A smarter approach to thematic investing

At a glance

• Thematic investing aims to capture powerful long-term trends, from AI and ageing populations to the clean energy transition. 
• The best investment opportunities aren't always the most talked about. Timing, valuations and staying power matter. 
• A disciplined approach can help investors separate genuine opportunities from market hype while maintaining a diversified portfolio.

Thematic investment funds have become an increasingly common component of investors’ portfolios. Unlike traditional equity allocations which focus on regions, market capitalisations or sectors, thematic funds look for the broad structural changes – sometimes called ‘megatrends’ – that could shape economies and markets over the long term. 

Popular themes include artificial intelligence, clean energy and demographic change. Demographic change, for example, could include a focus on ageing populations in developed markets. A thematic fund could look to uncover growth opportunities because of this shift, perhaps investing in companies that provide healthcare, retirement housing, medical supplies, or travel and leisure services for seniors. 

How do thematic funds work?

Thematic funds build a portfolio around the expected beneficiaries of a chosen trend, or they might be built around a values-focused objective, such as ethical or sustainable investing. These can be active or passive. Passive funds are usually based on observable datapoints, including revenue sources, for example, with limited manager discretion. Active thematic funds will usually employ more detailed analysis of the potential stock investments but charge higher fees.

So, what opportunities and risks should investors be considering?

The potential for long-term growth

Many themes offer long-term growth potential. Investors may benefit by gaining exposure before the wider market fully recognises an opportunity. In recent years, AI-related stocks have burgeoned as the technology has become an ever-growing part of daily life. Among those that benefited most would have been some of the early investors in thematic AI funds. 

Thematic strategies can support innovation by providing capital for businesses leading change, with, for example, new technologies disrupting established industries. Investors may be able to tap into this potential for fast growth before the companies become mainstream. However, as many nascent technologies will be developed by privately owned companies, public market thematic funds may only offer partial exposure to all the businesses driving a theme’s emergence and growth.

Thematic investing can also help investors align their portfolios with personal values, such as environmental or social priorities, while still aiming to meet financial goals. The expectation would be that long-term growth could come from structural changes, such as global warming leading to a refocusing of resources and a shift in leadership towards the companies that adapt to these changes. 

Timing matters

A strong theme does not automatically mean it is a strong investment. For example, the timing needs to be right. If investors arrive late, after a theme has already attracted substantial flows and raised valuations, there may be little room for disappointment. Conversely, even if an investor is early, sometimes themes may be slow to develop or never materialise. Themes that have not met their potential so far arguably include the hydrogen economy and fuel cell technology, and genomics. 

Avoiding crowded trades

The internet transformed how we live and do business. The dot-com enthusiasm that built up on the back of this showed that huge technological change can still lead to hefty losses as expectations, investor crowding, and valuations ultimately outpaced internet companies’ profitability, leading to a bursting of the bubble. 

Understand your exposure

Dilution impacts exposure to a theme. Companies in a thematic portfolio may have divisions dedicated to the sought-after factor, but also revenues and resources focused elsewhere. For example, an EV car maker may also produce cars with traditional combustion engines.

Prepare for volatility

Thematic portfolios can experience sharp valuation swings, with volatility notable in emerging technologies, early-stage industries or illiquid stocks. Investors should assess whether price changes reflect broader market dynamics or changing market perceptions about a theme and its long-term investment rationale.

Diversification matters 

We believe investors should avoid heavy reliance on one or two themes or cluster of related funds. For example, rather than investing in only technology-led themes such as AI, robotics, fintech or digitalisation, they could combine these with healthcare, demographic or sustainability themes, dependent on different industry dynamics. Thematic exposure can also complement conventional global or regional funds, which can help reduce the impact any periods of weak thematic performance, while still retaining access to the long-term growth potential that they believe the theme can provide.

Regulatory risks to consider

Themes built around new technologies or policy-sensitive areas can be exposed to regulatory change, which may quickly alter the outlook for companies or sectors. For example, a shift in tax policy can unravel profit forecasts and negatively impact the key theme of a fund.  

Five ways to separate opportunity from hype

• Seek enduring change: Is the theme underpinned by potentially durable structural change?
• Price check: Even strong themes can disappoint if valuations already reflect growth expectations.
• Underlying exposure: Remember not all companies potentially exposed to a theme will benefit to the same extent. And thematic funds don’t bring pure exposure to a theme – assess where the sales on profits of holdings genuinely come from the theme.
• Analyse forward: What needs to happen for adoption of the theme? What could limit, delay or halt progress.
• Diversified approach: Reflect on what you own and consider the potential for volatility. Use thematic funds as part of a portfolio of broader investments.

The bottom line

Thematic investing can be a useful addition to portfolios if investors avoid chasing after each interesting theme and can focus on disciplined consideration of which trends are likely to endure and look at investing at attractive valuation level. If prudently done, thematic investing can uncover growth potential to compliment a diversified, balanced portfolio.