`Thematic' investing is an increasingly popular long-term investment strategy. It aims to capitalise on long term social and economic trends that promise higher long-term revenue growth than the broader economy. Artificial intelligence, energy transition, and healthcare for an ageing population are currently highly popular themes.
One problem with thematic investing is the bandwagon effect in which companies re-structure their operations to give the appearance of being engaged in a popular theme. They usually do this in a bid to attract investors.
These companies normally have weak operations or they would not change industries so readily. In addition, they often manipulate their accounts to create an inflated impression of their involvement in a particular theme.
As a consequence, passive thematic ETF portfolios often have a lot of low-quality companies. Reflecting this, thematic ETFs typically have worse-than-average accounting risk scores than the border market. This feature makes the Transparently Risk Engine (TRE) especially suited to thematic investing, whether active or passive. The TRE, as amply noted elsewhere in this blog, is an AI-powered tool that measures companies’ accounting risk.
The best examples of the bandwagon effect were seen during the dotcom boom. At this time, dozens of Australian junior mining companies and small Chinese manufacturers, both with absolutely no background in the internet or eCommerce, adopted dotcom names and embarked upon “Internet-related activities” in a bid to raise capital.
When the dotcom boom turned bust, these companies, or at least those that survived, reverted to minerals exploration and manufacturing. Similar problems have occurred with 3D printing and AI.
Using Transparently to build a thematic portfolio
Based on this experience, several of our clients have found the Transparently system especially useful for investing in themes. One client, for example, was particularly interested in the intersection between AI and robotics.
To narrow their selection, that client turned to a popular ETF investing in this theme, the Robotics & Artificial Intelligence ETF (BOTZ) offered by Global-X. This ETF contains 49 companies. The median risk score of these companies is 58% versus the global median of 50%, suggesting above average accounting risk.
To simplify their task, the client eliminated all companies in the ETF with an accounting risk score higher than 50%. This narrowed the selection to a short list of 19 companies from which they eventually settled on two. Additionally, the client was seeking to diversify away from their overweight allocation to the US and was delighted to find that the filter provided by the MRA delivered a high number of Asian and European names.
Were we to embark upon a similar process today, the short list of companies with above average accounting quality would contain the names shown in Figure I. Extensive point-in-time analysis undertaken by Transparently has demonstrated that accounting quality can be a strong indicator of returns.
On this basis, this list of 18 companies could be expected to outperform the full list of companies in the ETF over time. We hasten to add the disclaimer that we’re not in the business of making stock recommendations and that past performance is never an indication of future returns. Our main goal is to endorse accounting quality as a factor investors should consider in portfolio construction.
Figure I: Automation and robotics companies with above average accounting quality
As readers would appreciate, it is far easier to reduce a list of 18 stocks to a handful of high conviction names than it is to reduce a list of 49 companies. We expect that an increasing number of clients will be using the Transparently platform to narrow down their thematic ideas using the Transparently platform.
This is certainly an area where AI augmentation should allow active managers to outperform passive thematic ETFs.
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