Assessing the added value of thematic investments – Investors’ Corner – Investors’ Corner BNP Paribas

Investing in themes is different from investing in sovereignbonds, corporate bonds, equities and other traditional asset classes. In fact,it can transcend them, just as it can transcend factor, regional or sectorstrategies. These characteristics make thematic investing an appealingadditional allocation to a diversified portfolio.

Themes are structural megatrends that shape societies,affecting economies and redefining business models. The drivers of such trendscan be demographic shifts, social or behavioural changes, environmentaldevelopments, resource scarcity, economic imbalances, transfer of power,technological advances and regulatory or political changes.

Thematic investing allows investors to invest in assets thatare better positioned to profit from such transformative changes. When it comesto stocks and corporate bonds, it is important to select companies generating asignificant part of their revenues from selling products or services related tothe theme. For those companies, there should be an outsized impact from valuecreation.

In this article, we are focusing on environmentalsustainability, the energy transition, disruptive technology, consumerinnovation and healthcare innovation as investable themes that can earninvestors attractive returns irrespective of whether their profile isconservative, moderate or aggressive.

For the more common themes, benchmark indices are availablefrom the traditional index vendors. However, there is a limited consensus onwhich assets should be included in a portfolio representing the theme, so thedispersion of return from one thematic benchmark index to another can be large.Using thematic benchmarks from more than one provider is often a good idea.

For themes that relate to specific sectors of the economy e.g., energy, healthcare or consumer goods the relevant sector index can beused as a benchmark. However, in such cases, it is particularly important toassess the expected added value from biasing the portfolio selection towardsthose companies more exposed to the theme.

The answer depends on parameters such as the size and thelevel of diversification of the portfolio.

We believe a core-satellite framework, adding thematicinvestments to the satellite next to a core of equities, bonds and cash, can bean adequate solution for most investors, in particular for those with largeportfolios looking to invest in low-capacity themes, or for smaller investorswho prefer to limit their active allocations to thematic investments.

To implement such framework, it is necessary to understandeach thematic investment in terms of expected risk, return and interaction withother investments.

For thematic strategies investing in stocks and bonds, theexpected returns, risk and correlations can be derived from:

To assess the exposure of the theme to traditional riskfactors, the returns of the chosen benchmark can be a good starting pointbefore estimating how much excess return the thematic tilt is likely to add.

In this example of a core-satellite multi-asset portfoliowith and without thematic investments, we consider

Source: Bloomberg,FactSet, MSCI, Standard & Poors, Stoxx and BNP Paribas Asset Management.For illustration purposes only. Past performance is not indicative of futureperformance.

The portfolios were generated from the robust portfoliooptimisation framework in use at BNP Paribas Asset Management for theconstruction of multi-asset portfolios. This framework relies on expectedreturns, risks and correlations estimated for each of the investmentsconsidered.

In general, the thematic investments replace a number ofcore and diversifying investments.

Below we show the impact of adding thematic investments tothe portfolio, increasing expected returns at comparable levels of risk. Theallocation to the satellite also increases considerably.

Source: Bloomberg,FactSet, MSCI, Standard & Poors, Stoxx and BNP Paribas Asset Management.For illustration purposes only. Past performance is not indicative of futureperformance.

We believe thematic investments can help diversifytraditional portfolios and generate excess returns at comparable levels ofrisk. They can add a dimension in portfolios that transcends asset classes,sectors, regions and investment styles.

Read ALLOCATING TO THEMATIC INVESTMENTS An investmentrationale for institutional investors

In this paper, we propose a framework for allocating tothemes while taking into account the expected returns from the various assetsand the expected alphas for the themes.

The paper includes a detailed example of an allocation toequities and bonds for the five themes and show how the allocation changesaccording to an investors level of risk aversion.

Any views expressedhere are those of the author as of the date of publication, are based onavailable information, and are subject to change without notice. Individualportfolio management teams may hold different views and may take differentinvestment decisions for different clients. The views expressed in this podcastdo not in any way constitute investment advice.

The value ofinvestments and the income they generate may go down as well as up and it ispossible that investors will not recover their initial outlay. Past performanceis no guarantee for future returns.

Investing in emergingmarkets, or specialised or restricted sectors is likely to be subject to ahigher-than-average volatility due to a high degree of concentration, greateruncertainty because less information is available, there is less liquidity ordue to greater sensitivity to changes in market conditions (social, politicaland economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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Assessing the added value of thematic investments - Investors' Corner - Investors' Corner BNP Paribas