What makes thematic equities sound long-term investments?

Time was when thematic equities were niche investments. But over the past five years, they have become mainstream for an expanding circle of investors. Since the end of 2019, assets held by thematic equity portfolios have increased from USD270 billion to USD560 billion while the number of thematic stock funds has more than doubled to approximately 2,800.

Still, that expansion has lost some steam more recently.  As asset managers rushed to launch new thematic strategies to meet a surge demand in the immediate aftermath of Covid-19, it seemed inevitable that many of those hastily-constructed funds would struggle to live up to investors’ expectations.

And so it proved. Thematic portfolios drew net inflows of USD360 billion during the post-pandemic equity market rally of 2021 only to suffer net outflows totalling USD50 billion in the subsequent three and a half years as their returns deteriorated.Flows data from Morningstar, 2024. This is a reminder that not all thematic equities are created equal.

In our view, thematic equity portfolios are capable of delivering superior risk-adjusted returns over the long run. The problem is that few of the funds available possess genuine staying power.

Investment success ultimately hinges on being able to incorporate a complex set of considerations into the building and management of portfolios.

First, there is the construction of the investment universe itself, which involves pinpointing areas of the economy that are witnessing momentous change and growth.

Then there's the selection of companies. The task here is to identify and invest in specialist, fast-expanding firms that can sustain high levels of profit growth far into the future.

None of this is easy. It demands a deep understanding of complicated economic and non-economic phenomena – research that requires resources on a scale that aren’t available to every asset manager. 

A second advantage is the potential for corporate earnings to surprise to the upside. As Fig 3 shows, thematic companies have delivered persistently higher earnings per share (EPS) growth over the past 15 years. At the same time, this structural advantage is not reflected in analysts' long-term earnings forecasts. This suggests thematic companies have greater potential to deliver forecast-beating profits in the years ahead. 

A third advantage is that thematic firms - the ones in Pictet Asset Management's  universe - score well on factors that are widely associated with high quality, well-run businesses. The analysis, which uses the HOLT framework for identifying firms that enjoy an Empirical Competitive Advantage Period (or eCAP) – finds that our thematic universe contains a higher-than-average preponderance of companies with strong 'quality' characteristics. 

Their earnings have been more stable and reliable over the past five years than those of the majority of firms and they more frequently enjoy rates of profit growth that exceed their cost of capital. Moreover, their profitability tends to hold up better even when the economy sours. Our calculations show that all sectors represented in thematic portfolios have delivered a rise in economic operating profit in each of the last 20 years.  By contrast, many sectors within the MSCI ACWI index have seen year-on-year declines in economic profit several times during that period (see Fig. 4 and Fig. 5).

At Pictet Asset Management, we identify specialist companies using our own thematic purity factor. This quantifies what proportion of a firm’s revenues (or enterprise value) is tied to a specific investment theme. So for a company to qualify for possible inclusion in our Clean Energy Transition strategy, for example, clean energy-related activities must account for at least 33% of its revenues or enterprise value. The purity across our thematic portfolios averages around 80%.

Pictet Asset Management avoids this pitfall by ensuring that all of its thematic portfolios are managed by specialist teams that focus on their theme.

This ensures comprehensive coverage of all stocks in a given thematic investment universe. What's more, in assuming responsibility for company analysis and portfolio construction, thematic investment managers develop a deep understanding of value chains that transcend traditional industry boundaries.

This knowledge is crucial in assessing a company’s competitive position and, ultimately, its earnings prospects and valuation.

There is evidence that specialist managers that choose stocks from a narrow universe deliver better returns against their benchmark than generalist portfolio managers do. 

Analysing Morningstar fund data, we find that generalist fund managers (those that compare themselves either to MSCI ACWI or the S&P 500) tend to perform worse versus their benchmark than sector specialist fund managers do versus their own reference index (see Fig. 7). 

A similar assessment of returns from thematic exchange-traded-funds worldwide shows that Pictet Asset Management thematic funds have more frequently than not outperformed such ETFs over the past two, three and five years (see Fig. 8).

The advantage specialist investment managers enjoy over generalists is also borne out by our own analysis of stock selection. 

In this study, we found that a thematic equity investment manager with a reasonable level of stock-picking skill - or one that achieves an information ratio of approximately 0.5 against a thematic benchmark - has a greater than 55% chance of outperforming a mainstream index such as the MSCI ACWI.