Thematic investing:  what lessons from the past for portfolio construction?

12 January 2023

Based on BNPP AM, Invesco & WisdomTree market insights and our proprietary research, we have provided a simple and easily achievable methodology that does not require a new nomenclature for efficient selection of thematic funds. We detail below the first conclusions that can be drawn based on this methodology.

Having a clear vision of what the past teaches us is key to making efficient allocation decisions. To do this, we have used our thematic fund selection methodology set out in the article: "Thematic investing: a new fund selection methodology by BSD Investing and L'allocataire" as well as the BSD Investing methodology to compare active and passive funds, on all funds domiciled in Europe index and non-index according to their initial investment universe.  At this stage, we have listed 5 investment universes: Global, Developed Countries, Europe, Eurozone, Emerging Markets and Asia ex Japan and analyzed the risk-return profiles of the different thematic funds for each of these universes.

Our research has allowed us to answer three fundamental questions about thematic investing at this stage:

1. Should investors choose a fund invested in a broad or in a specific theme?  The selection of the theme counts

Over 5 years, our analysis reveals a very wide dispersion of returns and risks within each sub-segment. On the whole, strategies on broad themes appear to be less successful than those on specific themes.  This corroborates the results highlighted in the WisdomTree study, which shows that a diversified basket of specific thematic funds in many cases would have significantly outperformed a fund with a broad approach to thematic investing (How to harness the power of megatrends in your portfolio? WisdomTree April 2021).

5-year risk-return of thematic funds domiciled in Europe

Source BSD Investing, Morningstar between 31/12/2017 and 31/12/2022

2. What is the importance of the timing for investing in Thematic funds?

Over 5 years, thematic funds underperformed the MSCI ACWI by 0.1% and 26% of funds outperformed the index (Source: BSD Investing between 31/12/  2017 and 31/12/2022). Using the same methodology as what the market uses today in comparing the performance of active and passive funds, one could conclude that this type of strategy is of limited interest. However, these results have the same biases as those of the performance comparison between active and passive funds.  These include biases introduced when looking at performance between two fixed dates and not over a rolling period (cf. BSD Investing methodology for comparing the performance of active and passive funds).  In fact, further analysis reveals that the average outperformance spread between thematic funds and the MSCI ACWI index over 1 year over the last 5 years is 1.2% and that 44% of the time more than 50% of funds outperform the benchmark. In this segment, the past clearly shows us that the probability of selecting the right thematic fund and generating outperformance is significant.  It also underlines the importance of the entry point into the themes, and this in addition to the structural interest of the theme for a portfolio. This raises, more broadly, the question of the opportunity cost of the theme, which we will address in our next thematic special report in Q2, 2023.

Thematic funds vs MSCI AWCI over 5 years

 1-year rolling performance spread                                                   % of strategies outperforming

Source: BSD Investing, Morningstar between 31/12/2017 and 31/12/2022

3. Should investors choose an active or passive management thematic fund? The need of new fund leaderboards integrating both active and index funds

This methodology, for the first time, makes it possible to compare all the different themes with each other, whether they are in index format or active funds.  As we demonstrated in our article "thematic investing a new selection methodology by BSD Investing and L'Allocataire", any thematic investment is an active investment aimed at outperforming a benchmark. There is no active vs. passive management debate in thematic investing.

It remains to be seen, however, whether non-index investing is preferable to index investing for thematic funds.  Observation of the past tells us that the index fund or non-index criteria is not a differentiating element in performance generation (see graph below).

This reinforces the idea of ​​the need for a single classification of active and index funds on this thematic segment. Thanks to our methodology, all funds either index or non index can, now, be ranked together taking into account all their specificities (costs, performance, impact of stock selection either when creating the index or managing the portfolio on performance....). Those new leaderboards will be revealed in the next editions of our newsletter.

Performance, risk over 5 years of active vs. index funds on thematics

Source BSD Investing, Morningstar between 31/12/2017 and 31/12/2022

Conclusion

  • Overall, strategies on broad themes appear to be less efficient than those on specific themes
  • An in-depth analysis of the thematic universe indicates a significant probability of generating outperformance and underlines the importance of investment timing.
  • The active vs. passive management debate does not exist in the thematic investment segment. A thematic investment involves an active management decision aimed at outperforming the benchmark regardless of the index or non-index implementation mode.  The active funds vs. passive funds criterion does not appear to be a significant criterion for generating performance.
Marlene Hassine Konqui & Ahmed Khelifa, CFA