Do’s & Don’ts Of Thematic Investing

Due to a weather related power outage I am publishing the entire post here, instead of excerpting and linking. I am headed over to see the Mint 400 this weekend. Embedded in this post are some pictures from last year’s inspection day.

Barron’s had a couple of interesting and related articles. One was about investing in themes and the other was an interview with Cressida Hogg who runs an unlisted infrastructure fund whose clients include the Canada Pension Fund.

The big idea with thematic investing is isolating where fundamental tailwinds, lasting for years potentially, might exist. The way I have described this before is that the money is going to spent and hopefully that translates into higher equity prices. Infrastructure is a good example of this, there is no question that many governments, not just the promise in the US, have been and will continue to spend money modernizing or otherwise improving and then maintaining things like the electrical grid, transportation infrastructure, ports and so on.

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The ETF industry has of course reacted to the demand for investment themes creating dozens of niche funds covering segments like timber, social media, demographics, emerging market consumers and of course infrastructure. Thematic funds like these often draw criticism for being gimmicky and if you think that then you shouldn’t use them. I’ve long believed that they do have a place in diversified portfolios.

I think defense contractors can be a good example. There are a couple of ETFs for this niche (naming names is a compliance no-no) and in looking through to the holdings you would see they are both proxies for the industrial sector which is important in terms of what else you might own. Picking one of these ETFs, some other niche ETF for a different theme that is still an industrial proxy and a large position in some mega cap industrial stock with a big dividend in such a way that you end up with 30% in the sector makes your portfolio very cyclical and volatile.

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This pertains to most of the other sectors as well, technology being one with many themes. These funds are a midpoint between owning a broad sector fund and an individual stock.

Taking this a little further we can look at infrastructure ETFs. ETF.com says there are ten of them but there is at least one missing from their list.

Portfolio manager Hogg has 38% of her portfolio in toll roads. Where the fund is unlisted it can’t be easily tracked of course but the publicly traded toll road stocks look a lot like utilities in terms of how they trade; higher yields and lower volatility. That also likely means they are interest rate sensitive.

In looking at the listing of infrastructure ETFs there is a mix of utility sector proxies and industrial sector proxies along with one technology oriented fund. It is crucial to understand the attributes of thematic funds, if you’re going to use them. Constructing a portfolio with narrow based proxies (sector funds, thematic funds and individual stock) requires understanding things like volatility, correlation, the extent to which a hold increases or decreases average market cap, sector weightings, country weightings and few others.

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Whenever the next bear market comes there will be investors who learn the hard way they had too much exposure, more than they realized, in whatever turns out to be ground zero for that bear market. Looking through each holding and understanding not only the individual attributes but how they all might work together should minimize the chance of owning too much tech in 2000 or too many financials in 2008.

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