According to Bloomberg, thematic exchange-traded funds (ETFs) could in aggregate manage $500 billion of assets globally within five years – more than is held in all the sector-focused ETFs combined.
Thematic ETFs have in total already surpassed any individual GICS sector within the S&P 500 index, with more than $180 billion of assets, and are greater than twice the size of any single sector apart from technology.
Despite traditional sector-based funds being a longstanding bedrock of portfolio construction, this doesn’t surprise us. When, in the past, we looked at how investors were trying to access long-term growth themes, we saw great inefficiency. It seemed to us that too many investors were reliant upon proxies – sectors being the most typically used.
We felt that such proxies could not offer pure and disciplined exposure to a theme. They were often prone to owning stocks only tangentially related to the desired theme, which were often already held within their market-cap equity portfolios. Part of the issue tended to be that these proxies were often built with only a top-down methodology.
The problem with solely top-down approaches is that they have tended to rely on traditional sectors, which can be too broad, too backwards looking, and too market-cap biased to reflect the important forces that are transforming every aspect of how we live and work, in our view. The rise of robotics, artificial intelligence, and automation affects more than just technology stocks, for example; the popularity of ecommerce is not simply a trend reshaping the retail sector.
Hit for six
So, what can themes offer that sector or broad market indices do not? First, we believe thematic strategies can focus exposure on companies driving (or benefitting from) the growth of new industries and economies, while seeking to avoid incumbent companies being disrupted by these structural changes. For example, owning a consumer discretionary ETF to tap into the rise of ecommerce would leave an investor owning the likes of Amazon* – but also the traditional retailers being challenged by this theme.
Second, by adopting a thematic approach that does not rely on traditional sectors, investors can gain unique exposure to companies not widely held in their traditional equity portfolios. This can provide a complementary exposure to many mid- and small-cap companies, with very low overlap with investors’ existing market-cap equity holdings.
Third, we believe a well-designed thematic approach can deliver purer exposure to these new economies. To identify these companies requires expert macro research and understanding of the drivers of these themes, as well as a bottom-up understanding of individual companies. This is essentially a process that classifies new industries which may well become sectors in the future.
Fourth, thematic indices can embrace the globalised nature of the modern economy as themes, by their nature, are global. To return to ecommerce, a US broad market index would not capture international pioneers like Rakuten*. As mentioned, themes can also give greater weight to small- and mid-cap stocks. Indices built only according to market capitalisation give the greatest prominence to the largest stocks, which can be the incumbents most at risk of disruption from emerging pioneers.
Fifth, thematic approaches can span sectors as well as geographies. Traditional sector classifications are simultaneously too broad and too narrow: broad because a theme like artificial intelligence is only a subset of a sector like technology or industrials; and narrow because companies involved in the rise of artificial intelligence could have been assigned to diverse sectors like technology or industrials by traditional classification methodologies.
Sixth, themes can be dynamic and adaptive. Traditional classification taxonomies may be infrequently updated, so traditional sectors may not keep pace with innovative businesses. For example, since 1999 there have been only two new GICS sector updates: the extraction of the real-estate sector from the financials sector in 2016, and the creation of the communication-services sector in 2018. Prior to this latter move, Netflix* had been in the consumer-discretionary sector alongside the likes of McDonald’s*, and Facebook* sat in the technology sector alongside hardware and software manufacturers like Apple* and Microsoft*.
For these reasons, we believe that thematic strategies can form the building blocks of growth portfolios. Growth investors have always sought exposure to themes; well-designed thematic strategies now give them the opportunity to do so more purely, in a complementary way to their existing equity holdings and with transparent, systematic implementation.
*For illustrative purposes only. Reference to a particular security is on a historical basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.
Capital at risk. The value of an investment and any income taken from it is not guaranteed and can go down as well as up; you may not get back the amount you originally invested.