The Many Challenges of Thematic Investing

Thematic investing has been hot recently. But identifying lasting trends, getting in early and finding the right vehicles isn’t easy.

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Thematic investing has gained considerable prominence recently, as a number of new exchange-traded funds (ETFs) have been introduced that employ the strategy.

But money managers and analysts have mixed views about the thematic investing concept, which attempts to design funds that profit from trends. If you discover a lasting trend early in its life cycle, they say, and choose securities that actually benefit from it, thematic investing can work well. These are difficult hurdles, however. “There are some successful approaches, but I start off skeptical,” says Russel Kinnel, director of manager research at Morningstar in Chicago.

Thematic funds account for 30 percent of the 187 new ETFs introduced so far this year, focusing on trends as diverse as obesity, Millennials’ consumption, aging and health and fitness.

The first challenge with thematic funds is knowing whether you have found a long-term trend or a very short-lived fad. “You have to make sure your trends have legs,” says Karim Ahamed, senior investment adviser for wealth management firm HPM Partners in Chicago.

Ahamed notes that three to four years ago investment managers came out with funds to protect against rising interest rates, thinking that stronger economic growth and a reversal of the Federal Reserve’s massive quantitative-easing program would push rates higher for a long time. Of course rates have hardly budged. Other funds were introduced to take advantage of China’s booming economic growth, which proceeded to slow markedly.

Themes can be rendered moot by a range of factors, including changes in government policy and advances in technology. Some themes amount to a distillation of what investment bankers are selling, Kinnel says: A bank sponsoring an initial public offering might tout the company as fitting into a broader theme.

Even if you do identify a lasting theme, you may not make much money from it if you don’t come to the table early enough. “The problem is that you may be buying something that’s already priced in,” Kinnel says. “You could have made money early on with cloud computing, but today that’s priced in.” He cites the aging of America and the shale revolution as other examples. “Analysts aren’t idiots who are unaware of demographics,” he says.

Then there’s the issue of choosing the right securities for a given trend. “That’s definitely a challenge,” Kinnel says. “If you were investing in the Internet, would you have known to choose Google over Yahoo, and Amazon.com over other retailers? Some people did, but more often that’s only evident down the road.”

Nonetheless, if you hit it right, the rewards can be plentiful. While many investors have embraced passive strategies, there is a movement among institutional investors to step away from chasing indexes and from plain vanilla active investing, Ahamed says. “The usual benchmark investing at best keeps up with an index,” he says. “There’s not a tremendous opportunity for upside. Thematic investing offers more ways to generate returns.”

He and his colleagues are investigating water scarcity as a theme, though it hasn’t been easy to find appropriate investment vehicles. “We looked at desalination and found there’s not many commercially available applications in the U.S.,” Ahamed says.

Advisors Capital Management of Ridgewood, New Jersey, frequently uses thematic investing in its stock portfolios. One theme it likes is the effects of demographics on housing. “We should have 1.5 million households formed per year, well above the new-construction rate of about 1.2 million,” says Charles Lieberman, the firm’s chief investment officer.

He and his colleagues also see low energy prices as a durable theme. Accordingly, they sought out a company that sells to the housing sector and uses plenty of energy to make its products. They chose USG, which uses natural gas in manufacturing wallboard. The stock has gained 6.4 percent so far this year. “We look for as many themes as make sense and give us a diversified base,” Lieberman says. “So if we’re right on average, it should work out well.” The firm has 45 to 50 positions in a portfolio, and a single theme would generally account for two or three of them.

The total number of thematic positions depends on how many viable trends Advisors Capital uncovers. “If we had 40 themes and that filled up a portfolio, I’d have no problem as long as it was properly diversified,” Lieberman says.

But can thematic investments provide diversification? “That depends on how [the funds] are run and where they invest,” Kinnel says. “The funds may have parallels with more typical growth funds. If the themes are more in the alternative-investment space, then the funds might have more diversification value.”

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