Quality investments: The key to sustainable thematic returns

Equity funds that focus on specific themes, such as technology, healthcare or clean energy, can vary significantly in their returns. These variations can be attributed to differences in the performance of the underlying themes, the timing of investments and the selection of specific securities within each theme. For example, during periods when technology stocks outperform the broader market, technology-focused thematic funds often generate higher returns. Conversely, funds that focus on themes that underperform, such as traditional energy stocks in times of transition to renewable energy, can fall behind. This divergence highlights the importance of theme selection and the dynamic nature of market conditions and sustainability initiatives impacting thematic funds. But even within the same investment theme, product returns can vary widely, as the example of ‘Energy Transition’ in the chart below shows.

Several triggers for differing returns

The different returns of the thematic equity funds can be attributed, among other things, to the different investment styles of the fund managers, such as growth, value and quality approaches. Growth-oriented funds generally invest in companies that are expected to achieve above-average sales and earnings growth, often in rapidly expanding sectors such as technology or biotechnology. These funds can achieve high returns in bull markets. In downturns, however, when highly valued shares are increasingly affected, they can correct more sharply. In contrast, value-oriented funds focus on undervalued stocks that are trading at prices below their intrinsic value and are often found in more established sectors. These funds tend to perform well when investors focus less on the revenue and earnings growth of companies and more on the valuation characteristics of the shares. On the other hand, they can lag behind in speculative growth phases. Finally, quality-orientated funds, which focus on companies with a solid financial position and stable earnings, try to balance the volatility of growth and the conservatism of value investing. This leads to different return profiles that reflect the strategic orientation of robust, well-managed companies. In practice, the different approaches can be combined.

Return on capital as a possible quality feature

Quality-oriented shares are often characterised by an above-average return on invested capital (ROIC). It is calculated as net operating profit after tax divided by the invested capital. A high return on investment can be a sign that a company is utilising its resources efficiently in order to generate high returns. It also reflects its competitive advantage, operational efficiency and sound management practices. For example, companies such as Apple and Microsoft that consistently report a high return on capital are often considered quality investments as they have historically been able to generate significant returns on their investments, emphasising their long-term financial health and strategic skill. Other notable quality characteristics in addition to a high return on capital include low financial leverage, a competitive business model and an attractive ESG profile.

More resilient companies

Companies with a high return on capital tend to be more resilient to economic downturns, as their efficient operations and strong balance sheets provide a buffer against market volatility. This resilience can translate into more stable and consistent returns over time, reducing overall risk for investors. In addition, quality stocks often have sustainable competitive advantages such as high brand recognition, a loyal customer base and innovative capabilities that contribute to their long-term growth potential.

Empirical studies such as those by Asness, Frazzini and Pedersen (2019) have shown that portfolios with high-quality stocks tend to outperform portfolios with lower-quality counterparts over the long term, which is a compelling argument in favour of a quality-oriented investment strategy.1 Those focussing on small caps from a thematic perspective will also find that high quality small caps have outperformed the small cap asset class by 1.8% per annum in the dominant US market since 1976.2 This advantage is all the more important when you consider that size matters in the context of thematic equities. Small and mid-cap stocks, which are currently undervalued, often have a higher thematic exposure than large caps due to their growth potential, market orientation and strategic flexibility.

Small and mid-caps are usually in earlier growth phases, operate in niche markets or emerging industries and can adapt quickly to new trends and technologies. They are less diversified than large caps, so they are more directly linked to specific investment themes. Finally, we also find evidence in our own analyses that quality pays off. Finally, the Morningstar ‘Sector Equity Ecology’ peer group, which includes numerous climate-related funds, shows that the current three-year performance of the products correlates positively with the return on invested capital (ROIC) of the products (see chart below).

Quality-orientated funds demonstrate robust investment approach

The returns of thematic equity funds are inherently divergent due to the different performance of the underlying themes. The distinction between growth, value and quality approaches exacerbates this divergence, with each style having unique risk and return characteristics.

Quality-oriented funds, which focus on companies with high returns on capital, offer a robust investment approach that often leads to more stable and superior returns over time. By emphasising financial health, operational efficiency, competitive advantages and an attractive ESG profile, quality investing offers a compelling argument for investors looking for continuity and consistent performance in their portfolios.

As active thematic investing evolves, a focus on stock selection and quality could play a critical role in navigating the complexities and opportunities in this dynamic investment landscape.