Looking to Invest in a Thematic? Index Construction Matters
The next big thing.
You believe you’ve found it and want to invest in the trend.
Or perhaps you are seeking to diversify your portfolio beyond the standard asset type, market cap size, industry focus, and growth/value buckets so many indexes or mutual funds follow.
In this post, we outline how to choose one thematic investment vehicle over another. And why we believe that an index constructed to capture the full value chain of that trend offers significant advantages.
The What, Why, When, How & Where of Thematic Investing
How do you choose among the many thematic options out there? First, start by asking yourself if your goal is short-term or long-term.
What often dominates the news are flash-in-the-pan themes, followed quickly with investment products to attract your dollars. Recall 3-D printing, cybersecurity, and cryptocurrency? All crazes that boomed when these topics dominated the news. We don’t dismiss there is money to be made trading equities or buying narrowly focused indexes as the herd jumps aboard a particular “theme.” As we all know, media quickly moves on to other hot topics, and indexes often must stretch to fill out a basket of public securities that adhere to the theme. If you were to examine the companies included in these narrow indexes deeply, you would often find constituents that are only marginally or tangentially related to the concept.
Perhaps instead, you are a longer-term investor targeting Megatrends, such as demographic and social change, rapid urbanization, or climate change. These examples, among others, all have the potential to fundamentally change the economic dynamics across industries over several years or decades. In these cases, consider how the full value chain index model can be designed to aim for higher risk-adjusted returns over time.
Selecting one or even a few themes to incorporate into a balanced portfolio involves making choices. Do you choose a narrow subsector because of your familiarity in that arena, or just follow the herd? Even with Megatrends, are you choosing one long-term change over another; or buying a product that gives exposure to several inter-lapping trends?
Once an investor decides on a theme, how do you choose among the numerous index products claiming to capture the upside of that big idea? We propose three primary strategies:
- Choose a general index that covers a broad selection of every company currently engaged in the theme, regardless of technology, location, or size.
- Select a narrow index that targets the innovators and producers of a sub-segment of a theme you believe will be the most impactful and profitable.
- Opt for a full value chain index that incorporates not only the producers but also the consumers and suppliers. In this approach, investors may benefit from the first and second derivative upside in growth and profits across the economy.
Timing when to invest in a theme can be as impactful to your portfolio as picking the right idea or product. Every new technological, social, environmental, or geopolitical change progresses through a cycle of recognition, innovation, acceptance, and wide-spread adoption. Is the theme just an idea that you believe buyers will surely recognize soon, or is there already evidence of a growing demand environment? Be mindful of the time trajectory of the theme. Just as venture capitalists specialize in early-stage startups or companies with an established customer base, the stage of a theme’s cycle has risk/reward trade-offs.
Determining the geographic focus of a thematic index depends on numerous factors. How will this product fit within your overall portfolio? What region has the highest potential for supply and demand at the time of your investment? What are the liquidity and transparency differentials among public companies in different countries and regions? All serious considerations in context.
The Reality: Economic Shifts Take Time to Develop
Innovators often do not reap all the economic benefits of a trend. Once sufficient sustainable demand is evident, more prominent players will often supplant the innovators. First movers also tend to trend towards commoditization with shrinking margins. Over time, the consumers benefit from lower prices, more predictable cost of materials, and enhanced margin leverage.
It can be challenging to predict which part of a value chain will benefit during a cyclical vs. secular shift. Cyclical cycles, like waves on the surface of the ocean, see various sectors or sub-sectors rise and fall as the short-term environment changes, while secular shifts are like the current of the sea slowly changing overall direction over time. To achieve the best long-term upside to a trend, exposure to both producers and consumers often generates higher long-term returns with less risk and volatility.
Especially with Megatrends, the evolution of how companies operate, and how government regulations and geopolitics impact the trend, materializes over many years. It takes time for the interdependence between producers and consumers to develop to the point where the consumers, in turn, become suppliers to the producers.
So What is a Full Value Chain Approach?
The construction of traditional thematic indexes consists of a basket of companies that produce products and services, and sometimes their suppliers, that in some proportion service the overall investing concept. These indexes fail to consider or account for the marginal benefits consumers gain from embracing the trend.
The full value chain index model takes a more holistic approach and adapts by using high-quality quantitative data to reconstitute annually as the secular trend develops over time. For secular Megatrend developments, an annual reconstitution is preferred as the thematic evolves over the long-term versus the quarterly rebalancing approaches other indexes embrace as they attempt to time the individual companies or part of a trend that will outperform over the next quarter.
Think of other innovations in history that have fundamentally changed the economic landscape over time. Such as the discovery of oil or the invention of the semiconductor.
Let us use the semiconductor sector as an example. Assume you were an investor when the first semiconductor and technology companies went public. In the early days, these companies created some of America’s wealthiest titans, and taking a narrow investment approach would make sense.
But for the long-term investor, a more diversified portfolio, a full value chain index approach for example, that included the software developers and the customer companies that purchased technology to drive efficiency and productivity, would likely see a higher risk/return profile than a standard focused index.
As with any transformational innovators, semiconductors are now only a small part of the ecosystem of value through its creation and advancements. The customers of technology now span every corner of the economy. The secular shift from semiconductors to today’s automation was not always evident. The timing of choosing a full value chain approach is most appropriate when you recognize the innovators have moved beyond initial customer trials to wider-spread customer adoption. It is at this point when a more comprehensive approach captures the margin shifts from suppliers to consumers throughout all economic cycles.
The Investment Risks & Rewards of a Full Value Chain Approach
The concept of the full value chain index is still in its infancy and is best applied to emerging sectors that have a strong likelihood of fundamentally shifting the economic landscape over time. A risk/reward trade-off in choosing the best index product depends on the quality of the underlying data used in a quantifiable process and a clearly defined methodology of how companies are selected.
The primary benefit of a full value chain index is diversification by including companies from nearly every industry throughout the economy. This approach offers less volatility and reduces the idiosyncratic risk of picking only the producers or one chosen technology or sub-sector in a volatile emerging sector.
Full value chain indexes lend themselves to a longer-term investing approach and have more cushion to weather both economic and business cycles. As we outlined in the oil sector example, as the business cycle of a theme progresses, the margin capture of full value chain model companies will naturally transition from the producers to the consumers.
The flip side is the potential to miss out on the short-term boom of an individual part of a trend. As noted earlier, you can undoubtedly take a laser-focused bet on a specific piece with great reward. However, such a narrow approach requires you to have tremendous insight or expertise on the sub-sector, technology, and the complex network of suppliers and demand environment; and timing can make all the difference even if you chose a promising thematic.
Renewable Energy: A Prime Example for Full Value Chain Indexing
Renewable energy benefits from the merging Megatrends of climate change, technology advancements, and rapid urbanization as an inevitable and investable idea worth considering.
The renewable energy sector consists of several different competing and complementary core technology producers, with an overlapping web of suppliers. One choice would be a broad-based sector index that covers all these technologies or one that targets a specific sub-sector, such as wind, solar, or electric vehicles. Most renewable energy indexes focus on this approach.
So, is now the right time to consider a general, narrow, or full value chain approach?
It is important to note that the producers of renewable energy – the wind, solar, geothermal, and other technologies are not recent innovations. In fact, many suppliers are well into the commoditization trap with shrinking margins and rapidly declining prices from over-competition.
It can be argued the renewable energy sector is now at the business cycle stage of growing customer adoption – moving beyond the customer trial stages the sector was in a decade ago.
This is precisely the timing of the business cycle where the full value chain approach excels.
The general and narrow renewable energy indexes miss out on the complex interdependence amongst producers and consumers driving overall growth in the sector. As we have highlighted in other blog posts, corporate purchases of renewable energy to power their businesses have been proliferating. The impact is widespread across the economy, with companies committing to both more substantial projects and a greater variety of producer solutions.
As the chart below illustrates, the producers of renewable energy intertwine with green transportation and the demand-pull of industries across the economy.
The Renewable Energy Value Chain
Source: BP Capital Advisors Research
Morningstar® North America Renewable Energy IndexSM Value Chain Model
We believe the next trend in thematic investing will incorporate a more holistic approach to index construction.
In the Morningstar® North America Renewable Energy Index℠, Morningstar® has approached renewable energy in a fundamentally different way than other renewable energy indexes in the market. It seeks to capture all the players that will benefit over the long-term from the long-term shift to more renewable energy usage.
The index is constructed to include the producers and consumers of renewable energy:
- Producers: Various technology types of production and suppliers (solar, wind, geothermal, biomass)
- Green Transportation: Electric vehicles, suppliers and operators
- Consumers: Companies from a wide range of industries that are purchasing large renewable energy projects
The index is one of the few renewable energy indexes generated through an exclusively quantitative process derived by leading ESG research firm Sustainalytics. Consumer companies must have 25% or 50% of their primary power needs fulfilled through renewables, depending on their carbon risk profile. Even so, the index is still heavily weighted to the producers and green transportation companies, with consuming companies allocated no more than 25% of the total index portfolio.
The inclusion of companies that purchase renewable energy projects in the Morningstar® index offers more diversification and potentially less volatility through business and economic cycles than comparable renewable energy indexes.
We expect to see Morningstar® and other index companies increase the creation and marketing of the full value chain approach to thematic investing over the coming years.
As you follow the steps of selecting the right thematic or Megatrend for your portfolio, consider the advantages the full value chain approach delivers.
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For more information about the risks of investing in the Fund, see the section in the Fund’s Prospectus titled “Principal Investment Risks.”
Additional Disclosures: The value of stocks of information technology companies and companies that rely heavily on technology is particularly vulnerable to rapid changes in technology product cycles, rapid product obsolescence, government regulation and competition, both domestically and internationally.
Stock prices for companies in the utilities sector are affected by supply and demand, operating costs, governmental regulation, environmental factors, liabilities for environmental damage and general civil liabilities, and rate caps or rate changes.
An investor cannot invest in an index.