What are the Strengths and Risks of Thematic Investing
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The world in which we live in is dynamic and changes with time. Investments in companies listed on the stock exchanges should be based on the premise that today’s circumstances are going to change based on various evolving factors ranging from industry dynamics, consumer behaviour, regulations, economic cycles, interest rates and market sentiment.
What is Thematic Investing?
Thematic investing is a unique approach to investing wherein the decision to invest is based on your understanding of the future of your ideas. By nature, everyone prefers to invest in something that they can relate to.
Hence, it is easier to take a decision based on your individual expectations of the future rather than doing your own research from scratch that can be quite overwhelming for most people who are not professionals.
Thematic investing solves this problem and allows you to invest in professionally designed portfolios and give you a concentrated exposure in line with your thinking process. This method is most effective way of investing keeping in mind that it requires little to no time to design.
It is more concentrated as compared to regular passive mutual fund investing. Usually, mutual funds have between 40-80 stocks in a portfolio and because of the over diversification in their investments, the returns tend to be much lower than the potential.
Thematic investing is about having few stocks in the portfolio, which represent a more focused projection of the future. If your view turns out to be right, your returns will be much higher than what mutual funds can deliver.
This is because as opposed to the ‘spray & pray’ approach adopted by diversified equity funds, thematic portfolios tend to be heavily weighted in stocks and when they outperform it can have a significant impact on your returns.
There is a wide variety of themes that investors can choose from in thematic investing as opposed to the lack of choice offered by diversified equity schemes which tend to be more or less the same when compared with one another.
Another important feature is that themes can be customized by individual investors based on their own preferences; a feature not available in mutual fund investing. You can also choose different variants of each portfolio based on your risk profile.
Basically, there are a lot of powerful features inbuilt which can help you save time, energy and potentially increase your returns. Also, if you can buy any number of themes you want to achieve diversification. But the fundamental intent of diversification via thematic investing is to get exposure to several large trends as opposed to plain risk mitigation.
A concentrated portfolio by nature is exposed to downside risks which can be caused by domestic and international regulatory changes, exogenous shocks, changes in tax policies, radical disruption/innovation which can affect the outcome of events etc. It is a fact that disruption tends to create new trends and subdue existing ones. If the theme is subjected to such shocks which are not expected by market participants, the euphoria can cause large corrections.
One such example is what happened to the pharmaceutical exports industry when US FDA began raiding Indian companies’ factories for malpractices/lack of quality controls and imposed penalties which impacted them.
This coupled with the unexpectedly elected Trump administration that had vowed to bring down the price of drugs had threatened India’s dominance in the generic space in the US.
This would reduce the revenues and margins for Indian drug makers, which were heavily dependent on them for revenues. It is important to keep track of the cyclicality of the themes from time to time to ensure that they are on track as expected. Other risks involved are the same that come with equity investing.
It also goes without saying that the performance is ultimately subject to market risks and there are no guarantees of fixed returns. If the overall market is bearish, it could impact the returns in the medium term even if the companies are declaring good results as expected.