How to Pick the Right Theme for Investors?

Original Release on August 12th, 2021: Investor interest in thematic equity products such as ETFs has rapidly surged, particularly among tech themes. Why the momentum may only grow.

----- Transcript -----

Andrew Sheets This week we are bringing you 4 encores of deep dives into different kinds of investing we consider at Morgan Stanley. Thanks to all our listeners for a great year and happy holidays!

Graham Secker Welcome to Thoughts on the Market. I'm Graham Secker, Head of the European and UK Equity Strategy Team.

Ed Stanley And I'm Ed Stanley, Head of European Thematic Research.

Graham Secker And today on the podcast, we'll be talking about the continued interest in thematic investing in Europe. It's Thursday, August the 12th, at 3 p.m. in London.

Graham Secker So, Ed, I really wanted to talk to you today because investor appetite for thematic related equity products such as ETFs, mutual funds and the like has grown to the point that thematics has actually been carved out from our traditional sector research at Morgan Stanley. So as head of the European Thematic Investing team, can you walk us through what's behind the increased interest in this area and how you see the thematic landscape evolving over the next couple of years?

Ed Stanley Thanks, Graham. To understand thematics, first you have to look at the geographies. And when you do that, it's really a two-horse race. Of the $450 billion in global thematic mutual funds in June this year, 60% of that was in Europe. So the lion's share. And then there's the U.S., which is the second largest geography for thematic investing, but growing very quickly indeed. If you look in the US year to date, for example, there have been over 100 thematic ETF launches-- comfortably double the run rate of thematic starts in 2020. Once you've looked at geography, then you have to look at the landscape by theme. And this is where thematic investing gets really interesting. The breadth of and growth in thematic strategies is truly extraordinary. Fund starts are compounding over 40% over the last three years and inflows for those funds have seen high double digit, and even triple digit growth, so far this year. Most obviously, themes like genomics and eSports fall into that high growth category. We even saw a dedicated ETF launch in June this year, particularly trying to gain exposure to the metaverse, which is the first of its kind. So while we don't make explicit forecasts on where we think thematic investing is going to be in a one year view, the momentum is showing no signs of slowing down. In fact, quite the opposite.

Graham Secker So with any number of themes to choose from, the world really is your oyster, I think. So how do you whittle down or cherry pick where you spend your time?

Ed Stanley It's a great question and that's really my number one challenge. While we're never short of ideas, determining which theme is the zeitgeist of the day is absolutely critical. And to do that, our thematic research really hinges on two streams of analysis. On the one hand, demographic change and on the other, disruptive innovation. We believe that these two groupings and the subthemes therein hold the key to shifting future consumption patterns, which ultimately all investors need to be conscious of. But with that said, for most investors to be interested in a theme, it needs to be actionable within at least three to five years. Consequently, for a theme to work, investors need a relatively near-term catalyst. So when we're looking within disruptive innovation, for example, we need to think what's the catalyst to make investors care about this theme? Be that a product launch, start-up funding, falling technology costs, regulation or government policy. When you can twin up an interesting thematic idea with a catalyst, that's really where we focus our attention.

Graham Secker Another question I want to ask is, how do you test the pulse of the market to determine what is a live thematic debate and where you think investors may be too early or late to a theme?

Ed Stanley Well, I suppose this really narrows down the previous point. So we now have our theme, so to speak. We have to ask ourselves, does the market already care about this theme or will the market care in the not-too-distant future? And this is where we think we've come up with a relatively interesting and novel solution to screen for that. Through a combination of four things: patent analysis, capital spending patterns by companies, the velocity of comments made by company management teams and finally, using Google Trends momentum data, we believe that we can relatively accurately pick which themes are either gathering momentum or, on the flip side, those that may have been past their initial peak of excitement.

Graham Secker Okay. And on that point, what are some of the key themes you're watching right now?

Ed Stanley Well, I suppose one that we can't ignore, particularly given my previous comments, is hydrogen. On all of the metrics I just mentioned, it's flashing green. Whether that's pattern analysis, company transcripts, CapEx intensity. It's a hotly debated theme as investors try to grapple with this long-term potential for the fuel. But even more simply, if we take a step back, one really only needs to look at the fund startups to see where the really exciting themes are. If we look back to January 2018, for example, there are only a handful of fintech funds around the world. Today, there are nearly 200 that we're keeping track of. Part of my role is to predict what is going to be the next fintech when it comes to themes. And the themes that are most likely to tick those boxes are, in my view, the near-term ones, electric vehicles, cybersecurity, 5G; the medium term, which encompasses augmented, virtual reality as well as eSports; and then longer term, you have space, quantum computing are all beginning to show telltale signs of thematic focus areas.

Graham Secker Thanks, Ed. And finally, I want to ask you about concerns over a thematic bubble. There's been an exponential rise in the number of thematic products being set up recently. There's also been a high degree of attrition for thematic ETFs. So to what degree do you think the ongoing growth in thematic investing is here to stay? And how vulnerable do you think it could be to a prolonged technology bear market, for example?

Ed Stanley You're absolutely right. Plenty of thematic ETFs, particularly in the US, have come and gone. That will likely continue to happen, particularly in themes where hopes exceed reality. What happens in a prolonged downturn remains to be seen in all honesty. We don't have enough back history from a wide enough variety or sample of these thematic funds, to be sure. But the test case of covid highlighted the early signs of structural growth in this market. There are more thematic funds post-covid than pre-. So my view is that this is absolutely a structural rather than a cyclical phenomenon, particularly as younger marginal investors increasingly want exposure to themes rather than sectors and geographies. But while I believe that thematic investing is a structural trend, no doubt it clearly leans towards tech-heavy equities and growth as a factor, particularly. So the bigger existential threat perhaps isn't so much a bear market, but instead persistently high interest rate environments, which remains to be seen. But for now, at the very least, the future looks pretty bright for thematics in our view.

Graham Secker Very interesting. Thanks for taking the time to talk today, Ed.

Ed Stanley Great speaking with you, Graham.

Graham Secker As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.