Lockdowns lend weight to thematic investing approach

In a world reeling from the Covid-19 pandemic, investors have been flocking to thematic funds. The trends this approach tries to capture — be it in healthcare, technology or energy transition — seem only to have been reinforced by the crisis, and investors appear reassured by the long-term nature of the approach. 

The past 12 months have been a very successful period for thematic investing, reports Steve Freedman, head of research and sustainability, thematic equities at Pictet Asset Management. Pictet is by far the largest player in the European thematic investing space (see table), and Mr Freedman claims the firm saw assets invested in thematic strategies grow by more than 50 per cent, with its Clean Energy and Global Environmental Opportunities funds seeing assets more than triple.

The pandemic has clearly played its part. “This massive shock to our economic and social system has, in many ways, stimulated investors to thinking thematically,” explains Mr Freedman. “You have a shock — you know there will be winners and losers, and some assumptions about longer term drivers are now in question. This was very apparent in terms of the questions clients were asking us.”

Increasing interest in environmental, social and governance (ESG) was evident from inflows into Pictet’s environmental strategies. “We saw ESG investing grow quite considerably. It has been years in the making, with investor interest growing, but it was very helpful during the first quarter of last year, when we saw the massive drawdown in the markets, that ESG strategies tended to perform better, partly because of the sectors they were less exposed to.”

Pictet launched a new strategy in November, Pictet-Human, which focuses on companies with consumer-centric business models which aim to deal with the challenges of modern society, such as transient work, starting families later, living longer, online entertainment, exercise and dating.

For Pictet, which already has a wide range of thematic funds, the key when launching new strategies is to ensure the new fund does not replicate what is going on in the others, says Mr Freedman. With all the upheaval witnessed over the past year, some of the firm’s funds have seen more activity within their holdings than they might normally expect to. 

“But in other cases it was more thinking about, not what to buy now, but how the universe might evolve. What new segments might emerge that are not investible yet? We can follow them on the private markets and be ready when an IPO comes along,” adds Mr Freedman.

Record flows

BlackRock also enjoyed record flows into both its actively managed thematic funds and its ETFs, and performance was also impressive, reports Rob Powell, its head of thematic and sector product strategy. “Many themes demonstrated resilience through the pandemic-driven volatility in the first quarter of 2020, and then delivered very strong relative returns as markets rebounded, dispelling one of the common myths surrounding thematic investments — that they’ll struggle in times of crisis.”

While Covid-19 has been devastating to lives, livelihoods and economies all over the world, it has served to accelerate the disruption that many thematic funds are focused on, leading to very strong performance for some of the companies driving the themes, he explains. “Crises are often described as agents of change, and investors have looked to capture permanent changes in behaviour that have resulted from this unprecedented crisis,” says Mr Powell. 

Many portfolios were poorly positioned for these accelerated structural shifts though, he claims, which lead to an increase in thematic adoption within European investors’ portfolios. Investors are increasingly looking to capture disruption across the cycle and protect portfolios against future ‘black swan’ events, adds Mr Powell.

BlackRock now has 20 thematic funds available in its Emea range, the most recent launch being the BGF Multi Theme Equity Fund, which looks to combine different themes into a single product. 

A similar strategy is also gearing up for launch at Fidelity, which plans to repurpose its Global Thematic Opportunities fund as a thematic strategy. “The purpose of this fund is to identify thematic strategies that are run by portfolio managers within Fidelity that are likely to benefit from the megatrends  impacting the global economy over the medium term,” says Nick Peters, portfolio manager, multi-asset at Fidelity International.

Mr Peters is looking to select what he thinks are the most attractive of the 20 themes run by Fidelity’s equity team. He has highlighted global technology; global demographics; water and waste; climate solutions; the China consumer; innovation in medicine; and global future leaders.

The next step is to tag each strategy either as core or satellite. Core means the theme is not linked to a specific sector, which makes it valuable from a diversification perspective, whereas a satellite would be driven by a single factor. Core holdings will tend to have a higher weighting in the fund —
10–20 per cent – while a satellite would be 7.5–15 per cent. 

The portfolio as a whole will look to touch on all of the Steep acronym for change — social, technological, environmental, economic and political. 

“We all recognise their importance in driving global growth going forward, and it is difficult to time how and when those factors are going to influence markets and consumer behaviour. But it is also a challenge as I will need to find internal strategies to play them effectively, while also having one eye on valuation and sentiment,” says Mr Peters.

Generating cash

It is one thing to identify a theme, says Anu Narula, head of Global Equities at Mirabaud Asset Management, but you should only invest in companies that are generating cash flow from exposure to it. He gives the example of the millennial consumer. 

“Everyone is familiar with that theme, but for us it really came to life in 2017, when Fabrizio Freda, the CEO of Estée Lauder, said that 5 out of 10 per cent of the company’s sales growth was coming from millennials and he was going to allocate 50 per cent of his capital budget there.” 

Mirabaud is looking for themes with an under allocation of capital and excess demand. Some of these will be the megatrends, which are in play throughout, whereas others have more of a cycle, which the firm will look to or the period in which demand exceeds supply. 

“This provides diversity to the fund,” says Mr Narula. “We don’t just want to be in all the crowded areas. The biggest risk I see with theme funds is you get correlated to one factor and if that plays out, where do you go?” 

Some five of the eight themes Mirabaud has exposure to accelerated last year because of the pandemic — explosion of data; platform companies; health and wellbeing; automation; and millennial consumer. 

The other three found the going to be tougher. The ageing demographic theme was hit because of the nature of the pandemic, while the service economy has been hit by lockdowns. Real estate and infrastructure was also affected, but Mr Narula is confident that all of these themes will recover as the world begins to recover from the pandemic.

It is not possible to find compelling investment cases in all themes, he explains. One example he gives is cyber security, an undoubted growth area but one with a great deal of “lumpiness” to be found in company business models within the sector. “The quality of the companies does not match up to the theme itself,” says Mr Narula. Another is electric vehicles, which he is monitoring, but as yet he is finding it hard to identify companies which are generating sufficient levels of cash.

The coronavirus pandemic has accelerated adoption rates for thematic strategies and started to shift them from being niche solutions towards becoming mainstream, says Angus Muirhead, head of Thematic Equities at Credit Suisse Asset Management. The Credit Suisse approach is for each strategy to focus on a single theme based upon a long-term growth trend. 

“We focus on identifying disruptive innovations and take a ‘pure-play’ approach in order to deliver a high level of exposure to a given theme,” he says. This helps generate a well-diversified portfolio with a small- to mid-cap bias, investing in companies often not included in the major stock indices, claims Mr Muirhead.

Although passive managers can capture broadly defined themes, he believes that in many of these early-stage areas the competitive landscape is dynamic, with technology and innovation changing the playing field significantly. 

“This is why we believe that active managers can add a rich layer of value through stock selection based on thorough, bottom-up fundamental research,” adds Mr Muirhead.

The Credit Suisse Digital Health fund has undoubtedly benefitted from the pandemic (see Table).  

“Companies across the world are telling us that Covid-19 has accelerated digitalisation in healthcare by three to five years,” he explains. The adoption rate of telehealth has increased from 1 per cent pre-pandemic to about 20 per cent, while the productivity of pharmaceutical representatives has increased by 30 per cent thanks to digital customer relationship management tools, he claims. 

“The pandemic created a tipping point, forcing the realisation that we are on a multi-year journey of digitalisation in the healthcare industry,” says Mr Muirhead. 

Another fund operating in booming sector, though this time a passive one, is the VanEck Vectors Video Gaming and eSports Ucits ETF. Video games and eSports were already growing before the pandemic, but enforced lockdowns have only seen the sector accelerate to new highs. 

“Covid has turned the focus onto new entertainment, so people, and money, are flooding into this space,” says Dominik Poiger, product manager at VanEck. When national football leagues were shut down, online gaming leagues were being shown on TV. And he does not believe the trend will reverse even should the lockdowns end. 

“The companies active in this space have been fantastically innovative in the past, changing revenue models from one time transaction models to gaming as service, to the subscription model. We don’t know how this will develop with virtual and augmented reality. People want interactive entertainment and games are truly interactive.“ 

The index the fund tracks has the rule that the company needs to derive at least 50 per cent of its revenues from video gaming or eSports. That means, for example, Sony, which makes the Playstation, or Microsoft with the Xbox, are not in there because they do not reach that threshold. 

“They would not be pure play investments,” says Mr Poiger. “There is no Amazon or Alphabet. You get Activision, who make World of Warcraft and the Overwatch League, they are one of the top holdings. You get Nintendo, Nvidia. They are not only video game publishers, but hardware manufacturers.”

There is also room for a thematic approach in the alternative space, says Marc Syz, managing director of SYZ Capital. “We have liquid alternatives, hedge funds, that we allocate capital to, and then we have private markets, private equity. The common thread in everything we do is that we take a thematic approach.” 

The only way to generate alpha is looking for things that have been mispriced by the market or participants, he claims. SYZ researches trends, industries and themes that it believes will offer better risk/return rewards over the coming years. It is looking for niche situations, and then tries to invest in those with specialised managers or industry specialists.

“But it is one thing to discover a theme, quite another to execute on it,” says Mr Syz. “That is where, over generations, we have built networks in Europe, in Asia, in the US, developing the right network of specialists and individuals in different industries.”

One area the firm has been active in for quite some time is litigation finance. “A lot of people cannot litigate and we will partner up with speciality litigators to back some of these and then have contractual agreements to share the profits. It is a nice diversifier, completely uncorrelated to capital markets. And also we are helping the little guy.”

Mr Syz sees great potential in artificial intelligence and reports that the firm is working with a Swiss university to create an investible theme in the space. Another trend it has been monitoring and is now looking to invest in is how technology is helping farmers become more productive, particularly in emerging markets. The music royalties space is also of interest, as is the payments space within financial technology. 

“Some of these things we have been working on for a while, others have been accelerated by the pandemic,” says Mr Syz. With so much uncertainty surrounding markets and the real economy, the firm is recommending that its clients should allocate a certain proportion of their assets to areas which are completely uncorrelated. 

“In order to build wealth you first need to protect it, and build a robust portfolio. And that is why we look at diverse themes that have to have massive growth potential, and that are here to stay, not fads that will fizzle out.”   

VIEW FROM MORNINGSTAR: Reassuring calm amid Covid storm 

In a turbulent year for markets, thematic funds emerged as some of the biggest winners. Assets under management (AuM) doubled to £160bn ($224bn) over 2020.

Europe is home to the largest market for thematic funds by assets globally. These funds attempt to harness secular growth themes ranging from artificial intelligence to cannabis.

Funds tracking an energy transition theme were some of the stand-out performers of the year. For example, the iShares Global Clean Energy ETF posted triple-digit returns and grew AuM by more than 10 times over the year.

The disruptive volatility experienced in the oil markets led many to seek alternatives and to revaluate the associated risk and return of alternative energy sources. The favourable US election result and other pro-environmental political developments globally were also supportive.

Funds tracking technology themes have also caught the eye. Allianz Global Artificial Intelligence fund, whose largest holdings include tech darlings Amazon, Facebook and Tesla, returned 95 per cent to investors in 2020. 

Pictet Asset Management remains the largest thematic fund provider in Europe by a considerable margin. The thematic specialist manages five of the largest thematic funds in Europe, including the Pictet Global Megatrend Select fund. Rather than tracking a single growth theme, this fund targets 10 distinct themes.

Despite a relatively muted performance in 2020, the Pictet Water fund still attracted strong net inflows. The case for investing in a water theme remains compelling. Fresh water is not distributed equitably across population centres, nations or regions. Moreover, given its weight, water is not easy to transport in sufficiently large quantities.

As populations continue to grow, supply and demand for water is set to become progressively more imbalanced especially in arid regions with contaminated water.

For regions with easily accessible water resources, like rivers and underground aquifers, the risk of overconsumption and inefficient recycling are real threats to the sustainability of these resources. These constraints pose a global profit opportunity.

Kenneth Lamont, senior analyst, manager research, Morningstar