the word “thematic” as in Thematic investing, my cartography training as a geo-environmentalist before my foray into the world of finance kicks in as it does for many other people when they encounter certain words.

As it is in thematic cartography, so it is in thematic investing; the difference is in the application.

In thematic cartography, thematic maps are distinguished by statistics, color, point symbol, choropleth, isopleth, etc.

In thematic investing, there are just as many themes as one can fathom – technology growth, polarization, economic growth, etc.

This article discusses thematic investing, how it works, the pros and the cons, as well as nay other things you need to know.

What is thematic investing?

This is the creation of a portfolio or portions of it by putting together a cohort of companies that are involved in the same sectors or subsectors.

Sectors that the investor believes will perform better than the normal or whose future prospects far outweigh average market returns upon investing in them.

This then by inference means that you have to have studied the market and the sector for long enough to see things that others are not seeing or have knowledge that many are not inclined intuitively to have.

The world’s largest investment company Blackrock Inc defines thematic investment as “an approach which focuses on predicted long-term trends rather than specific companies or sectors, enabling investors to access structural, one-off shifts that can change an entire industry.”

Blackrock as an investment firm focuses on 5 megatrends, which are rapid urbanization, climate change, and resource scarcity, shifting economic power, and demographic and social change – all of which are driven by technological breakthrough.

Types of investing themes

#1 – Periodic themes

Periodic themes are themes that have a short span and are generally regular in occurrence.

They can result from changes in the internal politics of a company, an alteration in the business cycle, or something that has a short-term effect.

Sometimes these themes are predictable and expected but do not last long enough but last long enough to correct or displace things such as a stock bubble.

Examples of periodic themes are asset valuations, volatility, interest rates, and currency values.

#2 – Disruptive themes

Disruptive themes are mostly long term themes as they can last for a very long time until a periodic theme phase that sometimes corrects a hike or a bubble.

Disruptive themes can be created by the discovery of breakthrough technology, medicine, or financial leverage.

Changing demographics and consumer behavior can bring about disruptive themes.

What is a thematic trend?

To really understand what a thematic trend is all about, you need to understand the issue with investing and its attendant risk.

For every 10 products that investors invest in, 9 are most likely going to fail, and one will probably be a mega-hit.

For an investor, what happens if for some reason you don’t invest in the 10th one? You lose out, that means all the money you have spent on the remaining 9 has gone to waste.

That kind of risk is what many investors try to avoid by going around and taking on many different tactics.

A thematic trend is basically what an investor sees that helps him predict that this asset will perform better than others.

A theme is about change, so the question is “what is changing?” Can you tell? Can you see where the future is headed?

If you can, then you can probably make yourself tons of money by investing in companies that are taking steps in that direction.

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There are many types of thematic trends and they are followed based on perception, market reality, and performance.

They are megatrends, macroeconomic, and microeconomic trends.

#1 – Megatrends

i – Technological breakthrough

Since technology continues to open up previously unexplored markets, and with the knowledge that technology will continue to grow tremendously while driving exponential progress across the tech sector and beyond.

It only makes sense that this is a trend and is one that investors should invest in.

ii – Climate change and resource scarcity

The world is going green and that is no joke. Investors know this too, probably before average joe knew about it.

Technology continues to make it easier to achieve the goals of a cleaner world so investors are more inclined to invest in companies that help people go green.

Companies that help drive the prediction that by the year 2050 the world’s energy is going to be from solar and wind sources will be invested in.

iii – Demographics and social change

This is a lot to take in in the sense that you need to get your predictions right. Consumerism is consuming the world as it is and that brings with it some repercussions.

Longer lifespans and modern lifestyles will affect the way health products are produced and consumed.

In parts of the world, more than 60% of the population will be less than 20 years of age, and by 2030 there is projected to be a 45% increase in the 60+ population.

This is a theme that investors can ride on if they select the right companies with the right products.

Macro-economic trends are trends that impact the broader macro-economic environment, including rising rates, inflation, the growth of an emerging-markets middle class, or global trade patterns.

Micro-economic trends are trends that emerge at the company level, including factor-based strategies that account for certain company characteristics.

Characteristics such as management structure, or ESG (environmental, social and governance)-type metrics, such as female representation and employee level and management level.

What is factor investing?

Investopedia describes factor investing as “a strategy that chooses securities on attributes that are associated with higher returns.

There are two main types of factors that have driven returns of stocks, bonds, and other factors: macroeconomic factors and style factors.

The former captures broad risks across asset classes while the latter aims to explain returns and risks within asset classes.”

Factor investing is one theme that helps to hedge against risk by enhancing diversification.

The problem with diversification in factor investing is that it will be all for nothing if the gains that are supposed to come out of it are lost when balancing.

How does thematic investing work?

Thematic investing works by pooling companies within a similar trend that are believed to have the potential for outsized returns together in a portfolio and investing in them.

It is an investment that is betting on the future of trends. If you believe something based on what you have observed, then you put your money there.

The collection of companies that do similar things within a sector of interest is called a theme.

Like waves, thematic investing is betting on the ability of companies or countries or any asset whatsoever to take advantage of a trend.

What are the pros of thematic investing?

  • It is very focused on the performance of the assets
  • If invested well, it has the potential to make living conditions generally better
  • It incentivizes a progressive investing mindset

What are the cons of thematic investing?

  • Like all other forms of investing, the investor faces the risk of losing the invested amount.
  • For the most part, thematic investing is more theoretical than practical.
  • If not properly understood, the investor could be left chasing fads, and most times late.

Conclusion

Rather than linear diversification, thematic investing selects as few companies as possible within a theme and adds it to its portfolio by investing in them.

So while diversification helps reduce risk, it offers lower returns than when a theme is created and money invested in them all.

if you understand thematic investing, it then becomes easy to apply.

References

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