How Thematic Strategies Differ from Sector Funds

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, and 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. 

For example, the artificial intelligence theme includes a large contingent of information technology companies, but the rest come from the communication services, consumer discretionary, and financials sectors. The cyber security theme, on the other hand, draws almost entirely from information technology stocks.

Themes concentrated within a single sector can also differ significantly from funds tracking those sectors by virtue of what they exclude. For example, 100% of the stocks in Schwab’s dining out theme come from the consumer discretionary sector, but the exposure it provides would likely be quite unlike what you might get from a sector-focused fund. Why? The theme includes 25 companies, and they are concentrated in the consumer discretionary sector's restaurant sub-industry. In contrast, a fund tracking the S&P 500 Consumer Discretionary Index would likely include 52 companies, with online retailer Amazon and electric carmaker Tesla occupying the largest weightings. That may not a bad thing, but an investor looking for exposure to restaurants might opt for a more targeted approach.

A perhaps more surprising example comes from Schwab's U.S. housing theme, which you can see below. 

You might expect a housing-focused theme to include quite a few real estate companies, but real estate accounts for only about 18%. Consumer discretionary stocks, with a nearly 72% weighting, are the largest sector in this theme—as large homebuilders such as DR Horton and Lennar Corp reside there. Financials, including some mortgage and titling companies, make up about 7%, while industrials round out the rest. 

To be sure, these are just a few examples from Schwab's offerings. Other providers' thematic strategies might pursue similar goals with totally different holdings or sector concentrations, depending on their models and research. 

No matter how a thematic strategy allocates, it's probably still going to look different from even superficially similar sector-focused alternatives. And such differences can be the building blocks of additional diversification.   

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.