Sometimes an investing idea is too broad for a single stock, sector, or index—the building blocks of which many traditional investing strategies are constructed. That can pose a challenge to the idea-curious investor.
Think of it like this: A technology such as artificial intelligence (AI) doesn't have its own official sector classification, and many companies say they're developing AI, using it, or are otherwise involved with it. But how do you know which of them truly represent the field? And more to the point, how do you go about creating a portfolio of the most relevant AI investments?
You could pick out a few well-known tech stocks, or perhaps spend some time reading company reports to identify more niche players, but it may not be easy to identify pertinent investments—especially if they happen to be outside the tech industry.
That's where an investing style known as "thematic" hopes to make a difference. The goal is to develop investing products that allow you to easily put money into ideas, personal values, or trends—especially new or potentially transformative technology or social forces—that don't fit squarely into the existing classifications. Thematic investing uses research to identify companies relevant to a particular theme and then group them into lists, baskets, or funds you can invest in. In contrast to sector investing, themes can include investments that span many industries.
However, it's important to note that cutting loose of traditional sectors and indexes doesn't mean thematic-minded investors should also abandon the traditional best practices of investing. The number of thematic investment products, in the form mutual funds, exchange-traded funds (ETFs), or stock lists, has exploded in recent years, meaning there are thousands of options out there already managing hundreds of billions of dollars of assets. Many of them claim to offer access to trendy ideas or can even seem fun, but they should still be approached with a disciplined eye.
Here, we'll talk about how themes work and how investors could approach investing in them.
What is thematic investing?
Although thematic investing is becoming more visible these days, the first thematic fund, according to Morningstar,1 dates to the post-WWII era, when a company set up an investing fund to capitalize on the then-new technology of television. The industry has developed in fits and starts since then, and now offers a broad array of investing strategies.
These strategies can generally be grouped in two buckets. One contains themes that seek to provide some measure of extra performance over more traditional approaches. Such strategies might focus on emerging technology like AI, electric cars, or 3D printing, or attempt to invest in the interests of certain demographic groups or social changes such as aging societies. Think big, long-term structural forces with the potential to remake the economy.
The other bucket has more of a personal values or lifestyle orientation. This could mean trends like online gaming, workplace diversity, or healthy food. Other themes may focus on particular kinds of music or consumer goods. To be clear: Having a personal values orientation doesn't necessarily mean such strategies aren't also seeking extra returns. Rather, they tend to foreground certain interests or social ideas.
As noted above, these strategies can be stock lists or funds. Many of them are actively managed, but you can also find passive funds.
How are themes built?
What constitutes a theme is where things get interesting. Whereas traditional industrial sectors group companies doing similar kinds of business, and traditional indexes select companies based on their market capitalization (or other fundamental or technical measures), thematic strategies start with an idea or trend and find publicly traded companies that seem relevant.
That makes it a research-intensive style of investing. Why? A company's thematic relevance may not be obvious from its name or main business line. For example, a company making solar panels may be an easy one to slot into a renewable energy theme, but other themes may be less clear. How do interested investors pick companies representing the future of workplace diversity? Similarly, a video game company might have a small unit working on, say, potentially transformative robotics technology, but you wouldn't guess it from the main operations.
Without recourse to standard classifications or measures of relevance, thematic investing products have to stand on their ability to both identify investable themes and find investments that support those themes. That can mean using technology like AI to scan company reports and other information to pull potentially thematically linked companies together into a bundle or relying on the expertise of professional fund managers to declare a theme and then pick and choose stocks.
Then, it's up to the fund manager or researchers to asses whether the assembled portfolios are performing as intended, without straying from their targeted themes. This can involve establishing benchmarks for thematic relevance that are separate from more traditional measures of performance, such as returns or volatility.
How do you assess a thematic investment?
Investors, of course, also have a watchdog role in ensuring their thematic investments continue to suit their goals—whether in terms of returns, thematic exposure, or the enactment of their personal values—and complement their broader portfolios.
So, here are some points to consider when evaluating a thematic investment or buying stocks from a thematic list:
- Is the theme durable? Here it's important to distinguish between technological developments or social forces that are likely to persist into the future and mere fads. Your timeframe for the investment matters, as well. You wouldn't want to make a long-term investment in a particular innovation or social change if you weren't convinced it would continue for the duration of your exposure to it.
- Is the approach sound? This is where you need to research the methodology behind the thematic investment. Is the fund manager or research team sufficiently transparent about how they identify themes and pick relevant stocks? Or is it more of a black box relying on your trust? That's not to say you can't go on trust—just be sure you're ok with the consequences.
- Do the stocks in the theme make sense? If the information is available, it's worth checking which stocks a strategy uses to bring a theme to life, as well as how the strategy weights them. Some stocks may surprise you or come from sectors you wouldn't have thought to look in, which can be where a thematic investment can offer value. However, if a stock pick seems almost random, or based on a hunch, or if the rationale for the weighting is unclear, consider doublechecking the methodology.
- Does the thematic investment fit your personal portfolio? Assuming you have a diversified, strategic long-term portfolio allocation, the question for your thematic investment becomes: How does it fit with the rest of your holdings? Will it skew your stock allocation in an undesirable direction? Is it duplicative? For example, if your stock allocation is guided by the S&P 500® Index, you may already have plenty of exposure to certain large companies and might not need additional holdings to suit a theme. Similarly, if you already have a lot of growth or value stocks, you should check to make sure a thematic investment doesn't add more weight to your fundamental approach. And remember, thematic investments intentionally focus on particular trends or social forces, which could create concentration risks in your stock portfolio if those trends or social forces don't pan out as expected.
- What is your goal for the investment? Again, in the absence of benchmarks, it'll be up to you to define success for your thematic investment. Are you looking for extra return? What benchmark will you use to gauge performance? Do you have a return target? What is your time frame? Or are you looking for an investment that reflects a personal value? Is the investment adhering to it?
- Is the strategy performing as intended? Once you've made an investment, keep an eye out for what might be called style drift, in which a fund manager or research team appears to drift into areas of the market that don't quite fit their strategy, perhaps in search of better returns if their original picks don't work out. On the other hand, there's also a risk that a thematic investment won't change enough to suit the times. For example, imagine that the hypothetical video game company mentioned above spun off its innovative robotics unit into a separate company, but your investment remained in the video game company.
Thematic strategies can give investors a way to invest according to their convictions, whether that means a belief about the way things are going or one about the way they should be going. This approach also opens the way to new kinds of diversification and the application of clever research in your investing portfolio.
Just remember that for all the talk of innovation, the old rules of thoughtful investing should still apply.
1 "Morningstar Global Thematic Funds Landscape 2022," March 2022.
Learn more about thematic investing at Schwab.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Investing involves risks including loss of principal.
Investment research for thematic stock lists is provided by Charles Schwab Investment Management, Inc. (CSIM). CSIM is an affiliate of Charles Schwab & Co., Inc. ("Schwab"). Both CSIM and Schwab are separate entities and subsidiaries of The Charles Schwab Corporation.
Thematic stock lists are not intended to be investment advice or a recommendation of any stock. Investing in stocks can be volatile and involves risk, including loss of principal. Consider your individual circumstances prior to investing.0722-2VSB