Pensions World

Tim Hodgson, Towers Watson, explains the thinking behind thematic investing

We believe thematic investing or even just thinking about investment themes has merits in shaping both the asset allocation and the risk management processes. The essential idea is to start positioning portfolios to benefit from tomorrow’s trends today; and the idea seems to have resonance with some institutional investors. In this article, we review why we think thematic investing is a good idea and set out how we currently identify the themes we believe will be important for the foreseeable future; this will necessarily be a high level overview.

Famous for being famous

But first let us briefly contemplate the Mona Lisa’s fame to illustrate our thinking.

Why is the Mona Lisa the world’s most famous painting? Is it that enigmatic smile? Is it some intrinsic superiority of the brush strokes? Does it capture for all cultures, across all time, some underlying essence of the human condition? Or is it “merely” famous for being famous?

Imagine we were back in 1852 and our task was to predict which painting would be the most famous by the end of the 20th century. How would we go about this? Is there any reason why we would select a painting within the Louvre in Paris rather than any other gallery around the world? Let us assume we selected the Louvre, whether by luck or by judgment, how would we now assess its paintings? If we decided to go by value, we would see an estimate of market value of 90,000 francs – but some of the works of Raphael were valued at up to 600,000 francs. Data on visitor numbers is not available, but there is nothing in the written record to suggest that the Mona Lisa was a particular draw.

The current hypothesis is that the Mona Lisa became the world’s most famous painting through a process of cumulative advantage heavily influenced by luck. It was stolen in August 1911 by an Italian and taken “home”, generating a very human story involving love, justice, patriotism and international negotiations. It just so happened that this occurred at the time that newspapers were first able to print photographs, causing a wide distribution of the now famous image. Consequently, when Marcel Duchamp was looking for an image to parody in 1919 he chose Mona Lisa – which only increased the painting’s fame.

Subsequent treatments by Salvador Dalí and Andy Warhol further added to the cumulative advantage, to the extent that people will now go to the Louvre to look at the backs of people’s heads looking at the Mona Lisa. Our conjecture is that if we rewound history and let it play again, it is likely that a different painting would become the most famous. We now need a seamless transition into thematic investing.

Mega trends

We are living in a rapidly changing world. Whether it is the emergence of a new disruptive technology or the rise of an entire nation, we are witnessing the playing out of powerful financial and economic trends faster than ever before. Investing has been and will continue to be shaped by mega trends. These global mega trends or powerful seismic shifts will provide opportunities to investors who can take a long term view and identify the beneficiaries of those changes in advance of them becoming widely recognised.

Thematic investing is about capitalising on future trends – identifying (and profiting from) the winners and, just as importantly, avoiding (or underweighting) the losers. Its forward looking nature stands in clear contrast to the more widely used approach of market capitalisation, investing where it is implicitly assumed that the past winners will continue to win out and therefore deserve more attention and weight in the portfolio.

Prediction is difficult

One of the key challenges of thematic investing is that the successful identification of themes will not necessarily lead to successful investments. History is littered with examples of industries moving from highly fragmented to concentrated – bicycles, cars, aeroplanes, computers – but gives no guide on how to predict which of the numerous initial companies will come to dominate the industry, viz the Mona Lisa example. Consequently, we need to redefine success, given that picking the individual winner will be too difficult. Instead success for us will be identifying the broad theme and a number of different ways to access that theme. This immediately suggests that successful thematic investing is more about selecting appropriate baskets of investments rather than trying to pick single securities.

However, even the identification of themes is not easy and we do not believe there is any process which will guarantee results. Our preferred approach is to ensure our minds are open to considering any lateral idea, irrespective of sector or geography. Essentially an asset owner is seeking to build a level of conviction in a working hypothesis – that the future will be different in the following way… because of these reasons… While it is important to test these hypotheses as far, and as quantitatively, as possible, we must remember that the point of thematic investing is to be an early adopter. Therefore there will be no definitive proof in advance.

Portfolio positioning

The degree to which asset owners can implement thematic thinking varies as suggested by the Table. The simplest option is engagement with their current active managers. This approach will not increase the governance requirement much, but there is limited scope for the client’s own thematic convictions to feed through into the portfolio. At the other end of the spectrum, asset owners with high governance capability and a well defined process to select and define the relevant themes can take a do-it-yourself approach. In this case, there are likely to be problems with performance measurement – who is accountable for which components of the return? In the middle is the route of employing dedicated thematic managers which solves some of the problems, although the capacity of such products can be limited.

Interconnected categories

Having briefly reviewed the attraction of the concept as well as some of the practical issues associated with thematic investing, we turn now to identify a number of themes we consider are worthy of future review. We look at the world in terms of six categories: finance, economics, politics, society, environment and technology. These categories are large and broad and significant exploration can be done within each. However, the categories are not independent – they are deeply interconnected and this interconnectedness both increases the difficulty and the interest of the analysis. For example, during the Thatcher/Reagan years finance and economics was generally perceived to be independent of politics, but post-2008 it is hard to envisage when such a degree of separation might be seen again. Similarly, we can note that it is likely to be fruitful to explore the overlap between technology and the environment. What happens here is, in turn, likely to impact on society and politics and vice versa.

Many other threads could be drawn any number of ways through these categories, which, although complicated, is surely an exercise that increases the range of investment possibilities and enriches the asset allocation process. I pointed out at the start that space would restrict us to a high level overview, but I hope this has been enough to whet some appetites … as a degree of enthusiasm will be necessary to get through the hard work required to transform the concept outlined here into implementable portfolio positions.