Sunday, March 08, 2015

Thematic Investing Train Leaves The Station

The finance sector is always ready to entertain some new theory.  The latest is thematic investing, which can mean just about anything.  A handful of asset managers and consultancies have think pieces telling institutional clients how to make this work.  Do a Web search to read them yourselves.  I poked around a number of reputable sources tracking thematic investing to see what's missing from the discussion.

Academic validation is the main missing link.  The academic research on focus investing validates a very selective approach to investing in a small portfolio of actively selected stocks, provided those stocks have strong fundamentals and are held for the long term.  Books covering Warren Buffett's methodology support this conclusion but it's worth mentioning that Buffett himself is genetically unique.  No other human investor or human-created selection screen has been able to duplicate his performance.  Ten years is the minimum for a long-term holding but active investors pursuing thematic investing usually don't have that kind of patience.

Whether an average investor can outperform a broad market simply by starting with a pure macro idea is questionable.  Investors awaiting hard evidence need only look at the poor track records of most hedge funds and sector-specific mutual funds to see the problems facing theme investing.  The longer think pieces I've read on thematic investing emphasize wishy-washy concepts like hunches, feelings, and inclinations.  Those are poor reasons to pick stocks.  Thematic investing appeals to some of the lamest institutional investors, specifically sovereign wealth funds and pension plans, who fell for the Swensen-Yale investing model when it was hot.

Plenty of macro ideas are just plain bad.  "Globalization" is a very broad theme implying multinational corporations are best suited to handle it.  The trouble is that multinationals are often tied to the regulatory environment of their home countries.  Here's one I won't try:  the "food-water-energy security nexus."  It matters to geopolitical strategists who try to predict conflict flashpoints.  It matters less to corporations that play it primarily by mitigating its risk.

Thematic investing is not for everyone.  Investors are welcome to pick their favorite sectors provided they know a sector inside and out.  Sector market leaders have pricing power and the sectors themselves have barriers to entry (like switching costs) that deter competitors.  Those are components of a Buffet-style durable competitive advantage.  The dearth of competent investment managers means the mediocre majority will fall back on weak top-down selection strategies.  Thematic investing is gaining speed with people who don't know where they're going.