Breaking Down Thematic Investments
This transcript has been edited for clarity.
Dan Carreno: Thank you for tuning in to Rewilding Wall Street where we provide insights and analysis into the ever evolving world of sustainable investing. I am Dan Carreno.
Brittany Damico: And I'm Brittany Damico. And in this episode, we are going to be discussing one of the most underappreciated tools for portfolio construction, which are thematic investments. In our experience, we've noticed that there are a lot of asset allocators out there that have not been incorporating thematics into their portfolios. And these tools are a really great way to align your portfolios with client values and just to invest in the future in general. So I'm going to tee up a question for you here, Dan. I've heard you say that thematic investments are a tool for aligning a portfolio with the future. What do you mean by that?
Dan Carreno: Yeah, well thanks for teeing it up, Brittany. I mean, this is an interesting conversation. This is one of those things that's come up a lot in our conversations with financial professionals as of late. So aligning a portfolio with the future, what do we mean by that? Well, most portfolios these days are more or less based upon market cap weightings, right? Most of them, not all but most. And if you think about it from that perspective, if you are weighting a portfolio in that regard, if you're using indexes that use market cap weightings, the largest parts of those indexes are the things that have already grown substantially over the last 3, 5, 10 year periods, whether it be industries, sectors or individual companies. So you're inherently aligned with the past. That portfolio is going to have a higher weighting to the things that have already done well, and it's going to inherently have lower weightings to things of the future. And we've seen this play out historically as one example. If we look back at 2008 and we looked at global indices, commodities had just gone through this huge super cycle after the rise of a lot of developing economies. So commodities were sort of overexposed in most market cap weighted indexes. And then you fast forward to the year 2020, that percentage of commodities shrunk from 25% down to 8%. And then conversely, if you look at that same time period, 2008 to 2020, information technology was only 10% of global indexes back in 2008. And that has grown to 23% by 2020. So if you think about it from that perspective, Brittany, if somebody had used a thematic fund or a thematic exposure in their portfolio to gain some extra exposure to tech back in 2008, they would've benefited from that, right? They would've benefited from aligning their portfolio with the future. Also, I think about it from another perspective too, which is a word that gets thrown around in investing circles all the time, which is disruption, right? Disruption given the current trajectory and acceleration of innovation and technological development, it's happening more and more and it's impacting portfolios and financial markets more and more. And I would also say that having some degree of thematic exposure in a portfolio is a tool to align an investor's portfolio with disruption. And of course, not those companies that are being disrupted, but those that are actually doing the disruption. So I mean, what do we mean by that term? Well, right, I think most of us probably remember Blockbuster video, right?
Brittany Damico: Nostalgia..
Dan Carreno: Friday nights go run a movie. Your favorite movie that you really wanted was never on the shelves for whatever reason, you'd have to go and check the rewind box. Do you remember that?
Brittany Damico: That was a thing. Oh my gosh.
Dan Carreno: And of course, streaming services, like Netflix came along and bye-bye Blockbuster, classic example of disruption. If we look at it at a larger scale from a market perspective, Goldman Sachs has actually run some really interesting analysis and numbers on this, and we'll have a link in the podcast transcript to this data. But it shows going back to 2011, the 10 year period, going to 2012 companies that were on sort of the losing end of disruption underperform the S&P 500 on average by 237%. Companies that were on the winning end of disruption over that 10 year period outperformed the S&P 500 by 549%. Thank you Goldman Sachs for that.
Brittany Damico: I'm glad that you went a little deeper into the definition of disruption. I do think that is a term that is thrown around the industry quite a bit, so I do appreciate you going into a little bit more depth there. All right, so that's all well and good in terms of looking at financials and analytics, but let's talk about thematics more so from a value aligning standpoint, more of the storytelling and a direct engagement, a way that you can really invest directly into a theme that you feel really passionate about. So can you give me a little bit more detail about how thematics play a role from that perspective?
Dan Carreno: Okay, yeah. This is something I've heard from just a lot of the financial professionals that I work with, is that there's kind of this disproportionate benefit from thematic investments from a psychological standpoint. And what we mean by that is that sometimes a thematic fund in a portfolio could be 2, 5, 7, 10%. It could be a relatively small percentage of a portfolio, but oftentimes it's the part of the portfolio that a client actually really identifies with. Or if they hear the story about a particular fund or theme, it's the thing that they remember. I mean, we all love broad index funds. They're great, they're cheap, they're diversified, they're not great stories. Nobody remembers a story about an index fund. So it kind of provides, I think, just an opportunity to help people just kind of engage with their investments a little bit more and to have a story around that that makes them feel
Brittany Damico: Heard.
Dan Carreno: Thank you. Thank you, Brittany. That's the word I was looking for.
Brittany Damico: I couldn't agree more. I think if you look back historically thematics were like the ESG and the sustainable investing before that was common terminology, it was the part of investing –well, maybe not necessarily sustainable investing, it would depend on the type of strategy – but I think having that connection, the story, having some value alignment component there, I think has always been a drawing element for investors and such an easy way for an advisor to find a connection with somebody.
Dan Carreno: So I mean, there was this survey that came out from Kitces, Michael Kitces not that long ago, back in 2020, they basically pulled a whole bunch of investors and they asked what investors look for in a financial advisor. And the results of that came back as these were the top five responses. It was:
1. Helps me reach my financial goals.
2. Has relevant skills and knowledge.
3. Communicates and explains financial concepts well.
4. helps me maximize returns, and
5. Has a good reputation and positive reviews.
Okay, let's forget about five. But if we think about one through four on that list, I mean it's not that the thematic investment in a large asset allocation is like the driving force to any of those elements, but it helps sort of illustrate those skills in a financial advisor, right? Communicates and explains financial concepts. Well, I mean, being able to tell the story around a particular investment theme I think is a great way to do that. We all know people respond well to stories, they don't respond to data. Being able to speak in a really educated and passionate way about a theme that the client or investor is also passionate about. It is a great way just to illustrate that a financial professional has the qualities that the market is looking for.
Brittany Damico: Oh, absolutely. I think if you're sitting in the seat of a client of a financial advisor. The advisor can be excellent at explaining some sort of equal weight or market cap strategy that integrates machine learning and AI and all these different elements, but that might be something that goes over the head of the client. They may not understand that narrative, but when you start actually telling a story about something specific, the story is where people feel that really deep connection and will walk out saying, I learned something. My financial advisor taught me this thing about an investment, and I feel empowered. And I think that's a really strong emotion to be able to provide somebody. So with that in mind, if our listeners are picking up what we're putting down, if they're buying into this argument, what are some of the best practices that you've seen for integrating thematic investments into different asset allocations?
Dan Carreno: Okay, Brittany. Well, I mean this is where I have to say that it is not our intention to present thematic investments and thematic funds as any kind of silver bullet that they're foolproof. They obviously have drawbacks, right? I mean, the theme cannot work out. People can certainly lose money, lose their investments. These types of funds can be more volatile. They typically have higher expense ratios. So of course we're talking about them within the context of a relatively small allocation within a greater portfolio. So that said, we've done our own research and pulled in data from different sources, plus just our observations from the field, so to speak. And a few things that I would mention here is obviously first and foremost with any investment is suitability. Is it right for that person? And so of course investors that actually have that time horizon in order to benefit from the theme, I think that's one key element.
Next, what's the right exposure? We get this question a lot. There's a lot of good data out there. I welcome people to kind of do their own research, but I've seen studies that show anywhere from 5 all the way up to as much as 20%, just from a sheer analytical risk and return profile standpoint can actually be beneficial to a portfolio in terms of improving risk as well as volatility numbers. And then there, there's actually the idea of choosing the right theme. There's a lot of different thematic funds out there. Obviously not every one of those themes is going to play out well. Next I would say choosing the right manager course is critical. It gets a little trickier here because so many of these thematic funds, they're not going to have five or 10 year track records. Nobody launched a fund about AI back in 2002. That was not a thing. And so in many cases, you're looking at newer funds, newer portfolio managers, lack of track record. So qualitative aspects can be really helpful, right? For example, does anybody in the investment team have actual industry experience? If you are investing in healthcare, for example, does anybody on the investment team actually have real industry experience in healthcare? So those types of qualitative points can sort of come to the fore a little bit more. And then finally, the last thing I'm going to say here is some really nerdy portfolio stuff, but focusing on dollar weighted returns versus time weighted returns. So what do we mean by that? Effectively it means that entry point really matters. And I've read a lot of material about thematic funds and in many cases, admittedly they can get bad press. And from what I can tell, usually bad experiences in thematic funds are because people are chasing a hot dot, right? Something all of a sudden is all over the news, people flood into these funds, valuations go out of control and people buy into the froth. And so if you're already buying into a theme that is super popular, the fund has really crazy flows that are out of control, valuations are high, it might be a red flag. So thinking about trying to identify these themes at a time where valuations and that focus on time, I'm sorry, dollar weighted returns, it still makes sense.
Brittany Damico: Alright, that was a lot of information. So I'm going to just do a quick summary of just some bullet points there. I think that might be helpful as the takeaway, but I think everything you said obviously is incredibly valuable. But the big picture here in terms of integration is ensuring suitability, determining that proper exposure, choosing the right themes, choosing the right managers, and then that focus on dollar weighted returns again, by identifying the red flags.
Dan Carreno: Well, yeah, when you say it like that, Brittany, it sounds really simple. I just used a lot of words. Sorry.
Brittany Damico: No, I think that was an amazing explanation.
Dan Carreno: Alright, well on that note with Brittany, so succinctly, summarizing my long diatribe, which again, I appreciate, probably a good time to start thinking about wrapping up. But before we do, we usually close out our podcast with our segment that we call ‘Around the Campfire’. And here is where we just share a couple of things from our lives that we've come across recently that are just interesting, and maybe not necessarily related to dollar weighted returns. So with that in mind, Brittany, what's come across your desk recently that has been interesting, inspirational, and fun?
Brittany Damico: So Seattle had the slightest little peak of potential spring. We had some sun, a little bit warmer weather, and I started thinking about getting back to the garden and planting and what I was going to do in terms of new plant buying for the spring. And I started doing a lot of research on terrariums. For anybody who's not familiar, it's a small nearly self-sustaining ecosystem. Usually in some sort of glass dome, incorporate some pebbles, some moss, some charcoal, some soil, and then a select variety of different plants you can make them. It's a fun, creative project and a little science project, and they're beautiful. You can use different air plants, you can do it with succulents. And I got really inspired and excited and I'm going to be creating probably more than I need for my house this summer in
Dan Carreno: Interesting. I know nothing about terrariums. Are there any animals in there? Do you put insects or anything? Or is it just all plants?
Brittany Damico: Well, I don't know. I'm sure insects may wander in there, but it's not intentional from what I've seen, it's more so you just spray it with water every once in a while and then the water goes down and it's filtered through the charcoal and then it's humid in the environment so it builds back up on the walls and then seeps back down. So it's this self-sustaining environment for these plants that are traditionally challenging to keep alive (in my own personal experience, I'm sure there's people who are better at it than I am). but it's just an interesting little science project that beautiful and creative.So I'm excited.
Dan Carreno: I like it. So my Around the Campfire is actually not a book that I've had a chance to read yet, but I listened to a podcast about it last week and heard the author speak. The author is named Christina Thompson, and the book is called Sea People, and Puzzle of Polynesia is the subtitle. And it's really all about how Polynesians were just these amazing ocean navigators and the fact that they were able to move from Asia through these different islands in the South Pacific into eventually find and populate the islands of Hawaii, which when you look at a map are just, I mean the term needle in a haystack doesn't even begin to describe it. I mean the sheer improbability of these folks just setting out in these outrigger canoes and navigating by the stars and being able to find these islands in the middle of the ocean and then populate them and settle there. I mean, just the sheer improbability of it is just really striking when you step back and think about it. So I listened to the author on the podcast. I'm definitely going to read the book, but I just wanted to share just how underappreciated a human achievement that was. So yeah, that was my Around the Campfire.
Brittany Damico: I love it. As a University of Hawaii alum, one fact I always like to share, and that I think most people know, but I always think it's interesting, is that Hawaii is the most isolated landmass in the entire world. So for people that long ago to find it is really special. That's really interesting.
Dan Carreno: One in a million. I don't know what the probabilities are, but it seems small. So anyway, we'll wrap it up there. For those that are interested in more information about us, about O-Six Impact Partners, you can go to our website, which is osixpartners.com. Of course, please feel free to reach out to us through the website, and we do appreciate you tuning in today, listening to this podcast. And we will be back soon with another episode of Rewilding Wall Street.
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