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October 2019

Thematic stocks – an alternative to mainstream global equities

Rolf Banz looks at why thematic equity investment may be a better way for investors to manage their global equity portfolio.


Overview – thematic equity investment: beyond just alpha

This paper asserts that thematic investment may be a better way to manage global equity portfolios. We believe that the fundamental features of Pictet Asset Management’s (Pictet AM) thematic investment strategy have an important positive impact on performance. In addition, thematic investing overcomes most of the limitations of traditional active management.

We start with a discussion of the distinctive qualities of Pictet AM’s theme strategies as building blocks for a global equity portfolio. We then contrast these qualities with the shortcomings inherent in the approach most actively-managed equity mutual funds follow. Finally, we look at how institutional investors might incorporate thematic investments into their portfolios, analysing one approach that could feasibly serve as an alternative to a mainstream global equity allocation. We also discuss the factors investors should consider before embracing thematic investments.

Thematic investing – a source of sustainable capital growth

The primary purpose of a thematic equity strategy is to invest in assets whose returns are influenced by structural forces of change that evolve independently of the economic cycle. In other words, thematic investing focuses on identifying enduring sources of capital growth.

At Pictet AM, we achieve this by following a disciplined investment process. First, and with the help of outside experts, we undertake research to unearth megatrends, the term we give to the most powerful trends transforming the investment landscape.

We currently have a list of 14 such trends (see Fig. 1). 
14 megatrends

Source: Pictet Asset Management

We then perform analyses to identify investment themes that are likely to benefit from one or more of these megatrends. At this time, we pursue 10 such themes. Different themes may represent very different levels of abstraction and generality; investment themes normally span a number of economic sectors and are invariably global and long-term in nature. Each theme also harnesses different combinations of megatrends. In all cases, we translate the abstract concepts underlying a theme into a list of coherent characteristics that potential investments must share.

For each thematic strategy, we maintain a list of stocks that meet those characteristics. An important criterion for inclusion is thematic “purity”. Only companies whose activities predominantly lie within the scope of a particular theme become candidates for investment: pure plays are always favoured over more diversified companies.

There is, in fact, a large body of research that suggests specialist companies make for better long-term investments than larger, more diversified firms. This literature, which appears to have been overlooked in recent years, points to the existence of a “conglomerate discount” – i.e. that big firms are worth less than the sum of their parts.1

The flipside of this is that portfolios made up of pure plays, firms that specialise in activities in which they have a distinctive competitive edge, can be expected to do better than a portfolio that contains conglomerates. (Although mega cap companies are no longer called conglomerates, a large number of such firms pursue the same wide range of activities). This focus on purity creates a tailwind for the thematic strategies.

The advantages of Pictet AM’s philosophy underlying thematic investment are:
  • By their very nature, megatrends are long-term phenomena. This encourages us to invest for the long term as well.
  • The investment universe is made up of specialist companies that are well placed to benefit from those megatrends. This should translate into superior long-term performance prospects.
  • The companies in our thematic universe share many important attributes that are historically associated with superior profit growth and earnings power. This makes the investment process more focused and less complex, which in turn increases the probability of successful stock picking.

Specialist companies, specialist investment managers

Adding value - beyond mere alpha

Many investors consider active management of equity portfolios as expensive, unlikely to add value after costs. 
Even though the average active investor must underperform, there are, of course, managers who add value consistently. We believe that Pictet AM’s thematic teams are among them for the following reasons: 
  • The design of the thematic strategies incorporates a broader view of alpha, one that goes beyond simply beating an index. Thematic investing encompasses a holistic approach, starting with the selection of an appropriate – and superior – investment universe.
  • We allow the investment teams complete freedom in the selection of their stocks, eliminating ‘forced’ or ‘uninformed’ investment decisions.
  • We focus on stock selection, which is generally more promising than sector/regional or market timing bets.2  

Coherent investment process

The starting point for each theme strategy is not a benchmark but a broad investment universe. Since there are no consensus indices for thematic strategies, the investment teams do not need to obsess about matching a benchmark but are able to focus on finding the most attractive stocks for their portfolio instead. The strategies are truly benchmark agnostic.
Size of the universe

Source: MSCI, Pictet Asset Management; data as of 31.01.2016; Overlap is the proportion of portfolio holdings that also feature in the MSCI Index. It is the sum of all overlapping holdings, calculated by summing the minimum of the two weights. Active share is the percentage of the portfolio that is not represented in the index. Data for traditional active global funds taken from the largest 10 actively-managed global equity UCITS funds in Morningstar Universe

The investment management teams analyse companies within the context of a theme’s stock universe. The output of the stock selection part of the process is a ranking based on a company’s perceived attractiveness.3 

Fig. 2 shows the key positive features of the thematic investment universe. The first is that the universe is large – there are almost as many thematic stocks as there are companies represented in mainstream equity indices. The second, and perhaps more important characteristic, is that thematic companies are, at the same time, very focused in their business activities, with ‘pure plays’ making up a significant part of the investible market. A third feature of thematic equity investments is that they are rarely accessible via mainstream stock indices.

As Fig. 2 also shows, our Global Megatrend Selection (GMS) strategy – which is a combination of all 9 of our individual thematic strategies – has a high active share and a lowoverlap with the MSCI World Index. In other words, the portfolio’s make-up bears no resemblance to the index. 
For each thematic strategy, there are explicit rules for the construction of the portfolio. 
Subsequent return, % annualised, by sector analyst rating, after stock rating issued 2009-2016
Total return of stocks, % , annualised by sector analyst rating

Source: Fidelity; data covers period 31.08.2009-31.01.2016. The Equity Summary Score provides a consolidated view of the ratings from a number of independent research providers on Fidelity.com. Historically, the maximum number of providers has been between 10 and 12. Only stocks that have 4 or more firms rating them have an Equity Summary Score. It uses the providers’ relative, historical, recommendation performance along with other factors to give an aggregate, historical accuracy-weighted indication of the independent research firms’ stock sentiment. For more detail on the methodology used, see link

Portfolio weights are based primarily on the analysts’ ranking and purity. Thematic purity is a proprietary, quantitative indication of how specialised a company’s activities are. The higher the rating, the more specialised the firm.

If, for example, a company within our Pictet-Water strategy is found to have a purity of 50, this means that half of its enterprise value4 is derived from products and services that cater to the water industry. The average purity of the companies in our thematic portfolios is at least 65.

The clear organisation and the simple construction process combine to maximise the likelihood of successful stock selection. 

There is ample evidence that stock picking within – rather than across – sectors can work reasonably well for talented analysts. They seem to be able to discriminate between stocks that will perform well – their “best ideas” – and those that will do less well, on average.

This is shown in Fig. 3, which gives the aggregate performance of ‘buy’ and ‘sell’ recommendations obtained from independent research organisations. It was collated by a US fund manager.

The data shows that past performance appears to be in alignment with the stock rating. Even though these results represent the averages of thousands of recommendations, stock selection within sectors does seem to have the potential to add value.

Specialists not generalists

Each thematic strategy is managed by a dedicated investment team, which carries out its own research and constructs its own portfolio. Each team member is a portfolio manager, sharing responsibility for the management of the strategy. By dedicating all their attention to a clearly-defined universe of stocks, investment managers develop distinctive, specialist expertise.

This gives them an advantage over the typical active global equity team, which works rather differently. A large number of mainstream global equity funds are run by managers that are supported by several analysts, whose task it is to generate lists of their best ideas within their assigned sectors. The portfolio construction team then chooses stocks from among those recommendations.

Sector-specific analysts tend to be good predictors of stock performance.

Naturally, portfolio managers are less focused than analysts – they have to cover a substantially larger universe of stocks. This can make it very difficult to add value in the portfolio construction process. A study compared the performance of single- sector and multi-industry sector funds managed by the same Boston-based fund house.5 The asset manager runs dozens of single-sector equity funds and hundreds of multi-industry sector funds. Its study compared the performance of every multi-sector fund with that of a (theoretical) portfolio composed of single-sector funds with the same sector weights as the multisector fund portfolio. The results are quite striking: the portfolios of single-sector funds outperformed the multiindustry sector funds by an average of just under 3 per cent per year over a 10 year period.

So, as these results show, cherrypicking stocks from a list of analyst recommendations is very difficult to do, not least because some of the investments made are not really best ideas at all, but simply ‘fillers’ to ensure that the portfolio remains within the tracking error limit imposed by clients. Only the very best portfolio constructors who use this approach can hope to add value.

To summarise, there is some evidence that skilled, experienced analysts can separate future winners from losers within industry sectors. But some of that added value can be lost due to a complex portfolio construction process. Pictet AM’s thematic approach avoids this complexity by having portfolios managed by specialist teams that focus on a single theme. This integrated approach ensures that there is credible coverage of all stocks in their investment universe.

A digression on benchmarks

The proponents of passive management tell us that indexation is the best, if not the only imaginable, solution: it offers a low cost, perfect replication of market performance. 
Major world equity indices vs alternatively-weighted variants
Thematic stocks

Source: MSCI, Pictet Asset Management; data covering period 05.01.2001-31.01.2016; tracking error calculations taken from weekly observations.

What is forgotten in this somewhat simplistic view is that the chosen index does generally not include the entire market. Any market index is an arbitrary choice both in terms of the stocks that it includes and the weighting of those stocks.

Market capitalisation is only one imaginable weighting scheme. It is convenient, macro consistent and it does to some extent lead to selfrebalancing.

Yet credible alternatives exist; from equal weights to a range of fundamental weighting schemes.

To see why opting for the passive approach is, in reality, an active investment decision, investors need only look at the impact indices’ arbitrary weighting schemes can have on their historical returns.

Fig. 4 shows that replacing the standard MSCI World index with other, equally plausible indices from the MSCI family would have led to rather different, in many cases significantly better, investment results. It shows that the tracking error – which measures active risk – of some of the alternative indices relative to the standard world index is substantial, i.e., a significant part of the active risk of portfolio is due to the choice of index.
There cannot be any purely passive investment since the selection of any index is very much an active decision. The obsessive focus on standard benchmarks also encourages investors
to disregard stocks that are not included in those indices. 
FIG. 5 - ANNUALISED RETURNS, %, 2001-2016
Annualised returns, %, 2001-2016

Source: MSCI, Pictet Asset Management; data as of 31.01.2016

This usually results in a large cap bias. We might therefore be able to obtain better results by simply expanding the investment

Pictet AM’s thematic teams exploit this fact. They do not try to beat an arbitrary index through tightly controlled relative bets – to control tracking error – but focus instead on the creation of and selection from the most attractive investment universe possible.

Thus, one unfortunate side effect of the rise of passive management is that it has led investors to focus exclusively on matching a standard index, while disregarding the rather more important question of selecting a reasonable weighting scheme for a benchmark based on a broadly defined investment universe.

A distinctive portfolio building block

Naturally, whether the GMS strategy or investments in mainstream stocks lead to better results is ultimately an empirical question.

Source: Pictet Asset Management, Thomson Reuters Datastream; Data covering 30.11.2008-31.01.2016; Returns in US dollars, gross of fees.

The results for the strategy compared to the MSCI ACWI indices since inception are shown in Figures 6 and 7.

History suggests that the GMS strategy is an attractive alternative to both index funds and traditional active portfolios.

But its attractions go way beyond just performance.

GMS is also a better diversified portfolio than the typical actively-managed global equity fund – both in terms of the number of securities it holds and the extent to which its holdings overlap with those in MSCI global stock indices.

This diversity has given the strategy a defensive quality – during periods in which global equity indices have suffered heavy monthly falls, GMS has persistently delivered a positive relative return.
GMS strategy vs MSCI World all-country index

Source: Pictet Asset Management, Thomson Reuters Datastream; Data covering 30.11.2008-31.01.2016; Returns in US dollars, gross of fees.


Conclusions and caveats

main attractions of Pictet AM’s thematic approach

The potential of megatrend-driven themes

If our assertion of the superior return potential of megatrend-driven themes is correct, then the investment universe of our thematic strategies should outperform the broader market. This is an important tailwind that contributes positively to long-term returns. The constituents of the thematic strategies are by construction mostly pure plays on the theme rather than firms with a diversified portfolio of activities. They therefore benefit from not being subject to the conglomerate discount.

Active investment management

The active investment management of the thematic approach overcomes the shortcomings inherent in traditional longonly equity funds. Pictet AM’s thematic team is organised in a way that maximises its chances for success. The freedom from obsessive benchmark tracking facilitates stock selection and avoids forced bets.[7] There is no complex portfolio construction element than can dilute the value of good stock selection.

A ready-made alternative to traditional active (and passive) global equity portfolios

With the GMS strategy, we have a ready-made alternative to traditional active (and passive) global equity portfolios with exceptionally attractive characteristics. It is very broadly diversified, yet obviously active, with distinctive building blocks that avoid the usual focus on “institutional favourites” but seek to find focused companies with exceptional long-term prospects.

However, a thematic approach is not for everybody. 

Anybody subject to a short investment horizon should not consider our thematic approach. Investors unable to tolerate significant deviations from the standard benchmarks should also abstain since there will be periods – possibly extended ones – when thematic equities lag the MSCI indices. But for investors who are willing and able to get away from the herd and take a longer-term view, the thematic approach offers highly attractive prospects indeed.