From benchmarks to themes: Investing with a focus on the future

The decade and a half since the onset of the global financial crisis in 2007-2008 has been marked by significant structural changes in the world’s economy. Following more than a decade of persistently low interest rates, inflation has soared in 2022, prompting central banks to raise interest rates to the highest levels seen this century; after a period of lacklustre economic growth, the pandemic prompted stop-start growth, followed by tighter monetary policy that has tipped many big countries toward recession.

Economies find themselves in flux. Many major business sectors have experienced significant disruption – and in some cases destruction – at the hands of new technologies, new competitors and new business models, with the recent enthusiasm for artificial intelligence only the most recent of series of developments. Amid these changes, the trend toward globalisation has stalled, risking economic polarisation and the emergence of mutually suspicious global trading blocs.

The changes have influenced an ongoing reappraisal by many institutional investors and other asset allocators of the best way to manage investment portfolios. Does it make sense, for example, to determine investment in companies according to where they choose to be headquartered or listed – which may have little to do with where they generate or distribute goods or services – or simply to disregard national or regional boundaries? For example, the luxury goods and drinks conglomerate LVMH is still regarded as a French company, although only 10% of its revenues come from its home country, and only 29% from Europe as a whole.

Benchmark limitations

Another issue that requires re-examination is whether, at a time when companies appear more vulnerable to significant disruption from economic developments, natural disaster, political events or even war, does it make sense to base investment strategies on traditional benchmarks?

The risk of this approach is that it may direct investment toward long-established incumbent companies that could find themselves on the wrong end of technological change, while ignoring the new and smaller businesses that are bringing that change about. The climate transition itself poses a dilemma: should investors give more weight to the recent surge in profitability of fossil fuel extraction and its use in energy generation, or to the risk that companies will be left with expensive stranded assets such as coal mines and oilfields that can no longer be exploited?

There are wider problems with benchmark-based investing, as are highlighted in a 2014 paper by McKinsey analysts Vincent Bérubé, Sacha Ghai, and Jonathan Tétrault  ”From indexes to insights: The rise of thematic investing”. They argue: “The short-term focus of quarterly benchmarking works against one of institutional investors’ great advantages, their long-term investment horizon.

Relative-investment frameworks can lead to an undesirable exposure to certain risks.

“A zealous focus on the benchmark means investors can miss chances to capture mispriced assets; they can also miss out on the liquidity premium, which they collect by buying illiquid long-term assets at a discount. Relative-investment frameworks can lead to an undesirable exposure to certain risks.”

Broad global trends

Over the past decade or so, many institutional investors have responded to these issues by focusing on themes. This involves identifying long-term, well-established and persistent trends in the global economy and society, and finding companies that stand to benefit from them, wherever they might be in the world.

This makes intuitive sense. Investing with a narrow geographic scope when companies compete globally seems to make progressively less sense, albeit recently with the caveat that trends such as ‘nearshoring’ and ‘friendshoring’ must also be taken into account. Still, if a German consumer goods company is losing European market share to a more nimble French competitor, investors would benefit from having the French company in their portfolio – but the competitive threat might not be evident if their focus is solely on Germany’s domestic market.

The themes investors are examining tend to be broad, such as global population growth. The United Nations currently predicts that the world’s population will reach 9.7 billion by 2050; meanwhile, there will also be substantial growth in the size of the middle classes, primarily as a result of rising prosperity among emerging market countries, headed by China and India. This would have implications for patterns of consumption, agriculture and housing, and could greatly affect the growth prospects of companies in a wide range of sectors.

Ageing population

In parallel, urbanisation is a major trend across the globe. Already more than half of the world’s population lives in cities, and as many as 1.5 million people join the global urban population every week – increasing demand for infrastructure such as energy supplies, roads, utilities and mobile telecommunications.

Meanwhile, population ageing is changing assumptions in ways that will affect investment considerations. Soon there will be more over-65s worldwide than under-fives, and countries led by Japan and Italy are already well down the road toward a severe imbalance between the growing number of inactive pensioners and a shrinking active workforce. This change will mean significant opportunities for companies geared to the needs of elderly people facing longer decades of retirement than in the past, and those specialising in machines, networks and systems that reduce the need for human labour.

Advocates of thematic investment argue that it circumvents the messy business of trying to forecast the economic outlook for individual countries. Forecasting can be a haphazard business at the best of times, and the likelihood of predicting accurately the outlook for the future and taking the right investment decisions as a result is low.

Advocates of thematic investment argue that it circumvents the messy business of trying to forecast the economic outlook for individual countries.

Convergence with sustainability

The adoption of thematic approaches dovetails with the emergence of the sustainable investment shift. Investing through a sustainability lens – paying attention to companies’ environmental and social impact, as well as their governance – can be both a major theme in itself and an overlay applied to portfolios drawn up according to other criteria. For example, the growing urgency of heading off climate change should benefit companies active in renewable energy provision, as well as the infrastructure needed to bring solar, wind and wave energy to consumers and businesses. Then there is the need to develop technology to minimise pollution and facilitate the recycling of existing resources.

Themes enable investors to look forward rather than back, which is important at a time when, more than ever, past performance is a poor guide to the future. The historic performance of a high street retailer or department store is meaningless in the era of Amazon, but a thematic approach can guide investors toward companies set to capitalise on digital disruption.

However, thematic investing does pose some challenges. It is not always easy to obtain pure exposure to a particular theme. Some of the leading drivers of alternative energy solutions are companies that also continue to exploit significant legacy fossil fuel businesses, for instance.

It is not always easy to obtain pure exposure to a particular theme.

Adapting financial models

Similarly, artificial intelligence may account for only a small part of the revenues of companies that stand to benefit most from it. Thematic investors need to take decisions on how much exposure is meaningful in order to benefit from the hoped-for performance.

At the same time, existing financial models may prove inadequate in terms of accommodating thematic investment. Many portfolio managers continue to be bound to return targets tied to traditional-style benchmarks or base their asset allocation on narrow geographic criteria. Without changing this approach, it can be difficult to incorporate thematic investing into an overall strategy, no matter how compelling the logic.

Thematic investment is evolving and continues to gain momentum. However, it is still a relatively new investment approach, and vindication of some of the theories and assumptions that underpin themes will come only with time. But since thematic investment is designed to reflect the world as it is, rather than what it used to be, it is likely to make further inroads into the mainstream investment firmament over the long term.