Demand and supply are rising but asset owners should be clear on intent and risk in sustainability-themed funds.
As sustainability-minded asset owners seek increasingly to focus on outcomes and impacts, rather than just managing ESG risks, they typically find they need to narrow their focus. Even the largest investors can’t fight every battle or exploit every opportunity. This has led to greater demand for funds that target specific sustainability themes. But are these thematic funds delivering and are there hidden risks?
Historically, thematic funds have sought to derive returns by aligning investment strategy with a substantial shift or megatrend. In recent years, many thematic funds have been launched to derive returns from specific aspects of the growing appreciation that economic activity must be sustainable and equitable.
Such ESG-based megatrends might include disruptive technologies, low-carbon companies or the United Nations Sustainable Development Goals (SDGs). Thematic funds might target a limited number of SDGs, or a specific type of disruptive technology, such as hydrogen or carbon capture.
Asset managers typically build thematic funds and strategies by identifying a structural shift in the market, finding companies with high exposure to those shifts and timing the theme so as to “enter early enough that earnings and forecasts have not fully priced in the theme’s potential”, according to a report by New York-based global ETF provider Global X.
Over the past three years, the collective assets under management (AUM) in thematic funds has more than tripled to US$595 billion from US$174 billion worldwide, according to a Morningstar report. But this represents only 2.1% of all assets invested in equity funds globally, compared to 0.6% 10 years ago.
Furthermore, 36% of institutional investors said they already use or plan to use thematic strategies, with 90% of all investors agreeing that thematic investing has a positive impact on long-term performance, according to a 2021 survey by BNP Paribas Asset Management (BNPP AM).
“Thematic funds resonate with investors because they allow them to focus on an area of the market that’s meaningful to them, offering a targeted, concentrated exposure to a structural trend which is much more diluted in a broader fund,” says Victoria Leggett, Head of Impact Investing at Geneva-based private bank and wealth management firm UBP, which serves private and institutional clients.
But backing a more narrowly focused thematic fund isn’t without risk, experts warn, because it can expose investors to the volatility these themes might be subjected to. To mitigate, asset managers often try to design funds to be slightly broader in nature, allowing scope for cross-sector investment selection or the launch of multi-theme funds.
Even so, thematic funds seem set to grow in popularity, because they allow investors to identify and focus on “the winners of tomorrow’s economy, not the losers”, says Chris Varco, Head of Sustainable and Impact Investing Research, Europe, at investment firm Cambridge Associates.
This tendency of thematic funds to target one or more social and environmental outcomes can blur the boundaries between thematic and impact-focused solutions.
For example, DWS group recently expanded its thematic ESG product range with a blue economy fund and Nordea Asset Management (NAM) launched a thematic global equity strategy targeting both climate and social issues.
As impact investing refers to investments that aim to generate a positive environmental or social impact, such as contributing to the SDGs, there is clear scope for overlap.
Before identifying the differences between the two strategies, My-Linh Ngo, Head of ESG Investment at BlueBay Asset Management, says investors need to understand the similarities.
“Firstly, there is the feature of intentionality: both are about a positive way of investing. Instead of screening out, it’s about screening in. It’s about a proactive allocation of capital towards environmental or social benefits for people and/or the planet,” she says.
Furthermore, both thematic and impact strategies seek quantitative evidence of the positive outcomes and impacts that result from their investments, Ngo adds. “This can be in terms of reduced carbon emissions or social benefits to target populations or communities, or contributing to the SDGs.”
Thematic versus impact
Despite this broad commonality, Dan Scott, Head of Thematics and Impact at Vontobel Asset Management, still sees clear differences.
Impact strategies are driven by a moral desire to contribute to global goals and “make a difference”, he argues, whereas thematic strategies aim to “categorise equities in such a way that we understand which parts of the global economy are best positioned to offer [financial] benefits”.
This difference means that impact investors may be more inclined to invest in companies that have the long-term potential to deliver strong social and environment-related performance without delivering immediate results. In comparison, investors applying a thematic investment approach may be more focused on returns, looking to outperform a relative benchmark or an absolute return benchmark in the longer term.
However, a thematic investing strategy can also qualify as an impact investing strategy, says Derek Butcher, Senior ESG Analyst at RBC Global Asset Management.
“One thematic investing strategy could be designed to invest in broader ESG themes to solely benefit from the long-term outlook on those themes, with no stated mandate to contribute to positive environmental or social outcomes. However, another strategy targeting the same theme may communicate to clients that it is investing in that specific ESG theme to contribute to positive environmental or social impacts. The stated intent in the latter strategy demonstrates the impact focus,” he explains.
Asset owners looking to be more targeted in their approach to driving their social and environmental performance while maintaining financial returns are therefore turning to thematic products that allow for specificity, says Varco.
“They could have an interest in education technology, access to healthcare or energy efficient real estate, for example,” he says.
Thematic funds will typically continue to concentrate on specific outcomes,” agrees UBP’s Leggett. The danger of identifying ESG as a megatrend is that it “potentially understates the huge and structural shift that needs to take place across all themes and asset classes, in order for finance to play its part in fixing the world’s problems”, she warns.
Managing risk in “dollars and cents”
Investors in and issuers of thematic funds are making a “trifecta bet”, according to the Morningstar report.
They are collectively betting on the fact they are able to pick a “winning theme”, select a fund that is well-placed to “survive and harness that theme”, and are further “making a wager when valuations show that the market hasn’t already priced in the theme’s potential”, Morningstar said.
When the main focus of a fund is to drive returns, a broader theme allows for “more flexibility” and therefore better management of potential risk, according to Joerg Schneider, Portfolio Manager at Union Investment, the investment arm of the DZ Bank Group.
But it’s incredibly challenging selecting themes that are going to deliver returns over a sustained period of time without high levels of volatility, admits Vontobel’s Scott. To mitigate the risk of choosing an emerging theme that fails, Scott says he prefers to select themes that “already have a certain maturity to them”.
“What we need is for a prospective theme to develop to a stage where it’s being implemented in business models, where there’s an application for it in industrial, service or manufacturing processes. [Vontobel] needs to be able to see that theme in dollars and cents before we decide to invest in that theme,” he adds.
While more than two-thirds of all thematic funds (sustainability-focused or otherwise) globally outperformed global equity markets in the year ending March 2021, this success rate dropped to 22% over a trailing 15-year period, with 57% of those thematic funds closing during that time, according to the Morningstar report.
“Because of their narrower exposure and higher risk profile, thematic funds are best used to complement rather than replace existing core holdings,” the report said.
Hedging against long-term risks
Institutional investors need to be able to stomach volatility if backing a single theme, Scott acknowledges. But, to mitigate this, multi-theme strategies are increasingly being launched to entice investment.
Vontobel launched the Fund II – 3-Alpha Megatrends last month, which offers access to multiple, structurally growing investment themes. The idea is that, if one theme dips or underperforms, the fund as a whole will still be benefiting from returns secured across other included themes. This takes thematic investing closer to traditional investment models, but still offers investors a strategy featuring a concentrated selection of macroeconomic trends.
Asset owners, such as pension schemes, may also view thematic investing through the lens of potential risk reduction, according to the Global X report, by employing it as a method of “hedging against long-term external risks”.
For example, a pension plan for employees at an oil corporate depends on annual contributions from the company to fund its obligations. If that company’s oil prices fall and it faces financial stress, the contributions risk being cut. “Therefore, the pension plan inherently has risks associated with oil prices […] a fund may actively look for ways to hedge the risk of an oil decline,” the report noted.
Despite the failure rate of other thematic funds, experts are confident that ESG-related themes are going to be just as pertinent in 30 years’ time across all sectors and industries – particularly concerning climate-related issues. This lowers the risk of volatility that these thematic funds will be exposed to.
With a record 237 new thematic funds debuting globally in 2020 (compared to 167 in 2019), according to the Morningstar report, an ever-increasing range of themes are continuing to be brought to market.
Thematic investing will grow in popularity, particularly in the responsible investing space, experts predict, even as the differences between impact and thematic become more challenging to define.
Thematic investing isn’t constrained by geographies or sectors, so it will continue to be an increasingly attractive option for investors who want to mitigate the global risks posed by social and environmental issues, says Schneider.
“Long term risks posed by the likes of human rights and climate change are emerging issues that need to be addressed, which translates to great opportunities for thematic investors. They will remain important for a long time,” he says.