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Capitalium CIO: the good, the bad and the ugly of thematic investing

Capitalium CIO: the good, the bad and the ugly of thematic investing

This Citywire Switzerland article was written by Sébastien Leutwyler, Managing Partner and CIO at Geneva-based independent asset manager Capitalium Advisors.

Like any business, finance is subject to the vagaries of fashion. Thematic investments, for example, are bringing forth both investor interest and investment inflows.

On top of sound fundamental reasons, it is clear that the upcoming cycle peak in the financial markets (with record highs on many equity indices and shifts in central bank monetary policies) and the resulting uncertainties are ripe for the emergence of thematic investments as tactical allocations.

In looking into how this actually affects clients’ portfolios, let’s first recall some of the special features of thematic investments. With some exceptions, thematic investments are mainly in equities. The global nature of individual themes removes the geographical barriers that usually characterise investments.

Themes generally revolve around broad economic trends that can be classified arbitrarily into five categories: disruptive technologies (artificial intelligence, robotics or autonomous vehicles), wealth transfer (the sharing economy), demographic challenges (ageing populations, the leisure society and medical trends), globalisation (urbanisation and the emerging middle classes) and environmental questions, with this last category including a multitude of individual sub-themes.

One more thing: as many critics often claim, thematic investments require a long investment horizon to pay off – a horizon that very few investors are willing to grant their portfolio managers.

Fears of market correction

Even so, thematic investments have been popular with financiers, who have added a dose of them to their allocations. As 2017 draws to a close, this trend is being driven by the convergence of two connected phenomena.

The first, somewhat temporary, is a lack of market visibility and growing fears of a market correction.

At a time of much tentativeness in portfolio construction, thematic funds are used to add new exposure without the need for much explanation of one’s economic, geographical, sectoral or style views. This is a rather marketing-oriented approach in which the client is offered an intuitive solution; the themes are universal and easily understandable.

What’s more, thematic investments can take the blame if there is an across-the-board market decline, instead of the choice of theme.

Finding a focus

The success of thematic funds is also being driven by structural and societal factors. As they become increasingly aware of the potential impacts of financial investments on trends in our societies, today’s clients demand that their portfolios carry some meaning. Thematic investments are more efficient at doing so.

In addition, there is growing interest in start-ups and entrepreneurship almost everywhere in the world. Thematic investments are usually found in the private equity or venture capital component of portfolios, but the listed equity route offers an alternative that is more accessible to clients – for example, investing in Silicon Valley success stories. Regulators limit access to private equity and venture capital by non-sophisticated investors, due to their high minimum investments, their long-term investment horizon and the risks inherent in private equity.

So there are many causes for the growing success of thematic strategies, but don’t overlook the impact they can have on daily portfolio management metrics. The main difficulty is in orienting one’s choice to a theme with economic virtues that match its financial potential.

In other words, make sure that the financial market offers the right instruments for expressing a theme optimally throughout its value chain and life-cycle. Stock-picking and timing are essential in guaranteeing that a 'good long-term idea' doesn’t turn into a 'short-term disaster'.

Keep in mind that because most of them carry equity risk, thematic investments make it far more difficult to grasp the overall risks to the client’s portfolio.

Because thematic funds’ compositions vary and fluctuate over time, they have an impact on both underlying exposures (due to geographical diversifications and sector rotations) and correlation metrics. The problem here is in piling on risks of the same nature, which cannot be properly grasped through a theme-by-theme assessment.

Watch your footing

While thematic funds have a clear role to play in a portfolio during any economic cycle, they shouldn’t be abused, for several reasons.

First of all, because the theme’s and the client’s time horizons are seldom aligned.

Second, because among all the possible themes, those that seek to be more structural (for example, sustainable investments and mergers & acquisitions) and less correlated to major equity indices offer a more robust diversification to portfolios than those based on high-beta stocks.

It is reasonable to assume that conventional investments are also able to exploit the dynamics inherent in a theme-by-theme approach. It would be hard indeed to imagine a traditional US growth stock fund manager not taking technological disruption trends into account in his stock-picking.

And, third, keep in mind that many of the highest-yielding themes are still reserved for private equity. The barriers to entry set up by insiders will continue to limit access for traditional investors.

As is often the case, you can’t have your cake and eat it…

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