What are thematic stocks?

Introduction

‘Thematic stocks’ is a relatively new term and one that is rapidly growing in popularity, but which describes a long-established practice. The idea is simple: to bunch together different stocks according to a theme, which may be geopolitical, technological, geographical, sector-based, or even to do with financial metrics such as P/E ratio, and trade them together based on the predicted impacts of that theme. It is closely related to sector based investing, with the only real difference that themes are slightly more complicated and can include a wider range of stocks than a simple sector-based funds. CFD traders don’t use the kind of buy and hold strategies popular with either sector or thematic investing, but it is still worthwhile understanding this trend and its impacts on the market.

Large numbers of investors do use themes to guide their decision-making, which means stocks linked to popular themes may outperform their peers; this should be familiar from the tendency of companies or sectors mentioned positively in the news to see increased (usually upwards) volatility. Short term technical strategies may require adjusting if there is sustained upwards pressure in a sector or stock, so it is important to know what themes are currently being discussed in financial media. Cynics will look at thematic investing and see a new term for herd behaviour, but everything depends on both how accurate the perceived theme is, and how many high-quality trading opportunities it creates.

An example

Let’s say you take overvalued equity markets as your starting observation, and this leads you to develop a value theme, predicting that this historically abnormal situation will reverse and cheaper stocks start to outperform. To potentially profit from this view, you could trade exclusively value stocks, either selecting them individually or using a dedicated index that includes them based on a pre-set criteria. If you choose the latter, this means you are placing trust in the index provider that they have an accurate system for identifying value – this will normally be published, so you should be able to easily check – and that the index is regularly updated to reflect changes in market prices. The other kinds of theme, geographical or sector, are much simpler, since they do not change over the lifetime of the stock.

Thematic equities investors try to identify challenges or situations they view happening worldwide, and develop an investment strategy based on this theme, and the themes are as varied as their investors, though as noted above this is often shaped by the preferred topics of the financial press. Successful thematic investing works by identifying themes which may be profitable, and then applying filters to choose companies or sectors within that theme that may outperform the broader market.

What is a theme?

A theme can be simple or complex. If you believe that electric cars are going to grow significantly in market share, you likely also think demand for rare earth metals will increase due to their use in car batteries. Together these views form an investment theme of electronic vehicles, one which could result in any number of market events: increasing share price of electric vehicle manufacturers, increasing share prices of metals and mining companies, strengthening of rare earth metal exporting nations’ currencies, perhaps also a weakening of oil prices, or share price declines for energy companies. Any investment strategy aimed at targeting those predicted changes would qualify as thematic investing, even if it were as simple as buying shares in (or long CFDs on) Tesla stock.

Most thematic investing, however, involves buying multiple stocks, currencies, or commodity contracts, often helpfully packaged in a single index. There are many sector- or geography-based indices that can be used as a simple way of accessing specific price action. Let’s imagine another theme, interest rate rises, that views rate rises as a strong negative for equity markets and instead opens long positions in markets that retain low interest rates. Using only indices based on national stock markets you could generate a simple strategy where you go long in any national stock market that maintains low rates or decreases them, while opening short positions when a central bank announces a tightening cycle. This requires minimal screening of individual stocks and only simple, highly traded indexes for market access, but can still be used to profit from a technical theme. This type of strategy is possible using index CFDs, but traders must be aware of timeframes when using thematic or sector-based strategies, as thematic portfolios usually generate profits on long timescales.

Where do themes come from?

Themes emerge when there is real disruption to an industry, but there are further requirements for a theme to prove profitable. Firstly, it must be possible to trade, and secondly the broader market needs to become aware of it, but not until after you have opened your position. A fully priced-in trend may never become profitable, since the whole market will rotate into the relevant stocks or currencies as soon as it becomes apparent. This creates a tricky scenario where investors are looking for trends which either have further to run or that have only just been identified, with the second scenario unlikely considering market participants read the same websites and newspapers, and so receive the same financial information at the same time. What instead happens is that different market participants disagree on the importance of a given trend or the best way to trade it, so thematic investment strategies normally go over well-trodden ground but do so using an unusual method or put more weight on a specific theme than other traders. Finally, the possibility for contrarian investing exists wherever there is an emerging theme – these strategies can be highly profitable, but since they often involve shorting successful stocks, they also have much more room to go wrong.

Themes and indices

Highly specific themes, such as the technological disruption of a single industry, will require traders to identify individual stocks. But broader ones, let’s say trade conflict, could involve the use of simple geographic indices. If you believe that trade conflict will benefit countries with mixed manufacturing / services contributions to GDP and punish those which rely too heavily on imports, you can simply buy geographic thematic ETFs of e.g. Chinese stocks and trade them against European ones. The ability to trade indices has made this process much simpler. In fact, thematic investing only really took off for retail investors after index ETFs became widely available – most retail investors are not interested in or capable of screening hundreds of stocks to create a balanced portfolio of 30-40 positions. Thematic ETFs mean that investors can buy in to a theme without a minimum investment amount, broadening access to this type of investing.

Other than geographical ETFs, such as European equities or American equities, many indexes track the performance of a specific sector. Taking a particular investment theme; sustainability, automatization etc, you can find a matching index that will allow you to share in the expected growth of this sector. Index CFDs offer the interesting opportunity of ‘shorting’ ETFs, sharing in the negative price action of a given index. This is essentially impossible to do in equity markets, so CFDs offer great flexibility to traders who have a contrarian or negative view on a specific theme. The limiting factor in shorting ETFs is holding period, as thematic investing normally takes place over a timeframe of many months to several years, which is inappropriate for a CFD position, but CFD investors can still profit off a negative theme by biasing their technical strategies towards downwards moves.

Sector and thematic indices

CFD index traders can share in the prices of different themes by going long or short on a thematic ETF, which can be the same as a sector index like a ‘metals and mining’ ETF. Another simple example would be an equity index linked to the stocks of a single country such as the UAE or Germany. Different ways of dividing stocks are used to produce the thematic ETFs used in these strategies, so it is worth familiarising yourself with the basic categories.

Geographic

This is the simplest type of index. A UK stocks index will track a major national index like the FTSE, while a regional index based on MENA would track the largest stocks from across the broader region. These can be used for investment themes where a single nation or broader region is expected to out or underperform others. Geographic indexes normally include the largest companies by market capitalisation in a single territory or listed on a single stock exchange, and in some cases may not be an accurate reflection of the national economy. For example, the FTSE100 in London includes a large number of heavily weighted companies that produce most of their profits outside of the UK, notably banks, energy companies and miners, and so care must be taken to differentiate between performance of the national economy and the ‘national’ index.

Sector

Sector ETFs include industries and groups of industries like utilities, consumer goods, travel, or healthcare. They offer great flexibility for investors looking to trade themes that will impact a single industry, such as automatization or sustainability. Note that these indices include all the largest companies in that sector and will not differentiate based on financial health or business operations. Complex conglomerates can also be tough to categorise by sector; just as one example American car manufacturer General Motors includes an internal bank, but would not be included in a financial services index.

Thematic ETFs

Properly thematic ETFs such as ‘value’ or ‘growth’ indices filter the companies they traded based on certain characteristics. For example, a value thematic ETF might include all US companies which constitute a part of the S&P500 index that have a P/E ratio below 30, potentially meaning they are undervalued. Certain types of investors favour these stocks because they believe they have more long-term growth potential or are underpriced relative to the overall market. The obvious problem with thematic ETFs is that market prices change, so rebalancing is often required to keep the index in-line with market realities.

Themes and CFD trading

The obvious problem with thematic investor for CFD traders is the timeframe. Like all long equity strategies, thematic investing positions are held for months or years, often as part of a retirement portfolio. Since CFD positions are usually intraday or held over one or two sessions, sharing in the full price action of a thematic strategy is not possible. But that doesn’t mean we can’t still benefit from thematic principles: if you are convinced by the long-term case of a theme, you can use this to bias your short-term trading in a particular direction.

Trends are made up of smaller subtrends – prices do not move exclusively in one direction for many sessions, and within sessions there are always consolidations mixed in with the prevailing trend. In order for a positive long-term trend to emerge, the various sub-trends that make up the overarching trend must be stronger in one direction.

For example, if in six short-term trends, three uptrends and three corrections, the average upwards move is larger than the average of the downwards corrections, the overall trend is positive. This also means a technical strategy that creates buy or sell signals for short-term position taking in this market will perform better if it is biased towards buy signals rather than sell ones. This can be done by setting lower standards for a signal on oscillators like the RSI if the direction conforms with the overall trend, for example using 20 rather than 30 to indicate oversold while maintaining an 80 cut-off for overbought conditions to maximise the number of ‘buy’ signals.

Final words: risk management in thematic investing

Great care should be taken when using this or similar approaches, since it breaks the principle of trading on a single timescale. For this reason, some traders completely refuse to allow longer term market trends to influence their day trading, since it requires monitoring two different charts separately and making assumptions about how they will interact. If you do decide to use long term, thematic trends to guide your short-term technical strategies, make sure you protect yourself with adequate risk management  provisions, including close stop losses and a limited maximum position size.

Even if you don’t try and work thematic investing into your day trading strategies, it is useful to be well informed about it as it is one of the trends driving contemporary equities trading. Being aware of how long-term investors make decisions will help you better understand market behaviour, improve your general financial literacy, and help you make informed decisions in your CFD trading.