New research from BNP Paribas Asset Management’s Quant Research Group delves into thematic investing strategies. These approaches invest in the long-term megatrends shaping economies, society and business models. This second of our two extracts* investigates the typical biases of such thematic strategies.
Here we assess the allocation to equities of active and passive (i.e., exchange-traded fund) thematic strategies. The strategies selected invest in themes including sustainable food & agriculture, sustainable water, climate impact, environmental sustainability, innovation in healthcare and consumption, sustainable energy and disruptive technology.
Different themes have different biases
Different themes have different biases. Below we show the typical biases that can be expected in various thematic equity strategies and that tend to persist over time. These were measured by comparing active and passive portfolio allocations with the allocation of an MSCI World index portfolio.
Why did we use the broad MSCI World index? While this may not be the natural benchmark for the selected thematic funds, we believe the results are useful for an investor replacing a global investment portfolio tracking the MSCI World with a thematic strategy.
Investors should be aware that choosing such a strategy introduces biases such as tracking error risk that are absent from a passive MSCI World portfolio. Tracking error results from the composition of the strategy being notably different from the composition of the index.
Decomposing the tracking error risk of each of the selected thematic active strategies and ETFs, we find that the tracking error risk is relatively high. It is made up of:
- A beta[1] different from 1 (unlike the beta of the MSCI portfolio)
- Contributions from style, industry and country biases
- A contribution from risk related to excess returns not correlated with the returns of any of the other biases.
Exhibit 1
Marginal contributions of systematic risk factors such as beta, styles, industries or countries to the tracking error of selected active thematic strategies relative to MSCI World index
Data as of 27 June 2024. For illustrative purposes only. This is not an offer to buy nor a solicitation to sell securities, or investment advice. Past performance is no guarantee of future performance. Source: MSCI and BNP Paribas Asset Management.
The thematic strategies in exhibit 1 are managed actively. This gives portfolio managers more flexibility to manage the exposure to beta, to companies with different market capitalisations, and to different investment styles in line with the markets targeted, the sector allocated to, and the investment ideas implemented.
Exhibit 2
Marginal contributions of systematic risk factors such as beta, styles, industries or countries to the tracking error of selected thematic ETFs relative to MSCI World index
Data as of 27 June 2024. For illustrative purposes only. This is not an offer to buy nor a solicitation to sell securities, or investment advice. Past performance is no guarantee of future performance. Source: MSCI and BNP Paribas Asset Management.
As shown, tracking errors relative to the MSCI World portfolio vary from one portfolio to the next. Contrary to perception, beta – the extent to which the portfolio moves with the index – is not a major contributor to the tracking error.
We believe these findings mean that portfolio construction and risk management are of paramount importance when it comes to integrating thematic investing into a global asset allocation portfolio.
Investors need to assess the systematic biases that come with investing in thematic strategies and take them into account when allocating to thematic investments because what they most likely want is just the tracking error associated with the theme since this can generate thematic value.
Strategic asset allocation including thematic investments
The easiest way to avoid unexpected performance is to construct a satellite to invest in thematic strategies. Investors should allocate to a selection of specialised thematic strategies with, for example, different betas, so that the beta of the overall portfolio is close to 1 (and in line with the beta of the MSCI portfolio that it is replacing). This goes a long way to managing other biases and making sure that excess returns from thematic investing are derived as much as possible from thematic alpha.
Instead of, or alongside, the more specialised thematic strategies, investors may also consider allocating to broader strategies that invest across a wider range of themes, so that they can harvest thematic alpha from strategies with more diversified biases.
Two examples:
- In a healthcare innovators strategy, positions in large pharmaceutical companies, which typically have a more defensive beta bias, can be combined with biotech holdings, which often have more of a growth bias.
- In an energy transition strategy, positions in growth-oriented tech companies can be combined with holdings in income-generating utilities, creating flexibility to manage the beta of the strategy.
More sophisticated investors can go one step further and make sure that they control for various exposures to systematic biases. It is difficult for us to see how this goal can be reached without using portfolio optimisation.
A recent BNPP AM paper[2] explained in detail how to use robust portfolio optimisation to make sure that the tracking error of the thematic satellite portfolio is exposed to only thematic tracking error.
The final strategic allocation portfolio with a thematic satellite can be set up such that it has the same exposures to systematic biases as a portfolio without thematic strategies. Incorporating just a modest amount of thematic alpha by adding thematic investments can increase the returns and Sharpe ratios[3] of strategic asset allocation portfolios significantly.
*also read: Investing in megatrends with thematic and exchange-traded funds (Part 1) (bnpparibas-am.com).
References
[2] Koye Somefun, Romain Perchet, Chenyang Yin, Raul Leote de Carvalho. (2022) “Allocation to Thematic Investments” Financial Analysts Journal, https://doi.org/10.1080/0015198X.2022.2112895
[3] The Sharpe ratio describes how much excess return you receive for each additional unit of risk you assume. A higher ratio implies a higher investment return compared to the amount of risk of the investment. https://www.investopedia.com/articles/07/sharpe_ratio.asp
Disclaimer
Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and 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.
