September 07, 2021
September 07, 2021 | Adviser News
The Seven Sins of Thematic Investing
by Lazard Asset Management
Thematic investing offers a compelling way to capture the most important structural changes of our time - but only if implementation is robust. A deeper understanding of implementation issues can help an investor ask the right questions to distinguish a genuine investment thesis from slick marketing.
Lazard’s Global Thematic Equity team shares its decades of experience in identifying and avoiding the seven sins of thematic investing.
Common Implementation Mistakes in Long-Term Equity Strategies
We believe thematic investing offers investors a compelling opportunity to capture the most important structural changes of our time—but only if implementation is robust. The Lazard Global Thematic Equity team has honed its approach to long-term investing for decades, and we have learned through experience and close observation some of the mistakes investors can and do make.
In our companion paper, “Capturing Structural Change: A Guide to Thematic Investing,” we offered a comprehensive introduction to thematic investing, highlighting benefits in terms of return generation, risk mitigation, and sustainability integration. That paper also noted the importance of robust implementation. Over the years, we have identified many key implementation errors and, indeed, made a few of our own. Unfortunately, we see these errors playing out across the industry to this day, with potentially negative consequences for unwitting investors.
Many of the “thematic” investments available today are little more than slick marketing, in our view, and do not offer an opportunity to achieve excess returns over the long term. In this paper, we offer our insights as to how to identify and avoid implementation risks in thematic equity strategies. We provide suggested solutions, alongside a checklist of questions to ask managers to ascertain whether they are committing one of the seven sins of thematic investing.
In 2017, the Thinking Ahead Institute published a paper1 that detailed eight ways investors could create value over the long term, whether through enhanced returns or lower costs and loss mitigation. One of the potential sources of enhanced returns was thematic investing. The paper, however, noted the complexity of robust implementation.
Our decades of experience running thematic equity strategies lead us to heartily agree that investors can only realize the significant benefits of thematic investing if a strategy is implemented properly.
We have grouped potential mistakes into seven categories. This is not an exhaustive list and we focus only on certain aspects of thematic investment. There is a strong behavioral element to many of these mistakes because, in our view, human nature doesn’t change. In addition to documenting the problems we have seen, we offer our solutions to ensure a robust investment process and portfolio implementation, as well as a checklist of what to look for (and look out for) in a thematic strategy. Many of the observations here are equally applicable to other long-term equity approaches and even other asset classes.
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. Single-theme strategies are likewise susceptible to narrative fallacies as they create additional incentives for confirmation bias, where investment teams seek out evidence that confirms a strategy’s relevance and ignore evidence that undermines it. These risks can be mitigated by introducing competition for capital across multiple themes.
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. 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 ahead of an inherently uncertain future.
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. For this reason, we develop our own proprietary themes with an eye toward isolating specific structural changes that will generate returns. We also permit themes to evolve over time so they avoid obsolescence. Theme design should ultimately be as precise as possible rather than convey a grand vision— managers should use a scalpel, not a sledgehammer.
Sin No. 4: Puzzling Purity
Stocks that appear to be valid candidates for a theme might actually have very little relevance. Managers must look beyond simple purity metrics and choose companies that truly stand to benefit from the diverse potential drivers of structural change. Managers should also cross-check for idiosyncratic risk and valuation. Finding the right pieces to solve a thematic puzzle necessitates going beyond the obvious.
Sin No. 5: One-Trick Pony
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 geography, sector, or style. Sensible portfolio construction should employ diversification across different fundamental thematic ideas.
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. We place equal weight on both traditional fundamental analysis and sustainability-related externalities in our assessments, which we view as the very definition of ESG integration.
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. Covering a specific geography or industry, even for decades, might not produce enough learning opportunities. We advocate instead for a global, cross-sector approach. An independent relationship with highly experienced research analysts can provide a valuable reality check.