From Indexes To Insights: The Rise Of Thematic Investing
51From indexes to insights:The rise of thematic investingLeading institutions say this new approach can deliver betterperformance over the long term than their traditional methods.Here’s how they’re putting it in place.Vincent Bérubé,Sacha Ghai, andJonathan TétraultOver the past few years, a number of structuralassets; they can also miss out on the liquidityeconomic changes—a persistent bout of his-premium, which they collect by buyingtorically low interest rates, the polarization ofilliquid long-term assets at a discount. Second,growth between developed countries andrelative-investment frameworks can lead toemerging economies, and global deleveraging—an undesirable exposure to certain risks. Finally,have had an impact on how institutionalthe very nature of the strategic asset-allocationinvestors deploy capital. The “metabolic rate”process used to select benchmarks also holdsof the economy is also accelerating, withinvestors back. Strategic asset allocation is back-industry dynamics evolving faster than ever andward looking and fails to incorporate emerg-profit pools shifting across value chains ining trends and forward-looking perspectives onmany industries, thanks to unprecedented tech-the economy.nological innovations.To meet their absolute-return targets, manyIn this challenging environment, many insti-institutional investors are therefore start-tutional investors have started to question theiring to complement relative investing with atraditional “relative investment” frameworks,number of “absolute focused” investmentwhich are structured around either adhering to orstrategies, which can take the form of a greaterdeviating from benchmarks and indexes. Theseallocation to illiquid asset classes, con-frameworks often fail to achieve the specified ratecentrated portfolios, or relationship-investingof absolute return for three reasons. First, thestrategies, among other options.short-term focus of quarterly benchmarking worksagainst one of institutional investors’ greatIn addition, many are turning to “thematic”advantages, their long-term investment horizon.investment strategies. That was the mostA zealous focus on the benchmark meansintriguing insight we took from a series ofinvestors can miss chances to capture mispricedinterviews we conducted in 2013 with about
52McKinsey on Investing Number 1, Winter 2014/15a dozen pension funds, sovereign-wealth funds,thematic investing but also in other strategies.and other institutional investors. Broadly speaking,Third, it provides investors with a dynamicthematic-investment approaches seek to capture,and flexible way to validate and express theiracross asset classes and around the world,hunches by applying a forward-looking lensthe opportunities created by long-term structuralto investment decisions.trends and the medium-term cyclicality oftenassociated with these trends. Some investors haveInvestors have long been aware of thematicdeployed thematic strategies for years; theyinvesting, but many thought it too complex toappreciate the way these allow them to activelyimplement because of restrictive portfoliomanage risk and ensure that their capital isstructures, risk limits, and the challenge of puttingdeployed against the opportunities that best reflectin place the capabilities and processes neededtheir investment convictions. However, manyto develop truly distinctive investment insights.institutions have not yet taken advantage of suchIn recent years, however, a number of investorsapproaches. In this article, we outline a pro-have taken tactical and creative approaches tocess that some investors are using to develop andimplement some form of thematic investing,execute thematic-investing strategies.usually as an addition to their overall investmentframework. Exhibit 2 illustrates four of theseDemystifying thematic investingapproaches. It should be noted that newcomersto the strategy tend to allocate a significantThematic investing requires a fundamental under-portion of their active risk budget to it. This givesstanding of the impact of long-term economic,them the same total risk budget as before—political, and social trends on regions and sectors,though the risk profile may shift as a result ofwhich reveals investable opportunities.more concentrated and less liquid investments—Thematic investors develop proprietary viewsbut focuses it on opportunities that are moreon how the second- and third-order effectsaligned with their convictions.of structural trends will create hot spots or discontinuities in certain sectors and regionsEmbarking on the journeywhere value and risk will be concentrated. Thisis a big departure from relative strategies;The ability to fold a thematic strategy into aExhibit 1 illustrates some of the differences.relative-investing framework is good news forinvestors that have held back because theyAdopting a thematic-investing approach candid not wish to completely overhaul their approachyield three types of benefits for investors. First, itand their portfolio. But it still requires the rightallows investors to generate alpha at scale byresearch capabilities and a disciplined investmentfocusing on investment opportunities in hot spotsprocess. Our focus here is on the latter.1where a significant amount of capital can bedeployed. Second, the more systematic investmentA structured and rigorous approach is required notprocess and in-depth research required foronly to identify investable themes but also tothematic investing builds a deeper understandingprioritize them. The following five-step approachof the underlying drivers of value creation anddoes both and has been implemented by a numberrisk; investors can use this knowledge not just inof leading thematic investors.
53From indexes to insights: The rise of thematic investingMoInvesting 2014Indices to InsightsExhibit 1 of 2Exhibit 1Relative and thematic frameworks differ in several dimensions.Relative frameworkThematic frameworkAsset allocationAsset classes as building blocksSector and country exposure asbuilding blocks (matrix view)Portfolio constructionWeight of asset classes inportfolio based on economic cyclesand market conditionsSelection of themes, sectors, orregions across asset classes basedon underlying market trendsAlpha generationBased on security selection relativeto an indexBased on selecting groups ofcompanies that will benefit fromlong-term support of structural trendsDecision processPortfolio managers allocate capitalwithin defined mandatesInvestment committee arbitragesopportunities across themesInvestment performanceMeasured relative to an index(typically on an annual basis)Measured against an absolutetarget or a risk-adjusted index (overa 3- to 5-year rolling history)ExpertiseInvestment professionals withexperience in a given asset classor sectorInvestment professionals with acombination of in-depth regionaland sector experience acrossasset classesResearchTypically occurs within portfolios, withresearch performed at security levelCentral group develops house viewson priority themes and opportunitiesfor institution1. Consider the trendsA few factors are important to consider whenIdentifying the right trends to consider is essential.prioritizing trends. First, is the trend reallyAt this early stage, investors should holdstructural, or is it conjectural or short term inbroad internal dialogues to make sure all relevantnature? Does it have material implications fortrends are considered and to gain agreementthe evolution of certain sectors or regions? Second,on the rationale that will be used to prioritize anddoes the institution have the ability to generateultimately select some for more research.distinctive insights about that specific trend and
54McKinsey on Investing Number 1, Winter 2014/15MoInvesting 2014Indices to InsightsExhibit 2 of 2Exhibit 2Institutions are using a range of approaches to develop thematicinvesting strategies.Lower commitmentto thematic strategyApproachExampleDevelop thematic views withinexisting structureUse current risk limits in an internationalequity portfolio to increase exposureto specific solar-module producers inresponse to a renewable-energy themeDevelop and implement thematicinvestments within the risk limits andstructure of the current portfolioPut in place a thematic overlayFrom the center, establish a thematicoverlay portfolio or shift asset allocationsand increase their duration based onhouse views on sector/geographyCreate a single-asset-classthematic mandateAllocate capital to portfolios ormandates with investment strategiesthat rely on developing forwardlooking thematic viewsCreate a multiasset-classthematic mandateHigher commitmentto thematic strategyCreate a thematic fund to generatethe most attractive long-termrisk-adjusted returns by investing invarious asset classesGain long-term exposure to wheat priceby investing in wheat futures as part of athematic-overlay portfolioCreate and capitalize an equity portfoliowith a clear purpose of gaining long-termexposure to renewable energyCreate a portfolio—governed by amultiasset-class committee—looking intotechnology investments through acombination of venture-capital funds,direct private-equity investments,and public-equity positionsidentify sufficient investment opportunities?investor to a slowdown in Chinese consumerism.Third, are research and investment professionalsIn a nutshell, investors must ensure that theyexcited about the trend and willing to investunderstand their true exposure—both direct andtime looking into it?indirect—to these trends before conductingadditional analyses and seeking greater exposure.At this stage, investors should also develop arobust view of the institution’s explicit and implicit2. Move from trends to themesexposure to the selected trends before addingOnce key trends have been selected, investors mustmore long-term risk to the portfolio. For instance,trace them through to the themes they produce,an Australian investor may not own shares intypically the implications for a region or sector ofcompanies serving the rising middle class in China,interest. While the increased consumption ofyet a commodity-filled Australian equityfood in emerging markets is a powerful trend, forbenchmark can significantly expose that sameexample, the changing market for dairy protein
55From indexes to insights: The rise of thematic investingin China is a theme that can be realisticallytheme? Are there other assets that might do wellinvestigated for opportunities. In our experience,if the theme materializes? Can potential invest-the most attractive opportunities are foundments be made without running excessive risk?when multiple themes converge and reinforce oneanother in a specific region or sector and What is the risk that the theme will notwhen themes are expressed as discontinuities andmaterialize? The focus should be on counter-divergences from common knowledge.vailing forces and what they might mean for aThe identification of relevant themes depends ontry to avoid binary outcomes, as they presentinvestors’ ability to rapidly identify the effectshigher risks.potential investment. Investors typicallyof a trend on revenues and profit pools in affectedsubsectors. Making sense of vast amounts of Does the institution have the capabilities toinformation and identifying new economicdifferentiate itself? Factors such as distinctivepatterns in it is notoriously difficult. Most suc-knowledge, market access, a superiorcessful investors use external experts as thoughtunderstanding of the assets and their valuepartners and sounding boards to supplementchains, and existing relationships with ortheir internal knowledge. Our experience alsoprivileged access to the right partners shouldsuggests that investors that can rapidly moveall be considered.from interesting trends to themes before trying toidentify specific investment opportunities Does the theme fit within the current portfoliomove faster, get more impact from their researchconstruction and investment policies?investment, and develop more detailed insights.Choosing themes whose potential investmentscan be easily integrated and monitored within3. Select themesthe investment structure enables investors toPrioritizing themes is even more challenging, asmove rapidly and focus on building capabilitiesinvestors must make decisions based on imperfectrather than addressing governance issues.information and diverging points of view withinthe institution. The process can be time consumingThemes should be debated and prioritized byand frustrating without the right approach butrepresentatives from the investment, research, andrapid and effective if appropriately designed.risk teams to ensure both the soundness of thethinking and the alignment of the theme with theTo be successful at this important stage, institutionsoverall corporate perspective. This will preventtypically agree first on simple criteria based onthematic portfolios from becoming vehiclestheir risk/return profile and capabilities to investfor individuals to place large bets based on theirin a distinctive way. This boils down to fourpersonal biases.questions that should be asked about each theme:4. Develop an investment thesis Is the theme investable? Investors should assessOnce priority themes have been identified,the high-level attractiveness of the theme andinvestors must form an investment thesis describ-make sure there are ways to deploy capital againsting how and why value could be created fromit at the ground level. Are there companiesthese themes over time. This typically involves twowhose businesses are heavily exposed to thestages. First, investors develop an understanding
56McKinsey on Investing Number 1, Winter 2014/15of the value chains associated with a given theme, a selection of investments that have both highincluding the key players, industry dynamics,exposure to the theme and solid industryand performance drivers. Next, they develop afundamentals to offset the potential long-termperspective on how industry dynamics will benature of the investment and the risk that thealtered by the theme, forcing players to adapt andtheme will take time to materializecreating winners and losers. a clear investment approach—likely a set ofTo be successful at this stage, investors mustdiscrete investments, a portfolio of related assets,first ensure that their thesis is clear, grounded inor a platform for operations and subsequentobjective facts, and based on themes thatroll-up acquisitionshave a high degree of probability of materializing.Second, they must find insights into businessFinally, depending on the size of the portfolio andsystems beyond those most directly affected by thethe number of investments it includes, additionaltheme. For example, an investor looking intoconsideration might be given to the level ofthe impact on the transportation sector of popula-correlation of the various assets, as well as the keytions migrating to suburbs from large citysensitivities of specific thematic risk factors.centers may determine that the best investmentopportunity will be in the manufacturers ofbatteries that will power light trains rather than inthe transportation companies themselves orThematic investing provides an alternative toin the related infrastructure.traditional strategies—one that leverages thegreatest strengths of institutional investors while5. Build the portfolioproviding the opportunity to develop proprie-With a clear investment thesis in mind, investorstary knowledge and informed opinions. Bycan start a “scan and screen” process acrossunderstanding implicit sector exposures and thenasset classes to find the best ways to take a positiondetermining where and how to invest basedin the theme. Several characteristics mark theon well-researched and debated themes, institu-most distinctive investors at this stage:tions increase their chances of deliveringsuperior returns over time in an increasingly a clear perspective on the factors that willlead to success (that is, a concrete understandingof how value will be created and in whattime frame) a list of potential targets that is systematicallycomplex investment landscape.1 Regarding research, we heard from our interviewees thatthematic investors are shifting the emphasis of their sectorexperts from following companies to understanding sectordynamics. They are also finding new ways to combine sector andmacroeconomic perspectives.assessed against the success factors and monitoredover time to find the right entry (and exit) pointsVincent Bérubé (Vincent Berube@McKinsey.com) is a principal in McKinsey’s Montréal office, where JonathanTétrault (Jonathan Tetrault@McKinsey.com) is a director; Sacha Ghai (Sacha Ghai@McKinsey.com) is a director inthe Toronto office. Copyright 2014 McKinsey & Company. All rights reserved.
ing to complement relative investing with a number of “absolute focused” investment strategies, which can take the form of a greater allocation to illiquid asset classes, con- centrated portfolios, or relationship-investing strategies, among other options. In addition, many are turning to “thematic” investment strategies. That was the most
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Le genou de Lucy. Odile Jacob. 1999. Coppens Y. Pré-textes. L’homme préhistorique en morceaux. Eds Odile Jacob. 2011. Costentin J., Delaveau P. Café, thé, chocolat, les bons effets sur le cerveau et pour le corps. Editions Odile Jacob. 2010. 3 Crawford M., Marsh D. The driving force : food in human evolution and the future.
