Thematics: the new era for passive strategies

Thematic indices can offer diversification and market-beating returns, in some cases by using innovative index methodologies, says Christoph Schon at Qontigo.

Thematic indexing has seen exponential growth over the last few years as investors seek to diversify away from cycle-sensitive sector exposure and into long-term megatrends. Rather than sector indices, which comprise only stocks belonging to one segment of the economy, thematic indices often straddle multiple industries within a particular theme – such as digitalisation or smart city infrastructure – with the aim of delivering exposure to seismic shifts in the environment, demographics and technology.

These shifts or megatrends position portfolios for growth by seeking the beneficiaries of broad and disruptive developments that are changing our global economy and society. And while market volatility and macro concerns have challenged the performance of thematic indexing in the past two calendar years, there is no getting away from the fact that, in the long term, these strategies have performed better than traditional benchmarks.

Take, for example, STOXX’s thematic indices, which outperformed as a group every year between 2012 and 2020, delivering an average annual premium of 8% over the period. (Calculated using gross returns in dollars for 25 STOXX thematic strategies relative to those of the STOXX Global 1800 Index). Furthermore, the long-term returns of thematic strategies, including year-to-date performance, are markedly positive.

Megatrends and current market conditions

I recently read a Financial Times article with interest in which BlackRock warned that the traditional mix of stocks and bonds is ill-suited to a world of high inflation. Following a lavish decade of market highs, garnished with quantitative easing and seasoned with zero interest rates, investors are facing tough times ahead and leaner returns, thanks to higher inflation and interest rates. So much so that the world’s largest asset manager is calling time on the 60% stocks/40% fixed income approach, arguing it will no longer serve the market in the long term.

“While many thematic indices employ a stock selection methodology based on companies’ revenue streams, some themes call for a unique approach.”

While private markets are one way to go, it is timely that despite the more recent market dip, inflows into and innovation in thematic strategies have not slowed down. In fact, Qontigo data shows that passive thematic ETFs and funds attracted a net total of €17 billion in 2022, with a total of 182 thematic passive ETFs launched over the 12 months. In that same period, active mutual funds saw net outflows of €1.1 trillion.

The industrial Metaverse is no fad

With a soaring debut and subsequent decline, the Metaverse has seen a mixed response in recent years. However, unlike the consumer Metaverse (gaming, social media…), the industrial Metaverse is no fad.

Today, heavyweights from BMW, Boeing, Unilever, Siemens and even NASA, are establishing applications for immersive and interactive technologies in an industrial context, ranging from remote monitoring and online simulations to virtual replicas of physical assets — or digital twins. More recently, Mercedes Benz has built a digital twin of its EV plant in Rastatt, Germany, to simulate and monitor new planning and optimise processes without disrupting existing production.

If recent research is anything to go by, forecasts for the global digital twin industry stand to reach US$126 billion in value by 2030, from $6.5 billion in 2021. Capturing megatrends, such as technological innovation, is at the very core of thematic indexing, and the industrial Metaverse represents one of the biggest opportunities for future growth and investment in this space.

“While thematic indexing is not new, it’s evolving nature has made it popular not just for its growth potential but also for diversification.”

It is unsurprising, then, that there is plentiful demand and supply of indices relating to the Metaverse. However, while many thematic indices employ a stock selection methodology based on companies’ revenue streams, some themes call for a unique approach.

We believe the Metaverse is one such theme. According to studies by McKinsey and Bloomberg Intelligence, only 10-15% of its potential market size has been tapped so far. Using selection criteria based on current or past revenues is not an optimal indicator of how much a company is likely to benefit from the underlying megatrend going forward.

Take, for example, the STOXX Global Metaverse Index, which tracks the performance of the greatest innovators in technologies related to the theme, such as 3D-image modelling, digital twin, non-fungible tokens (NFTs) and virtual & augmented reality. Instead of revenue data, it utilises patents, a forward indicator, to find companies that are most likely to profit from nascent technological trends. This approach means companies can be identified and included in the investment strategy as early as possible in order to capture their full potential.

While thematic indexing is not new, it’s evolving nature has made it popular not just for its growth potential but also for diversification. It offers an alternative to traditional market capitalisation-weighted benchmarks and sector-based strategies, which often lack targeted exposures to economic drivers. Built effectively, a thematic index exposes users to the long-term returns the corresponding theme should generate. And thanks to new technologies and advanced research, the outlook remains as exciting as ever.

Christoph Schon is senior principal applied research at Qontigo.

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