Investing in themes is a different way of investing in sovereign bonds, corporate bonds, equities and other traditional asset classes. It is also different from investing in factor, regional or sector strategies. These characteristics make thematic investing an appealing additional allocation to a diversified portfolio.
What is thematic investing?
Themes are structural megatrends that shape societies, affecting economies and redefining business models. The drivers of such trends can be demographic shifts, social or behavioural changes, environmental developments, resource scarcity, economic imbalances, transfer of power, technological advances and regulatory or political changes.
Thematic investing allows investors to invest in assets that are better positioned to profit from such transformative changes. When it comes to stocks and corporate bonds, it is important to select companies generating a significant part of their revenues from selling products or services related to the theme. For those companies, there should be an outsized impact from value creation.
In this article, we are taking five themes – environmental sustainability, the energy transition, disruptive technology, consumer innovation and healthcare innovation – and propose an optimal allocation for investors with different profiles (conservative, moderate or aggressive). We then assess their added value in terms of portfolio returns.
For the more common themes, benchmark indices are available from the traditional index vendors. However, there is a limited consensus on which assets should be included in a portfolio representing the theme, so the dispersion of return from one thematic benchmark index to another can be large. Using thematic benchmarks from more than one provider is often a good idea.
For themes that relate to specific sectors of the economy – e.g., energy, healthcare or consumer goods – the relevant sector index can be used as a benchmark. However, in such cases, it is particularly important to assess the expected added value from biasing the portfolio selection towards those companies more exposed to the theme.
How to allocate to thematic investments in a portfolio?
The answer depends on parameters such as the size and the level of diversification of the portfolio.
We believe a core-satellite framework, adding thematic investments to the satellite next to a core of equities, bonds and cash, can be an adequate solution for most investors, in particular for those with large portfolios looking to invest in low-capacity themes, or for smaller investors who prefer to limit their active allocations to thematic investments.
To implement such framework, it is necessary to understand each thematic investment in terms of expected risk, return and interaction with other investments.
Returns and risks from thematic investing
For thematic strategies investing in stocks and bonds, the expected returns, risk and correlations can be derived from:
- Their exposure to traditional risk factors that drive stock and bond returns and risk
- An additional specific component related to the theme.
To assess the exposure of the theme to traditional risk factors, the returns of the chosen benchmark can be a good starting point before estimating how much excess return the thematic tilt is likely to add.
An example of an allocation to a theme in a core-satellite setup
In this example of a core-satellite multi-asset portfolio with and without thematic investments, we consider
- Three innovation-disruption themes involving equity investments
- Two sustainable themes, one investing in equities and one investing in corporate bonds.
The table shows portfolio weights. Source: Bloomberg, FactSet, MSCI, Standard & Poor’s, Stoxx and BNP Paribas Asset Management. For illustration purposes only. Past performance is not indicative of future performance.
The portfolios were generated from the robust portfolio optimisation framework in use at BNP Paribas Asset Management for the construction of multi-asset portfolios. This framework relies on expected returns, risks and correlations estimated for each of the investments considered.
In general, the thematic investments replace a number of core and diversifying investments.
Below we show the impact of adding thematic investments to the portfolio, increasing expected returns at comparable levels of risk. The allocation to the satellite also increases considerably.
Source: Bloomberg, FactSet, MSCI, Standard & Poor’s, Stoxx and BNP Paribas Asset Management. For illustration purposes only. Past performance is not indicative of future performance.
We believe thematic investments can help diversify traditional portfolios and generate excess returns at comparable levels of risk.
In this paper, we propose a framework for allocating to themes while taking into account the expected returns from the various assets and the expected alphas for the themes.
The paper includes a detailed example of an allocation to equities and bonds for five themes and shows how the allocation changes according to an investor’s level of risk aversion.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.