Benchmark investing vs thematic investing: five things you need to know

In our last article, we introduced the concept of thematic investing and looked at several advantages of this approach to portfolio management.

We highlighted the fact that in today’s world of rapid change, volatile investment markets and low interest rates, many investors have begun to question the traditional benchmark-based approach to asset allocation and portfolio construction, and that as a result, thematic investing has gained in popularity.

In this article, we take a more in-depth look at some of the key differences between benchmark investing and thematic investing. Here are five things you need to know about how the two approaches to investment management differ.

Investment Objectives

Let’s start with the aim of each approach, as the two styles have very different objectives.

With benchmark investing, the aim is simply to beat the benchmark index, with performance generally measured on an annual basis.

In contrast, thematic investing aims to profit from powerful, long-term trends that are shaping the world, with performance often measured over a longer-term time frame.

Portfolio Construction

As a result of the two approaches having different objectives, thematic portfolios are often constructed very differently to benchmark-based portfolios.

Generally speaking, benchmark-based portfolios tend to be constructed with a view to the economic cycle and current market conditions. The portfolio manager will consider the benchmark index and then go about ‘overweighting’ or ‘underweighting’ individual stocks in an effort to outperform the index. Most portfolio managers don’t drift too far from their respective benchmarks as they don’t want to run the risk of underperforming if their market views are incorrect.

In comparison, thematic portfolios are generally constructed using a basic three-step process. First, the portfolio manager will identify a number of dominant, long-term trends and translate these into investment ‘themes.’ Then, the portfolio manager will attempt to identify a number of companies that are poised to benefit from these trends. Lastly, the portfolio manager will pick out the best investment ideas and construct a portfolio.

Figure 1. The thematic investing process

So, the two investment styles are very different when it comes to portfolio construction. As such, thematic portfolios will often look quite unique.

Flexibility

Another key difference between the two approaches is the amount of flexibility that portfolio managers have. Broadly speaking, benchmark-oriented portfolios are quite inflexible. For example, a portfolio’s mandate may state that, at asset allocation level, the portfolio is not allowed to deviate from its benchmark asset allocation by more than a few percent.

In contrast, thematic investing tends to be much more flexible as thematic portfolio managers are given significantly more freedom as to how they invest. Figure 2 below illustrates this concept by showing a standard ‘balanced’ asset allocation versus the Featherstone Sensible Growth asset allocation.

Figure 2. A flexible asset allocation vs a balanced asset allocation

Thematic portfolios also tend to be more dynamic than benchmark-based portfolios. Whereas benchmark-oriented portfolios are often quite static, thematic portfolios can be adjusted to suit market conditions in an effort to capture the best opportunities and capitalise on long-term trends. Figure 3 below illustrates the dynamic nature of thematic portfolios.

Figure 3. Thematic portfolios are more dynamic than benchmark-based portfolios

Geographical Footprint

One implication of this extra flexibility is that thematic portfolios tend to have a much broader geographical footprint than benchmark-oriented portfolios.

The primary goal of thematic investing is to invest in companies that will benefit from long-term structural growth opportunities, however, where those companies are based or listed is of less importance. With less geographical restrictions than a traditional benchmark-oriented portfolio, a thematic portfolio is likely to have exposure to a broad range of economies, both developed and developing.

Diversification

Lastly, because thematic portfolios are so unique, they tend to offer far more diversification benefits than regular, benchmark-based portfolios.

Whereas benchmark-oriented portfolios tend to be highly correlated with mainstream equity indexes, thematic portfolios often have a lower correlation to mainstream indexes and may perform differently at times. As a result, they can be used to hedge other portfolio risks and to lower overall portfolio risk.

Of course, while a lower correlation to mainstream benchmark indexes is generally an advantage, one potential drawback to be aware of is that thematic portfolios may underperform benchmark indexes at times. This can be an issue for those who cannot tolerate significant deviations from mainstream benchmark indexes.

Summary

Thematic investing is a unique approach to investment management that is very different to traditional forms of investing. Whereas the goal of benchmark-based portfolios is simply to outperform the benchmark index, thematic portfolios seek to identify and profit from long-term structural trends that are shaping the world.

Relative to benchmark-based portfolios, thematic portfolios are generally more flexible, more dynamic, have broader geographical exposure, and are less correlated to mainstream equity indexes. As a result, not only can thematic portfolios provide investors with strong long-term returns, but they can also provide diversification benefits and help lower overall portfolio risk.

New call-to-action

This does not constitute advice.