Thematic investing has been steadily gaining in popularity over the past years, helped by ETFs that provide readily available exposure to niche sectors from Cyber-Security to Medical Devices. Thanks to these ready-made portfolios, investors get to access a theme without the burden of stock selection.
One of the most popular themes of late is FANG, the almost universally known acronym for the shares of tech companies Facebook, Amazon, Netflix ang Alphabet (formerly Google). These high-growth stocks are lumped together in one theme whose success is evident in the numbers. Since December 2012, about the time the acronym was first introduced, an equally weighted portfolio of the FANG stocks would have outperformed the S&P 500 index roughly fourfold. The popularity of the theme has prompted the NASDAQ exchange to launch listed futures trading on its own FANG+ Index, enlarging the original group by an additional six tech stocks.
Trading in futures, and other portfolio-based instruments such as ETFs, tend to push up the correlation of their underlying stocks. Depending on popularity, buying and selling of futures or ETFs may dominate trading flows in the underlying stocks. On account of this, the average pairwise correlation of the FANG stocks has increased threefold over the past six years to 60%. As investors pay less and less attention to stock-specific factors, the only proverbial free lunch in investing, diversification, gradually disappears. Instead of a free meal, the investor is picking diversification crumbs off the floor.
A better way to invest in thematic ideas, and other portfolio strategies, is by leaving the one-size-fits-all approach of futures and ETFs behind. The next generation of thematic investments is powered by portfolio investing platforms. The sophisticated technology underpinning a digital platform allows for a richer individual investment experience in these three aspects.
Firstly, stock selection based on a combination of thematic and quantitative criteria. For example screening for a quantitative factor like profitability has the potential to raise the quality of the stocks in the portfolio. Secondly, smart weighting algorithms can lead to optimized risk-adjusted returns. And finally, trading at the individual company level allows for individual trade allocation and timing decisions. This caters to individual needs like tax optimization or cash flow requirements.
ETFs have paved the way for the masses to efficiently access investment themes. As in other industries, financial technology moves from mass production, in this context collective investing, to mass customization with a production unit of one. A thematic investment solution perfectly tailored to the individual and optimized to maximize returns for a given level of risk at the time of investing.