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Investing in today’s themes, tomorrow’s sectors

Powerful long-term forces are shaping markets and the economy. When it comes to asset allocation and stock selection decisions, L&G ETF suggests that effective thematic exposure is a driver which not only boosts diversification but can potentially enhance returns

Innovation lies at the heart of many of the long-term forces, with technology changing our behaviour not only by helping people and businesses perform existing tasks more efficiently but by creating new solutions to longstanding challenges.

The question is how to harness the potential of these forces within a portfolio.

At L&G ETF, we believe the answer lies in thematic exposure. By allocating to secular growth themes through a transparent, liquid, and rules-based fund structure, investors can gain access to these themes in a unique manner and thereby potentially enhance returns and diversify their portfolios.

THEMATIC SCHEMATIC

But how do we identify a theme? For us, thematic investing is about identifying those opportunities that are driving structural and foundational changes in our lives, our work, and our society.

These themes share several characteristics, which in our view are:

• Disrupting and challenging traditional sectors and industries.

• Structurally changing the economy.

• Still in the early stages of transforming our world and so have immense growth potential.

• Currently experiencing increased adoption by delivering efficiencies or meeting evolving needs.

• Enjoying high market consensus growth forecasts.

In combination, these five attributes form a compelling investment proposition. By meeting all five criteria, we can have confidence that a theme addresses a wide opportunity set, has a high potential growth rate, and will endure through time.

As we look at the world today, there are three broad areas in which such themes are emerging:

• Technology: Technology has been at the forefront of every economic revolution and this is more evident now than ever. Every industry is at risk of being disrupted by new technologies.

• Energy & Resources: Climate constraints and technological improvements are radically changing the way we think about energy. The need for clean solutions and the battery revolution are here to stay.

• Demographics: The population in the developed world is ageing while a new young middle class is growing in emerging economies. These changing dynamics are setting in motion profound changes in consumer needs and behaviour.

BEYOND TRADITIONAL CLASSIFICATIONS

Thematic investing, however, can be associated with passive investing that heavily relies on traditional industry classifications. The robotics and automation theme is a good example: some investors may use industrials or even the technology sector as a proxy, but this offers at best only partial exposure to the theme and at worst exposure to the companies that are going to be disrupted by the theme.

This is because, while traditional industry classification approaches work well for mature markets and sectors, they may not be able to accurately identify companies related to individual themes that are in their nascent stages of development. Indeed, we think of themes as being the sectors of the future.

Thematic investing can of course also be undertaken through active stock picking, which typically requires bottom-up research and a deep dive into the characteristics of individual stocks.

We try to blend the positives of both these approaches: the transparent, systematic, and rules-based implementation of the former and the active bottom-up research of the latter.

We strongly believe that active research is essential in defining the thematic universe of stocks and we achieve that by working with independent experts who undertake bottom-up research. Through this process, we can identify companies across different sectors that are genuine leaders in that theme.

As investors come to recognise that themes and sectors are not equivalent, we expect them to demand better designed indices in the future.

FROM IDEA TO INDEX

So how do we design an investment strategy to capture the opportunity represented by a theme? Our process strikes a balance between identifying companies that are sufficiently developed to be attractive liquid investments but not yet beyond their period of maximum growth.

Companies in the start-up stage are, in our view, better suited to private capital and micro-cap investors; they are less appropriate for liquid funds such as ETFs. Companies at this point also carry higher risks: on average they have a low probability of very high returns but a high probability of low returns.

At the other end of their lifecycle, some of these companies and themes mature into the consolidation and saturation phases. Companies at these stages may not only be past their peak growth rates, but may be exposed to the risk of being disrupted by new entrants and technologies unless they continue to innovate and adapt to the evolving needs.

So, while a thematic strategy can invest in companies of any age, active research can help identify:

• Smaller companies that may not have been accurately captured by traditional sector classifications.

• Larger companies that are leaders in or heavily invest in a theme.

A well designed thematic strategy will offer exposure only to those companies already in the growth phase or directly exposed to such a growing market, where they have already demonstrated their viability but still remain at the forefront of the transformation being driven by the theme.

ACTIVE RESEARCH, SYSTEMATIC IMPLEMENTATION

Having determined that a theme both meets our criteria and is still in the growth phase, it is then necessary to identify the companies that offer the purest and most efficient exposure to that theme.

We believe that this can be most effectively achieved through a combination of active research and systematic implementation.

• Active research: Transformative themes not only cut across traditional industry classifications, but also disrupt the incumbent mega-caps that typically dominate traditional sector-based indices. Equally, because themes target rapidly growing areas of the economy, a static index may not capture the changing dynamics of the markets involved so well designed and bottom-up indices must also be able to evolve with the theme. It is therefore essential to draw on experts who can provide unique industry insights and fundamental research across a theme’s full value chain.

• Systematic implementation: Combining this active research with a transparent and rules-based systematic strategy implemented through an index of liquid securities helps to ensure that an investor’s exposure to a theme is not subject to behavioural biases or unintended risks. An equal weighting methodology can furthermore embed diversification in the thematic index and guard against stock-specific risks.

Blending active research and systematic implementation results in unique indices that offer purer exposure to a theme and differentiated underlying positions from an investor’s broader portfolio perspective. The active research assesses the purity of a company’s involvement in a theme – based on specific quantitative metrics such as the proportion of its revenues derived from activities related to the theme or its technology and relevant operational capacity – to exclude stocks only tangentially related to a theme.

We are therefore able to design investment strategies from the bottom up, rather than having to rely upon top-down screens based on existing traditional indices or sectors. While simplistic screens may capture some of the potential of a theme, they are unlikely to provide the purity of exposure that investors increasingly demand from their thematic exposures.

THEME CATCHER

To summarise, what do we look for when designing and building thematic ETFs?

• Long-term themes not captured in traditional investment funds.

• High consensus forecasts for market growth.

• Availability of research experts with a proven track record, who are selected after a thorough vetting process, to identify companies participating in a theme.

• A tailor-made index that employs a bottom-up approach and is designed to evolve and grow with the theme.

This combination of long-term secular growth themes, active research, and systematic, transparent, and rules-based implementation is a powerful investment proposition.


Find out more about L&G ETF here

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