Fund Focus: rules for thematic investing

Markets looked strong until very recently, but while tracker funds have done very well it has been certain sectors, and themes, driving the really big price moves.  

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The artificial intelligence (AI) theme has had a major influence on returns in recent years, from boosting names such as NVIDIA Corp (NASDAQ:NVDA) to hammering sectors like software, while the uptick in defence spending has driven massive gains for shares such as Rheinmetall AG (XETRA:RHM) and funds with a focus here. 

Source: FE Analytics. Past performance is not a guide to future performance.

That in turn has prompted some to reconsider how they build portfolios.

Ulrike Hoffmann-Burchardi, UBS Global Wealth Management’s chief investment officer, argued in the Financial Times last week that investors needed to not only focus on investment factors (such as growth and value), and instead attempt to capture some of the trends driving future returns. 

This does have some merit. Staying with the defence theme, companies in that sector aren’t always a big part of conventional indices or active funds with a generalist approach.

And as our table shows, funds investing in a hot theme can make you a lot of money, if the timing is right.

But there are a few health warnings that should be applied before you dive into a thematic fund. 

What you need to know 

A common criticism of thematic (and sector) funds is that they launch when a particular idea is already in vogue, meaning that they put money to work when a sector has already attracted lots of hype and high valuations.  

As those who piled into the iShares Global Clean Engy Trns ETF $ Acc GBP (LSE:INRA) in the pandemic found, that can sometimes mean a short run of very strong returns followed by some extremely poor performance. 

There’s an argument that a theme with more room to run will buck this trend, and defence ETFs could well continue to deliver the goods.

But investors are sitting on lots of momentum and should keep position sizes limited, and rebalance after big gains, as a way of limiting their potential losses in future.

Such funds can end up taking big positions in their winners.  

The Global X Defence Tech ETF USD Acc GBP (LSE:ARMG) has a 9.2% allocation to top holding Lockheed Martin Corp (NYSE:LMT), with two other positions accounting for more than 7% of the fund each.

That is a decent level of stock-specific risk although not all funds operate in this manner.  

The Invesco Defence Innovation ETF GBP (LSE:DFNX), the top-performing defence play from our list over the last year, has 60 holdings and very small position sizes. 

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Investors, meanwhile, should check how a fund is targeting its theme.

The defence funds, for example, differ in the extent to which they target that theme via the industrials sector, and how much they delve into sectors such as information technology to focus on areas such as cybersecurity. 

We’ve noted before that the lines are blurred between sectors and themes, but some sectors are more established than others.  

Defence might be more straightforward but targeting broader trends can involve some interpretation on the part of the fund provider.  

To give you one example, the iShares Ageing Population ETF USD Acc GBP (LSE:AGES) has around half its portfolio in healthcare stocks, as some considering this trend might expect.  

But you might be surprised to learn that around 42% of the fund is in the financials sector, via names such as Samsung Life.  

It’s therefore very important to know what exactly you are taking exposure to, and it could make sense to use a thematics fund as inspiration for your own stock picks rather than actually investing in it. 

An American dream?

Thematic investing can be a good way of backing sectors (or ideas) not well represented in a global tracker fund but some portfolios in this space are still very US-focused.  

Exchange-traded funds (ETFs) that target trends such as AI or digitalisation can end up having a big allocation there, and can at times have a high degree of correlation with moves in the S&P 500.

They therefore don’t offer as much diversification from the main market as we might expect. 

To their credit, AI funds don’t always simply load up on exposure to the Magnificent Seven shares and may well hold names unfamiliar to DIY investors.  

The Invesco Artificial Intllgnc Enblrs ETF GBP (LSE:IAIX), which has returned around 60% over a 12-month period, has just one Magnificent Seven member in its top 10 holdings list, with the likes of Lumentum Holdings Inc (NASDAQ:LITE) and Seagate Technology Holdings (NASDAQ:STX) among its biggest positions. 

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But another strong performer, the WisdomTree Art Intelligence ETF USD Acc (LSE:WTAI), does list some better-known names, from Nvidia to Samsung Electronics Co Ltd DR (LSE:SMSN), Alphabet Inc Class A (NASDAQ:GOOGL), Taiwan Semiconductor Manufacturing Co Ltd ADR (NYSE:TSM) and SK Hynix, in its top 10. 

Such differences highlight the need to do plenty of due diligence here, and to ask which more generalist funds are actively targeting some of these trends too.  

Names such as Artemis Global Income I Inc have benefited from exposure to defence and aerospace in recent history, while funds like WS Blue Whale Growth I Sterling Acc and Scottish Mortgage Ord (LSE:SMT) have plenty of focus on AI. 

Note that Blue Whale Growth, for example, lists both Lumentum and defence play Leonardo SpA Az nom Post raggruppamento (MTA:LDO) in its top 10.

Such names might give less concentrated exposure to themes that can rapidly be in, our out, of favour.