Globalisation, digitisation and automation make it impossible for portfolio managers to be experts on every topic. Information technology multiplied market drivers. Managers are asking themselves how they can navigate through this increasing informational noise to make their portfolios future proof. One solution is to focus on underlying, long-lasting themes.
Going thematic is more than merely identifying trends that will drive the markets in some undefined future. Assessing potential winners and losers on a regional or sectoral level is as important as evaluating how far a theme or trend has matured with respect to its market penetration. Climbing aboard the ‘hype train’ may deliver short-term gains. Still, it is likely that managers may stick with one of the many companies that doesn’t make it through the following downturn. When it comes to thematic investing, timing is everything.
Preparation and courage are crucial for asset managers and institutional investors. Theme investing requires structural changes in infrastructure, organisation as well as mindset. Research goes from focusing on a single asset class or region to encompassing many different instruments, industries and locations. Thematic research also starts from the top. That means a new approach to research is needed too.
Implementing themes into portfolios can be quite challenging, even after ones are identified and suitable financial instruments are found. Funds that focus on a single or a set of themes are one option to translate research topics into trades. But the market for suitable products is limited as they often lack diversification and are feasible for a comparatively small group of investors. A second challenge is a technical one. Theme investing is commonly done through a basket of different stocks, bonds or derivatives. For a portfolio manager it is complex, time consuming and expensive to buy and scale such a basket into an existing portfolio.
Many of these challenges can be solved with total return swaps. Baskets containing any kind of financial instruments are internally and cost-efficiently transformed into a single derivative that can easily be integrated while still ensuring the full transparency as if individually invested. By doing so, themes can be used widely and are no longer limited to dedicated funds. Another advantage of using total return swaps is that it makes investments possible on a more granular level, thus emphasising idiosyncratic opportunities. The risk of bringing an adverse factor bias into the portfolio is limited as this problem can be accounted for by constructing a factor-optimised basket.
Themes can be highlighted by regulatory changes, structural changes in underlying demand behaviour and even cultural changes. One current strategic theme is, for example, betting on fundamental changes in Japanese conglomerates. Corporate Japan has been characterised for many years by comparatively low shareholder returns and complex, inflexible and inefficient structures. New legislation promotes demergers and take-overs which should boost consolidation in several sectors, as well as higher pay-out ratios. The long-leg of a basket that profits from this trend could consist of those conglomerates where a structural change is likely to happen, whereas the short-leg could be the broader Japanese market. During the basket construction process, the implementation or control of factor bets is also possible. In this example a ‘long value’ and ‘short quality’ exposure could enhance possible returns as more radical structural changes are expected with companies with greater exposure to these factors.
An example of structural change coming from a cultural shift is a change in consumption behaviour. Millennials, especially, are prioritising experiences over material possessions. Experiences are more personal, individual, social and generally tend to make people happier than pure material consumption. Key drivers for this new trend are an overall growing prosperity, an ageing society, a mindset shift between generations X, Y and Z, as well as the democratisation of experiences as a whole, thanks to social media.
Companies benefiting from this gradually rising and persisting trend would be restaurants, social media firms, tourist focused brands, music businesses and video game studios. A basket of suitable single stocks (that again could easily be factor-optimised) wrapped into a total return swap would make this theme investible for many funds and investors. But coronavirus shows that timing remains crucial.
Taken together, thematic investing could enhance performance two-fold. First, it helps to further diversify a portfolio by pushing the efficient frontier of possible investment combinations further outwards. Second, themes help to reduce noise, identify and keep the most promising firms and by help generate active returns.
Philipp Brugger is Head of Investment Strategy at Union Investment