The risks and rewards of investing in ‘hot’ themes

Themes have generated plenty of excitement - and some big returns - in the last year, but the risks are also very real. This On The Money episode looks at the funds looking to capture themes and how to approach them.

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Dave Baxter, senior fund content specialist at interactive investor: From space exploration to artificial intelligence (AI), the big exciting investment themes seems to be driving a lot of recent movement in markets. It seems that the big money is now on identifying those themes and then successfully targeting them in your portfolio. 

There are many funds that attempt to do this, but the problem is these funds do come with all manner of potential drawbacks. That’s what we’re going to be exploring today. So, welcome back to On The Money, the show that looks at the issues affecting your savings and investments.

I’m Dave Baxter, I’m the senior fund content specialist here at ii and I have a great guest here to discuss our theme. That’s Dan Kemp, the founder of investment research business Portfolio Thinking, and before that he spent a long time working at Morningstar. So Dan, thank you very much for joining me.

Dan Kemp, founder of Portfolio Thinking: Dave, it’s great to be with you.

Dave Baxter: Good to see you again.

Dan Kemp: Indeed, it’s been a little while.

Dave Baxter: It has been a while. So, thematic investing; there are clear drawbacks to thematic exchange-traded funds (ETFs), which we will get into because people do need to be aware of them. But let’s kick off on more of a positive note.

To start, why would you think about thematic investing beyond just going into the main markets, the generalist funds? And beyond that, what are, personally for you, the exciting themes and are there any funds that have been standing out?

Dan Kemp: Well, the first thing I’d say is the way that we tend to invest is very rigid. It was created quite a long time ago. It’s full of very neat boxes that separate one type investment from another, and most portfolios are built up like a Lego house from very standardised blocks, and that can be very helpful. It makes it very easy to mathematically express a portfolio, but it’s not the sum total of investment.

There are other ways of thinking about investment, and one of the newer ways of thinking about it, one of the ways that’s most exciting for people - and we will talk about drawbacks later on, but starting on the positive - one of the ways that people are looking at investment now is through the lens of themes.

So, what are the big things that are happening across markets, across sectors, across companies, sometimes between equity shares and bonds, debt markets? What brings some of those companies together and creates a theme, and this new way of investing, new products we’re seeing launching, allows people to invest in line with that theme.

So, to get away from the Lego, it is a bit more like plasticine. You can start putting odd-shaped bits together to create a very different portfolio, and that can be very useful, but also, as you say, quite challenging. It’s a bit like having a wonderful new toolbox full of new tools you’re eager to use. You can make some wonderful things with those new tools, but they can be dangerous when misused.

Dave Baxter: So, if I were to put you on the spot, and clearly I am going to do that…

Dan Kemp: Good.

Dave Baxter: Excellent. Say, four themes. What four themes would be really exciting for you at the minute?

Dan Kemp: Well, I’ll struggle for four, to be honest. We’ll talk about why later on. But let let’s go for two. So, the first one is what we used to call ESG (environmental, social and governance), but that label became very unpopular in parts of the world, and so now people are scrambling around trying to find other labels. 

But there were lots and lots of funds launched a few years ago to help people express their values through their portfolios. A whole variety of different funds, some of which were very thematic in nature, things like alternative energy, for example. So, as the underlying investments there have gone out of favour, the prices you pay for those investments have fallen, the expected returns have risen, and you can get much better returns from those thematic funds now than you could have done when they were very popular.

I think there’s a broader message there, that sometimes the best time to access a theme is not when the fund is first issued because that’s when there’ll be a little hype around it, but sometimes when that theme has had a chance to mature, when some of the froth in valuations has come off, when the price is a little bit low and expected returns are higher, that’s a really good time to look at themes.

So, if you’re digging around for unpopular themes at the moment, there’s plenty that you can find in the ESG space.

One of the areas that I’ve been looking at over the last little while is things like alternative energy, of course, which was very popular and became very, very unpopular. When I was running the ESG portfolio, it was one of the great holes in my portfolio, trying to find really good value alternative energy stocks, it’s very difficult. Now it’s a little bit easier.

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Dave Baxter: Are there any names specifically that stand out? You immediately made me think of what used to be the poster child of thematic ETFs. I think it’s now got ‘sustainable’ or something else in the name, but it used to be called the iShares Global Clean Engy Trns ETF $Dist GBP. That was notorious in some ways because it became very popular back in 2020 amid a huge surge in ESG interest, took on billions of dollars, pounds in assets, had very strong returns in 2020, and then, unfortunately, those people who piled in, say in 2021, were then in for this period of really dire performance.

Dan Kemp: Yeah, and that’s exactly the challenge with themes, that when these things are very popular, the underlying prices can be very high. So, there’s really two key things when thinking about thematic investing. The first is the theme and whether you want to access that theme. So, clean energy is a great example.

People want to access that clean energy theme either for the short term expected returns as we saw, as you say, back in the early part of this decade, or now for that longer-term structural change that we’re likely to see in markets.

But the second is the quality with which that fund has been created. Like anything else, there’s a huge variation in the thought and the understanding and the research and the quality of the construction. And so that’s something where you really want to be aligning yourself. If you’re using a thematic fund in your portfolio, if you’re accessing a theme, think hard about how that portfolio was constructed to reflect that theme because there’s huge variation in the quality there. 

Dave Baxter: How would you judge that quality?

Dan Kemp: Well, there’s a couple of ways to judge it. The first is simply to read the documentation and, really, we often think about investment specialists poring over the details of investment documentation, but it’s something that we find fun, and actually a lot of the documentation that comes with a thematic fund is pretty easy to read. It’s pretty transparent about how the company has come up with the theme, and how they’re selecting stocks that are aligned to that theme. 

So, have a read of that, see if it is sufficiently differentiated, or whether, frankly, it feels a bit flaky. As ever, it’s worth doing your homework. There’s been some great research done by an old colleague of mine, Kenneth Lamont, who leads thematic research at Morningstar. Wonderful man, incredible cyclist, and alongside all that, he has really led a lot of pioneering research in thematic investing. 

So, again, he’s done a lot of work on identifying whether funds are sufficiently differentiated in terms of pursuing a theme, or sometimes whether just a collection of large growth stocks that are really in everybody’s portfolio because a lot of these themes are quite key to normal markets. So, that’s another area of research you can do.

Dave Baxter: So, just to stick with that point about the quality in the documentation, are there specific metrics that DIY investors could look for? You’ve already alluded to the fact that particularly with the more techy themes, you can end up with a lot of the big growth stocks, the big Magnificent Seven shares and so on, but beyond that, are there specific things you would look to see mentioned? 

Dan Kemp: One of things that I would do, just as an everyday investor with your savings, is look at the top 10 holdings. So, sometimes in a fund, the smaller holdings are somewhat hidden from investors. You can get them in the annual report and accounts, again, something I find fun. But if you don’t find that fun, you certainly get the top 10 holdings on the website of the thematic investors. I’m sure they can get the top 10 holdings for you. 

So, you could get these top 10 holdings, and then start comparing those with, let’s say, traditional market funds. For example, if you want to access an AI theme, which is obviously very, very popular at the moment, and you look at your fund and the top 10 are NVIDIA Corp and Alphabet Inc Class A, which owns Google, and Meta Platforms Inc Class A, which owns Facebook, and Amazon.com Inc, which we all know, and Microsoft Corp, then, really, have you got a deep AI theme or, actually, are you just buying large-cap US tech?

Someone may say, why does that make a difference? One of the reasons it makes a difference is because the fees that are charged to you as an investor for thematic funds, are often a lot higher than traditional tracking funds. So, you want to make sure that you’re really getting access to the theme that you’re targeting and not just that broad market exposure that’s been repackaged with a slightly higher fee.

Dave Baxter: Yeah. To give one example, I was looking at one of these recently launched quantum computing ETFs, and perhaps I’m not giving it enough credit, but at a glance it was charging something like 0.5%, so that’s much more expensive than your S&P tracker and so on, and in its top 10 holdings, four of the names were those Mag Seven companies. 

Dan Kemp: Yeah. It’s a perfect example. So, if you do deeper research, you may find there are some fantastic names there, which you’ve never heard of, which are really key to what’s happening in quantum computing. 

The thing to remember though is, are they really going to drive the returns of that fund, or are the drivers of that fund going to be those large general US tech stocks?

One of the reasons for thematics, as we mentioned earlier, is that it gets you away from those standard classifications, and as people look at the US market at the moment, the biggest market in the world, then it is really dominated by large technology companies.

If you’re then trying to diversify away from just holding these US technology companies into a very specific theme, and what you find is you’re holding exactly the same technology companies that you used to hold in your broad ETF, not only are you paying more, but you’re getting the same exposure. That’s why it’s so important to understand how these stocks are being selected, and how they’re being weighted in the portfolio, that’s a really key point, but then also, what are you getting for the extra fees you’re paying?

Dave Baxter: Yeah. One interesting side point is that you can, as an investor, always simply use these funds as inspiration and perhaps then go and look at specific stocks if you’re comfortable and have the knowledge to do that.

For those who do have the time and the interest, you can look at a variety of, say, AI funds, defence funds, space ETFs, that kind of thing, and you can look at some of the holdings that would crop up commonly, and then perhaps that’s your initial step towards what might be an interesting holding.

Dan Kemp: Exactly right. So, there’s that coordination, and again, this is what Kenneth has done, looking at which stocks best exemplify a theme that are unique to that theme rather than a crossover with other markets. You’re right, that sort of research, that’s really helpful. If you see a company that you don’t know very well cropping up in multiple versions of the same theme, that could be a very good sign. It doesn’t mean it’s a good investment of course, that’s a completely different question, but it probably means it’s a good expression of the theme.

Dave Baxter: It could potentially be a crowded trade, that could be the other indicator it’s giving you, but it’s at least some information.

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Dan Kemp: Exactly, and that is the key thing to be aware of with thematics, that we are creatures who love a story. That is how we’ve evolved over millions of years. We are creatures who tell each other stories, we love stories, we organise things by stories, and so one of the great challenges of thematic investing is to get away from those stories, because once you latch on to a story, then you tend to forget about more traditional valuation metrics, more traditional drives of returns, and you can just buy into a story even if the expected returns are quite low because it’s popular, because you’re hearing the story over and over again.

Just because you’re investing in a thematic fund doesn’t mean you can throw away traditional analysis, the traditional way of picking investments. If you hold on to that, then you can access this wonderful canvas of thematic funds, of different ways of investing, while maintaining that discipline of sound investing across your whole portfolio.

Dave Baxter: I’m interested in that note made in your earlier points when you were talking about clean energy funds and the fact that you see them at the minute as an interesting contrarian buy.

Perhaps that is one possible strategy because, as you mentioned, thematic funds are very much driven by narratives, sentiments and often the tide very much seems to be in or out. So, maybe one starting point is to look at areas that are perhaps receiving bad news, and the performance has come off, and investors don’t seem interested in it, and that could be, again, just a starting point but an interesting approach.

Dan Kemp: This is it, you see, contrarian investing. I found a kindred spirit. Exactly. Look for things that people hate, and it’s a game that so difficult to do because we are built to align ourselves with the crowd, and to align ourselves with that narrative.

So, when there’s a strong narrative that’s very positive about one part of the market and very negative about another part of the market, we naturally see all the positives with that popular part of market. We can only see negatives with the unpopular part, and typically, that’s why prices have fallen so far. But, if you can dig around in the unpopular themes, then there may be some terrific investments there.

Dave Baxter: But imagine I’m less of a contrarian and I’m looking at a theme, a really obvious one that I haven’t mentioned yet is defence spending. Defence stocks have been absolutely flying for at least a couple of years, and let’s say you view that as a big structural trend. You don’t think this is simply a high, and you want to be in now to do that compounding. Are there ways to do that sensibly and to mitigate the risk that you’re just buying in high and then setting yourself up for a hefty loss at first?

Dan Kemp: Yeah, of course. There’s three ways of looking at this. The first is, if you’re just trying to make money from a theme on its own, let’s say, or you think that theme will deliver returns, then you have to start by thinking about what you know as an investor that no one else knows. 

So, if you are betting on defence stocks because you’ve seen this change in the geopolitical landscape [and] you expect spending to increase in defence, then who is not thinking about that? Who’s not caught on to that idea?

If it’s an idea that everyone else has, it’s already likely to be in the price of these companies. You will never get on top of a theme faster than the market as a whole because so much happens electronically in nanoseconds these days to reflect new news. So, don’t expect to be able to get on a theme ahead of other people. That’s not a great way of doing it.

A good way of doing it is to say, well, I think one of the things that may dominate the fiscal environment, that may dominate the world over the coming decade, is the importance of defence.

But as I look at my portfolio, I’m woefully underinvested in defence. Let’s say I have a lot of US exposure, great. I’ve got loads of technology stocks. I might have a lot of emerging market exposure in my portfolio. Great. Lots more technology stocks. I might have some other things. I may have no real exposure to defence, and that may be a real hole in the portfolio. So, actually, a defence ETF may plug that hole in your portfolio. 

So, I’m going to shift my analogy from Lego to a jigsaw. It’s only children’s toys, that’s all I have, sorry. So, think about a jigsaw, think about where that missing piece is, and that missing piece may be the same shape as a thematic fund. So there, you can add that in and build out the whole picture. I think that’s a really useful way of doing it, but if you’re just doing the analysis, then remember that most funds will give you some idea of the combined valuation of the underlying holdings.

So, at a very essential level, you can understand whether you’re buying something that’s very expensively priced or very cheaply priced. Now, I’m not an advocate for a single-metric analysis. It tends to be not a great way of succeeding when you’re investing, but it will give you some picture. 

Again, if you look at these stocks, and they all look very fashionable and very positive, probably that’s in the price, but you can do some basic financial analysis to understand whether these stocks are very expensively valued or could be cheaply valued. So, think about it as a piece of the jigsaw, think about that underlying analysis.

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Dave Baxter: It’s worth mentioning that a really great thing about ETFs is that the disclosure level tends to be much higher than for your average open-ended active funds. Normally, particularly with the really big boys like iShares, you can go into all the holdings. You can also look at metrics like price/earnings ratios and so on. So, you can give yourself an idea of where things are valued and you can really pick into what’s in the portfolio.

I wanted to touch on another element of thematic funds, which is concentration. Something I’ve always borne in mind when I’ve done various bits of analysis on thematic funds is that they can sometimes very much go one way or the other.

Sometimes they have really big bets. Some of the defence funds, for example, have had really big holding sizes in things like Rheinmetall AG and some of the leading stocks, whereas some others will be much more spread out. What are your thoughts on that? Is it good to bet really big?

Dan Kemp: I’d say absolutely not. I just want to, as I answer that, reinforce that point about ETFs. That’s so important, that disclosure being able to go deep into portfolio holdings. You’re right, that is a regulatory requirement for most ETFs. So, a great tool for people to understand what’s in there.

When you’re building a portfolio, there are different ways that you can decide on the size of the holding. Everyone has different views. You could have something that is just equally weighted. So, every stock, whether it’s a large company or a small company, gets an equal share of the capital.

What’s more likely is that you have the largest companies take the largest share of the capital, so what we’d call a market capitalisation weighted system, which is how most of the main indices work. That’s a very intuitive way of weighting a portfolio, the larger stocks get more weight. 

It’s a bit of a challenge when it comes to thematics because if you take a company like Amazon, for example, you may be accessing it because of its AI exposure, but it’s quite a big shop as well, and it’s got other aspects, it’s a big technology producer, and so there’s other aspects of that business, so you’re probably not getting the pure play to the theme that you really want.

So, one of the things to think about is if you are seeing very large companies consuming most of the capital in a theme, that’s a very normal way of putting together a portfolio, but it may not be the best way to access a theme.

Dave Baxter: That’s a tricky balance though, isn’t it? Because the iShares fund I mentioned earlier, the clean energy fund, that had to rejig itself and change its methodology of the index it tracks because it got to a situation where it was actually backing more things like mid-cap companies, and then the fund became so big that that became a liquidity problem because it’s this massive fund with huge volume of money.

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Dan Kemp: Yeah, so there’s a really good point and the chance of liquidity is not just on the way in, of course, but if the tide moves away from a theme, then you can have liquidity-driven price falls because the fund becomes a forced seller. So, no, that is incredibly important. 

At the same time, when you’re thinking about thematic investing, often that’s talking about stocks that are going to be future winners. It’s quite difficult to pick winners because markets change. So, rather than pre-selecting your winner in the emerging theme, so you think, OK, this company is going to be the winner and that’s why it has the most capital, then it’s probably better to spread out your capital across a large number of companies. If we roll back the clock 25 years, I don’t think many of us would have picked the winners of today’s technology boom.

So, it’s really important to not focus too much capital in what is a very competitive emerging market often, which is linked to these things. I don’t mean emerging market in terms of other countries.

Dave Baxter: Emerging sector?

Dan Kemp: Emerging sector, exactly right.

Dave Baxter: Finally, we’ve mentioned generalist funds, and then themes do fill some of those gaps. Beyond AI, because we’ve already discussed that, are there themes that you think are already perhaps covered enough, or you can get enough exposure to via your more generalist funds, be that a tracker or an actively managed fund?

Dan Kemp: Yeah, I think you certainly can. And again, in different parts of the world, you get access to different themes through the exposure that you have. 

So again, we typically start with the US when we think about the AI theme naturally. But if you look at a normal UK investment fund, people sometimes say, well, I don’t want to invest in a UK investment fund because I’m not really sure about where the UK economy is going. Well, a UK investment fund is not actually a reflection on the UK.

These are global businesses that dominate with international revenue streams, so you’re almost accessing global trade through your UK fund.

As you look at, let’s say, a Taiwanese fund, you’re really buying a very large-chip manufacturer there in Taiwan Semiconductor Manufacturing Co Ltd ADR. When you’re looking at an Australian fund, you’re buying a bag that is dominated by mining companies and by Australian financials. 

So again, in different parts of world, there’s different emphasis on sectors and on themes. You can access some of these themes through general funds without having to go to specialist themes. It’s much easier to go to specialist themes, but that’s not the only way of accessing these themes.

Dave Baxter: Yeah. It’s worth noting that they do crop up over time. One name in South Korea is SK Hynix. That’s been doing enormous numbers in the last year or so and that has started to crop up in emerging market indices, actually in a handful of global funds as well. So, you do see it creep in, but perhaps in a less forceful manner.

Dan Kemp: So, here’s a really important point, and you mentioned Hynix there. If you look at Korea, for example, there’s really two dominant companies there, Samsung Electronics Co Ltd DR and SK Hynix, the memory manufacturer. Samsung obviously much broader. 

Now, they make up a very large proportion of the South Korean market. I’m not going to give you a number because it’ll change overnight. They’re going up so quickly, or they have been going up so quickly, they might go down quickly, but it’ll change. But it’s a very large portion, and a much higher portion than a traditional open-ended fund, an actively managed fund can access.

So, that really is a reminder for investors that if you want to access Samsung and SK Hynix, and you do it through a traditional Korean fund, you may find that you’re woefully underweight in those stocks, and you have lots of other Korean stocks. They may be great companies too, but you may not be getting the exposure you want because of regulatory limits on the size of exposure you can have within a traditional fund.

So again, all these things come into play. It all goes back to the same lesson, know what you own and why you own it, and that should be the starting point for investing rather than the badge on the tin. You don’t always get what you’re expecting if you just go by the badge.

Dave Baxter: Yeah, and lots of due diligence.

Dan Kemp: Yes, generally, obviously, in investment ordinarily, but particularly when you’re getting into niche parts of the market, when you’re getting into less liquid vehicles, when you’re getting into themes, then, really, if you’re going to do that on your own, then expect it to be an enormous amount of work. A lot of fun, but an enormous amount of work.

Dave Baxter: Well, on that note, that’s all we have time for. Thanks for coming in.

Dan Kemp: It’s an absolute pleasure, Dave.

Dave Baxter: And thank you for watching and for listening. Do remember, if you want more fund analysis from me and from others, there’s lots of that on ii.co.uk. 

Also, do let us know what you’re thinking either via the comments or by emailing us directly at: OTM@ii.co.uk. I hope you enjoyed it and catch you next time.