THEMATIC INVESTING: A NATURAL WAY OF THINKING ABOUT PORTFOLIOS

LPL RESEARCH PRIVATE CLIENT THOUGHT LEADERSHIP DISRUPTIVE INSIGHTS THEMATIC INVESTING: A NATURAL WAY OF THINKING ABOUT PORTFOLIOS October 2015 THEMATIC INVESTING ALLOWS INVESTORS TO MOVE AWAY FROM THE STYLE BOX MENTALITY, AND INSTEAD FOCUS ON BROAD TRENDS THAT MAY IMPACT SOCIETY, THE ECONOMY, AND BUSINESS IN THE FUTURE. ARE STYLE BOXES GOING OUT OF STYLE? Style boxes, a simple method of classifying investments based on size (small, medium, or large) and basic characteristic (value, core, or growth), have become a common tool over the past couple of decades as an easy way for investors to visualize their investment options. However, the simplicity of style boxes also creates limitations that may lead investors to overlook meaningful exposure to the themes that could shape the economy, and thus the markets, over the coming years. Imagine an investor on the golf course, talking to her friends about a new stock that she purchased. Is she likely to be talking excitedly about the fact that it falls into the mid cap value style box, or more likely to be explaining how the company she bought is on its way to becoming an industry leader? This example illustrates one of the major disconnects between investors and the financial industry. The industry has been conditioned to think in terms of style boxes, while investors usually think in terms of themes [Figure 1]. 1 THE FINANCIAL INDUSTRY AND INDIVIDUAL INVESTORS LOOK AT INVESTING DIFFERENTLY Large Value Growth Small Industry View Investor View Source: LPL Research 10/13/15 01

Thematic investing allows investors to move away from the style box mentality, and instead focus on broad trends that may impact society, the economy, and business in the future. Although they ve recently increased in popularity, themes have always been present in investing. For example, an investor who wants to focus on smaller, technology-oriented companies with the hope of investing in the next breakthrough innovation may choose a small growth fund that fits neatly in the traditional style boxes. However, the fund may be invested in multiple sectors and industries and not focused on the investor s desired theme. And even if it is, the investor may be pigeonholed and missing out on mid cap or large cap technology companies that may grow as fast or faster. An investor following a thematic approach may instead opt to purchase a mix of mutual funds or exchangetraded funds (ETF) that focus on the monetization of cybersecurity, cloud computing, and other internet technologies that the investor believes will be a part of everyday life in the future. The style boxes may still be used as a tool to determine portfolio characteristics, but given that the investor isn t tied to a specific investment style, he is free to choose fund managers that have the flexibility to focus on the sectors and industries that best fit with the selected theme. Figure 2 illustrates this concept with two potential themes, which are also discussed in more detail in the following section. Investing in mutual funds and ETFs involves risk, including possible loss of principal. There is no guarantee that any strategy will be successful. 2 A DIAGRAM OF TWO POTENTIAL THEMES THEME THESIS IMPLICATIONS/ OPPORTUNITES HEALTHCARE SERVICES AGING POPULATIONS Population growth has slowed and share of 60-year-olds (and older) in many developed economies (such as Germany and Japan) is growing rapidly. MEDICAL DEVICES LEISURE & ENTERTAINMENT Growth of housing stock has not grown to match population since end of recession. Housing construction and sales remain subdued relative to long-term history. HOME BUILDERS NEW HOUSING Interest rates may rise only gradually and remain low. Demand for housing likely to remain elevated. Regional banks may benefit from increased mortgage activity REGIONAL BANKS CONSUMER DISCRETIONARY & RETAILERS Source: LPL Research 10/13/15 02

THEME: AGING POPULATIONS Aging populations is a good example of a theme, and has multiple investing implications. Populations, especially in developed nations, are getting older and will demand or require specialized goods and services. According to U.S. Census Bureau data, the percentage of the U.S. population over the age of 65 was 13.7% in 2012. By 2050, it is expected to climb to 22.1%. Statistics for other developed nations such as Germany and Japan reflect an even greater shift to an older population. A few investable implications for this theme include healthcare services, medical devices, and leisure and entertainment. Healthcare services should benefit from an aging population, as usage generally increases with age. The National Institute on Aging has indicated that the increasing share of elderly population is pushing overall healthcare spending higher in the developed world. A 2010 study by the Centers for Medicare & Medicaid Services seems to confirm this, finding that U.S. per capita healthcare spending for those over 65 was nearly 200% greater than their working age (19- to 64-year-old) counterparts. Medical devices will likely benefit for the same reason, and also from the independent nature of the Baby Boomer generation, which may mean more of an emphasis on aging in place in their own homes rather than moving to assisted living or skilled nursing facilities. An older population also means a greater percentage of retirees with additional leisure time; thus, companies catering to leisure and entertainment may also stand to benefit, all else equal. Figure 3 shows the performance of the aging populations theme, each sub-theme, and the S&P 500 over the past five years. 3 PERFORMANCE OF THE AGING POPULATIONS THEME AND SUB-THEMES OVER THE PAST FIVE YEARS $26,000 Aging Population Leisure Products Healthcare Equipment Healthcare Services S&P 500 24,000 22,000 20,000 18,000 16,000 14,000 12,000 10,000 8,000 10 11 12 13 14 15 Source: LPL Research, FactSet, Standard & Poor s 10/13/15 Aging population theme is 1/3 S&P healthcare services subindustry, 1/3 S&P healthcare equipment subindustry, and 1/3 S&P leisure products subindustry. Data as of 08/31/15. 03

THEME: NEW HOUSING The housing market has bounced back from the Great Recession and is another theme that provides several opportunities. Although prices have increased, fundamental support remains strong in our view (a previous Thought Leadership publication, Are the GSEs In-Line for Another Bailout? explores the housing market recovery in more detail). Several drivers are likely to help the housing market, including growth in housing units, which has lagged the pace of household formation since the end of the Great Recession; subdued levels of construction relative to history [Figure 4]; and the likelihood that interest rates may rise, but only gradually, and still reflect a historically low interest rate environment for the foreseeable future. Demand, therefore, may remain elevated relative to supply, a recipe for strength in existing home sales and new construction. Potential beneficiaries of the new housing theme include not only home builders, but also home improvement retailers, as new homeowners remodel and outfit their new homes with furniture, appliances, and other furnishings; and regional banks, which may benefit from strength in mortgage demand. Figure 5 shows the performance of each sub-theme in housing over the past five years. 4 2450 1950 1450 950 450 90 HOUSING STARTS REMAIN BELOW THE LONG-TERM AVERAGE Housing Starts (Thousands) 95 00 05 Source: LPL Research, Haver, Census Bureau 10/13/15 Data as of 08/31/15 10 Average 15 5 PERFORMANCE OF THE NEW HOUSING THEME AND SUB-THEMES OVER THE PAST FIVE YEARS $50,000 New Housing Home Builders Home Improvement Retailers Regional Banks S&P 500 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 10 11 12 13 14 15 Source: LPL Research, FactSet, Standard & Poor s 10/13/15 New housing theme is 1/3 S&P home building subindustry, 1/3 S&P home improvement retail subindustry, and 1/3 S&P regional banks subindustry. Data as of 08/31/15 04

DEFINING ADDITIONAL THEMES So what should investors look for when trying to develop their own themes? The following criteria can help to provide a framework: Investable Based on broader societal, economic, and business trends Longer-term in nature (two to five years, and longer is better) Investable The ability to invest in a theme may be an obvious criterion, but there are numerous examples of would-be themes that may not be investable. One example is the commercialization of drone technology. Countless news stories have suggested that drones have the potential to change the world through avenues such as delivery services, and many investors have rightly asked themselves if there is a way to capitalize on this new trend. Several publicly traded companies are either testing or developing drones for delivery or other purposes, but drones aren t generally the main focus of their businesses. They may represent a very small portion of overall profits in the future, or simply a way of managing expenses rather than serving as a revenue generator. Thus, although it may be possible to invest in companies that are pursuing this technology, the performance of these companies is likely to be driven by other business lines, meaning investors may not end up with the exposure they desire. Based on Broad Societal, Economic, and Business Trends Broader-based themes have more potential investment opportunities than narrow themes. An example of a theme that may be defined too narrowly would be focusing on pharmaceutical companies, based on the idea that an aging population will likely require more prescription medicines. Expanding to a broader theme of aging populations would bring in additional investment options, such as senior housing, home health service providers, and sources of leisure activities. Longer-Term in Nature Society doesn t change overnight, and companies driving change may go in and out of favor over time. Investors need to keep this in mind when selecting themes and sub-themes, and should try to avoid short-term ideas that may go out of favor quickly and never recover. The performance charts of the aging populations and new housing themes both illustrate this point. DOES DIVERSIFICATION MATTER FOR THEMATIC PORTFOLIOS? Just as diversification is important in the style box world, it is also important in thematic investing. When a single theme is applied to an existing portfolio, diversification may mean using several subthemes made up of one or more individual positions, in order to potentially reduce volatility. If several themes are combined to create a purely thematic portfolio, diversification can be taken a step further by investing in multiple high-level themes, each with several sub-themes. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not ensure against market risk. 05

BRINGING IT ALL TOGETHER The example of the investor on the golf course highlights what can, at times, be a significant disconnect between the financial industry and investors. The industry tends to talk about investments in terms of investing style, while investors talk in terms of stories the why behind the style choice. Thematic investing offers a process that can overcome this disconnect, while still allowing investors to construct a diversified portfolio. Investors may choose to fine-tune their portfolio using the traditional style boxes, but rather than simply making sure all of the boxes are checked, this portfolio will be better positioned to access the themes that may impact and shape the economy and markets moving forward. LPL Research is exploring the possibility of adding a thematic portfolio offering in the future, so stay tuned for additional information on this topic. IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The purchase of certain securities may be required to affect some of the strategies. Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market. Because of its narrow focus, specialty sector investing, such as healthcare, financials, or energy, will be subject to greater volatility than investing more broadly across many sectors and companies. Investing in real estate/reits involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained. INDEX DEFINITIONS The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. This research material has been prepared by LPL Financial. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity. Not FDIC or NCUA/NCUSIF Insured No Bank or Credit Union Guarantee May Lose Value Not Guaranteed by Any Government Agency Not a Bank/Credit Union Deposit RES 5234 1015 Tracking #1-428810 (Exp. 10/16) 06