Thematic and Megatrend investing

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Buyer beware we’re always being told but being aware is sometimes not that easy, especially when you’re being sold a lemon which you thought was a naartjie!

Thematic and Megatrend investing is still very much in its infancy in the South African market when one compares to the global investment landscape but it is starting to make inroads. Investors really need to be cautious. According to Morningstar there were 1952 surviving thematic funds in the global database as of December 2021 and 589 new thematic funds in 2021 alone.

Why the boom? Well part of it relates to growth in ETFs which has become a popular investment structure with many positives. Investors have started to wise up to many of the poor practices by so many asset managers. High fees for benchmark hugging, a general underperformance by most compared to their benchmarks, excessive concentration risk having generated great past returns only to cause dire performance when single stocks go belly up. Many firms often become too large and old and stale that the early outperformance is hard to maintain, amongst other issues.

Hence, ETFs which track indices, have afforded investors a great tool to own all the shares in an index cheaply, providing diversification and an inherent positive selection bias in that winners enter indices and losers drop out. Investors don’t have to do anything to participate in that dynamic and shifting mix of shares in the index.

So, what has that got do with thematic and megatrend investing? Quite a lot actually, and it relates to the investment and finance industry always innovating and wanting to figure out a clever way to make money. Due to the boom in ETFs coupled with advances in trading technology it is now cheaper and easier than ever before to run and launch an ETF. A basket of stocks which may historically have been sold as structured product or sold as a basket swap trade with a bank can now be packaged and marketed to retail customers as a thematic ETF. Post the Global Financial Crisis (GFC) positive changes in regulation have made trading derivatives and marketing structured products with their intrinsic counterparty and other risks much harder. ETFs are liquid and trade on exchange and can be offered to retail customers quite easily but as an issuer you don’t make too much money if the fees are very low. So how do you charge more in fees? You create something really exciting and interesting and package it as an ETF – Voilà – the boom in thematics has ensued. So, this great ETF tool is now being used to package stocks into generally higher margin products. The cost of thematic ETFs far exceeds the cost of ETFs on traditional indices like the Nikkei225, FTSE100 or S&P500.

But does that mean they should be avoided? Not at all, but one really should pay caution to the wind (and solar and geothermal). Many of the themes resonate with investors because they understand or have heard of important topics of our time like Clean Energy and Decarbonisation, Cyber Security, Artificial Intelligence, Robotics, eSports and Gaming, Cloud Computing, eCommerce, Sustainable Food, Cannabis deregulation (or regulation – depends from which angle you think about it). We could go on for pages. Bottom line is all these themes are important and sound great as investment propositions but how does one gain access? Which stocks do you buy if you want to pick your own thematic shares – even if you knew all the participants (companies) within a particular thematic ecosystem where would you begin in choosing the winners? Do you have the knowledge, do you have the data, do you have the time? Probably not, hence investors just buy the thematic ETF. But that may not be wise for many reasons.

Firstly, which theme is the most important and will perform the best? Some themes are more mature and others are nascent or frontier. It is difficult to decide so some investors opt to own a basket of themes with the view some must shoot the lights out and the others hopefully trundle along and net net all is well. But how do you size that basket of thematic ETFs? 10 themes at 10% weight each, 20 themes at 5% weight each, or something more punchy, 5 themes at 20% weight each. We do not think this is a wise approach for many reasons including the fact that many stocks overlap across themes (Amazon sits in both Cloud Computing and eCommerce), some themes are concentrated to one country or sector, some have dreadful purity of expression i.e. the stocks in the thematic ETF don’t seem to accurately reflect the purported theme – one Cyber Security ETF we analysed had Accenture as a top 2 holding – not sure we’d agree that’s a Cyber company. We think investors initially need to do fundamental analysis on which themes are likely to be winners and are not too mature, not too nascent, not too overvalued and likely to do well over the long term. Then they should carefully think about weighting them appropriately to ensure adequate country, sector and security level diversification with beneficial correlation effects considered i.e. blending certain themes together which are uncorrelated can improve portfolio risk.

Secondly, and very importantly, there are often many ETFs available to express your thematic or megatrend view, in decarbonisation and clean energy there are 100’s of ETFs with differing slants on the expression. Some are more focussed on wind and solar or companies which produce and sell clean energy, others are focussed more on the full value chain including miners who supply the raw commodities to make photovoltaic panels or wind turbines. Many flavours. So, how do you choose the ETF – it is no mean feat. At Omba we have performed analysis on 100’s if not 1000’s of ETFs and selecting the final one for inclusion in a portfolio is an arduous task. Fortunately, helped by some internal technology tools we have developed an ability to handle big data sets, to look under the hood of the ETFs to understand what you’re getting. What percentage of stocks are loss making, what are the valuation metrics of the ETF using many traditional methods – what are the leverage ratios of the companies, what percentage do the top 5 or top 10 stocks make up (assessing concentration risk), what sort of earnings growth have they exhibited, what is the liquidity of the ETF and underlying stocks therein etc? Those are generally quantitative metrics but what about the qualitative aspects – credibility of the issuer, age of the ETF, synthetic or physically backed, stock lending considerations, size of the ETF, fees charged etc? Through a scoring process using both the quantitative and qualitative metrics we can come to a reasonably well-informed opinion of which one we’d want to own.

Finally, one needs to think about how they all fit together. Just slapping on a random percentage weight and number of themes in our view is a flawed approach. At Omba we believe traditional finance has evolved enough that you can somewhat rely on traditional methods of portfolio construction – looking at volatility, VAR contribution and performing correlation analysis and overlap analysis to weight them thoughtfully. This does come with challenges as the trading history of the ETFs is often quite short and thus we have to solve these problems with other methods, including sensible human judgement based on the experience we’ve gained in kicking the tyres of many ETFs for many years now.

Overall, we think thematic investing is exciting but the buyer really should be aware of the challenges and pitfalls because you might really want that naartjie and not the lemon with which you ended up.  

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