What’s in an investment theme?

Thematic investing has become increasingly popular in recent years. While the pandemic has put a (temporary) halt to the launch of new thematic indices and funds, I think in the next couple of years, we will continue to see more and more themes launched by index providers and asset managers. But not all thematic investment approaches are created equal.

Index providers like S&P and MSCI launch thematic indices in order to attract ETF providers who will licence these indices and replicate them with a new ETF. Meanwhile, asset managers often launch thematic funds that are more based on active management and fundamental analysis of the stocks exposed to a given theme.

While I am a fan of index investments in many instances, there are exceptions when I think an index investment may not be the best way to invest. The more inefficient a market is, the more likely it is that active management and fundamental analysis can create outperformance, and the more likely it is that an index solution will be stuck in potentially illiquid or extremely expensive stocks.

Take for instance the recent invasion of Russia into Ukraine. It took MSCI and FTSE a week to announce changes in their emerging market indices and to exclude Russian stocks from their indices. And these changes will become effective in the index at an even later date. That means that index investors in emerging markets were stuck with Russian stocks that dropped more than 50% in a day or two. And by the time these stocks are excluded from the index and ETFs try to sell them, trading in these stocks was halted in all Western markets and difficult, if not impossible in Moscow. In other words, the rules-based investment style of index funds, which so often works in their favour has caused a lot of harm to investors in this case.

Of course, the Russian invasion is an extreme case and as I said, the rules-based investment approach of index funds is in developed and liquid markets typically the best approach for investors. But not even then is a rules-based approach always a great idea. Take a look at the factor exposures of the main thematic indices launched by S&P and MSCI since 2013 below.

Factor exposures of thematic indices (Left: S&P, right: MSCI)

Source: Blitz (2021). Note: WML = Momentum, CMA = Investment, RMW = Profitability, HML = Value.

Note how especially the S&P thematic indices all have a large bet against value stocks and against profitable “quality” stocks. In the case of the MSCI indices, the bias against quality and value is less pronounced but still visible.

In essence, thematic indices are all heavily geared towards expensive and unprofitable stocks, i.e. glamour stocks. And that means that passive funds following these thematic indices are likely to invest in overpriced and overhyped stocks.

This means that these thematic indices can only create strong performance if the value and quality factors underperform for a long time and/or if the idiosyncratic returns of companies exposed to a theme are so high that they overcome the systematic return drag from betting against value and quality.

This also means it opens up opportunities for active managers and fundamental analysis. If the thematic indices are actively betting against value and quality, it should be possible to create thematic portfolios that have a smaller bet against these factors or even a positive exposure to these factors. A portfolio that is invested in value stocks with high profitability exposed to these themes should be able to systematically outperform these thematic indices in the long run.