How to Build a Thematic Equity Portfolio

From stock picking to benchmark selection, the construction of an active thematic equity portfolio will play a crucial role in its ability to deliver on a theme’s return potential.

It’s tempting to think that thematic equity portfolios are fundamentally different from other types of portfolios. After all, if a thematic trend is fueling earnings growth in clearly defined sectors, industries and markets, it sounds like it should be relatively easy to build a portfolio of companies that are at the heart of the action.

Unfortunately, it’s a bit more difficult than that. We believe thematic portfolios must be grounded to the same rigor and discipline as any other active equity portfolio. The main difference is how the opportunity set is defined—that is, as a universe of stocks with exposure to the theme. That process begins with identifying a theme and clear sub-themes, and then creating a universe of stocks that reflect thematic purity.

Since themes and sub-themes are constantly evolving, a thematic universe of stocks will naturally evolve over time, too. That means investors should update the thematic universe at regular intervals to ensure that it faithfully reflects the chosen theme. However, don’t fall into the short-termism trap by reactively redefining an investment theme’s criteria in order to shoehorn a hot stock into a portfolio. In our view, theme definitions should be rigid, while changes to sub-themes and holdings must be done based on principles and a rigorous process.

Choosing Stocks with Staying Power

How investors select stocks for a thematic portfolio will ultimately determine whether it delivers on the theme’s return potential. That’s why we believe active management is especially important in thematic portfolios. Some companies that are exposed to a theme may simply not have good businesses or may suffer from bad management, yet passive thematic portfolios will hold them anyway. And even in active portfolios, a clearly defined process is necessary to ensure that investors aren’t seduced by sexy thematic stories in outperforming stocks that aren’t supported by strong fundamentals.

Of course, stock-selection processes will differ according to a portfolio’s investment philosophy. But some basic principles should always apply.

We believe quantitative tools and fundamental research should be used together to create portfolios (Display). Fundamental research is used to develop investment insights related to the company’s business outlook and competitive advantages. Quantitative analysis helps sift through a broader universe of stocks to identify companies with strong quantitative features, such as quality (e.g., profitability and balance-sheet strength), valuation, momentum and sentiment.

Research must evaluate a company’s business strategy, management teams and pricing power—and the share price valuation relative to its earnings potential. Even robust companies might trade at expensive valuations that add investment risk. To generate alpha—or above-market returns—investors should target compelling themes, track the evolution of the related trends and companies, and discover the best related stocks in the defined universe. Risk-management tools are crucial because thematic universes may be more concentrated or skewed toward different investment styles, factors and market capitalizations.

Beyond stock selection, the technical considerations that shape portfolio construction must also be considered in any thematic allocation. Some features require special attention.

Benchmarks and Sources of Risk

Choosing a traditional broad-based benchmark can be tricky because the group of stocks selected to represent a particular theme are likely to create a substantially different allocation than a traditional broad market index. Thematic portfolios will almost certainly have different sector or industry weights than broad benchmarks. In addition, the factor or style exposures will be markedly different even across themes. As a result, thematic portfolios will typically have significantly higher ex-ante tracking error to a broad benchmark.

But a thoughtful manager should be able to measure and clearly articulate the sources of active risk versus a defined universe of companies that align with a specified theme or themes. While some thematic portfolios do benchmark to a broad market index, we believe that investors can benefit from referencing a thematic benchmark to gain a better understanding of performance patterns—especially during shorter periods. Clearly articulating and communicating how active risk is sourced in a thematic portfolio can help clients make more-informed portfolio allocation decisions.

Thematic benchmarks can be useful to help a portfolio generate investment ideas by providing a naïve screen of companies as an opportunity set to sift for good investments.

This approach can also provide a more meaningful way to benchmark the risk/reward profile of a thematic portfolio (Display). For example, we measured the attributes of three model thematic portfolios versus a thematic benchmark and the broad MSCI World Index. These portfolios showed much lower tracking error, of about 3.0%, versus the thematic benchmarks, and between 4.1% and 4.9% in relation to the broad benchmark. What’s more, the model portfolio’s risk versus that of the broad benchmark is driven by factors including countries, sectors and styles; in contrast, when measured against the thematic benchmark, the model thematic portfolio’s risk is driven by stock-specific risk.

We can also gauge the factor, sector, style and currency risks accordingly. But investors must be aware of the ramifications of using a bespoke thematic benchmark. In the short run, expect big deviations versus a broad index. Yet over the long term, we expect themes with higher expected growth to outperform the broad benchmarks. If the trade-off between diversification and short-term performance is understood, clients will be better prepared for periods when a thematic strategy lags the broad market.

Understanding these trade-offs can help portfolio managers consider the pros and cons of each approach. For instance, a portfolio that has lower risk versus a thematic benchmark is positioned relatively passive to the theme. Yet this portfolio would still have high active risk compared to the broad market benchmark. We believe active thematic portfolios should be able to demonstrate that they are taking active risk versus the thematic benchmark.

Thematic benchmarks can also help investors measure performance and gauge the efficacy of an active thematic strategy. If the thematic benchmark performs well but the portfolio underperforms, it suggests that poor stock selection is the culprit, rather than the theme itself.

This blog is based on our recent white paper, entitled: Thematic Investing: More Than Just a Good Story.