October 2011

THEMATIC INVESTING: Zen and the art of long

Zen-GardenIt can be hard for thematic investors now as short-term decisions influence stock markets, finds Fiona Rintoul, who looks at certain themes driving the sector and asks how long we need to wait until they produce results.
With stock markets jumping up and down at the slightest provocation, now might seem like a hard time to be a thematic investor, where the focus is very much on the long term – sometimes the very long term. And it is hard. “It’s very difficult to be a long-term investor when the market is very focused on short-term trading on macro news,” says Steve Cheetham, senior portfolio manager at AllianceBernstein. Thematic investing requires belief and a kind of Zen-like ability to stay focused on that belief and shut out the white noise of short-term market movements. So it is not for everyone. “It’s essentially a strategy for long-run risk-taking investors,” says Cheetham. “There will be years when the funds don’t perform.” As with Zen, theme investing can be quite relaxing. “We take a long-term horizon that is different from following today’s red screens on Bloomberg, or thinking about where we are in the cycle,” says Henk Grootveld, head of thematic investment at Robeco. “Because we’re interested in the long-term and don’t want to time the cycle, we look at the things we do know.” In the case of Robeco, these can be summarised in the following four global trends:
• Demographics (the world’s growing, ageing, and urbanising population)
• Scarce natural resources (oil, minerals, food, and water)
• Environmental awareness (climate change and pollution)
• The rise of emerging markets (China, India, and Africa) The company runs twelve thematic funds, plus Rolinco, a fund that makes allocations to what it considers to be the most promising thematic equity strategies offered by Robeco and SAM (sustainable asset management). At the moment, these are global consumer trends, natural resources, infrastructure, new world financials, sustainable agribusiness, smart energy, and healthy living/health and wellness. But however strong one’s focus on how the future will be shaped by these themes, the meditative gaze will inevitably falter from time to time. Everyone knows that markets are particularly irrational during periods of extreme volatility, but that does not make it any easier to keep your head when all around you are losing theirs, particularly if your investors are kicking up. Jeff Munroe, chief investment officer at Newton Investment Management, which runs all its funds on a thematic basis, cites the example of 2009 when banks were doubling in value. Newton continued to avoid banks because its “deleveraging” theme told it that they would be challenged. But some clients were not happy about that because they thought, as Munroe puts it, “recovery was coming and everything was going to be fantastic”. Newton stuck to its guns and was proved right. But it is easy to imagine how difficult it could be to stick to a theme if you were repeatedly proved wrong – or not proved right quickly enough. “We want to be pragmatic,” says Munroe. “We don’t want to be too dogmatic about the themes. We have to respect the fact that our clients want to see performance relative to what other people are achieving.” Nonetheless, Munroe preferred to miss out on short-term performance from banks that were rapidly rising in value but that one of his themes told him was challenged. This was not just because it would have involved two decisions – when to buy and when to sell – but because if the timing went wrong, it would be hard to explain to investors that the fund had bought something the investment management company did not really believe in. “If you’re very short-term and all your clients are judging you on is performance, they don’t know what you believe in,” he says. Which is not to say that the short term does not matter. “Short-term influences are very important and we are on top of them,” he adds. But thematic investing is about the long term. As Towers Watson puts it in a recent report on the topic, thematic investing is about predicting the future whereas a market-capitalisation approach implicitly assumes that past winners will continue to win. Or as Grootveld puts it: “We only use the benchmark for risk purposes. For us, the benchmark is a snapshot of the past. We want the winners of the future.” This may make thematic investing more appropriate in today’s fast-changing world than other strategies, but there is one problem, also identified by Towers Watson: predicting the future is hard. The consultancy quotes the Danish physicist, Niels Bohr: “Prediction is very difficult, especially about the future.” How long till I’m rich?
As themes – or predictions for the future – play out, the question arises of how long investors will be prepared to wait for tangible results. Some themes may take ten years or more to reach their full potential. Cheetham cites the example of genomic medicine, which he describes as one of AllianceBernstein’s most exciting themes. Ultimately, genomic medicine could lead to developments such as being able to screen breast cancer patients to determine whether they will benefit from chemotherapy (the majority do not), and creating replacement body parts. But “ultimately” is the key word. The theme is in its very earliest stages and could take ten to 20 years to reach its full potential. That will be too long for many, even on the institutional side. “In the institutional space, it’s become much more difficult that it was,” notes Cheetham. And not only that. A theme that is in its early stages may be filled with potential and be a sound and solid prediction of the future, but be short on investable assets. “The sanity check is what can you invest in today?” he asks. Therefore, for many thematic investors, the selection of themes is a three-stage process: finding the idea, usually through some kind of brainstorming, testing it, and working out if there is an investable universe. Themes are reviewed periodically, typically once a year, and may morph as the world changes. Thus, Newton’s “becalmed and debt and credit” theme introduced in 2005, morphed into “all change” in 2007, then “deleveraging”. Sometimes a good theme is not investable, even if it is not in its infancy. Grootveld gives the example of water. There are many facts that point to this being a good theme. Seventy per cent of all agriculture depends on water from rain and the groundwater level is falling everywhere apart from Europe, but government intervention is making the theme hard to play. Rolinco has sold its holdings in a  water fund,  says Grootveld, “because it will be hard to come up with water ideas if government continues to suppress prices. It’s holding me back from investing”. There is also the question of how themes fit together. In multi-theme portfolios, there is a possibility for conflict, though most managers suggest this is rare. And there is the other side: the conviction that comes with several themes pointing in the same direction. Some companies, such as Robeco, offer single-theme funds, whereas others consider this too dangerous. “Single-theme funds may be appropriate for sophisticated investors who are able to use them as building blocks,” says Cheetham. “Otherwise, we would say that people shouldn’t invest in single-theme funds because it is almost impossible to get sensible portfolio diversification.” Content and risk
Cheetham also identifies another problem with single-theme funds: they are exciting – or at least more exciting that your typical global equity portfolio. Thematic investing has sometimes been accused of being a triumph of marketing over content. While Cheetham, no doubt, would not endorse that view, he does see a problem, particularly in the retail market, with the fact that thematic funds market well. “People leap on themes when they are flavour of the month,” he says. “Each of us needs to be very careful that we don’t recommend these funds to people for whom they are not suitable.” However, it is important to remember that there are probably as many ways of investing thematically as there are thematic funds. At Newton, for example, the thematic approach is not so much about finding an investable universe around the themes as about using the themes to guide investment choices. Thus, some themes are negative. An example is the “government”, which is basically an expression of Newton’s fears about what governments globally might do. This leads Newton to avoid certain companies. For example, those that are vulnerable to having additional taxes slapped on them as governments implement austerity measures. And Newton would not see all its funds as high-risk. It is trying to offer what Munroe describes as a good test of any fund manager over time: a good return with modest risk. ©2011 funds europe

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