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The Case for Thematic Investing

This disclaimer informs readers that the views, thoughts, and opinions expressed in the text belong solely to the author, and not necessarily to the author's employer, organization, committee or other group or individual. You should not treat any opinion expressed on this article as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of an opinion.

In the last few months, I wrote few blog posts related to economic and political changes and categorized as 'Investment Insights.' In this blog, I would like to provide the rationale behind labeling them as investment insights.

One personal reason for not recommending specific stocks or investments is to avoid conflict of interest, as I work as an Investment Analyst for a Global Equity Fund. The motivation for writing about economic and political changes is because I have developed a keen interest in thematic investing.

The blog post will provide the case for thematic investing. Specifically, I would explore why researching thematically and creating buffers on the upcoming themes would be beneficial for all type of investors.

The Search for Good Companies.

When the information asymmetry was very high, an investor was rewarded well for finding good companies. The investor with more information, better intelligence, and sound wisdom were able the outperform the herd.

Asymmetric information, also known as "information failure," occurs when one party to an economic transaction possesses more excellent material knowledge than the other party.

Two developments made this strategy useless. Information asymmetry reduced and the wisdom of the average herd increased (by learning from the wise investors).

Embracing Second Level Thinking

Second-level thinking was based on the idea that first, you find good companies to invest in and evaluate whether it is overvalued or not. For example, thinking that Google is a great company, but it is over-valued. The first level thinker would buy Google irrespective of the valuation, while the second level would not. This strategy could be called value investing.

Historically, value stocks performed better than growth stocks. Value stocks have low prices in relation to their net worth, which can be measured by accounting book value. Growth stocks are relatively costly in comparison to book value.

Source: Asset Management: A Systematic Approach to Factor Investing

The strategy stopped working by 2002 & 2003. It is because the use of accounting book value to evaluate whether a stock is over-valued or under-valued. Due to a rise in the intangible economy, the relevance for tangible (book-value) reduced.

Some investors were able to adapt faster and others remained with the old methods. They under-performed the market.

The Rise of Factor Investing

Every one year, three years, five years, ten years, thirty years, fifty years & hundred years, several factors out-perform the rest of the market, in general. The factors could be of many types. Some of them broken down as follows:

1. Macro-Economic Factors

1. Economic Growth such as GDP Growth.

2. Inflation such as CPI.

3. Volatility.

4. Productivity Risk.

5. Demographic Risk.

6. Political Risk.

7. Technological Risk.

2. Fundamental Factors

1. Size Factors such as Small Cap. 2. Value Factor as discussed in the last part.

3. Firm Investment Risk.

3. Momentum Investing

In general, the performance of the asset class could be broken down into the following way.

The Benefits of Rebalancing

A portfolio manager who was able to do the following was able to outperform the market:

1. Find structurally growing factors. It could be intentionally or could be due to restrictions applied by clients. For example, if an investor is only allowed to invest in growth stocks and if they outperform, then the investor will be rewarded although due to luck.

2. Have second-level thinking as mentioned before to find idiosyncratic alpha.

3. Embrace rebalancing and diversification.

For example, if an investor has found outperforming factors and can rebalance based on second-level thinking will exceed the investor who has not diversified and rebalanced.

If you do the math, Second level thinker will out-perform first-level thinkers. The example is not a real-world example; the chart is used to demonstrate the theory.

The Rise of Third Level Thinking

The first level thinker thinks I will buy Google because it is a good company.

The second-level thinker says I will not buy Google because although it is a good company, it is over-valued.

The third level thinker thinks I will buy Google because the second level thinker feels that it is over-valued. The third level thinker believes that the second level thinker will be forced to buy the company in the future.

For example, although the growth stocks are expensive, they out-performed massively vs. value stocks in 2019.

Source: Eikon

In my theory, due to this phenomena, following thing has happened. It was supposed to be a gradual but the market has become very efficient (hehe).

So the following things an out-performer could do:

1. Keep on investing on out-performers and good companies. 2. Invest in under-performer or bad companies. 3. Sell everything and wait for Armageddon.

What an under-performer could do:

1. Keep on holding on under-performer.

2. Go momentum.

3. Pray to god.

The Need for Thematic Investing

The fundamental investors come from accounting and business background. They are a firm believer in Adam Smith, Warren Buffett, Spinoza, McKinsey & Company and they believe that everything else is just bullshit. Some of them breathe and dream stocks. In other words, their primary focus is on Fundamental Factors such as,

1. Size Factors like small-cap, large-cap.

2. Value Factor, as discussed in the second part of the blog.

3. Firm Investment Risk.

In this context, the risk is both positive and negative.

Some of them, such as portfolio managers or financial sector analyst like me, also focuses on:

1. Economic Growth, such as GDP Growth.

2. Inflation, such as CPI.

3. Volatility.

Some of them, such as technocrats and consumer sector analysts, also focuses on:

1. Demographic Risk.

2. Technological Risk.

The Quants focus a lot on momentum investing. They believe that their algorithms are faster, better, and more adaptable than humans.

Most of the investors have given up on political risk. The risk for some investors could be an opportunity for others. I believe that political risks are highly misunderstood and sooner than later, the tide will turn.


Thematic Investing is all about identifying inflection points caused by economical changes, demographic changes, technological changes, societal changes and political changes.

It requires a holistic approach and coupled with fundamental and Quant approach, the investor could massively outperform (or under-perform, if they identify wrong themes) the market.

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