Boost portfolio returns with thematic equities strategies

From robotics to clean energy, thematic equity strategies strive to capitalise on sources of long-term secular growth. But the arguments for allocating capital to thematic equities don't end there. Thematic stocks also hold their own from an asset allocation view point, helping diversify a portfolio's investments and potentially improving its risk-adjusted returns.

That’s because, by its very nature, thematic investment favours companies with distinctive characteristics and that are differentiated from those represented in mainstream global indices – be that in terms of size, sector or style.

A hallmark of thematic equities portfolios is that they contain stocks that don’t feature prominently in common stock indices. That is probably not surprising given that thematic funds tend to concentrate investments in niche industries. Less obvious, however, is that this holds true even for broad, multi-themed strategies such as Pictet Asset Management’s Global Megatrend Selection (GMS).

In fact, a third of the stocks in the GMS portfolio are entirely absent from the MSCI All Countries World Index (ACWI); the overlap by weight between the two stands at just 26% (see Fig. 1). In other words, thematic equity portfolios have a significant active allocation relative to the index, known as a high active share.Overlap is calculated as the sum of all overlapping portfolio holdings within the index, adding up the minimum of the two weights.

A high active share can sometimes mean that investments are concentrated in just a few sectors, but this is not the case for multi-themed strategies. The sector composition of GMS is broad, but significantly different from that of ACWI (see Fig. 2). Notably, GMS features more industrial and healthcare stocks, while the allocation to financials is much reduced relative to ACWI and energy is entirely absent.

These results do not arise by chance. Our search for high quality businesses with solid growth characteristics tends to eliminate many companies in energy and financials sectors, which have struggled to sustain upward momentum in economic profits over the long term (see “What makes thematic equities sound long-term investments”).

This approach, naturally, means GMS has different style factor exposure relative to the global indices (see Fig. 3). For instance, by concentrating investments in companies with long-term growth fundamentals (as opposed to short-term drivers) tends to be reflected in lower exposure to value and momentum factors than global equity indices.

Another distinguishing feature of GMS is that it also has much lower exposure to size – in other words, the strategy has a higher share of small- and medium-sized companies than ACWI. This arises from our investment process: because we prioritise high thematic purity, we naturally favour specialist firms over diversified conglomerates (which derive their revenues from a myriad of different sources). Many of these specialised companies are small, niche businesses. And the high specialisation of our investment teams means we have the capacity to do our own analysis on otherwise under-researched companies.

History suggests that the market leaders’ winning streak won’t last forever. Mean reversion is one of the most powerful forces in financial markets. There are tentative signs that megacap stocks may be starting to fall out of favour. And our Secular Outlook 2025 forecasts that market performance will broaden out beyond the megacaps over the next five years.

A different analysis we undertook shows that, after a three-year outperformance streak, the odds of the outperforming sector underperforming in the subsequent few years are about even. After a five-year winning streak, meanwhile, the probability of a long period of underperformance rises to 60% (see Fig. 5). This suggests that the winning streak of the megacap companies in IT and communication services that have outperformed in five of the past six years (with 2022 being the exception) will not last indefinitely. That’s not to say those sectors should be ignored, merely to call for careful stock selection.

Of course, the probability of underperformance is only one aspect of the risk stock investors face. The magnitude of underperformance in cases when it occurs is another. In the same analysis, we found that a  reversal could see the former stock market stars lose 10-15% in one year, and over 30% if the underperformance persists over three years (see Fig. 6).

A shift in performance would present an opportunity for the size premium to re-establish itself, and for smaller companies to shine.

With 17 % exposure to small and mid-caps (companies with market capitalisation under USD10 billion), GMS is well-placed to capitalise on this opportunity, compared to the broad market index, which provides 3% exposure (see Fig. 7).

Smaller companies bring other advantages, too. Research shows that strategies investing in small- and mid-sized companies tend to do better versus their benchmarks that than their large cap focused peers (Fig. 8). One reason for this could be that investment research bears more fruit in these less intensely researched areas of the equity market.

Our thematic investment process, therefore, does not just help to unearth companies with promising long-term growth prospects and sound fundamentals. Adding thematic equities to a portfolio improves diversification across factors and company size and adds resilience for times of global uncertainty. It should thus lead to higher risk adjusted returns.