How Thematic Strategies Differ from Sector Funds

Part of the appeal of thematic investment strategies is that they can venture beyond traditional sector classifications when bundling stocks, potentially giving you new ways to diversify.

Here we'll take a closer look at how themes and sectors differ, and how thematic strategies can give you a targeted exposure to different parts of the economy.

Let's start with sectors, since those are perhaps the more familiar of the two.

Standard & Poor's and MSCI created the modern system for grouping and classifying stocks by industrial sector when they launched the Global Industry Classification Standard (GICS^®) back in 1999. Under this framework, companies are sorted into one of 11 sectors according to their principal business activity—consumer discretionary, communication services, consumer staples, energy, financials, health care, industrials, information technology, materials, real estate, or utilities—as determined by revenue sources and other factors. Each sector also contains subdivisions for industry group, industry, and sub-industry. Every company within a sector is assigned one classification in each of those tiers.

Standardized sector and industry definitions paved the way for investing strategies such as sector-focused exchange-traded funds (ETFs). Such funds can be useful if you expect a certain sector to do better—or worse—than the rest of the economy over a given period.

Because they can include all the stocks in a sector, sector ETFs can offer a measure of diversification beyond what you might get if you'd invested in just a handful of stocks.

Like sectors, thematic strategies also group together companies and slices of the economy, but they have a different way of doing so. They may target ideas or trends—especially new or potentially transformative technology or social forces—that don't fit squarely into the existing classifications.

As a result, thematic strategies can be both more targeted than sector-based ones, at least insofar as they focus on a particular idea or trend, and more broad-based, because they can consider stocks from any industry or sector, so long as they are relevant or consistent with the theme. Additionally, a stock can be relevant to any number of themes, whereas it will only ever belong to one sector. Finally, sector designations tend to be backward-looking, since they depend on a company's current or past business activity, while thematic strategies can focus on a business's potential future business opportunities.

Of course, thematic relevance is somewhat subjective. Themes don't have recourse to a GICS equivalent to arbitrate differences between investment offerings or determine which ones should be included where. Every strategy will reflect the views of the research provider, so be sure you do your research before deploying a thematic strategy.

Here are some examples to clarify these differences. The chart below shows four technology-oriented Schwab Investing Themes™: artificial intelligence, big data, cloud computing, and cyber security. As you can see, each theme starts with a heavy dollop of stocks from the information technology sector but then diverge.

Of course, diversification only makes sense in the context of your portfolio. Thematic strategies on their own won't give you a diversified portfolio, so it's essential to determine how one might work with the rest of your holdings—especially if you rely on funds tracking market-cap weighted indexes.

Such funds can automatically provide a lot of exposure to certain large companies, so employing a thematic strategy that increases your exposure to those companies could make your portfolio less diverse. Similarly, there's no rule preventing a particular stock from appearing in multiple themes, be sure to review the list of stocks in a theme before you invest.

That said, how you're investing matters. If you're using a thematic fund, you might not have any say over what stocks are included. If you're using a theme-based stock list, though, you may be able to exclude certain companies to avoid unwanted concentration.

Thematic strategies can help you explore otherwise untapped parts of the market and add a new dimension to your portfolio—but only if you use them correctly.