With global reach rather than national dominance now the key to success for the world's major companies, thematic investing looks set to grow in importance
Having practiced thematic investing for much of the 1990s and the first two years of the new millennium, we are not surprised to see this 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.
At Sarasin, the thematic approach is central to the entire investment process, unlike many of our peers, who appear less strict in their implementation of thematic principles or disregard them altogether in favour of the index tracking or quasi-index tracking approach.
Consider a FTSE 100 index tracker or an active UK equity fund with a low tracking error. In all likelihood, at the end of 1996, the closest thing to a technology company in these portfolios would have been BT and C&W, both of which were valued more like utilities than technology stocks. BT, for example, had a P/E of 11 and a dividend yield of 6%.
At the peak of the market in March 2000, the same portfolio contained not only BT and C&W but Vodafone, Marconi, Psion, Sage, Misys, Sema, Logica, Arm, CMG, Marconi, Telewest, Colt Telecom, Energis, CWC, Freeserve and Baltimore Technologies.
Were investors in UK trackers aware they had more money invested in Colt Telecom than British Airways, M&S, Whitbread, Thames Water, WH Smith, Pilkington, British Steel, Rank, Tarmac, Associated British Ports and British Land combined, and more money in Vodafone than the entire UK food, drink, tobacco, electricity, gas, water, aerospace, defence, steel, engineering and construction sectors? Probably not.
It is sobering to note the market capitalisation of Colt Telecom today is less than any of these companies.
The above example illustrates in simple terms the problems with index trackers and their quasi-equivalents. Such funds reflect what has happened in the past, they do not even attempt to predict what will happen in the future. They are backward rather than forward looking.
We may successfully drive our cars for a time based on the view from the rear mirror or steer our boat according to the direction of the wake but that does not mean it is appropriate or without risk. Similarly, investment professionals that allocate assets based on the weighting of companies in the indices are assuming past performance will continue and the performance of a share is positively correlated with the size of the company.
Index trackers and active funds with a low tracking error are typically sold as low-risk products. But surely a fund that held 33% of its assets in the technology sector after the biggest bull market in history cannot reasonably be described as low risk:
It is so described because the term tracking error is often confused with risk. For most investors, tracking error does not equate to risk. Risk may be defined as being the likelihood of losing money or the chance assets will not cover liabilities but for most investors it does not refer to the likelihood of deviating, positively or negatively, from an index.
The FTSE 100 index illustrates the problem. Currently, the 10 largest companies in the UK account for 53% of the FTSE 100 index. To the traditional investor, holding 53% of their UK portfolio in these 10 stocks might seem a zero-risk strategy. But it is seen as zero risk only because it produces zero tracking error.
Perhaps zero risk would more appropriately describe the likelihood of the fund manager losing his or her job if they match the index. However, one cannot argue that allocating more than half of your money to just 10 companies produces a zero risk of losing money for investors.
At Sarasin, portfolios are constructed to reflect the risk profile of the fund or client, not the risk profile of the index. And we do not change the risk profile of portfolios just because the risk profile of the index changes. If we buy a stock, it is because we like it, not because we are trying to keep our tracking error down.
Although the thematic approach works well in periods of strong economic growth, it is also particularly suited to the current environment.
For the majority of readers, the experience of the past two-and-a-half years is unprecedented. From the peak in March 2000, global equities have fallen by 50%, far exceeding the previous post-war record peak-to-trough decline of 37% in the early 1970s (Source: Bloomberg, October 2002).
There has been much written about the current bear market, just as there was considerable effort to explain the earlier bull market. Certainly, the market's willingness to pay a record and unsustainable multiple of record and unsustainable earnings was responsible for the initial excess but its demise is much more fundamental in nature.
Not only is the global economy more synchronised today than it has been for years, making significant country or industry asset allocation weightings redundant, but the lack of growth leaves whole swathes of the stock market unattractive.
However the lack of economic growth and inflation is not a short-term phenomenon. Nominal GDP growth (real + inflation) has been slowing for more than 20 years. Indeed, the three largest economies in the world ' the United States, Japan and Germany ' have stopped growing altogether (on an equal weighted basis) for the first time in more than 40 years.
Nominal GDP growth is, essentially, the top-line for companies. Diversifying by country and industry and buying the major stocks in the indices will ensure investors capture nominal GDP growth. This will certainly lag the double-digit growth enjoyed in the 1980s and 1990s and returns to shareholders are likely to be equally disappointing.
The thematic approach seeks to identify growth in a world in which little growth exists. Allocating assets to poor companies, buying companies that are expected to do badly simply because they are major constituents of the indices, is not our strategy. Even an apparently successful policy of underweighting bad companies will negatively impact performance. In such a difficult environment, investors must take advantage of every opportunity available to them to make money.
Unlike traditional fund managers, the thematic approach requires us to focus exclusively on the good companies and does not allow us to underweight bad companies.
Although fund managers are quick to criticise inflexible corporate practices, the majority of the industry is managing money in the same way it did 20 years ago. Since it is clear the global economy has changed beyond recognition, why does the industry not reflect this in its investment process?
At Sarasin, global investment by theme was developed from the realisation that geographic domicile is a flawed way of allocating assets, where the key to success for the world's major companies is global reach rather than national dominance.
In a period of low nominal GDP growth, tracking broad indices is likely to ensure low returns. Better, surely, to identify the themes that are growing faster than the economy as a whole, discard the rest and buy the leading companies wherever they happen to be quoted.
Choose the companies you think will do well in the future not those that have done well in the past. Buy stocks because you like them not because they happen to be heavily weighted in the indices.
The debate between active and passive fund management will continue. However, it is becoming increasingly clear buying every company in the index will guarantee mediocrity at a time when mediocrity will not suffice.
If, on the other hand, investors are prepared to pay active fees, make sure fund managers are truly active and don't use low tracking error as an excuse for making poor investment decisions.
Index trackers are typically sold as low-risk products but this is not necessarily the case.
The thematic approach seeks to identify growth in a world where little growth exists.
It is becoming increasingly clear that buying every company in the index will guarantee mediocrity.
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