September 07, 2021
September 07, 2021 | Adviser News
The Seven Sins of Thematic Investing: Sin No. 2 Foggy Forecasting
by Lazard Asset Management
Forecasting, particularly as far out as the next decade, is at best imprecise and at worst dangerous. Investors should ask managers where their ideas originate and prioritize sources grounded in real-world experience rather than popular consensus. We source most of our ideas from discussions with companies themselves, as they will be allocating the capital that will drive structural change. Managers should be humble about their ability to predict future outcomes amid unforeseeable risks and be wary of attempts at optimization around an inherently uncertain future.
Lazard Global Thematic Approach
|Underestimating future uncertainty
||“Inevitable” changes fail to materialize.
||Source likely structural changes from empirical company observations to improve scenario analysis
|Inadequate analysis of interaction between structural changes
||Focus on one aspect of future change (e.g.,disruption, sustainability) but hold others constant||Combine multiple structural changes and their interactions into a view of the next decade
|Excessive confidence based on false precision
||Process built on long-term target prices, leading to excess concentration or continual optimization||Portfolio construction designed to allow for “unknown unknowns”.
The source of thematic ideas matters a lot. Popular perceptions of the future are frequently incorrect in terms of magnitude, direction, or timing. The primary aim of both the media and many “thought leaders” is to attract eyeballs, rather than to offer up rigorous accountability, which should be an unsettling thought to those investing in products that treat these sources as primary proof points and actionable information.
We believe that thematic insights should be grounded in real-world experience. That’s why company management teams are the primary source of our understanding of the most significant structural changes of the next decade. We meet with a large number of management teams each year who offer direct data points about structural changes within their industries, economies, and markets. As the companies will likely be key enablers of these structural changes and are deploying capital to make them happen, their views represent an invaluable primary source.
It should be noted that we approach our conversations with a healthy dose of skepticism. We supplement them with information from our global research team and seek conflicting views by speaking to, for example, both incumbents and disruptors. Having the experience and expertise to properly evaluate and weigh the information that comes out of these discussions is, in our view, a widely underappreciated investment attribute. We discuss this further in Sin No. 7, “The Wrong Resume”.
Insights from our meetings form the basis of our Global Framework, an overview of how we think the world will change over the next decade. Yet, crucially, structural changes do not happen in isolation. The Global Framework blends together all the key structural changes we identify in a single place, ensuring we consider the interactions between them. This is preferable to the unrealistic assumption that any strategy can perfectly isolate a single structural change.
Even if they are inspired by a manager’s vision, investors should also expect the people managing their money to be humble about their ability to know the future. For thematic managers, this humility needs to be incorporated from first principles, starting with the investment philosophy and carrying right through to stock selection and position sizing. Features such as 10-year target prices, extreme outsized positions in single stocks, or excessively precise optimization of theme or stock weights are, in our view, red flags that suggest hubris.