Guest article: Aligning your portfolio with future trends using thematic ETFs

A guest article by our PrimePartner Invesco

In 2022 we painfully experienced how quickly the world around us can change. War, energy shocks and inflation presented investors with unprecedented challenges. Especially in such a volatile environment, it can be worth focusing more on the structural changes that will shape our future.

One of the largest and most important of these transformative trends - the energy transition - has received additional impetus from the events of recent months. Others, such as demographic change or technological progress, continue to advance, challenging existing business models and opening up new opportunities for forward-looking companies - and all those who invest in the shares of these companies.

The choice of trends to invest in are as numerous as the challenges facing our world. It is important to distinguish between short-term hype and long-term structural changes. The latter includes topics such as blockchain, artificial intelligence and robotics as well as biotech and genomics, e-mobility or clean energy. For those interested in investing, however, it might be difficult to determine which companies can potentially profit from which trend or how fast and in which direction a certain development will proceed. Even defining a topic and its potential relevance can be challenging. Especially with new, dynamically developing topics such as blockchain; opportunities, valuation prospects and potential risks can only be determined with specialist expertise.

At Invesco, we believe that it is not always easy to identify companies that are involved in the blockchain ecosystem. And few analysts have the necessary expertise to identify and properly value blockchain assets.

Thematic funds relieve investors of the burden of constantly monitoring trends and selecting the most promising individual stocks. Because they invest in a more concentrated and targeted manner than broad index funds, they are often more volatile - especially over shorter periods of time. Index funds are investment funds that aim to track a specific stock market index. Over the longer term, however, they are usually good at capturing thematic trends and are often seen as more differentiated, less concurrent potential sources of return that are less influenced by regional and sector-specific market cycles. This makes thematic funds particularly suitable as long-term strategic positions to complement a portfolio's core investments.

The potential return from investing in companies with the potential for strong structural growth based on long-term, transformative trends makes thematic investing increasingly attractive. ETFs (exchange-traded funds) make this exposure particularly easy, liquid and cost-effective which is why Invesco believes they are increasingly the product of choice for those looking to invest thematically.

Broad diversification, liquidity and transparency are the most important criterias in favour of ETFs when it comes to thematic investing. Transformative trends are dynamic by nature and therefore associated with higher volatility. A diversified passive portfolio can reduce this volatility. A passive portfolio is a portfolio of securities that only changes when another variable, such as a market index, changes.

Another challenge is potentially lower liquidity, as thematic investing often focuses on smaller companies. An ETF can take this into account in stock selection and weighting to ensure sufficient liquidity. By tracking indices that serve as benchmarks for the ETFs, with clear rules regarding the definition and mapping of a theme, thematic ETFs also offer a high degree of transparency.

However, the value of thematic ETFs may fluctuate more due to economic and market conditions or due to a focus on a specific region as well as the concentration on a smaller number of positions compared to market-wide ETFs.

When selecting suitable thematic ETFs, investors should ask themselves several questions: Does the theme make sense? Do they get significant theme exposure? How often will the portfolio be rebalanced? What function can the thematic ETF play in the portfolio? What is the cost of participation in the theme, i.e. the total cost of the thematic ETF?

While many ETFs are based on traditional index methods, a one-size-fits-all approach - such as the usual compilation of an index according to the market value of the companies it contains - does not work for thematic investments. The indices underlying Invesco's thematic ETFs take different approaches depending on how dynamically a theme is developing and what types of companies are affected by the theme.

The Frankfurt Future Institute has described megatrends as "avalanches in slow motion" because they develop slowly but have an enormous impact on all areas of life. Developments such as climate change, digitalisation and demographic change can fundamentally change our everyday lives, political priorities and the business environment of companies. All of these could be reasons to expand one's portfolio with thematic investments. As a strategic addition to the core investments of portfolios, thematic ETFs offer a way to invest in a more targeted yet broadly diversified manner.