Opening doors to performers
Thematic investment enables an investor to take a complex world of more than 2,000 stocks and, through a disciplined process, turn it into a manageable, investable portfolio.
This is how Guy Monson, chief investment officer of Sarasin Chiswell, explains the appeal of thematic investment. Monson pioneered the use of thematic investment in the management of global equity portfolios when he launched the EquiSar fund 10 years ago. Today the concept is one of the key tools of asset management.
Essentially, thematic investment means moving away from the
allocation of assets along geographical lines in favour of an allocation that crosses borders. In thematic investment a portfolio’s geographic spread of assets is simply the by-product of a series of thematic investment choices.
The same is true of sectors. Thematic investment discards sector labels and looks at what a company actually does.
“We coined the word thematic - the cross border influences which are neither country, industry or style based - to define this approach. It was a completely new word 10 years ago. Now it is an established form of global investing and there is hardly an investment house across Europe that wouldn’t say that investment themes are part of their approach.”
Monson says the need for thematic investment soon becomes apparent when an investor tries to fit a large global company into a particular regional or sectoral pigeon-hole for allocation purposes.
“My argument for thematic investment 10 years ago was very simple. If you looked at what was then the largest company in the world, General Electric, you would see that it fitted no single country or industry box. Its largest division was power generation, its greatest turnover was in leasing and its highest margins were in medical technology. So what kind of company was it?”
Locating the company regionally was also a problem. “As was the case with almost every global company, General Electric didn’t even have a national base, and approximately 50% of its sales came from international markets,” Monson says.
“So if you could not identify the largest company in the world and the industry it was in, and could not identify the country it was in, what good are country or industry based models for global investors?”
The attraction of the thematic approach is that it gives investors the freedom to look for performing companies anywhere in the world, he says. This approach relies on being able to invest in a high proportion of emerging markets.
One of the most significant changes over the past 10 years has been in the change in the status and importance of emerging markets, Monson says. “In 10 years we’ve gone from a period where emerging markets were synonymous with risk to one where, on the purchasing power parity measure, they represents half of the world, and have probably contributed 13-14% of the growth of the world.
“We’ve gone from a situation when there were 45m internet users world wide. There’s now a billion and 36% of those are in Asia - 10% more than there are in the Americas.
“In the same period, the volume of global trade and foreign direct investment has expanded We’re expecting a 22% increase in FDI globally this year to $1.2trn (€950bn)of investment flows across borders.
Ideally, thematic investment needs a benchmark that truly reflects the significance of companies in emerging market economies, Monson says. “If I had the choice, I would benchmark the thematic approach not to the MSCI World index, as we do at the moment, but to the MSCI World GDP weighted index. Unfortunately very few people have the index, and it’s not widely used.
“The GDP weighted index ignores the size of the stockmarket. It just says ‘how big is your local economy - that’s the weight we’re going to give to your local stock market.’” He says: “Weightings for GDP weighted world index are approximately 33% US, 33% Europe, 15% developed Asia and between 20 and 25% emerging markets.”
Globalisation accounts for part of the success of thematic investment as a concept, Monson says, and two broad themes - the globalisation of exports and the growth of the internet as a means of transmitting global data - have benefited the thematic approach.
Thematic investment has worked, says Monson, because the world has got smaller. “Exports from China have grown five times by value over 25 years and now account for over 30% of global exports. The emerging market as a whole represents 43% of global exports. So 43% of cross border trade is emerging market originated.”
The growth of international free trade has also favoured thematic investment. Foreign direct investment into the emerging world is currently €557bn, 34 times the size of the figure 25 years ago.
“Between the 1950s and 1980s there were only 17 regional trade agreements around the world. By the early 1990s there were 74,and in 2001 there were 96.,” says Monson. “The so-called BRICs - Brazil, Russia India and China - have contributed 30% to world growth over the last five years.”
One development which has encouraged free trade and capital investment has been the collapse of emerging market credit yield spreads. During the Asian crisis eight years ago, emerging market companies were paying borrowers 1600 basis points, 16% over Treasuries to borrowers. Today they are paying only 170 basis points.
Another factor that has reinforced the case for thematic investment is the consolidation of world currencies. Currency systems are effectively as closely linked today as they were under the Bretton Woods agreement of 1944, which pegged currencies together from after the second world war until 1971.
Monson suggest that a similar situation exists today. Only 17% of world currencies float freely today. The rest of the world is belongs broadly to three currency blocs - the yen, the dollar, and the euro.
For thematic investors, the significant bloc is the dollar bloc since it covers most of the emerging world. Most countries in the emerging world peg their currencies to the US dollar which lowers the currency risk and the cost of capital in the region.
“That means that when Bill Bernanke sets interest rates to deflect a US housing crunch, he is setting rates not just for the overheated market in Arizona, Florida, Las Vegas and California, he’s setting interest rates for the whole of the dollar bloc. No-one else can really move their interest rates without him,” says Monson
“It also means that within the fast growing emerging world you have the same interest rate as you have in America but an economy growing at 3%.
“That’s given enormous impetus to capital growth and capital investment - another helpful factor for thematic investment.”
These developments are not confined to emerging markets. Monson points out European companies have been quick to capitalise on growth opportunities outside their own country. Siemens, for example, has doubled its business as it has moved into markets outside Germany. In 1990, 75% of Siemens business was in Europe. This has fallen to 50% as it has begun to invest in the Americas, Asia Pacific and Africa.
“For thematic investors, location no longer really matters. Nestlé has about 10% of its overall sales in Switzerland and less than 30% in Europe. It’s a truly global company,” he says.
The main factor that makes thematic investing suitable today, he suggests, is the convergence of the world’s markets. The global economy is becoming increasingly synchronised. “Back in the 1980s we had differences of interest rate of 10% or more between US and Europe . Now everything moves in a broadly synchronised fashion,” he says.
“This has also resulted in an extraordinary coming together of world bond yields. This has meant that country-based investing has become extremely unrewarding. It is extremely difficult to add alpha through country allocation.”
Ten years ago the correlation between UK equities and European equities was around half, meaning that 50% of the time European equities went up while UK equities went down. ” This meant you could do some really interesting trades moving money between UK and European equities.Today the correlation 92%, meaning that that in 92 days out of 100 UK and Europe will move in exactly the same direction. The CAC against the FTSE 100 is virtually a perfect fit.”
This synchronicity is worldwoide. “All of the world’s markets move in the same direction 67% of the time. So 67 days out of 100 there simply isn’t a trade to be done moving money between global markets. “
This produces challenges for investment managers, particularly indexers. “We think indices are highly correlated, particularly in today’s global economy and they perform in a very similar way. Allocating money in this way does very little to raise performance or lower volatility,” Monson says.
“Certainly low tracking error is one of the issues and ETFs represent very cheap index vehicles for number of markets worldwide. But low tracking error is not the same as low risk.”
The main problem with indexation is that, in contrast to thematic investment, it cannot cope with change, he says. “The indexing approach is cheap and highly effective, but only as long as the world doesn’t change. I compare running an index fund to someone steering a ship by going to the stern and looking at the direction of the wake. You know where you have been.
“Yesterday’s success stories must be tomorrow’s success stories for indexing to work. But over the last 10 years we’ve had some radical changes in the world, and that has been a period under which indexing does not operate well. The enormous outperformance of the UK index funds in the mid 1990s reflected a pharma industry, an oil industry and a banking industry, that were all growing simultaneously.”
Thematic investment has to look for future rather than past successes, and find what causes a company to be successful
onson uses five key themes to identify winning companies. The first is global pricing power: “We like anybody who can put their prices up regardless of the low inflation world in which live.
The second is global convergence: “Groups that can tie in to the single dollar area, for example.”
The third is intellectual property and innovation. ” We believe the only way to fight cheap emerging market products is to out-innovate. We believe an old fashioned R & D driven style market like the 1980s is due back in Europe again.”
The fourth is corporate restructuring, perhaps the cornerstone of Monson’s thematic approach. Monson cites the turnaround of Swedish company Ericsson as the flagship of European restructuring. “They cut operating costs by 52% in just two years. Their margins went sharply negative, but in two years they turned the business round with operating margins higher than they’d seen in the last 15 years.”
The fifth parameter is efficiency and automation. “Companies that are changing their business model to be able to do things better.”
These themes are not cast in stone, and can be changed or abandoned, says Monson. “This depends on the economics cycle and the speed in which the theme is reflected in equity valuations. We expect a new theme to have a life of at least three years but there is no hard and fast rule over this. One theme, corporate restructuring, has existed throughout the 10-year life of the fund, while profiting from inflation lasted little more than a year.”
One reason why thematic investment is now part of the investment manager’s toolkit is that it is relatively uncomplicated and easy to use, says Monson
“The thematic approach is particularly attractive because its understandable. People know what you mean by global convergence, they know that they are looking for pricing power and they read about corporate restructuring. It’s a very user friendly approach to investment.”