Morningstar - Q1 2023 - 33

Pros and Cons of Active and Passive Approaches to Thematic Investing
When it comes to thematic investing, the
dividing line between active and passive is less
distinct than elsewhere. Ultimately, in
deciding how to select and weight holdings,
even passive or index-based strategies
are making large active bets against peers and
the wider market. That said, each approach
does have its pros and cons:
The Pros of an Active Approach
gManagers have greater flexibility than they
would at an index strategy.
gManagers can constantly monitor exposure
to the theme as it evolves, buying and
selling holdings as they rise or fall in relevance
to the chosen theme, and they can
overweight better holdings and/or exclude
poorly run businesses.
gManagers can incorporate a broader variety of
data sources and analytical tools to inform
their security selection and weighting decisions.
gManagers can invest in less-liquid, less-seasoned
securities than most passive peers. This
might allow them broader and earlier access
to companies positioned to capitalize on the
theme relative to indexed peers.
The Cons of an Active Approach
gActive thematic funds are more expensive than
their passive peers.
gThere is scant evidence that, as a group, active
managers use their flexibility to great effect.
The Pros of a Passive Approach
gTracking an index is rigid.
gTracking an index results in relatively lower fees
and greater transparency than an active strategy.
Because the strategy is codified, the monitoring
costs of passive strategies tend to be lower, too.
The Cons of a Passive Approach
gRigidity can also be a disadvantage. Thematic
indexes rely on fixed rules to select and
weight stocks. As themes and datasets evolve,
an index approach may be at risk of being
caught flat-footed.
gThe liquidity constraints that underlie the
construction of a robust index also mean that a
passive fund is restricted in how far it can
reach down the market-cap ladder in order to
search for relevant investment opportunities.
How Passive Funds Track a Theme
There is no single theme beta. Even passive funds
that track similar themes can adopt very
different approaches to selecting and weighting
holdings. Index-tracking thematic funds
use one or more of the following approaches
to selecting holdings:
Revenue
Most passive funds select stocks based on the
revenue that companies derive from a defined
set of activities. For example, an alternative
energy fund may select constituents based on the
percentage of revenue tied to solar, wind,
or wave power. This approach is logical and simple.
One potential downside is that it is primarily
backward-looking. This can leave investors gazing
in the rear view mirror, which may be particularly
problematic in rapidly developing areas
such as technology, where projected revenue
can exceed current revenue. To remedy this
situation, some strategies employ forecast revenue
instead, which adds a layer of uncertainty.
Committee
In some cases, a committee of experts meets to
decide which stocks align with the desired theme,
supplementing quantitative inputs like revenue
sources with a more qualitative assessment.
The committee can offer a " soft touch " approach,
which allows the strategy to adapt to meet
changes in the investment landscape.
On the other hand, it means the strategy is
reliant on the judgment of the committee and is,
therefore, opaque. Committees like this
usually sit once or twice a year and can be slow
to react to market changes. The committee
is often lent credibility by being overseen by
specialist organizations (like a trade association)
or well-known experts in their fields.
Other Approaches
Some index providers rely on cutting-edge
natural language technology to scrape other data
sources, such as marketing documents, academic
papers, and patent submissions. The advantage of
this approach, particularly in the fast-moving
world of technology, is that it is forward-looking.
There are also claims that this approach can help
generate an informational edge.
A downside is the black-box nature of these
strategies. Some selection processes that
rely on natural language processing can be gamed
by companies hoping to opportunistically
raise capital.
How Passive Thematic Funds Weight Holdings
An index strategy can also differentiate itself by
how it weights holdings.
Modified Market Capitalization
Given the narrow nature of most thematic funds'
selection universes, a standard market-capweighting
approach will often result in large
weightings in a small handful of stocks. To correct
for this, most indexes have single stock, sector,
or geographic weighting caps and/or floors.
Tiered/Thematic Purity
Some funds implement more-complex tiered
or graded weighting approaches that prioritize
firms that offer greater exposure to the
underlying theme. For example, a specialized
robotics company such as U.S.-based
iRobot IRBT would be given a higher weighting
than a huge conglomerate like Siemens SIEGY,
for which robotics forms a smaller part of
overall operations.
Equal Weight
Another popular solution to the single-stock
concentration problem is to equally
weight constituents. Both modified-market-cap
and equal-weight approaches balance the
influence of larger companies and result
in a small-cap bias and in some cases raise
questions surrounding liquidity.
33
https://www.morningstar.com/stocks/xnas/irbt/quote https://www.morningstar.com/stocks/pinx/siegy/quote
Morningstar - Q1 2023

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