Pets, Pop and Sin Stocks: Not Every Fad Is a Thematic Portfolio

Many hot trends have been turned into equity portfolios. But fads aren’t investing themes and may be flawed as standalone investments.

What do pet lovers, Korean pop music and sin stocks have in common? Each is the subject of dedicated investment portfolios that aim to capitalize on offbeat trends. From the growing industry of pet-care products and services to the enduring appeal of booze and gambling, these types of portfolios aim to attract niche investors who want to channel their money toward areas of personal affinity and apparent return potential.

But not so fast. Such narrow areas fall short of our basic criteria for investable themes. They don’t benefit from a big trend that spurs spending over years, and they may not offer enough business diversity to allow for the construction of portfolios with high-quality companies and diverse sources of returns. In our view, fads simply don’t provide a sound foundation for long-term equity investment.

Some Sector Funds Are Thematic Strategies

What about sector-specific funds? Portfolios that focus on sectors such as healthcare and technology are popular vehicles for tapping into trends. Some investors may not consider sector portfolios to be thematic investments. We think it depends on how the portfolio is designed and constructed. For example, a weakly defined utilities-focused portfolio might hold stocks in the same sector that have very different growth trajectories, such as a nuclear utility and a coal utility.

In contrast, portfolios that clearly define a philosophy and process for capturing trends within a sector could qualify as a thematic investment approach, such as a technology fund focused on enablers of innovative disruption. In healthcare, a portfolio designed to target high-quality businesses that are exposed to long-term healthcare trends such as longevity and medical technological advances—rather than trying to predict scientific success—can provide access to the attractive growth and return potential prominent in the sector.

What About AI?

AI is a case in point. For investors, what’s most important is how a portfolio defines AI as a theme and searches for opportunities. Without a coherent definition, an AI-focused portfolio could pile into a few heavyweight US mega-cap companies, which could leave investors without sufficient diversification to manage risk. And while AI is clearly a powerful theme, investors should be careful to avoid faddish stocks that are riding on the wave of enthusiasm for the technology without having a quality business or a clear path to growth. We think a thematic portfolio driven by the AI revolution must first explain the types of companies it will target in order to build an allocation that offers strong risk-adjusted return potential.

Thematic portfolios can tap into stocks from different sectors that benefit from a trend. The relevant companies may change over time. Consider climate-focused investing—it draws on a theme with a very long duration, yet the technologies and growth areas within it are likely to evolve. Opportunities tied to security themes, such as cybersecurity or defense, could similarly evolve as regulations change and the political backdrop for relevant industries shifts. Identifying long-term themes can help reduce reliance on short-term macroeconomic outcomes while gaining resilience from slow but steady transitions that are less vulnerable to rapidly changing fashions and market whims.

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