Cost Effective Thematic Investment

05/09/2014

Last week we looked at what thematic investment is. This week I will show you a cost effective way of managing your portfolio to the theme you have chosen. I have used the example of healthcare but it could easily have been any number of other themes.

The most cost effective method of following a theme is to invest in an exchange traded fund (ETF). This is a fund that tracks a market index. An index is just a list of companies that have been grouped together using some common factor. There are many different indices for example: FT-SE 100 which lists the top 100 companies in UK by market value or S&P 500 which lists the top 500 companies in USA by market value. Whilst these are the major induces quoted daily to us in the news, there are many other indices. Some indices track healthcare companies.

An example of a healthcare index is MSCI US IMI Healthcare 25/50 index which includes many household names but also medium and small U.S. companies in the health care sector, as classified under the Global Industry Classification Standard (GICS). This GICS sector is made up of two main industry groups. The first group includes companies that manufacture health care equipment and supplies or provide health care related services (such as distributors of health care products, providers of basic healthcare services, and owners and operators of health care facilities and organizations). The second group includes companies primarily involved in the research, development, production, and marketing of pharmaceuticals and biotechnology products. An ETF will have a strategy for replicating the target index or a sub-group of the index.

From the above an investor can see that they have significantly increased their level of investment risk, when compared to a more diversified investment strategy, as this is typically an equity based investment, restricted to a specific country and a specific sector.

The other factor to consider is that an index may be bias towards one sub-sector of another. For example the UK FT-SE 100 is heavily bias towards financial services and mining, so news effecting these sectors will have a proportionately larger effect on the performance of that index than on one which is not bias.

Another aspect of ETF investment that investors need to consider is the method of replicating the performance of the index. There are principally two methods: synthetic and physical replication. Synthetic involves the purchase of a series of financial instruments from an investment bank.  Physical replication involves purchase of the stocks within the index. Both have their potential problems, primarily: the investment bank may not meet its obligations and the cost of buying physical stocks tends to be more expensive and the performance relative to the index is often not as accurate.

However, this post was supposed to be about cost effectiveness and by way of example a typical ETF in this sector has total fees of between 0.15% and 0.50% per annum, significantly lower than most actively managed funds and these can be easily purchased via a stockbroker or an independent financial adviser.

I hope the above is useful. Please let me know if you have any questions or comments.