September 07, 2021

September 07, 2021 | Adviser News


The Seven Sins of Thematic Investing: Sin No. 5 One-Trick Pony

by Lazard Asset Management

 

Having multiple themes is of no benefit if they are all the same underneath the surface. A thematic strategy should try to access multiple sources of return from structural change without permanently embedding a reliance on a particular factor based on geography, sector, or style. Sensible portfolio construction should employ diversification across different fundamental thematic ideas.

 

Implementation Risk

Description

Lazard Global Thematic Approach

Dominant factor exposure “Thematic” narrative is overlaid on a portfolio which really just expresses a single dominant factor. Incorporation of diversification between themes and within stock selection criteria; mitigate or openly disclose dominant factor exposures.
Insufficient risk mitigation at portfolio level One or more themes or stocks dominate portfolio performance. Themes and stocks are weighted broadly equally, such that each contributes evenly to portfolio return and risk objectives.
Insufficient risk management Portfolio construction is ultimately too reliant on either fundamental judgment or quantitative tools. Portfolio construction should employ a blend of qualitative and quantitative tools.


Anchoring to themes instead of a benchmark poses a range of questions around portfolio construction, particularly risk management. Traditional benchmark-centric approaches typically target relative portfolio characteristics such as active share and risk metrics such as tracking error, yet clearly these are not relevant to a benchmark-agnostic strategy. So how should a thematic portfolio consider risk?

In Sin No. 1, we discussed the relative risks of strategies based on a single theme as part of a larger concern with narrative fallacies. The cousin of the single-theme strategy is the “thematic” fund that is really a single-factor fund. In our view, a thematic fund should try to access multiple sources of return from structural change without permanently embedding a particular factor based on style, sector, or geography. To the extent that a single dominant factor cannot be mitigated or is part of the overall process and portfolio construction, it should be openly acknowledged and disclosed, in our view. Investors need to ask themselves if, under the guise of a “theme” they are being asked to pay active management fees for access to a relatively simple factor.

Instead, our approach returns to first principles. We are investing in long-term structural change, which is uncertain. The best defense against this uncertainty is to ensure that we are anchored to many different structural drivers, and not just putting all of our eggs in one basket. We have already established that we can capture exposure to a number of structural drivers in a single theme. By combining a number of themes together we can further enhance potential diversification benefits, provided that the themes are not driven by the same aspects of structural change. So, the first task is to ensure that themes are genuinely different from each other. We believe that this diversification at the theme level is superior to geographic or sector-level diversification, as it is driven by fundamental analysis of what actually drives businesses rather than arbitrary benchmark classifications.

How should capital be allocated between themes? Clearly, we should wish to optimize for perceived long-term return and risk, yet as we saw in Sin No. 2, “Foggy Forecasting”, we need to be humble about our ability to predict future outcomes amid unforeseeable risks. We typically try to design themes so that the overall perceived asymmetry - considering both long-term opportunities and downside risks - is broadly similar for each theme. For this reason, our portfolio generally consists of a number of approximately equally sized themes. Only if our qualitative and quantitative analyses suggest that a theme could potentially dominate overall portfolio performance at an equal weight would we reduce the weight of that theme to attempt to normalize its contribution to the portfolio.

Similarly, we believe all stocks in a theme should contribute equally to the theme’s return and risk profile, which normally translates into broadly equal position sizes. Occasionally, we may hold a security in a substandard position size, either because the company has high levels of idiosyncratic risk or because we believe certain risks are best mitigated through additional diversification. In the latter circumstance, we typically use a basket approach to implement the idea.

Quantitative tools can assist in risk management at both the theme and the stock levels. For example, the team monitors inter-theme correlations, theme volatilities, and overall portfolio volatility data as prompts for revisiting fundamental views. Though our strategies are benchmark-agnostic, we may monitor (but not manage) common benchmark-centric risk metrics to help us understand portfolio exposures. Yet, we also know that over the long run correlations and volatility metrics can change. Using both qualitative and quantitative processes are the best way to understand and manage risk.

In summary, we seek to mitigate exposure to unintended risks at the portfolio, theme, and stock levels. Managers need to be aware of dominant factor exposures and disclose them. It is also easy to become enamored with a theme or stock and allow either to dominate returns. Fundamentally different themes, implemented via broadly equal risk-adjusted weights at both the theme and the stock levels, can take the emotion out of portfolio construction decisions and acknowledge that there is much we cannot know.

Questions to Ask the Manager

  1. Are there any underlying dominant factor exposures? If so, are they temporary or permanent?
  2. Is one theme more significant than others in terms of size or risk-adjusted metrics?
  3. How are quantitative tools applied?
  4. How do you size theme and stock positions, and what is the underlying philosophy behind the approach?

September 07, 2021

Insights from our Partners: The Seven Sins of Thematic Investing

Lazard Asset Management’s Global Thematic Equity team shares its decades of experience in identifying and avoiding the seven sins of thematic investing.

September 07, 2021

Insights from our Partners: Sin No. 1 Narrative Fallacies

Thematic strategies are particularly vulnerable to building themes around slick, but ultimately empty, marketing narratives rather than genuine return opportunities.

September 07, 2021

Insights from our Partners: Sin No. 2 Foggy Forecasting

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.

September 07, 2021

Insights from our Partners: Sin No. 3 Sledgehammer Scope

Generic investment ideas are sledgehammers - simple, broadly defined investment propositions that make an immediate marketing impact but can leave lasting damage to portfolios. Themes that are designed too broadly in scope may not target the actual return opportunity.

September 07, 2021

Insights from our Partners: Sin No. 4 Puzzling Purity

Stocks that appear to be valid candidates for a theme might actually have very little relevance.

September 07, 2021

Insights from our Partners: Sin No. 6 Failure to Integrate

We observe that managers tend to make three mistakes when claiming to incorporate sustainability into their investment processes: failing to do it, pretending to do it, or doing it badly.

September 07, 2021

Insights from our Partners: Sin No. 7 The Wrong Resume

Genuine thematic experience is scarce. We believe it is crucial that investment teams on thematic strategies have had specific training and experience in analyzing many structural changes, not just time in the market.

 

Important information: The content of this publication are the opinions of the writer and is intended as general information only which does not take into account the personal investment objectives, financial situation or needs of any person. It is dated August 2021, is given in good faith and is derived from sources believed to be accurate as at this date, which may be subject to change. It should not be considered to be a comprehensive statement on any matter and should not be relied on as such.  Past performance is not a reliable indicator of future performance and should be used as a general guide only. Neither Zurich Australia Limited ABN 92 000 010 195 AFSL 232510, nor Zurich Investment Management Limited ABN 56 063 278 400 AFSL 232511 of 118 Mount Street North Sydney NSW 2060, nor any of its related entities, employees or directors (Zurich) give any warranty of reliability or accuracy nor accept any responsibility arising in any way including by reason of negligence for errors and omissions. Zurich recommends investors seek advice from appropriately qualified financial advisers. Zurich and its related entities receive remuneration such as fees, charges and premiums for the financial products which they issue. Details of these payments can be found in the relevant fund Product Disclosure Statement. No part of this document may be reproduced without prior written permission from Zurich.

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