This article first appeared on ETF Insider, ETF Stream’s monthly magazine for professional investors in Europe.
By Axel Lomholt, Chief Product Officer for Indices & Benchmarks, Qontigo
Last year’s market volatility and macro concerns raised challenges to the performance of thematic investing, but also brought an opportunity to reappraise the benefits and current developments in the segment.
After outperforming as a group every year between 2012 and 2020, delivering an average annual premium of 8% over the period, the STOXX Thematic indices underperformed the global market over the past two calendar years.1 Long-term returns, however, are still markedly in favor of thematic strategies — something one could expect due to their alignment with enduring structural changes, the so-called ‘megatrends’. This year, so far, has also ushered in far better performances for the suite.
The negative market backdrop, however, did not halt inflows into the strategies nor slowed innovation in thematic indices. According to Qontigo data, passive thematic ETFs and funds attracted a net total of 17 billion euros in 2022, while active mutual funds saw net outflows of 1.1 trillion euros. A total of 182 thematic passive ETFs launched over the twelve months.
Qontigo, administrator of STOXX indices, introduced its thematic offering in 2013. Today we count over two dozen indices, which target transformative megatrends across three broad categories: future technology, socio-demographics and the environment. Thematic indices including the STOXX® Global Automation & Robotics, STOXX® Global Digital Entertainment and Education, and STOXX® Global Breakthrough Healthcare have captured the imagination of investors, and have strong returns to show for the past decade.
New themes continue to emerge constantly, as shown by the number of new funds last year, testament to the rapid social and economic changes in our modern world. Equally important, the growth in thematic strategies is also driven by portfolio managers’ preference for passive products over active ones. Today, many active portfolios constitute a blend of broad-based ETFs and precision exposures such as thematic ETFs.
Amid growing investor commitments to net zero, climate action and the environment, sustainable thematics in particular have seen a surge in interest as a way to build targeted portfolios with real-world impact. We expect this interest to keep pace in 2023 and beyond, around topics such as clean energy, biodiversity and the circular economy.
New systems in thematic investing
Most STOXX thematic indices employ a stock selection methodology based on companies’ revenue streams, a direct and transparent way to link themes with corporate profits. With a granular and comprehensive business taxonomy as the FactSet Revere Business Industry Classifications System (RBICS), STOXX indices can zoom in on more than 1,800 corporate sectors, covering over 150,000 reported revenue segments, to ensure the precise commercial exposure to any given theme.
Yet, some themes call for different approaches, and advancements in technology are enabling innovation in the space. A case in point was the introduction of the STOXX® Global Metaverse index last August, which targets a nascent theme that’s too early in its development to be fully captured by existing revenues. Instead of focusing on sales, the index selects stocks based on their intellectual property rights in cutting-edge technologies associated with the Metaverse.
Patents are a vital, forward-looking alternative to determining which firms are likely to have a dominant position in a business segment once demand takes off in following years. As such, the Metaverse theme provides an opportunity to capitalize on earlier lifecycle innovation in technologies that will shape the virtual space, as well as industry with applications such as digital twin.
This unique patents-based selection framework employs our partner EconSight’s extensive patent specialist expertise, filings database and AI algorithms. The latter are designed to read, understand and categorize the text and technological context in over 130 million patent documents around the world.
Patents can also go deeper than revenue segment taxonomies in grasping in detail the actual output of companies and their standing within a given theme. For example, they can provide insights on whether a ceramics producer makes the inlay for hydrogen fuel tanks or if it manufactures toilets. The latter would not make a fitting investment in, say, a clean energy fund.
Some strategies will call for, or can be enhanced by, a hybrid selection model that combines core revenue and patents data inputs.
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For index providers, getting access to such novel applications and wealth of information opens exciting new doors. But we must be mindful that data innovation does not come at the expense of quality and transparency.
Artificial intelligence — fantastic to automate data processing and analytic procedures — cannot replace the work that goes into index building, from data research to investment methodologies. The driving force of next-generation index solutions requires in-depth industry know-how and out-of-the-box thinking. AI processes are important to assist our best index researchers, rather than to replace them.
Index as a passive investment vehicle has always benefited from rules-based and transparent methodologies, so that the outcome is a solution that is objective and easy to understand by investors. Advancements in AI do not change this fundamental nature of indices, but it allows us to enhance it by utilizing AI as a valuable research tool.
As our colleagues at EconSight have put it, AI is rarely much more than an uneducated child with enormous computing power and endless data storage. The key to high-quality investment data lies in combining that AI potential with human knowledge. Index expert research is key to ensure that the outcome is fit for purpose in investment strategies.
At Qontigo we aim to be leaders in thematic investing research. We have the means and the expertise to analyze and determine what defines a theme; whether it has a long life and solid growth prospects; whether it is investable; and which method and data source are best to harness the theme’s potential.
Flexibility in collaboration
Throughout this process, we make use of our flexibility and open architecture to incorporate and work with external input. We design thematic indices in close collaboration with partners and clients, often tailored to the latter’s needs, from conception to implementation.
Revenue streams still play key role
While technological breakthrough in data gathering is shaping new horizons in thematic investing, company revenues remain the key element to target the beneficiaries of more mature themes. As mentioned, that is true for the vast majority of the STOXX thematic strategies. Multi-year and -decade trends such as ageing population, digitalization, or automation and robotics, are already generating billions in sales from products and services.
As it happens with other investment segments, thematic investing has the determining principle and objective that stock selection should converge in the long run with revenue. Even with a patents-based process, the long-term expectation is to allocate capital to future sales.
And while most thematic approaches focus on reported sales, they are still breaking away from past performance. Thematic investors are making a forward-looking assessment of future growth, seeking to exploit unfolding structural and seismic change. It is a daring call — one where investors are capturing the spirit of a time.
Finally, it is worth noting that many have also turned to thematic investing in recent years for other benefits apart from growth. Principal among them is the search for diversification beyond traditional market capitalization-weighted benchmarks, and their sector-based division of markets that often lacks targeted exposures to the economic drivers of our modern times. Thematic portfolios can also offer some diversion from the typical economic cycle and its swings.
Using indices, meanwhile, can overcome certain difficulties associated with thematic investing, such as the investability of the theme or the cost of research of less-followed stocks.
Exciting outlook
Thematic investing is not new, but it is becoming more and more sophisticated, and we expect it to evolve further over the next decade. Built effectively, a thematic index exposes users to the long-term returns the corresponding theme is supposed to generate. Thanks to new technologies and advanced research, the outlook for thematic investing remains as exciting as ever.
1 Gross returns in dollars for 25 STOXX thematic strategies relative to those of the STOXX® Global 1800 Index. Data before index inception has been simulated.
