With catastrophic damage having been wreaked upon certain specialised investments ' especially TMT ' Frederic de Merode asks whether themed and sector funds have a place in a post-crash portfolio
Has the increasing correlation in global markets impacted the relative performance of theme and sector funds versus the overall market? Has it made the job of the asset manager easier or more difficult? Before addressing this particular issue, it might prove useful to explore the premise and relative merits of each investment approach.
Thematic funds were popular in the late 1990s and 2000. Sector funds were popular too, particularly if they specialised in telecommunications, media and technology (TMT). Having said that, those thematic funds which became popular at that time also tended to be heavily exposed to 'growth areas of the future', such as TMT.
The bursting of the bubble came as a rude awakening to believers in the new growth paradigm, be they investors or asset managers. Thematic funds that performed better when the bear market took hold were those with more exposure to the less cyclical areas of the market. An example might be a fund with a strong theme in environmental technology and with a solid exposure to utility stocks. Likewise, sector funds with a bias to the 'value' area of the market, such as an industrials fund, would also have performed well relative to the overall market or more general funds.
pros and cons
For many thematic or sector funds, the trend had either been a friend or an unforgiving foe. With the positives and negatives so vividly portrayed by the two-tier nature of recent stock market history, should wary investors radically change their opinion of these specialised funds? Arguably, the process may have started already. Momentum markets have tended to favour some styles over others, as well as some themes over others at particular times. By momentum, we mean the escalating outperformance of a limited area of the market.
Many retail investors are influenced by recent performance and will have voted with their feet. In order to mitigate the risk of buying a fund at the top and selling it at the bottom, it may be useful to explore the objectives of thematic and sector funds.
It can be argued that the whole premise behind thematic investing is rooted in the concept of top-down, or a macroeconomic base from which to proceed. Philosophically, it could be described as the belief that there are certain major trends within the economy, society or the business environment, which will act as a catalyst to the outperformance of certain companies. One well-known example of this is the demographic trend in the developed world that is used to justify the growth potential of pharmaceutical companies.
The argument usually follows the line that as populations in developed countries get proportionally older, their need for medicines and care grows at a proportionally larger rate. The logical conclusion one could derive from this is that providers of this medicine and care, such as pharmaceutical companies, become beneficiaries of this growing demand for their products. Demand rises, their sales increase, and as long as margins are not too eroded by price legislation or the loss of patent protection, their profits rise too, which usually leads to a rising share price.
A possible flaw with this approach is that, like many broad concepts, it is vulnerable to the variations that only closer scrutiny can bring. Sometimes, patents can be vulnerable. Legislation on the part of governments, wishing to reduce their healthcare costs, can severely impact the profits of certain drug makers by imposing price cuts on their products. The private sector, also a large consumer of healthcare products, is using the cost-cutting prerogative to cut back on their liabilities in this area.
In 2002 one of the US's leading car manufacturers said it was spending more on healthcare than on the purchase of steel, the primary resource for its products. The moves to reduce healthcare costs could favour some pharmaceutical companies over others, particularly those that can supply similar, but cheaper, alternative drugs. This highlights the importance of stock picking.
If one believes in the primacy of stock picking, then sector funds may have an edge over thematic funds which favour top-down decision-making. Some thematic funds have proven to be astute stock pickers, but the thematic overlay can sometimes act as a hindrance relative to a pure bottom-up, stock-picking approach. In theory, you would expect a thematic fund to make up for this through greater diversification. Sector funds, as the name suggests, are usually limited to a particular section of the overall market. Theme funds tend to have a broader range of investment options, but again, it is important to compare a fund's exposure to the overall market to determine that genuine diversification exists.
The fact that global markets, even Japan, which for many decades acted almost independently from markets in the US and Europe, have become more aligned, has raised some interesting challenges for thematic and sector funds.
How has greater global correlation affected each style? Momentum investing at sector level has considerably diminished. If one believes thematic funds and momentum investing are inextricably linked, then this development presents a major challenge. Thematic asset managers would presently argue they have more feathers to their bow. The fact that global sectors as well as regional equity markets are more closely correlated brings the stock-picking imperative to the fore.
Can these developments in the performance of global equities be quantified? A joint study conducted by a leading broker research house and a global fund management house has done just that. This measures four key influences on stock returns in developed countries from June 1989 to February 2003. These are global events, the influence of the local market (where the stock is listed), the influence of global markets (for example, globalisation) and stock-specific factors.
Comparing December 1999 to February 2003 shows an interesting development. In December 1999, stocks owed around 15% of their performance to global events. This fell to 10% in February 2003. Over the same timescale, the local market influence on performance moved from around 10% to 15%. Stock-specific factors, by far the largest component, reduced slightly from 60% to 50%. The biggest rise was in global market influence which moved from 10% to 20%.
What is a thematic asset manager attempting to achieve? In a word, outperformance. It may be the outperformance of a benchmark, a peer group or perhaps absolute returns. Likewise, what is a sector asset manager attempting to achieve? The same thing: outperformance. The key choice an investor has to face is which style may prove more conducive to their particular investment needs.
What do the voice of experience and the benefits of hindsight teach us about the relative merits of thematic or sector funds? The dividing line between one type of fund and the other can sometimes be difficult to determine for a private investor without the specialised tools at their disposal. As a result, it may be more useful to concentrate on what has worked in the past and how these funds fit within this context.
In the long run, and particularly during difficult times, it has been both prudent and rewarding to be globally diversified in equities. Diversification implies being present in global markets, global sectors, as well as in a variety of company sizes. The logical conclusion to this implies that both sector and theme funds can act as a useful diversifier to a global portfolio, but not as an alternative. Those investors who believe they can time certain themes and sectors should bear in mind that even top professionals find this difficult at the best of times. The professional answer to the challenge of adding value is usually addressed by stock picking.
In conclusion, the challenge of uncertain times reinforces the old adage that diversification is key and stock picking remains a key method to outperform. Theme and sector funds can be useful for this, as long as they are used as specialist, rather than core products for a majority of investors. The increase in global market correlation seems to have reinforced this message.
Investors must choose which style may prove more conducive to their particular investment needs.
Increased correlation in global markets has meant that themed funds and sector funds, while an interesting addition to a portfolio, should not become its core components.
Despite improved risk appetite
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