Should future trends drive your investment decisions?

thematic investing

Many investors consider future trends when making investment decisions. Popular examples of investable trends include the growing demand for green energy, mainstream adoption of electric vehicles and cybersecurity.  

The thesis is that if you can correctly spot/predict a trend in the early stages, then you can invest in the companies and sectors that are best positioned to benefit economically. This is called thematic investing.

What is thematic investing?

Thematic investing is an approach that seeks to capitalise on megatrends and/or long-term structural changes. Most thematic trends tend to relate to three broad categories being (1) demographic change, (2) technological innovation and (3) climate change.  

The goal is to invest in sectors or companies that are likely to benefit substantially from these changes. For example, electronic vehicles (EV’s) will likely benefit from increasing consumer demand because of an increasing focus on climate change. If you agree with this thesis, then you may be attracted to investing in not only EV manufactures but the downstream industries such as battery, sensor manufactures, rare material miners (e.g., lithium – Australia is the largest exporter of lithium) and so on.  

The main challenge with thematic investing is that it’s a higher risk strategy because it relies on your (trend) expectations materialising. Our expectations can often be shaped by our world view, personal experiences and the dominant narrative of the day. However, these things may not be useful when making investment decisions.

Also, because these themes are based on future outcomes, we must realise that expectations, products, technology and so on can change very quickly. Again, using EV’s as an example, whilst some valuable advancement have been made, there’s still plenty of opportunity for significant development in the future. Challenges such as battery storage, manufacturing costs, faster charging, battery recycling all need to be addressed. And the solution may not rest entirely with lithium batteries, but an alternative technology that is not discovered yet.

How trends ultimately play out is inherently difficult to predict.

An argument can be made that you don’t need to pick trends because when themes eventually materialise and result in value (profitable businesses/sectors), they will eventually be included in traditional share market indices.

The chart below was shared in a presentation by Research Affiliates about 2 years ago. It lists the top 10 most valuable global companies in each decade since 1980. As you can see, the top 10 change a lot from one decade to the next. This demonstrates how share indices change over time as new technologies and industries emerge and others become redundant.

Changing index

The best performing thematic ETF’s over the past 5 years have been cybersecurity, technology (even despite recent volatility) and healthcare. These trends are reflected in indices as the technology and health care sectors now account for 35% of the total global index.

Of course, the main downside with index investing is that you miss the first mover advantage i.e., investing when a product, tech or industry is in its infancy. But also, it is important to recognise that you also miss out on a lot of that risk too. The risk is that you invest in several thematic investments and only 1 out of 10 end up producing quality returns, which wouldn’t be an uncommon outcome.

Beware of limitations with index (ETF) funds

There are over 30 thematic ETF’s available to investors in Australia – here’s a list. Most of them do not have a long track record of performance, as most of them have been introduced over the last 3 to 5 years.

A track record is important because it proves that the index which the ETF tracks performs as you expect. That is, that the fund can track the index closely in a cost-effective manner.

Secondly, it is important to consider how the underlying index is constructed. Often ETF’s seek to provide as much diversification as possible, which is usually a positive attribute. However, if you want to focus on a particular thematic, then arguably we should aim to only invest in companies that are predominantly focused on that thematic (this is called a ‘high conviction’ strategy). Adding a company just for diversification dilutes the effectiveness of the product to reflect the given thematic.

Finally, consider the size of the ETF. ETF’s need to attract at least $50 million of funds to remain sustainable. If they are small, there’s a risk that the ETF provider will eventually close down the product.

I think it’s likely in many circumstances that an active investment management style suits thematic investing better than low-cost indexing.

You can use it as a satellite strategy maybe

Some investors adopt thematic investing as a satellite strategy. That is, their core strategy, which applies to say 80% of their portfolio (for example) is invested traditionally. Their satellite strategy, which applies to the remaining 20%, may include some thematic investing.

I don’t use thematic investing

My goal is not to achieve the highest returns. My goal is to maximise long term performance. Best-selling author, Morgan Housel says it perfectly below:

“Average returns for an above-average period of time = extreme outperformance. It’s the most obvious secret in investing.”

You must resist the temptation to chase above-average returns because doing so will invite you to take silly risks and in the long run, your investments will under-perform. Instead, my focus is to achieve average returns (say between 7% to 9% p.a.) over multiple decades, as that will achieve outstanding outcomes.

For example, an average return of 7.5% p.a. over 20 years will achieve a fourfold return ($100 will grow to over $400 in 20 years). Holding that investment for an additional 10 years (30 years in total), will result in a ninefold return.

This simple example demonstrates that an investors’ sole focus should be to maximise long term returns. You don’t achieve that by trying to swing for the fences and invest in the popular narrative for the day. You achieve that by having the discipline to stick to a low-cost, evidence-based approach (here’s the evidence).