Thematic Investing: Transcending the traditional

There is no escaping the changes that will drive the 21st century forward. Demographic shifts are responding to an ageing population, social attitudes are moving towards eliminating inequality and exhibiting a greater consideration for the environment. At the same time, resource scarcity is aggravating economic imbalances, more frequent transfers of power are resulting in political and regulatory change and the ongoing disruptive potential of technology cannot be disregarded.

In such a transformational world, is it time to broaden our investment horizons away from the traditional asset class, geographic and sector orientated framework? Incorporating a thematic element to strategic asset allocation could provide an effective way to harness some of the mega trends that are currently reforming economies, society and, importantly, driving financial markets.

What is thematic investing?
In essence, the goal of thematic investments is to provide the means to invest in assets whose returns are significantly impacted by an underlying theme. Such themes often relate to significant structural changes, such as the energy transition, healthcare innovation, consumer trends or disruptive technology. However, thematic investing is more than just a compelling story. Its goal is to identify the assets whose returns will be most impacted by these structural changes so that the overarching theme is transformed into an investible opportunity.

The basic investment premise of seeking out the winners and avoiding the losers has meant that thematic investing has tended to be associated with equity investments. But this doesn’t have to be the case. There are now a number of fixed income and even multi-asset thematic funds, underlining the notion that thematic investing can transcend the traditional classifications of asset class, sectors, regions and styles.

Not just about growth
While disruption and innovation are certainly key elements of thematic investing, the approach is not solely about finding the next exciting start-up. Themes can be defined around the different stages in a company’s lifecycle depending on the nature of that particular theme. For example, one industry may be disrupted because of a cost advantage, while another is impacted by the development of new products or services.

Ultimately, anything that can give a group of companies an advantage over their peers in a particular industry can be used to pursue an investment theme. However, the factors playing an important role in changing the balance of forces typically stem from the megatrends that are reshaping society. Be that globalisation, digitisation or regulatory trends.

What is important when looking for companies exposed to a theme is that the selected companies have a significant part of their business dedicated to activities related to the theme and generate a significant part of their revenues from selling products or services related to that theme.

Not necessarily about the long term
The nature of megatrends means that thematic investing is often focused on a medium-to-long-term horizon, but this is not always the case. Some themes may run their course more quickly and subsequently find themselves discounted by the market faster than others. It is therefore important to evaluate the extent to which a theme represents a good, ongoing investment opportunity – for example many investors were still buying tech funds in 2000, several months after the dot-com bubble had burst.

Other themes that have been strong in the past may be nearing the point of maturity – previously robust twentieth century activities are being replaced by innovative twenty-first century technologies – so it’s important to try and gauge when an investment theme has run its course even if the overarching drivers remain relevant and investable. The transportation sector is a clear example of such a transition as combustion engine vehicles are replaced by electric ones and the whole notion of transport as a service could transform how we use cars in the near future.

Applying a bottom-up investment strategy can be advantageous for thematic investors as it can be more subtle than just finding undervalued opportunities to hold over long investment horizons.

ESG or thematic? That is the question
A common misnomer is that an ESG (Environmental, Social and Governance) fund must be thematic.

Not all ESG investing is necessarily thematic investing. There is a difference between investing in companies just pursuing sustainable practices and companies deriving a significant component of their revenues from services and products related to sustainable themes. However, the desire to drive change in society has proven to be a strong motive for thematic investing in recent years.

The energy transition is a good example of this type of thematic investment. Climate change is perhaps the biggest challenge humanity has ever faced and is already having a profound impact on weather systems and economic outcomes. There are necessary steps that must be taken to address climate change and this will inevitably create investment opportunities.

Investing around a sustainably-orientated theme means finding companies well positioned to generate a measurable impact while profiting from this structural change.

Being mindful of risk
The premise of thematic investment is that portfolios seek to earn excess returns from assets whose returns are impacted by the structural changes underlying relevant themes. While such trends significantly impact economies and redefine business models creating the potential for attractive returns, it is important to recognise that traditional risk factors also apply.

Focusing on a specific theme will lead to higher concentration levels in the specified area, resulting in less diversification and raising the potential for more short-term volatility during times when that theme goes out of favour. However, a benefit of thematic investing is that it tends to avoid companies that are on the receiving end of disruption or decline.

Ensuring a thematic portfolio has an adequate risk management framework is critical to ensuring it is capable of handling the different risk exposures of the assets and themes, while also taking into account their expected returns, as well as the level of risk aversion of the end investor.

The potential to profit from transformative social changes
Thematic investing can provide investors with a means to take advantage of the immense changes that will transform our societies, economies and way of life over the coming decades. As with any major change, future champions will emerge from each trend and these champions should benefit with an outsized impact from value creation.

But where there are winners, there will also be losers, those exposed companies that are either unwilling or unable to adapt will be left behind. And the ability to distinguish between them will be critical for any investment strategy to truly succeed.

At BNP Paribas Asset Management, our forward-looking thematic investment strategies are positioned to capitalise on the megatrends shaping the future. Our investigative mindset and determination to consider all angles presents us with a strong understanding of these new ecosystems and upcoming business models. Covering a range of trends that includes the energy transition, environmental sustainability, equality and inclusive growth, health and wellness, as well as technology, we aim to provide sustainable thematic investment solutions for a changing world.

For further insights please read our white paper: Allocating to Thematic Investments

THEMATIC FUNDS

To view our thematic strategies please visit your local BNPP AM website via bnpparibas-am.com

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