The Case for Thematic Investment

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By Christian Nolting, Global Chief Investment Officer, Deutsche Bank Private Bank

As investors, we are all acutely aware of ongoing economic and policy developments. An assessment of “macro” issues, such as growth, inflation and central banks’ policies, has always provided an essential input to investment-portfolio construction and management, as well as to the selection of individual assets.

But many investors are also keen to consider the impacts of longer-term changes to economic, social and industrial structures. Such structural change is always happening. But current circumstances—and, in particular, the combination of rapid technological advances, climate change and related concerns about how populations will cope—have raised awareness of the importance of change. Assessing the impact of structural change in a portfolio may not only be a matter of identifying investment opportunities but also of reducing investment risks.

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How can investors approach this issue of structural economic and social change within a portfolio? One way is to try to identify the key issues that are driving this process of change and then invest in those long-term themes. With change continuing apace, such theme-based investment is unsurprisingly of great interest to many investors. But how exactly should it be done?

Deutsche Bank Private Bank has been identifying key investment themes for many years and in a more systematised way since 2017. Let me discuss here what we have learnt so far in constructing our long-term investment themes (LTITs) and managing them within portfolios.

Lesson #1: Thematic investment should complement existing investment strategies. Thematic investment is not a replacement for existing investment processes. For most investors, a portfolio based primarily on asset allocation between traditional asset classes rather than solely on thematic investment is likely to remain the most attractive option. A proven, conventional asset-allocation process to do this, with accompanying risk management, remains essential. Thematic investment can be used to complement this and direct investments to areas of particular interest to individual investors.

Lesson #2: Thematic investment needs processes, too. Even if thematic investment is seen as a “satellite” to a core portfolio, it still needs effective investment processes. This is not an area in which investments should be made on impulse. Key process questions involve how to identify an investment theme and how to invest in it. There are various ways to do this, but one approach is to break the analysis of a potential investment theme down into three pillars: economic fundamentals, lifecycle and sustainability. (Economic fundamentals include factors such as expected revenue and earnings growth for companies in the theme—their operating margins, market capitalisation and so on; lifecycle considerations include a theme’s maturity, level of current development and future prospects; sustainability brings in considerations of environmental, social and governance [ESG] factors.) However you construct your thematic-investment processes, I think that you will quickly realise that quantitative as well as qualitative analysis is essential.

Lesson #3: Don’t ignore portfolio risks. Looking at investments through the lens of long-term investment themes can help highlight many opportunities—but it can also generate individual asset and portfolio risks. As history has endlessly demonstrated, investing in new areas can fail as well as succeed. And if you are committing meaningful amounts to theme-based investments, this will have implications for your overall portfolio. Thematic investment in portfolios may require higher risk budgets, given such investments’ tendencies towards increased volatility compared to non-thematic equity investments.

How has our theme-based investment system evolved over the years? We currently have 11 long-term investment themes (LTITs), and they have formed natural groupings around the issues highlighted above—the environment, population and technology. We increasingly see these areas as posing three key global challenges: how to sustainably utilise and conserve our global resources (what we call “resource transition”), how to provide for the global population (“population support”) and how to develop key technologies to help us all do this (“next-phase technology”).

In the “resource transition” section, our long-term investment themes are circular material use, the sustainable food system, energy transition and the blue economy. “Population support” themes are infrastructure, healthcare and medtech (medical technology) and consumption megatrends. “Next-phase technology” includes artificial intelligence (AI), digitisation, smart mobility and cybersecurity.

These themes appear very diverse, but they can all be seen in the context of the fundamental issue of structural economic and social change. Some of these themes currently enjoy more visibility than others. Artificial intelligence, for example, is already driving growth across multiple areas and has created many investment opportunities both in processes and supporting hardware and services. Over the past year, its market impact has been profound—not just for individual securities but also for markets overall. AI’s high visibility has led to accessible and credible forecasts for revenues, market capitalisation and other indicators. At the other end of the visibility spectrum, the blue economy’s impacts on markets appear much more diffuse—although, in overall economic terms, the ocean remains highly important.

Visibility does not necessarily equate with investment opportunity, however. Thematic investment will still repay detailed investment analysis. Which areas are working well and which aren’t? Where are we in the investment cycle? Are we looking at the right industries within these long-term themes? Visibility also does not equate with sustainability. Whatever your degree of commitment to ESG investment, we do think any long-term investment should be sustainable—and not just in environmental but also social terms.

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I think we are at the beginning of some complex regulatory and social debates around many long-term investment themes, and investors need to be aware of this. Investors, for example, have recently woken up to the impact of AI on energy use and, thus, the environment; the effects of AI on societies, and not just through employment changes, are at present only speculated about. Most of the other 10 themes may also have major social implications. Again, analysis is needed to plan out an investment approach. We cannot just cover our eyes.

So, where are we going next with thematic investment? One point to make is that while these 11 themes are long term, they are not static—how and where to invest in them will continue to change. Smart mobility may provide a good example of this: This is not all about self-driving cars, with issues such as shared mobility and electrification potentially equally important. Our scientific understanding of issues such as biodiversity will also likely improve, and our ability to make better assessments of the viability of alternative energy sources will also change.

From an investor’s perspective, adding thematic investments to an existing equity portfolio provides a way to participate in structural social and economic change and potentially deliver investment returns in areas that may be of particular interest to an investor. But making informed investment decisions on these themes, based on fundamental analysis, is key. You need a process for identifying long-term investment themes and implementing them in a portfolio, not just a presumption that they will work. This process is likely to have several components and, importantly, must consider the portfolio impacts of the themes both individually and in combination. The details are important here. It will be important to monitor, for example, to what extent investing in several themes in a portfolio increases exposure to certain securities (perhaps held both in the “satellite” themes and the “core” portfolio) and the likely impact of this concentration on portfolio risk/return characteristics.

But with the right approach, theme-based investing is a fascinating area that provides a new perspective on investment at a time of rapid and continuing change.