51

From indexes to insights:

The rise of thematic investing
Leading institutions say this new approach can deliver better
performance over the long term than their traditional methods.
Here’s how they’re putting it in place.

Vincent Bérubé, Over the past few years, a number of structural assets; they can also miss out on the liquidity
Sacha Ghai, and economic changes—a persistent bout of his- premium, which they collect by buying
Jonathan Tétrault
torically low interest rates, the polarization of illiquid long-term assets at a discount. Second,
growth between developed countries and relative-investment frameworks can lead to
emerging economies, and global deleveraging— an undesirable exposure to certain risks. Finally,
have had an impact on how institutional the very nature of the strategic asset-allocation
investors deploy capital. The “metabolic rate” process used to select benchmarks also holds
of the economy is also accelerating, with investors back. Strategic asset allocation is back-
industry dynamics evolving faster than ever and ward looking and fails to incorporate emerg-
profit pools shifting across value chains in ing trends and forward-looking perspectives on
many industries, thanks to unprecedented tech- the economy.
nological innovations.
To meet their absolute-return targets, many
In this challenging environment, many insti- institutional investors are therefore start-
tutional investors have started to question their ing to complement relative investing with a
traditional “relative investment” frameworks, number of “absolute focused” investment
which are structured around either adhering to or strategies, which can take the form of a greater
deviating from benchmarks and indexes. These allocation to illiquid asset classes, con-
frameworks often fail to achieve the specified rate centrated portfolios, or relationship-investing
of absolute return for three reasons. First, the strategies, among other options.
short-term focus of quarterly benchmarking works
against one of institutional investors’ great In addition, many are turning to “thematic”
advantages, their long-term investment horizon. investment strategies. That was the most
A zealous focus on the benchmark means intriguing insight we took from a series of
investors can miss chances to capture mispriced interviews we conducted in 2013 with about
52 McKinsey on Investing Number 1, Winter 2014/15

a dozen pension funds, sovereign-wealth funds, thematic investing but also in other strategies.
and other institutional investors. Broadly speaking, Third, it provides investors with a dynamic
thematic-investment approaches seek to capture, and flexible way to validate and express their
across asset classes and around the world, hunches by applying a forward-looking lens
the opportunities created by long-term structural to investment decisions.
trends and the medium-term cyclicality often
associated with these trends. Some investors have Investors have long been aware of thematic
deployed thematic strategies for years; they investing, but many thought it too complex to
appreciate the way these allow them to actively implement because of restrictive portfolio
manage risk and ensure that their capital is structures, risk limits, and the challenge of putting
deployed against the opportunities that best reflect in place the capabilities and processes needed
their investment convictions. However, many to develop truly distinctive investment insights.
institutions have not yet taken advantage of such In recent years, however, a number of investors
approaches. In this article, we outline a pro- have taken tactical and creative approaches to
cess that some investors are using to develop and implement some form of thematic investing,
execute thematic-investing strategies. usually as an addition to their overall investment
framework. Exhibit 2 illustrates four of these
Demystifying thematic investing approaches. It should be noted that newcomers
to the strategy tend to allocate a significant
Thematic investing requires a fundamental under- portion of their active risk budget to it. This gives
standing of the impact of long-term economic, them the same total risk budget as before—
political, and social trends on regions and sectors, though the risk profile may shift as a result of
which reveals investable opportunities. more concentrated and less liquid investments—
Thematic investors develop proprietary views but focuses it on opportunities that are more
on how the second- and third-order effects aligned with their convictions.
of structural trends will create hot spots or dis-
continuities in certain sectors and regions Embarking on the journey
where value and risk will be concentrated. This
is a big departure from relative strategies; The ability to fold a thematic strategy into a
Exhibit 1 illustrates some of the differences. relative-investing framework is good news for
investors that have held back because they
Adopting a thematic-investing approach can did not wish to completely overhaul their approach
yield three types of benefits for investors. First, it and their portfolio. But it still requires the right
allows investors to generate alpha at scale by research capabilities and a disciplined investment
focusing on investment opportunities in hot spots process. Our focus here is on the latter.1
where a significant amount of capital can be
deployed. Second, the more systematic investment A structured and rigorous approach is required not
process and in-depth research required for only to identify investable themes but also to
thematic investing builds a deeper understanding prioritize them. The following five-step approach
of the underlying drivers of value creation and does both and has been implemented by a number
risk; investors can use this knowledge not just in of leading thematic investors.
 From indexes to insights: The rise of thematic investing 53

MoInvesting 2014
Indices to Insights
Exhibit 1 of 2

Exhibit 1 Relative and thematic frameworks differ in several dimensions.

Relative framework Thematic framework

Asset allocation Asset classes as building blocks Sector and country exposure as
building blocks (matrix view)

Portfolio construction Weight of asset classes in Selection of themes, sectors, or

portfolio based on economic cycles regions across asset classes based
and market conditions on underlying market trends

Alpha generation Based on security selection relative Based on selecting groups of

to an index companies that will benefit from
long-term support of structural trends

Decision process Portfolio managers allocate capital Investment committee arbitrages

within defined mandates opportunities across themes

Investment performance Measured relative to an index Measured against an absolute

(typically on an annual basis) target or a risk-adjusted index (over
a 3- to 5-year rolling history)

Expertise Investment professionals with Investment professionals with a

experience in a given asset class combination of in-depth regional
or sector and sector experience across
asset classes

Research Typically occurs within portfolios, with Central group develops house views
research performed at security level on priority themes and opportunities
for institution

1. Consider the trends A few factors are important to consider when

Identifying the right trends to consider is essential. prioritizing trends. First, is the trend really
At this early stage, investors should hold structural, or is it conjectural or short-term in
broad internal dialogues to make sure all relevant nature? Does it have material implications for
trends are considered and to gain agreement the evolution of certain sectors or regions? Second,
on the rationale that will be used to prioritize and does the institution have the ability to generate
ultimately select some for more research. distinctive insights about that specific trend and
54 McKinsey on Investing Number 1, Winter 2014/15

MoInvesting 2014
Indices to Insights
Exhibit 2 of 2

Exhibit 2 Institutions are using a range of approaches to develop thematic-

investing strategies.

Approach Example

Lower commitment Develop thematic views within Use current risk limits in an international
to thematic strategy existing structure equity portfolio to increase exposure
to specific solar-module producers in
Develop and implement thematic
response to a renewable-energy theme
investments within the risk limits and
structure of the current portfolio

Put in place a thematic overlay Gain long-term exposure to wheat price

by investing in wheat futures as part of a
From the center, establish a thematic-
thematic-overlay portfolio
overlay portfolio or shift asset allocations
and increase their duration based on
house views on sector/geography

Create a single-asset-class Create and capitalize an equity portfolio

thematic mandate with a clear purpose of gaining long-term
exposure to renewable energy
Allocate capital to portfolios or
mandates with investment strategies
that rely on developing forward-
looking thematic views

Create a multiasset-class Create a portfolio—governed by a

thematic mandate multiasset-class committee—looking into
technology investments through a
Create a thematic fund to generate
combination of venture-capital funds,
the most attractive long-term
direct private-equity investments,
Higher commitment risk-adjusted returns by investing in
and public-equity positions
to thematic strategy various asset classes

identify sufficient investment opportunities? investor to a slowdown in Chinese consumerism.

Third, are research and investment professionals In a nutshell, investors must ensure that they
excited about the trend and willing to invest understand their true exposure—both direct and
time looking into it? indirect—to these trends before conducting
additional analyses and seeking greater exposure.
At this stage, investors should also develop a
robust view of the institution’s explicit and implicit 2. Move from trends to themes
exposure to the selected trends before adding Once key trends have been selected, investors must
more long-term risk to the portfolio. For instance, trace them through to the themes they produce,
an Australian investor may not own shares in typically the implications for a region or sector of
companies serving the rising middle class in China, interest. While the increased consumption of
yet a commodity-filled Australian equity food in emerging markets is a powerful trend, for
benchmark can significantly expose that same example, the changing market for dairy protein
From indexes to insights: The rise of thematic investing 55

in China is a theme that can be realistically theme? Are there other assets that might do well
investigated for opportunities. In our experience, if the theme materializes? Can potential invest-
the most attractive opportunities are found ments be made without running excessive risk?
when multiple themes converge and reinforce one
another in a specific region or sector and • What is the risk that the theme will not
when themes are expressed as discontinuities and materialize? The focus should be on counter-
divergences from common knowledge. vailing forces and what they might mean for a
potential investment. Investors typically
The identification of relevant themes depends on try to avoid binary outcomes, as they present
investors’ ability to rapidly identify the effects higher risks.
of a trend on revenues and profit pools in affected
subsectors. Making sense of vast amounts of • Does the institution have the capabilities to
information and identifying new economic differentiate itself? Factors such as distinctive
patterns in it is notoriously difficult. Most suc- knowledge, market access, a superior
cessful investors use external experts as thought understanding of the assets and their value
partners and sounding boards to supplement chains, and existing relationships with or
their internal knowledge. Our experience also privileged access to the right partners should
suggests that investors that can rapidly move all be considered.
from interesting trends to themes before trying to
identify specific investment opportunities • Does the theme fit within the current portfolio
move faster, get more impact from their research construction and investment policies?
investment, and develop more detailed insights. Choosing themes whose potential investments
can be easily integrated and monitored within
3. Select themes the investment structure enables investors to
Prioritizing themes is even more challenging, as move rapidly and focus on building capabilities
investors must make decisions based on imperfect rather than addressing governance issues.
information and diverging points of view within
the institution. The process can be time consuming Themes should be debated and prioritized by
and frustrating without the right approach but representatives from the investment, research, and
rapid and effective if appropriately designed. risk teams to ensure both the soundness of the
thinking and the alignment of the theme with the
To be successful at this important stage, institutions overall corporate perspective. This will prevent
typically agree first on simple criteria based on thematic portfolios from becoming vehicles
their risk/return profile and capabilities to invest for individuals to place large bets based on their
in a distinctive way. This boils down to four personal biases.
questions that should be asked about each theme:
4. Develop an investment thesis
• Is the theme investable? Investors should assess Once priority themes have been identified,
the high-level attractiveness of the theme and investors must form an investment thesis describ-
make sure there are ways to deploy capital against ing how and why value could be created from
it at the ground level. Are there companies these themes over time. This typically involves two
whose businesses are heavily exposed to the stages. First, investors develop an understanding
56 McKinsey on Investing Number 1, Winter 2014/15

of the value chains associated with a given theme, • a selection of investments that have both high
including the key players, industry dynamics, exposure to the theme and solid industry
and performance drivers. Next, they develop a fundamentals to offset the potential long-term
perspective on how industry dynamics will be nature of the investment and the risk that the
altered by the theme, forcing players to adapt and theme will take time to materialize
creating winners and losers.
• a clear investment approach—likely a set of
To be successful at this stage, investors must discrete investments, a portfolio of related assets,
first ensure that their thesis is clear, grounded in or a platform for operations and subsequent
objective facts, and based on themes that roll-up acquisitions
have a high degree of probability of materializing.
Second, they must find insights into business Finally, depending on the size of the portfolio and
systems beyond those most directly affected by the the number of investments it includes, additional
theme. For example, an investor looking into consideration might be given to the level of
the impact on the transportation sector of popula- correlation of the various assets, as well as the key
tions migrating to suburbs from large city sensitivities of specific thematic risk factors.
centers may determine that the best investment
opportunity will be in the manufacturers of
batteries that will power light trains rather than in
the transportation companies themselves or Thematic investing provides an alternative to
in the related infrastructure. traditional strategies—one that leverages the
greatest strengths of institutional investors while
5. Build the portfolio providing the opportunity to develop proprie-
With a clear investment thesis in mind, investors tary knowledge and informed opinions. By
can start a “scan and screen” process across understanding implicit sector exposures and then
asset classes to find the best ways to take a position determining where and how to invest based
in the theme. Several characteristics mark the on well-researched and debated themes, institu-
most distinctive investors at this stage: tions increase their chances of delivering
superior returns over time in an increasingly
•a
 clear perspective on the factors that will complex investment landscape.
lead to success (that is, a concrete understanding
1 Regarding research, we heard from our interviewees that
of how value will be created and in what
thematic investors are shifting the emphasis of their sector
time frame) experts from following companies to understanding sector
dynamics. They are also finding new ways to combine sector and
macroeconomic perspectives.
•a
 list of potential targets that is systematically
assessed against the success factors and monitored
over time to find the right entry (and exit) points

Vincent Bérubé ([email protected]) is a principal in McKinsey’s Montréal office, where Jonathan

Tétrault ([email protected]) is a director; Sacha Ghai ([email protected]) is a director in
the Toronto office. Copyright © 2014 McKinsey & Company. All rights reserved.