Is Thematic Investing the New Stock Picking?

It won’t have escaped anyone’s attention that soaring military spending has boosted defense stocks. Yet while the pickup in defense orders at a time of heightened geopolitical tensions is an obvious trend, the share prices of some leading US defense contractors have not benefited.

Why? Because legislative deadlock in Washington has created government spending uncertainty. That has left shares in big US defense contractors like Lockheed Martin and RTX (formerly Raytheon) languishing. Meanwhile, shares in European companies like Italy’s Leonardo and Germany’s Rheinmetall have almost doubled¹. For retail investors, this highlights the difficulties of picking individual stocks and the advantages of thematic investing through ETFs. An investor who would have invested in a single name to make a play on the theme could have either won big or missed out on returns completely.

Competing With Efficient Markets is Hard

Investing in single stocks could be a risky business for most retail investors. Truly understanding the investment fundamentals of a company involves intense analysis. What are sales, cashflows and profits likely to be over the years to come? How valuable are a company’s assets? Is all this accurately discounted in the stock price valuation? Getting a better insight into a stock in what’s a fairly efficient stock market is a difficult game, even for expert professional investors.

By contrast, thematic ETFs are tools that allow retail investors to back a trend. To give another example, it might have been obvious to conclude that semiconductor companies would benefit from the generative artificial intelligence boom. But not all chip companies are equal. While Nvidia’s price has shot higher, Intel’s has floundered. An investment in a thematic semiconductor ETF, however, would have averaged out the winners and losers (see chart).

Source: Bloomberg. Past performance is not indicative of future returns. It is not possible to invest directly in an index.

There is some criticism of thematic ETFs because they encourage investors to back short-term trends, which can be unpredictable. Investing tends to reward long-term patience, rather than short-term momentum trading. Normally, the way to use thematic ETFs is to identify the longer-term trends that one believes in and then invest in them on the periphery of your portfolio - an allocation of up to 10% is usually enough.

An Innovation Whose Time Has Come

In my opinion, just as broad ETFs have been hailed as a brilliant innovation for broadening investor democracy, in a similar way thematic ETFs could allow retail investors to express their views about long-term trends. Well-informed retail investors are in a good position to take a view on themes like the ageing population, the energy transition and so on.

As more people back their views on such megatrends, investments in thematic ETFs are growing. The latest data shows assets up by more than a fifth in the first 11 months of 2023 to reach $268 billion, according to research company ETFGI.³

For retail investors who prefer to stay away from the complexities of backing single stocks, thematic ETFs could fill the gap. To answer the question in the title of this blog, thematic investing may well come to be seen as the new stock picking.