Thematic investing has increased in popularity since the 1990s with many new players jumping on the bandwagon. But what approach should fund managers be taking to get the best out the market?
Sarasin has been associated with thematic investing for much of the 1990s and has seen the approach gaining widespread acceptance in the UK. In this respect, the increasingly vocal support of independent rating agencies such as Standard & Poor's can only help our cause.
Unfortunately, unlike at Sarasin, where the thematic approach is central to our entire investment process, many of our thematic peers appear less strict in their implementation of thematic principles.
Indeed, a rather less charitable interpretation would be to suggest that they are driven more by their marketing departments than their investment departments.
Although the fund management industry is quick to criticise inflexible corporate practices, it is interesting to note that the majority of the industry is managing money in exactly the same way as it did 20 years ago. Before explaining the Sarasin approach to thematic investing, it is worth exploring some of these flaws in the traditional fund management process.
The traditional asset allocation process is less effective in reducing risk than it used to be. In the past, advocates of international diversification pointed to the low correlation between markets and suggested that one could therefore access the superior returns available from international markets without raising the risk profile of the fund. Unfortunately, globalisation has raised the correlation between regional indices to extraordinary levels. The FTSE 100, for example, experienced a 0.95 correlation with the S&P 500 in the 18 months ending June 30 2001, meaning that on 95 out of every 100 days, the FTSE 100 moved in the same direction as the S&P 500. This is despite the fact that they are open at the same time for only two hours a day.
Even Japan, which has historically demonstrated little correlation with the US, showed a correlation of 0.72 over the same period, despite the 14-hour time difference between New York and Tokyo. The net effect is that diversifying internationally to reduce risk is relatively ineffective if your portfolios mirror the regional indices.
The traditional asset allocation process provides fund managers with limited scope for outperformance. The bulk of the industry's resources are currently directed towards predicting whether the US stock market will perform better or worse than those in Europe or Japan.
In fact, regional indices are performing in an increasingly homogeneous manner. So, even if one had correctly predicted that the US would underperform Europe in 2000 for example, it would have yielded little value ' 1% to be precise.
Allocating assets by sector or theme, on the other hand, has the potential to add much more value because the divergence of sector returns is greater. Over the same period, global pharmaceuticals outperformed global technology by some 39% in dollar terms.
Market capitalisation-based indices also raise the stock risk for traditional investors. All key indices, with the exception of the Dow Jones Industrial, are constructed according to the market value of their constituent members. Currently, the top 10 holdings in the UK represent 56% of the FTSE 100 Index. To the traditional investor, holding 56% of their UK portfolio in these 10 stocks is a zero risk strategy. But I would suggest that zero risk refers to the likelihood of the fund manager losing the mandate, rather than to the risk of losing money.
Even if traditional investors dislike all of the top 10 stocks, they would still be under pressure to invest close to half of their money in them to reduce tracking error. It can hardly be described as good practice to deliberately invest money in poor stocks and hope they go down. Low tracking error does not mean low risk.
Allocating assets by country tells you little about the geographic exposure or risk you are taking. For example, BP ' the largest company in the UK ' generates 77% of its revenue outside the UK. GlaxoSmithkline, the second largest company, generates 71% of its revenue outside Europe.
It is no different on the continent ' Roche and Nokia generate 98% of their revenue outside their home market. It is clear that for blue-chip equities, the country of domicile is becoming increasingly meaningless.
At Sarasin, global investment by theme was developed from the realisation that investment according to geographic domicile was becoming an antiquated and flawed way of diversifying assets in a world in which the key to success for the world's major companies was global reach rather than national dominance.
Sarasin's thematic investment process has no geographic overlay or bias. This is the most important thematic discipline and the one that most clearly differentiates us from traditional investors. However, we also differ from most of our thematic peers in several respects.
First, rather perversely, some of our peers attempt to buy thematic stocks within a geographic structure. More often, however, they confuse themes with sectors. Many call their technology fund or their healthcare fund thematic ' to Sarasin, these are industry funds that are superior to geographically constrained funds in their structure but may have a short lifecycle and provide few opportunities for diversification. They perform well while the industry is in vogue but it is rare for performance to be sustained over the long term (as we have seen over the past 18 months in the case of technology).
A Sarasin theme is diversified by country and by industry. Our flagship fund, EquiSar, currently has just four themes ' sufficient for diversification purposes but focused enough to ensure the exclusion of all but the most interesting areas of the global stock market. Our themes are global pricing power, restructuring and shareholder value, global energy, e-business and efficiency.
Assets are allocated to each of the above themes in a proportion that reflects their relative appeal. Analysts are then required to identify the most attractive blue-chip equities that satisfy our themes irrespective of where they happen to be quoted. Portfolios contain a maximum of eighty stocks, ensuring that they remain dynamic and reflect our best ideas at any given point in time.
So, to summarise, we believe that the thematic investment approach, which transcends national boundaries, reflects the reality of a global market. In our world economy, regional growth rates, interest rates and inflation are converging and the great differences in returns previously identifiable between countries are now to be found between themes.
The debate between active and passive fund management will continue. Some investors may find the passive approach attractive. Although we strongly disagree, their low-cost structure is undeniable. However, if investors are willing to pay active fees, we would strongly recommend that they ensure that their fund managers are truly active and that they do not use low tracking error as an excuse for making poor investment decisions.
The traditional asset allocation process is less effective in reducing risk than in the past.
Regional indices are performing in an increasingly homogenous manner.
Allocating assets by country reveals little about the geographic exposure of risk you are taking.
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