While most of the money invested in Exchange-Traded Funds (“ETFs”) are in funds tracking common benchmarks such as the FTSE 100 or S&P 500 stock market indices, a growing number of ETFs offer exposure to less traditional areas of the market. Among the most interesting of these come under the category of “thematic” investments, which can be useful in diversified portfolios, particularly when the economy may be slowing down and growth becomes more difficult for investors to find.
What is a thematic investment?
The idea of thematic investing centres around, unsurprisingly, a theme. You can think about this being a natural evolution of the sector classification scheme. But, rather than grouping companies based simply on what sector a company’s main business area happens to fall into, a theme aims to identify companies that have exposure to a long-term trend. Their sector is largely immaterial.
A theme can be just about anything, but they tend to be linked to a transformational technology or new emerging industry. With such a variety on offer, we believe investors should be careful in their selection. A theme worthy of consideration should, in our opinion, have certain characteristics. We believe it should persist over a long period (otherwise, it’s just a fad). It needs to be clearly definable with enough companies having exposure to the theme to offer diversification. The theme should create material opportunities for the companies involved and drive their profitability … and therefore provide potential benefits for anyone investing in the theme.
Clean energy is a good example
The case for clean and renewable energy is driven by the need to reduce global warming and is supported by pledges from the nearly 200 global leaders who signed the Paris agreement on climate change. The goal of reaching “carbon neutrality” is expected to come primarily from the decarbonisation of the energy sector and other energy-intensive parts of the economy. These will not be quick fixes but will require a huge amount of investment over many years, with interim targets to assess progress. For example, the UK aims to have 95% of its electricity needs provided by low-carbon sources such as wind and solar by 2030 and for the power grid to be completely decarbonised by 2035.1
In our opinion, government-led initiatives for developing the necessary technologies will be critical in the transition to more renewable sources of energy, and manufacturers and installers of wind turbines and solar farms are likely to be among the companies in demand for decades to come. Meanwhile, hydrogen looks to be the low-carbon answer for industries in which electrification is not possible or is inefficient, such as shipping, aviation, steel, chemicals and industrial heating.
The broad clean energy theme may include companies developing the technologies, manufacturing all the necessary components, as well as those financing and managing the facilities, building offshore wind platforms and the under-water cables, and possibly any other company that stands to benefit from the growth of renewable energy. Another option would be to focus on one type of clean energy, such as the growth of wind or hydrogen energy, and target only those companies.
Gaining exposure to your chosen theme
Once you have identified a worthwhile theme, another important question is how to gain exposure to the theme most effectively. Many of the thematic ETFs are passive investment vehicles, either aiming to track an index from one of the large index providers such as MSCI, FTSE or S&P, or an index constructed by a firm that specialised in the theme.
Because themes are often driven by the growth of a new technology or industry, expertise is needed to fully understand not only the technology itself but also the companies involved and how to value the potential of their exposure to the theme. Although some large companies will be involved, there are also many smaller companies that could be potentially interesting, which again points to the need for someone who really knows and understands this space very well.
California-based WilderHill launched the world’s first global clean energy index in 2004 and is one of the most experienced providers of clean energy index solutions.
- The WilderHill Wind Energy Index is comprised of around 50 stocks, including companies involved in wind farm development, raw materials, wind technology innovation and the smarter grids needed for generation, storage and distribution.
- The WilderHill Hydrogen Economy Index is also comprised of around 50 stocks and includes companies involved in hydrogen fuel cells, green hydrogen, hydrogen generation, storage, innovation and hydrogen used in transportation.
These two indices attribute an equal weighting to each of the companies, as opposed to some other indices that assign weights based on the size of the company. These two WilderHill indices should also comprise a reasonable spread between large, medium-sized and smaller companies.
Why wind and hydrogen?
The cost of generating electricity on a utility-sized scale from onshore and offshore wind farms has fallen substantially over the past 10 years. Onshore wind is now among the cheapest sources of renewable energy and, in many parts of the world, it is now more cost-effective than a power plant using the cheapest available fossil fuel.2 Wind turbines are extremely effective at harnessing energy and converting it into electricity. For example, you can power a house for an entire day with just one rotation of the largest wind turbine, and the larger turbines planned for future builds should power more.3
The 93.6 gigawatts (GW) of wind capacity added to electricity power grids in 2021 brought the total global wind capacity to 837 GW.4 That’s not even close to where we need to be. The International Renewable Energy Agency (IRENA) and the International Energy Agency (IEA) estimate more than 8,000 GW of wind capacity will be needed by 2050 for the global economy to reach “net zero” in carbon emissions. If that happens, wind will generate more electricity than any other energy source.
Hydrogen is at an even earlier stage of development than wind and solar, but we believe it will be just as crucial for decarbonising industries in which electrification isn’t feasible. For instance, electricity is not an efficient heat source, but hydrogen could be the green solution for industrial and residential heating as well as in the chemicals and steel industries. Hydrogen also holds the key for shipping, aviation and long-haul vehicles including lorries and buses. When released, hydrogen produces no harmful greenhouse gas emissions.
You will see hydrogen described by colour, according to the process used to produce the hydrogen. While there are many others, we are only interested in two:
Green hydrogen is arguably the best solution from an environmental perspective but is currently the most expensive. It uses electricity produced from renewable energy such as wind or solar to drive an electrochemical decomposition of water. As a result, the process is entirely carbon-free.
Blue hydrogen involves a process known as steam reformation whereby natural gas and steam are combined, producing hydrogen but emitting carbon dioxide as a by-product. Carbon capture and storage (CCS) technology is used to trap those otherwise harmful emissions. This is often referred to as low-carbon hydrogen and could be important for meeting near-term energy needs.
We believe clean energy could be one of the most significant themes available to investors. For those companies exposed to decarbonisation efforts and the growth of clean energy technologies, government-led initiatives will fuel opportunities for decades to come. For many European countries, the danger of relying too heavily on fossil fuels has become painfully evident this year, which should encourage the EU and local governments to accelerate plans to increase wind and solar capacity, as well as develop hydrogen solutions. Investors can gain meaningful exposure to these themes through an ETF that invests broadly across the various clean energy technologies or ones that focus on specific technologies such as wind or hydrogen energy.
1 Department for Business, Energy and Industrial Strategy, October 2021
2 Source: Bloomberg NEF, June 2022, based on the cost of new-build projects in the first half of 2022.
3 Source: US Geological Survey, an agency of the US Department of the Interior, based on the electricity usage of average US home (893 kWh per month).
4 Source: Global Wind Energy Council, April 2022.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Investments into the clean energy sector are considerably exposed to investment trends focused on environmental factors and may have sensitivities towards ESG-related government regulations and tax implications.
Investments in small-sized companies tend to have a higher degree of risk than larger companies.
This is marketing material and not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.
Data as at 30 September 2022 unless otherwise stated.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.
This material has been communicated by Invesco Asset Management Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority.