Warming to a theme

A number of big themes are shaping the world of investment. It is up to active managers to figure out which ones will shape returns. Emma Wall reports

Imagine a G8 summit: topics on the agenda include climate change, population growth, inflation and poverty. But instead of David Cameron and Angela Merkel in attendance, pension trustees sit deciding the investment strategy for a scheme. For the uninitiated this may sound farfetched, yet why wouldn’t trustees look at the themes likely to dominate investment markets in the coming decades?
In September this year Towers Watson produced a “thematic-based secular outlook designed to set out its Global Investment Committee’s (GIC) long-run expectations for global economic growth”.
Entitled Secular Outlook 2013, the paper “expounds the merits of thematic investment relative to more traditional asset class-based investment frameworks and provides a new perspective on generating return and understanding risk”.
The paper made simple forecasts for the next decade and beyond, stating that emerging economies will outperform developed ones, but that it will be a bumpy ride.
While this shift in power from West to East is not exactly ground breaking when it comes to investment themes, the realisation that the growth in emerging markets will come with a cost is recent.
For almost 20 years emerging economies grew at an exponential rate, uninterrupted.  Since the credit crisis however growth has been faltering.
Following a bull run from a low point in 2009, emerging markets have moved sideways since late last year. While many blame lack of investor confidence, the market remains sticky.
As Secular Outlook puts it – while growth in the developing world is likely to be higher, significant headwinds need to be accounted for.  
These includes the need to rebalance sources of growth, and constraints due to resource scarcity.
“Emerging markets have a role to play as part of a broader investment strategy,” says Jupiter institutional business development director Mark Willmott. “They currently make up a larger part of world growth than their representative weight in portfolios.  While exposure to emerging markets can enhance investment returns and diversify risk, timing, valuations and investment horizon must all be considered.”
Many pensions advisers also name inflation and interest rate movements as a determining factor to investment.
Aegon UK investment director Nick Dixon said that the challenge of making a decent return in a low rate environment is a key theme when it comes to pension investing.
“This challenge has intensified since the credit crisis, as yields have substantially declined especially in low risk assets such as government bonds which can be suitable for retirement portfolios,” he says.
Not only do rates determine future returns from fixed interest assets, but they are also an indicator of the health of certain global economies.
“A major theme in the current investment environment is the unprecedented actions of central banks to stimulate economic growth,” says Humphreys. “The quantitative easing policies of central banks have contributed to a general reduction in the yields available on most developed market government bonds. The effects of quantitative easing and of low interest rates have been felt by DC members, as they have been a factor in the increase in annuity prices during this period.”
Schroders’ global equity team uses thematic investing to run their retail portfolios. Among their key themes are climate change and changing demographics.
Hugh Skinner, director in Fidelity’s DC business, agrees that the move to a low-carbon economy and the challenges of sustainably powering a growing world are key themes for the group.
“The world has changed immeasurably in the last 30 years. The next 30 seem likely to yield even more dramatic changes as a number of significant themes exert their influence on what is now a highly connected world. The major themes we see shaping the world of investment – from the rise of emerging market consumerism to changing demographics and low-carbon priorities – are also interconnected. As economic growth in emerging markets lifts people out of poverty, global consumption expands and an ageing global population heightens the world’s challenge to feed itself, climate change and geopolitics will continue to exert their influence. Demands on technological progress will increase to respond to these challenges.”
Specialist investment firm EIRIS advises many large pension funds on the importance of sustainable, socially and environmentally responsible choices – and how they can increase profit and income for scheme members. It says that since the credit crisis, and the more universally accepted knowledge of climate change, institutions are cottoning on to the importance of investing sustainably.
Aside from socio-economic themes, thematic investing can be dictated by the changing structure of the pensions system – and the rising number of members.
AllianceBernstein head of pensions strategies David Hutchins says: “Mandates will increasingly seek to align portfolio managers directly with client objectives rather than market benchmarks – this is being delivered via fiduciary DB mandates and target date funds in DC. The question then becomes, how do we manage portfolios and how do trustees and their advisers assess our performance.”
State Street Global Advisors head of UK DC Nigel Aston agrees that it is the challenges that face DC themes that continue to shape investment. “We think about three key forces at work. Firstly, risk: how much risk is right for the target audience and how do the various risk factors – volatility, inflation, conversion, longevity – change over the glidepath. Secondly, return: how much upside should the asset manager be able to generate for a given level of risk – in other words, what does a good risk-adjusted performance outcome look like? Thirdly, cost – what is a reasonable fee for a given level of risk and return. Unfortunately, you can’t optimise; it’s the role of effective DC governance to research, monitor and evolve the trade-offs between these competing forces.”
State Street research reveals that both schemes and workplace savers are less concerned with the how and why – instead valuing smooth returns and tail risk protection, even if it is at the expense of outperformance.
Barclays Corporate & Employer Solutions investment consultant Jesal Mistry agrees: “The main areas of discussion centre on the balance of risk and return and a focus on delivering improved, or indeed more certain investment outcomes.
“Following the credit crisis, investors and fund managers started to look at ways to develop strategies that mitigate volatility relative to equity markets, balancing the falls in asset values, with the ability to grow the value of the assets over time.  This is particularly important within DC arrangements as it is the member that directly takes the investment risk and there is no ‘top-up’ from the employer as there would be within a defined benefit arrangement.”
The question of cost has taken on greater weight in the recent past, as the pension system has come under media and regulatory scrutiny. Scheme members wish to understand what they are paying and why.
This speaks to Hutchins point that DC investment managers are looking to step up and take greater responsibility for understanding and delivering to clients’ real needs.
“In the past clients’ “wants” dominated, but these were often poorly captured by short-term market index based strategies,” he said.
The two things are not necessarily mutually exclusive.
Willmott points to academic evidence that shows that better outcomes can be achieved by selecting investments based on long term risk factors instead of traditional asset allocation by equities, bonds, regions or countries – but it is not enough simply to identify the themes, buy and hold.
“Thematic investing can play a part for DC investors within a long term, multi-asset solution,” he said. “However, active management is key as factors vary in their value and appeal over time.”
Of course thematic investing is not fool-proof. Managers must be careful that their key themes have not already been priced into the market.
Thematic investing, the principle of investing with a focus on broader macroeconomic issues, is already available as an investment choice within the DC market – and it looks set to grow in popularity.
“With themes and funds becoming more prominent, and with evidence that market cycles are becoming shorter since the economic crisis, thematic investing is increasing in prominence. Thematic funds are now made available on a self-select basis, plus developments in bespoke scheme fund design is allowing more progressive and tactical decisions to be used through market cycles,” said Skinner. “The continued trend of investing in diversified growth and multi asset funds is still growing in the DC market, and a variety of these options incorporate thematic investment strategies.” n
Thematic investing is a top-down approach to portfolio construction. It is up to the manager to identify the social, economic, technological and demographic trends that will drive the performance of securities.
“An investment manager will identify a small number of key investment themes and use the funds to effectively benefit from them,” explains AllianceBernstein head of pensions strategies David Hutchins. “For example the global demographic shift would encourage investors to seek to invest in companies that target older consumers, for example in healthcare.”
Thematic investing lends itself well to retirement saving schemes because of the long term objective. While many fund managers are restrained by the short-termist nature of their investors, the structure of a pension scheme allows trustees to identify depressed assets that may be volatile in the short term, but pay off over time.
“Thematic investing seeks to exploit the fact that markets typically underestimate the effects of these kinds of slow-moving trends in favour of a shorter-term outlook,” says Schroders Investment Management head of UK strategic solutions Mark Humphreys. “We would argue that the long-term approach of thematic investing is very relevant for defined contribution schemes, particularly when considering strategies for young DC members, who have long time horizons.”
Following a review of its in-house default investment strategy for DC clients in the fourth quarter of 2012, Aon Hewitt does exactly that, choosing to allocate to emerging markets during the first stages of pension saving.
“We support investing in equities in the growth phase of a lifestyle, as opposed to switching to a multi-asset approach adopted more broadly across the industry,” explains DC consultant for the firm, Ryan Taylor. “Historically, our allocation to equities had been met by investing in global equity funds predominantly focused on developed markets, whereas this review highlighted value in allocating to emerging markets.”
“Since this time we have been implementing this strategy with clients with a 10-15 per cent allocation to emerging market funds in the growth phase, where possible.”
Thematic investing can be a more efficient way of setting a portfolio strategy. Rather than being swayed by current market fluctuations, or the latest hot IPO, broad investment trends dominate decisions.
“The implementation of thematic investing needs to be thought through as short term investing can lead to high turnover of stocks in a portfolio, thereby increasing costs,” says Barclays Corporate & Employer Solutions investment consultant Jesal Mistry. “Longer-term thematic investing may be more cost efficient but investors will need to understand that returns may not be as favourable in the short term while themes develop and gain momentum.”