Thematic investing avoids the 'low-risk', index-hugging approach that saw more money invested in speculative plays like Colt Telecom than in BA, M&S, Whitbread and British Land combined
Thematic investing depends on change. It captures change and it exploits the power of change. The most important aspect of thematic investing lies in understanding this change and translating it into a coherent investment strategy. There is nothing more powerful than an idea whose time has come.
Themes do not have to be complex. Indeed, they are usually quite straightforward, reflecting changes in our lifestyles and in our economies. These changes create demand for products or services that can solve problems or offer new ways to satisfy needs.
Themes tend to have the following characteristics:
• They are dynamic
• They are flexible and they transcend countries, sectors and industries
• They are logical and easily understood
• They often display little correlation with one another
With Japan and most of Europe in or close to recession throughout the 1990s and the US slowing sharply recently, the global economy is experiencing its slowest period of growth for many years.
However, it is for secular rather than cyclical reasons that thematic investing is the appropriate investment style. The global economy has been slowing throughout the latter part of the 20th Century. Global nominal GDP (real GDP growth plus inflation) is growing more slowly than at any point in the past 30 years and the three largest economies in the world have simply stopped growing, on an equal weighted basis, for the first time in at least 40. In this extraordinary environment, investors are reassessing the traditional approach of constructing portfolios around the indices for the simple reason it is unlikely to deliver acceptable returns.
In an environment of excess supply, corporate profitability invariably suffers. The most proactive, dynamic and efficient organisations may succeed but if they do it will be at the expense of their weaker peers. Gains in market share therefore become the means by which companies grow their businesses.
Global investment themes are used to identify companies that can grow their earnings in an environment in which little or no growth exists. We try to differentiate between companies that deliver earnings growth through superior revenue growth (pricing power, survival of the fittest) and those that deliver earnings growth through cost control (restructuring, efficiency and automation). However, the key point is that profits rise faster than the market as a whole and that those earnings are re-rated by investors.
Having identified the best companies, the second, crucial, aspect of the thematic process is portfolio construction. In a difficult macro environment for equity markets, one simply cannot afford to deliberately buy bad companies. Amazingly, this is precisely what the majority of the fund management industry does ' it is called underweighting ' and it happens when a stock is bought to a level below its weight in the benchmark.
This approach is not justified on the basis of improving returns but, rather, on reducing 'risk'. One is tempted to ask what risk these people are afraid of ' the risk of poor performance or the risk of losing the mandate? In our view, even a 'successful' strategy of underweighting companies that subsequently perform badly cannot be justified because it still involves using clients' money to buy companies that one not only thought would do badly but that one hoped would do badly.
In its purest form, the thematic approach does not allow fund managers to buy underweight positions in stocks ' such stocks are simply not bought at all. We certainly don't feel obliged to buy companies we find unattractive simply because they are large components of the indices. Unfortunately, many of our thematic peers are not willing to 'risk' such an approach. They do little more than use thematics to identify the stocks they want to over-weight and they market-weight or under-weight the rest. This is essentially the same as the traditional approach, in that they deliberately buy companies they hope will do badly.
Many consultants and financial journalists recommend index trackers on the basis that low tracking error means low risk. I wonder how many of those commentators realised in March 2000 that they would have had more money invested in Colt Telecom than in British Airways, M&S, Whitbread, Thames Water, WH Smith, Pilkington, British Steel, Rank, Tarmac, Associated British Ports and British Land combined.
Was it really low risk to have more money in Vodafone than in the entire UK food, drink, tobacco, electricity, gas, water, aerospace, defence, steel, engineering and construction sectors combined? The issue was not and is not whether these companies are attractive, it is whether investors should have regarded 33% as a neutral, risk-free, exposure to the most volatile area of the market simply because the index was similarly weighted.
The beauty of the thematic approach is that changes to the indices do not require changes to our portfolios. Unlike advocates of the traditional approach, thematic investors are not required to hold more or less of a stock simply because its weighting in an index is rising or falling. We are not required to raise the risk profile of our portfolios just because the risk profile of the index is rising.
Equally, we are not prevented from buying stocks before they enter the indices. The 1996 launch of Sarasin's Global Equity Theme Fund, EquiSar, is a case in point. With the technology sector absent from the FTSE 100 index and barely figuring in the US (6% of the S&P 500), we recognised its potential and introduced global technology as one of four key global investment themes with a neutral weighting of 25%. At the beginning of 2001, with the sector dominating indices and investors attention, we removed the theme entirely. Few traditional investors enjoy such flexibility.
The world consists of thousands of companies each working towards their own goals and all, to a greater or lesser extent, seeking to generate value for shareholders and employees alike. Some find themselves swimming against a strong tide of global competition, pricing pressure and technological change. Others find themselves burdened with a management team that is unable or unwilling to acknowledge the speed at which its marketplace is changing. Some, however, are at the 'sweet spot' of the corporate landscape enjoying a proactive, shareholder-friendly management team and a business model that is not only appropriate for the new millennium but in fact goes some way towards shaping it.
Just as companies evolve, so too must the fund management industry. Theme selection rather than country selection will increasingly be recognised as the most important decision to make. Superior performance will come to those that can identify the major themes and the companies most likely to benefit from them ' companies operating in their own 'sweet spot'. Buying poor companies because they are heavily represented in the indices will guarantee mediocrity. Apart from the moral implications of this approach, the economy is simply too weak to allow oneself such luxuries.
Most funds deliberately buy companies when they underweight the benchmark.
Pure thematic investment does not allow managers to buy bad companies.
Thematic investing relies on understanding changes within the economy.
Investors are reassessing the traditional approach of constructing portfolios around indices as it is unlikely to deliver acceptable returns.
No preferred charging model
To 1,552 families and businesses
HL and Liberty SIPP slowest
Lifetime and annual allowances