Building a thematic responsible investment portfolio

Thematic and responsible investing have both been major themes in markets in recent years, but both have faced performance challenges as market sentiment shifts.

Many responsible investment portfolio managers are seeking greater diversification, as their portfolios have tended to be overly concentrated on the 'E' in environmental, social and governance investing and on renewable energy themes, but how can one go about identifying a viable theme within the responsible investing universe, and avoid simply being exposed to the latest fad?

Ralf Oberbannscheidt, head of thematic investing at Robeco, says thematic investment should be associated with problem solving, and as such he still sees a clear demand for themes tackling natural resource scarcity and solutions around that.

“Proper sustainable investment frameworks that, on the one hand research companies through a sustainable lens which embeds financially material ESG factors, but on the other hand also includes aspects of double materiality (ESG integration plus impact investing, active ownership and potential exclusions), will become more standard,” he says.

Oberbannscheidt says themes often emerge out of changes in consumer behaviour or external events such as the Covid pandemic, which created themes around healthcare investing and the technology needed to facilitate working from home.

But political and regulatory shifts can also influence the investment opportunities that emerge, as Hortense Bioy, Morningstar’s global director of sustainability research, says: “I expect innovation to continue in the sustainable investment space, driven by regulation and new opportunities.”

She points to the introduction of labels in the UK with sustainability disclosure requirements, something that could also materialise in the rest of Europe following a review of the sustainable finance disclosure regulation by the European Commission, as having the potential to spur product development. 

“The emergence of new data as a result of the implementation of disclosure rules across the world will have the same effect,” she adds.

Meanwhile the UN has set an agenda in the form of 17 sustainable development goals, with the aim to end poverty and inequality, protect the planet, and ensure that by 2030 all people enjoy health, justice and prosperity.

It sets a thematic framework for investors around which public policy, reform and development priorities are focused.

Asset managers such as Columbia Threadneedle have positioned their strategies to meet several of the SDGs, something it says its clients want to see. It invests in topics such as energy transition, human capital development and carbon policy, addressing eight of the 17 goals.

“Translating the UN SDGs to investment opportunities provides us, our clients, and the wider industry with a compelling means to contribute to sustainable development while aiming to achieve positive financial returns,” the firm says on its website.

Other investment managers pin their strategies around international agreements to curb global warming. 

Thematics Asset Management, an affiliate of Natixis Investment Managers, in October launched the Thematics Climate Selection fund, which targets companies whose emissions trajectories are aligned with the Paris Agreement of keeping the global temperature rise this century below 2C. 

The fund differentiates itself from typical thematic strategies in that it has multiple themes, spanning each of Thematics AM’s five strategies: artificial intelligence and robotics, safety, the subscription economy, water, and wellness.

Arnaud Bisschop, portfolio manager and head of ESG at Thematics AM, says: “We believe that by identifying the companies leading the charge in the adoption and disclosure of decarbonisation strategies, it is possible to turn transition risks into transition opportunities.”

David Gorman, an investment Analyst at Castlefield Investment Partners, says green transition and building sustainable infrastructure are long-term challenges the asset manager likes to help solve.

But he says the social element of ESG has also gained prominence since the pandemic “because companies had to work hard to support their employees during lockdowns and good employers did so. More recently and in a tight job market, better-run companies have helped their staff with cost of living challenges."

But Oberbannscheidt says this can be a tricky area to invest in, which is why “most managers currently focus on the environmental aspect of sustainable investing.

“That component is easier to understand, better regulated, and offers superior data quality versus a more social related theme,” he adds. “Dealing with humans and their actions is proven to be more finicky and requires different skills and tools to develop themes.”

Kate Elliot, head of ethical, sustainable and impact research at Rathbones Greenbank, anticipates ESG asset managers will focus more on natural capital investments and the biodiversity impact of investment portfolios going forward.

She points to the Kunming-Montreal Global Biodiversity Framework, agreed last year at Cop15, which saw 188 governments commit to addressing the ongoing loss of terrestrial and marine biodiversity.

She says: “The Kunming-Montreal Global Biodiversity Framework highlighted the importance of private capital flows to support global action on biodiversity loss. And the recent publication of the TNFD reporting guidelines has focused investor and corporate attention on the risks and opportunities that biodiversity presents. 

“The UN Environment Programme has estimated that we need to more than double the current level of investments into nature-based solutions by 2025 in order to meet climate and biodiversity goals, so there is clearly a significant opportunity for innovation in natural capital investments to help unlock financial flows.”

Rahul Sen Sharma, president and co-chief executive of index provider Indxx, says the next generation of impact investing prospects is likely to shift away from the well-known climate change theme and instead look for new chances in industry.

When it comes to exciting new themes emerging at present, he points to the mega-trends "transformational engines", including the move to renewable energy, health care innovation and cybersecurity, and "climate change and resource scarcity", including water, food, green metals, renewable energy, and carbon capture.

He says: “Thematic investing leverages the power of mega-trends to create feasible and diverse investment possibilities that reflect the magnitude of constant change today.”

But Bisschop says he avoids trying to predict what might be the next hot topic and instead looks for "inflection points at which multiple forces converge to give rise to a theme.

"Recent experience suggests that when it comes to ESG/sustainable investing investors are increasingly focused on the transparency, accountability and reporting offered by their investment managers, and more generally, how their investments are likely to perform in a world where geopolitical instability, demographic change, disruptive innovation and climate change present both, increasing risks as well as opportunities."

Growth bias

Bioy agrees that clients are increasingly looking for investments that can make a positive impact on the environment and society, which includes investments in new technology such as batteries, electric vehicles, and hydrogen.

But she points out that close to three-quarters of thematic funds have a growth bias, which means they perform better in low or falling interest rate environments. A similar thing can be said for many sustainable investment assets, which performed poorly in the current high inflation, high interest rate environment.

So how do managers diversify?

Sen Sharma says thematic strategies can be used to diversify wider portfolios by exposing them to non-traditional assets and industries. This strategy can help lessen the impact of market swings and sector-specific events on their portfolios.

Within sustainable thematic investing, he suggests diversifying the investments to avoid overexposure to a particular theme. “If you invest in renewable energy, you might also think about investing in water conservation or sustainable agriculture,” he says.

Diversifying the investments within a theme can also help lessen the danger of overexposure to a single firm. For example, a sustainable energy portfolio could contain companies that make solar panels, wind turbines, and hydroelectric power.

Oberbannscheidt says adopting multiple themes of course helps with diversification, but its not enough in isolation, as one also has to ensure the themes are uncorrelated to each other

“New theme ideas and the inclusion thereof should be checked properly for correlations," he says. "Second, one should always have a global view as different regions find themselves in different stages of thematic life cycles.”

Bioy says she regards many ESG funds as well-diversified. “These are the funds that follow a best-in-class approach. They invest in the best companies in each sector.”

But she says thematics are not immune to market swings. “Investors should bear in mind that new thematic funds are often introduced in periods of strong performance, like the new millennium and the mid-2000s,” she says. 

“But they tend to wane during downturns. Those trends indicate that investors' appetites for these strategies and the desire for providers to offer them typically move in sync with the broader market.”

This does not mean investors should time the market, as Chris Gannatti, global head of research at WisdomTree, puts it: “Trying to time thematics would be a great way to lose money over time.

“Our strategy would be much more centred upon focusing on themes we believe have the strongest potential. Ultimately, these are ‘mega-trends’, meaning that they don’t play out over a few months or a few years, but rather over 10 years or more.

“Even if there are some big waves of positive performance and other big waves of negative performance, if the themes truly play out there is a great chance, in our opinion, that thematic strategies can outperform the MSCI ACWI Index benchmark over a longer term.”

Fees can be high

When building a thematic portfolio there are a number of things to consider, says Bioy, not least that fees can be high.

“Higher fees charged by thematic funds have contributed to their relatively poor performance over longer periods, and their ability to outperform the global stock market tends to decline as strategies age.”

Sen Sharma says when building a thematic portfolio, investors typically consider three factors: 

• Long-term trends: Macroeconomic, technical, or demographic trends that are predicted to have a long-term impact on the economy and society.
• Investing ideas: These are distinct investing themes developed from long-term trends. For example, the increasing need for renewable energy could lead to a solar power investment theme.
• Disruption: The potential for new technology or business models to disrupt existing industries and provide new investment opportunities is referred to as disruption.

Oberbannscheidt says the hallmarks of a successful theme and portfolio are timing, monetisation opportunities, and scope of the investments.

"In other words, we are looking for large enough investable clusters, that are not hyped or explored, are on the way to generate economic profit, and, above all, have a sustainable contribution to society.

"Oftentimes a thematic portfolio has a variant perception not only on how the world will evolve, but also on variables that drive future earnings of an investment," he adds.

"Understanding a non-linear dynamic and processes of a secular change combined with fundamental company research tends to be the starting building blocks of successful thematic portfolios."

At Thematics AM Bisschop says he pays particular attention not to base portfolios on "nascent trends or fads that may prove short-lived or may not sustain superior and long-term returns for the companies exposed to them.

"We therefore strive to ascertain theme’s longevity, materiality and causation, ensuring that all our themes have transformative power, directional momentum and causal effect," he adds.

Gannatti says when building a thematic portfolio it is crucial to ensure the fund selector has the appropriate expertise to select each of the underlying stocks.

“There are no actual benchmark portfolios, meaning there is no externally understood example of what an AI portfolio or cybersecurity portfolio is, for example. 

“If the construction of the strategy can appropriately evaluate how each of the stocks reflects the theme, we then believe the next step is to ensure proper diversification, meaning that a single stock is not 10 per cent of the allocation, for instance. 

“From there, it could also make sense to be aware of the common benchmarks, like the Nasdaq 100 Index, and try to ensure a lower overlap against them."

Carmen Reichman is multi-media editor at FTAdviser