Variations on a theme

“Earth Matters”; “Population Dynamics”; “Networked World”; “Construction and Reconstruction”. Next year’s calendar for curators at the Science Museum, perhaps? No – in fact these are some of the concepts driving the thematic investment approach that Newton Investment Management has pursued since inception in 1977. “Stewart Newton had become quite bored with economists telling him, ‘We think French GDP is going to be 0.3 per cent rather than 0.4 per cent, German inflation is going to be this or that’,” explains Phil Collins, manager of the Newton Phoenix Multi Asset Fund. “The reliability of those forecasts is quite weak, and in any case if you look at where people have really made money, it’s been from the ability to predict significant changes like, for example, the rise of industrial manufacturing, of the service economy and IT.” The result was a focus on long-term, secular changes in economies and societies. This can lead to quite focused investment strategies - “Construction and Reconstruction”, for example, is simply about exposure to infrastructure companies and projects, and possibly industrial commodities – or more complex ones like “Networked World”, which is clearly about picking winners and losers in the telecoms sector, but also encompass the media, retail, banking and other companies tasked with positioning themselves within these networks. The same variety is evident in the four thematic funds that are part of Banque Syz & Co’s 20-strong Oyster Funds range. Oyster Responsible Development is almost a global diversified equity fund with an SRI-style tilt, whereas Oyster Global Warming is focused on companies involved in alternative energy or water and Oyster Oncology on the development of cancer diagnostics and treatment. Seeing the big picture Why invest in this way? One claim from Newton’s literature is that, “Because themes are about change, our process is much less likely to be caught out by change.” Good examples of this principle at work recently were “Becalmed” – developed markets had begun to behave as though the economic cycle had been abolished, leading to the excessive risk-taking associated with peaks in credit cycles – and the related theme of “Debt and Credit”. Newton does not claim to have been able to predict the timing or exact causes of last year’s credit crisis, but the argument is that thematic investment instills a “big-picture” discipline against the siren-song of short-termism: in this case Newton portfolios favoured financials with developing-world exposures over those exposed to the debt-burdened US and UK consumers. Now the crisis has materialized, “Becalmed” and “Debt and Credit” have been shelved and replaced with a new theme, “All Change” – which sees the medium-term characterized by moderating consumption, increased savings rates and a return to thrift (with regard to money, but also energy conservation and the reduction of food wastage). “By having the themes in place we are able to justify holding good companies through difficult times,” says Charlotte Winther, portfolio manager and COO with Nordea Investment Management & Funds, which has had a thematic investment process as part of active equities since 1992. “They almost give us the courage to maintain our long-term views on individual companies.” One might contend that a standard, top-down macro view would instill the same discipline – but at its best, thematic investing goes a step further, deconstructing some of the self-imposed constraints inherent in the traditional asset-management set-up. “You can find analysts who know everything about European food companies, and others – perhaps even in the same investment house - who are experts on US food companies, but you will not find anyone who knows about global food companies, let alone the entire value chain back to food producers and farming machinery manufacturers,” Ms Winther explains. “Because the same information is available to everyone instantly in the modern marketplace, the fact that we use that information in a different way gives us an edge.” A Nordea theme like “Emerging Consumer” cuts across regions and industrial sectors. The developing world’s growing urban middle class is changing its diet, creating opportunities in food production, processing, packaging and retailing; buying electronic, financial and lifestyle products; traveling more; the impact is broad – and creates opportunities for developed-world companies as much as local ones. “We are quite a small team of 13 investment professionals organised into global sector specialisms for information-gathering,” says Ms Winther. “But we all sit together and exchange this information so that when we go back to our desks, even though I am personally looking at industrials, I will have facts in my mind about pharma, banks, and so on, along with all the investment themes, which helps me to think about how the companies I cover might benefit from them.” Finally, thematic investing is fun, it engages intellectually with the Economist-reading international business class with whom wealth managers have to discuss investment products. “From a marketing perspective, there’s an ‘intuitiveness’ to it that people get,” says Mr Collins. “The private banking clients find thematic investing appealing because, by-and-large, they are switched on people doing business out in the world and they see many of these things first-hand," agrees Michael O’Sullivan, head of UK research at Credit Suisse's Private Bank. Wooing private wealth Even Nordea, whose client base is mostly institutional, is attempting to woo private wealth money by further emphasizing the thematic: alongside its regional equity products it intends to spin-out single-theme funds, starting with “Emerging Consumer”. Private wealth clients can own assets which might be out-of-bounds to institutional investors, which also face consultants struggling to categorise themed products within their risk models. The latter is an important concern, of course. Thematic investing is not just about cutting across regional, sectoral and asset-class boundaries, but about breaking free of standard portfolio construction models.“We look for things that do not mean-revert – that’s a key part of the process,” says Ms Winther. “But mean reversion is one of the main assumptions of the traditional models like CAPM (Capital Asset Pricing Model).” Modern portfolio theory is all about pushing out one’s efficient frontier by diversifying among mean-reverting asset classes; it does not cope well with structural changes to market regimes, when the correlation matrices upon which it is based break down and coefficients tend towards one. But these are precisely the phenomena that thematic investing seeks to exploit: per se, thematic investing is not concerned with diversifying, but concentrating risk – in effect, maximizing beta sensitivity to the beneficiaries of the theme. Most thematic investors are weighted towards equities – because it is difficult to express a thematic view with bonds, but also “simply because of the variety”, as Mr O’ Sullivan says. That might be private equity, but nonetheless that is still not a clear diversification play. Credit Suisse’s “Feeding Asia” theme drives investment in food companies, agricultural machinery manufacturers, fertilizer producers and plantation stocks – that certainly represents diversity, but it is also clear how they might correlate, even over the shorter-term. Indeed, Credit Suisse has pioneered the concept of thematic indices – on water, alternative energy, nanotechnology, even family businesses: these are systematic exposures. That remains true even when “Earth Matters” gives Newton a rationale for augmenting resource and agriculture stocks with long positions in commodity-related currencies, a new asset class altogether. With that in mind, some of these products should be treated as conviction-based satellite holdings, particularly single-theme products like the Oyster Funds, the various water and agriculture funds that have been appearing recently, or Nordea’s planned “Emerging Consumer” fund. However, where themes act more like guiding principles behind traditional-looking portfolios (as they do, generally, at Newton and Nordea), the approach might be pushed closer to one’s core exposure. For starters, you are buying not one theme, but several: Newton usually has about 14 in play at any one time. In addition, just because thematic exposures are systematic and long-term – the recent introduction of four new themes by Newton “is high turnover by our standards”, says Mr Collins – that does not make thematic investors passive. Active management “At the bottom-up stock-selection level, portfolio construction kicks-in to get exposure to the theme via the most robust portfolio possible,” says the Oyster Funds’ CEO Alan Mudie. The hypotheses translate into growth-biased portfolios, but that does not mean that managers do not exercise value discipline. “That’s one reason why the portfolios turnover underneath the longer-term constraint of the thematic idea. It’s active management within the constraints of the thematic bias.” At Nordea, there are several of these levels that can be actively rebalanced. The major theme of “Industrial Renaissance”, for example, comprehends three sub-strategies – aerospace; power and transportation; and other infrastructure. Each is long-term, but has a shorter-term risk-and-return “condition rating”. Beneath this level, each stock has a return target. Within “Environment and Resource Efficiency”, for example, is the sub-strategy of intelligent construction, represented in European portfolios by Schneider Electric, and the building-materials firm Saint-Gobain. Nordea maintains a strong view on the strategy, but these two positions were closed out in mid-2007 due to overwhelming macroeconomic fears around the construction sector. All of these metrics, at theme and stock level, are fed into a Barr-based optimizer which turns out a model portfolio. “That gives me an idea if I’m totally off-scale, correlation-wise,” explains Ms Winther.