June 24, 2021
The second CitiWire piece on Thematic investing is from two weeks ago and was about Investing in Energy, not just the fashionable Clean Energy Sector, but also the old fashioned stuff needed to keep the economy moving. Naturally we made some reference to some of the ideas already rehearsed in the blog, especially with relation to developments in ‘New Nuclear’ and also the key point that by restricting your investment universe you alter the risk/return profile of your portfolio and you need to bear that in mind when analysing returns – especially against a benchmark with a different risk profile.
There is an old market saying, that if you think you are getting a greater return without taking any greater risk, then you probably don’t understand the actual risks you are taking. To that end it is important to recognise that, while thematic investing can be either passive or active, the first and probably most important distinction is that it is taking a different set of risks compared to the broader market benchmark. Not having financials, for example, or, perhaps more pertinently, ESG funds not having energy stocks. From its peak in 2014, at 12% of the index, by March last year the US energy sector had dropped by almost 80%. The whole sector was then only about half the weight of Apple.
A strategy that allowed you to be ‘underweight’ 12% of the benchmark back then would clearly have delivered impressive returns, especially if you had been long tech on the other side. Of course, most active funds were not allowed to take that much ‘risk’, unlike ESG, which adopted exactly this strategy. This is not to criticise their performance, or more likely that of their ‘backtest’, but rather to point out the lack of sustainability of such a strategy for relative performance. When energy was down to 2% of the index, the ability to outperform by ‘not owning it’ was much reduced and when, as has subsequently happened, the sector actually more than doubles in a year, you start to run into serious relative performance issues.
In fact, rather than avoid energy, the theme should be how to play the dynamics of what, after all, is one of the biggest users of capital globally. Clean energy, for example, presented as something of a spinoff from ESG, was one of the top-performing thematics last year – an index tracker of the theme (INRG) was up 135% – but the risks it took to achieve that return involved not only a concentrated portfolio, but also a small-cap (illiquidity) premium. This is a common issue and can be both a positive and a negative for thematics. As money flowed into the sector, the small-cap stocks that dominated the index moved dramatically higher, creating a virtuous circle of performance attracting more flows, squeezing the stocks still higher.This is passive thematic investing, where the machines put most money into the biggest stocks as picked by, well, another machine. Eventually though, it corrects as the companies issue more shares and the flows willing to chase stories rather than cash-flow fade. Then, the virtuous circle can become vicious, INRG has dropped 25% year to date for example, while the trials and tribulations of ARK’s innovation-focused funds, for similar reasons, are also well known.
There are, however, more active funds looking beyond a simple clean energy index that have fared better in holding onto the benchmark gains from last year by rotating away from the narrow benchmark this year in a blend of passive and active. These include more nuanced themes like energy transition, or energy transfer, that try to pick individual companies that benefit from the transition in the sector rather than simply those in the thematic index – along with their weightings. The BNP Paribas Energy Transition fund is an example of such a strategy.
What can investors do?
An alternate approach, without resort to funds or stock picking, is to blend different ‘passive’ approaches to a broad energy theme. A mix of clean energy with old fashioned ‘dirty’ energy, for example, would be a pragmatic angle, recognising that while the political winds may be against oil and gas, the economic winds are still very much behind them. This is actually following the logic of thematics, looking for exposure to areas of the broader index that are benefiting from economic tailwinds and avoiding those facing headwinds.
Recognising that capital will be flowing where the returns are most favourable would have suggested that, having been starved of capital, the rise in oil prices was going to attract new capital, particularly into oil service companies – a very successful sub theme since the oil sector lows. Or indeed, what about alternative angles on clean energy not picked up by the computer generated indices and thus not by the trackers? In a week when Warren Buffet and Bill Gates announced the building of a new nuclear plant in Wyoming it’s perhaps not surprising to note that some of the best-performing ETFs year to date have been associated with uranium.
Thematic investing in energy makes sense given the huge amounts of capital flowing to different parts of the sector, but we can avoid the pitfalls of simple market cap weighted sector investing either by following a bottom-up stock picking fund approach or by taking a sub-theme asset allocation approach, both focussed on industry dynamics. Both are active, but in different ways and either can make sense, just so long as you understand the risks you are taking to get those returns.