Lazard Perspectives

Capturing Structural Change A Guide to Thematic Investing

How can capture the most important opportunities of the next decade? Thematic investing places structural change at the heart of a long-term equity portfolio and, in our view, can enhance returns, mitigate risks, and enable sustainability integration. It is time to change how we think about equity portfolio construction and focus on what matters—the big waves of structural change. Executive Summary A century ago, noted and trader Jesse Livermore observed that “the big swings make the big money,”1 and today his observations on markets and psychology are as relevant as ever. Our world is undergoing waves of structural change that will recalibrate the definition of business as usual. Yet, how do investors capture these changes and turn them into positive investment outcomes?

To paraphrase Livermore, we must face forward, such as “innovation” or “demographics.” These have conviction, and have patience. We believe may make for appealing narratives, but more often that benchmark-centric approaches—backward- than not, they fail to translate into a genuine return looking, risk-averse, and short-term—are an opportunity. Distinguishing genuine structural impediment to all three of these objectives. drivers from noise is a non-trivial exercise—we­ share Since they are weighted by market capitalization, our experience of distinguishing investing from benchmarks encode an extrapolation of yesterday storytelling. into tomorrow. Benchmarks effectively embed a We believe that the significant benefits of thematic fundamental framing bias about what is possible investing can only be realized if implementation or likely in the future—namely, that change from is robust. We have identified many key present conditions will be incremental. However, implementation errors over the years–and indeed we believe that truly transformative shifts have made a few of our own—and observe that tend to unfold at a non-linear pace, surprising many of these errors are still in evidence today markets in terms of both size and duration. Yet across the industry, with potentially negative these structural changes—the most important consequences for unwitting investors. In this fundamental driver of long-term investments—are paper we provide our views on some key thematic de-emphasized in a benchmark-centric approach. implementation issues, with more detail in our Instead, a thematic approach to investment companion white paper “The Seven Sins of places these waves of structural change at the Thematic Investing: Common Implementation heart of an equity portfolio. As we will show, Mistakes in Long-Term Equity Strategies.” organizing a portfolio around investment themes At a minimum, investors can use an appropriately offers benefits in terms of return maximization, constructed thematic equity portfolio to diversify risk mitigation, and sustainability integration. In their equity allocation alongside more traditional aggregate, a portfolio combining a number of approaches. However, the principles and concepts themes can transform the inherent uncertainty discussed herein are equally relevant to other asset of timing structural change into a differentiated classes. In conclusion, we believe that a robustly return stream for long-term investors. implemented thematic approach offers the means But what really is a theme? When many people to truly capture the big waves of structural change think of investment themes, they think of fairly and access the best investment opportunities of abstract, undifferentiated, top-down concepts the next decade. We believe that truly transformative shifts tend to unfold at a non-linear pace, surprising markets in terms of both size and duration. 4

Introduction A century ago, noted investor and trader We define structural change as Jesse Livermore observed that “the transformational shifts ... and we believe that big swings make the big money,” and today his observations on markets and the majority of an equity's value is derived from psychology are as relevant as ever. Our understanding these shifts over the long term. world is undergoing waves of structural change that will recalibrate the definition of business as usual. Yet, how do investors waves of structural change, and provide Asset allocators tend to consider the same capture these changes and turn them into access to the best investment opportunities set of questions: Should I allocate more to positive investment outcomes? of the next decade. my home country as a means of reducing risk, or is domestic bias actually a greater To paraphrase Livermore, we must face Establishing the risk to my portfolio? Are the large spreads forward, have conviction, and have Right Anchor in performance between sectors indicative patience. We believe that benchmark- of structural trends or imminent mean centric approaches—backward-looking, In our experience, the majority of equity reversion? Should I allocate to high growth risk-averse, and short-term—are investors are seeking the same thing: at potentially stretched valuations an impediment to all three of these differentiated long-term returns, sensible after a long period of outperformance? objectives. Instead, a thematic approach to risk management, and increasingly, the Should I add to value stocks even if that investment places these waves of structural integration of sustainability considerations means holding stocks with high financial change at the heart of an equity portfolio. into investment decisions (Exhibit 1). Yet leverage or challenged industry dynamics? many equity strategies fail to meet one Contrary to popular misconception, or more of these objectives. We believe All of these are reasonable questions, but structural change can occur in a variety of this is because of a framing problem—the they all assume that an investor’s ultimate different ways and is not limited merely majority of portfolios are fundamentally purpose is to turn certain dials up or down to shifts in companies’ growth prospects anchored to the wrong thing. in relation to a particular baseline—a or disruptive forces. In this paper, we benchmark—to achieve an acceptable outline many intersecting and non-linear Most equity strategies, and indeed, most level of relative returns. They all embed a structural changes that can materially of the asset management industry, use fundamental framing bias about what is transform the inherent value of securities benchmarks based on geography, sector, possible or likely in the future—namely, over the long term. and style as anchors for building portfolios that change from present conditions will and measuring performance. We believe As we will show, organizing a portfolio likely be incremental. Such an approach the tool is ill-suited to these tasks. Since does not target structural change. around investment themes can offer benefits they are weighted by market capitalization, in terms of return maximization, risk benchmarks encode an extrapolation of Instead, we believe that equity investors mitigation, and sustainability integration. yesterday into tomorrow. We do not believe should place structural change at the heart In aggregate, a portfolio combining a that the past is a good indicator of future of both their portfolios and processes number of themes can transform the returns, and it therefore follows that we see (Exhibit 2). We define structural change as inherent uncertainty of timing structural benchmarks as an arbitrary and suboptimal transformational shifts in business models, change into a differentiated return stream starting point for building long-term industries, economies, markets, regulation, for long-term investors, capture the big portfolios and measuring returns. and societal norms, and we believe that the majority of an equity’s value is derived from understanding these shifts over Exhibit 1 the long term. The evaluation of these The Three Objectives of (Almost) Every Investor shifts and their expression in a portfolio represents a discipline unto itself and is the core of our thematic investment approach.

Differentiated Sensible Risk Sustainability Replacing benchmarks with structural Long-Term Management Considerations 1 Returns 2 3 change as an anchor also allows us to reimagine investment specialization in a For illustrative purposes only. way that we believe better suits today’s Source: Lazard tightly integrated, fast-changing global 5

economy. Many asset allocators and specialists reinventing the wheel, seeking Exhibit 2 Benefits of Anchoring to Structural managers tend to divide the world into to understand their specific examples of Change Instead of Benchmarks geographic regions and allocate money structural change without the benefit of to regional specialists, yet in the modern broader context. world this appears to be an anachronism. • Technology platforms in Asia are Given the global nature of both companies leaping forward—what lessons are there and investors today, a geographic approach Starts with a clean slate for Western companies? rather than current market precludes the possibility of valuable consensus cross-regional investment insights. Sector • Analysts in the more conservative, long- specialization makes more sense, given the cycle industrial sector may only now depth of background knowledge required be tackling problems that those in the to understand the nuances of an industry, fast-moving consumer sector have been but it also reduces the potential for cross- grappling with for years—how can that Directly targets sectoral observations. Finally, the division knowledge be shared? the key source of of investment skill into specialization by differentiated returns • How can investors assess the potential style, notably growth versus value, remains of disruptors against the advantages of in our view an arbitrary distinction in that incumbents? all investors must surely seek to understand both these aspects of any investment. Structural change tends to cut across industries, styles, and geography, blurring Focuses the portfolio The ultimate goal of the division of labor the boundaries between them and on the long term should be to improve proficiency in the creating a high degree of commonality area that adds the most value. Yet in terms among the challenges facing companies For illustrative purposes only. Source: Lazard of understanding structural change, the today (Exhibit 3). industry often leaves geographic or sector

Exhibit 3 How Smarter Operating Systems in Computers and Smartphones Presaged the Industrial Internet

CONSUMER SYSTEMS INDUSTRIAL SYSTEMS

$

Microsoft Windows (1985) Nokia 1011 (1992) Apple iPhone (2007) Fanuc FIELD, Honeywell Forge, Johnson Controls OpenBlue The first modern PC experience, The first digital phone produced Apple’s first operating system, (2019-2020) allowing people to run multiple for the European GSM iPhoneOS, would eventually apps at once in different standard. In time, SMS morph into iOS, creating huge Digitized industrial operating systems windows. Relied on mouse messaging would become a value via third-party that collect massive amounts of data navigation and created a new powerful platform. applications. via sensors and analyze the data platform for users and using machine learning and artificial developers. intelligence to improve operations and reduce down time.

Computing and communications have evolved more quickly in the short-cycle consumer technology industry. Yet similar structural changes are now appearing in other long-cycle sectors, such as industrial systems.

For illustrative purposes only. Source: Lazard 6

Finally, in terms of sustainability integration, the asset management industry is in the throes of a debate about We believe the backward-facing nature how best to account for environmental, of data used in forming benchmarks is ill-suited social, and governance (ESG) issues and, in doing so, is recreating many of to a dynamic world in which the approach of the limitations of benchmark-centric a company or an entire industry to ESG and approaches. In particular, we believe the sustainability considerations can evolve rapidly. backward-facing nature of data used in forming benchmarks is ill-suited to a dynamic world in which the approach of proposition. Investors may suspect that it and societal norms, among others a company or an entire industry to ESG isn’t even really possible—that strategies (Exhibit 5). and sustainability considerations can that claim to orient toward structural evolve rapidly. Placing structural change Thematic investing is also not synonymous change, or thematic strategies, are merely at the heart of a long-term portfolio with or limited to investing in early-stage growth strategies in disguise. We agree compels investors to weigh ESG factors, disruptive businesses, where attractive that this may be true of many “thematic” which are a potent source of change at the narratives often obscure high failure rates. strategies, but we believe a truly thematic political and societal level, just as they do Such an approach also underappreciates approach is not limited to compounding more traditional financial variables. It is the ability of mature companies to evolve growth. A complete approach to thematic the “delta”—where we are going—that in response to structural challenges investing should include all stages of a matters, whether we are looking for and opportunities. A complete view of company’s life cycle (Exhibit 4). It is financial returns, sustainability goals, or structural change, in our view, should also true that positive structural changes some combination of the two. consider the entire adoption curve and may result in higher growth in terms companies in all parts of their life cycles. Is Structural Change of unit sales, pricing power, or both— compounding is a powerful force and a In addition, portfolios managed with Just Growth? relevant component of many investment structural change at their core part ways That the world will be different in themes. But structural change comes in with many benchmark-centric portfolios fundamental ways a decade from now is many additional forms as well, such as on the subject of mean reversion. hardly a surprising idea. Positioning to shifts in industry structure, regulation Many benchmarked portfolios are capitalize on structural change is a trickier and policy change, shifts in behavioral managed under the assumption that underperforming geographies, sectors, and investment styles will eventually Exhibit 4 outperform. However, we believe that A Complete Approach to Thematic Investing Should Include All Stages of a truly transformational shifts tend to unfold Company’s Life Cycle at a non-linear pace, surprising markets INNOVATION GROWTH MATURITY in terms of both size and duration. Opportunity: History is replete with companies that Disruption have been unable to adapt to structural change, with disastrous consequences for Risk: Opportunity: investors. A true thematic strategy is well High failure rate Adjacencies & placed to evaluate whether an optically Reinvention cheap, underperforming company has Risk: the potential for meaningful recovery, or Opportunity: whether it is a value trap due to structural Compounding Obsolescence considerations. Risk: Over-extrapolation Capturing Structural Change via Equities For illustrative purposes only. Many equity investors are focused on the Source: Lazard short term—indeed, a technological arms race is underway in short-term trading 7

Exhibit 5 Structural Change Comes in Many Forms

Structural change Description Return opportunity Financial expression Compounding growth Volume growth and pricing power Reinvestment at sustained high returns applied Market assigns higher multiple based support returns that are higher for longer over increased duration. on compounding attributes. (“beat the fade”). Disruption Non-linear shift in demand, supply, or Revenue driven by new adoption curve. Barriers Creation of new future profit pool, both driven by innovation in technology to entry determine profitability. possibly cannibalizing incumbents. or business model.

Industry structure Shifting competitive advantages Shifts in relative pricing power, operating Structural shift in growth, margin, or between outsourced/vertically integrated leverage, or both may drive structural change perceived risk profile. models and supply chain constituents. in which economic rent is accrued. Geopolitical and regulation risk may be impacted.

Pricing models Shifts in industry pricing models and Transition from cost-plus to market-price model, Price setters typically valued higher conventions. or unit to bundled (e.g., subscription or project) than price takers. Bundled pricing pricing enables shifts in value capture models can capture adjacent revenues and reduce risk. Risk transfers Changes in business model can Shift from product to service model typically Improvement or deterioration in substantially shift the balance of transfers returns and risks to supplier. growth expectations, margins, return opportunity and risk between customer expectations, cyclicality, or cost of and supplier. capital. Capital intensity Relative cost of labor and capital Replacement of capital for labor (or vice versa) Improvements in returns for a given may drive structural change in capital can materially shift economic rent accrual level of capital. intensity. between factors of production. Competition Industry consolidation, competition, Industry profit pools are generally supported Pricing power, scale advantages, new entrants, and potential substitutes by oligopolistic characteristics. Monopolistic higher margins and returns may drive structural change in industry tendencies and disruptive competitors are risks. returns. Policy / Regulation Changes in the presence, structure, and Non-linear change in assessment of return Pricing of externalities can materially goals of regulation may drive structural sustainability. change cost-of-capital and return changes in permitted returns and expectations. perceived industry stability. Behavioral shifts/ Shifts in societal norms may drive Dramatic reassessment of demand forecasts, Structural shift in return expectations. Societal norms structural changes in perceived industry mitigating costs, or both. Possible concern about continuing opportunities and risks. viability of business. Relative scarcity Stores of value may become increasingly Intrinsic scarcity premium can shift over time Repricing of scarce assets as stores valuable in certain macro scenarios. based on, for example, perceived pricing power. of value.

Source: Lazard

and investing, as investors search for ways a theoretically perpetual duration, and in investors—but additionally it is a genuine to be a fraction of a second faster or a hair fact, we believe that the majority of the area of investment advantage for humans more efficient than their competitors. value of an equity is derived from the long over machines. Enormous sums are being invested across term—our strategies focus on the next financial markets to obtain an advantage decade. Structural changes that impact Themes and Return via new data sources and methods of long-term metrics can therefore lead to Generation analysis, including artificial intelligence. dramatic shifts in the value of equities for The predictable result is that it is becoming an investor with a longer time horizon. For most equity investment strategies, increasingly difficult for any investor to a benchmark provides an initial anchor An additional consideration is that have an edge over any other in forecasting for populating a portfolio. Thematic algorithmic approaches have less of an near-term financials, yet this is where the approaches replace this anchor with edge when analyzing structural changes majority of investors deploy their efforts. themes. But what really is a theme? which, particularly in the early stages, can When many people think of investment We disagree with the premise that equities be hard to identify and measure. Structural themes, they think of fairly abstract, are inherently short-term vehicles and view change therefore not only represents an undifferentiated, top-down concepts such them instead as an excellent way to harness opportunity for return enhancement as “innovation” or “demographics.” These long-term structural change. Equities have and risk mitigation for long-term equity may make for appealing narratives, but 8

changes can have a very material impact on company valuations and equity prices We believe that truly transformational once they are appreciated. shifts tend to unfold at a non-linear pace ... One benefit of long-term investing, history is replete with companies that have however, is that, unlike a short-term investment thesis, it is not necessary been unable to adapt to structural change, with to identify a specific catalyst for this disastrous consequences for investors. market realization, provided there is reason to believe that it will occur within our investment time horizon. more often than not, they fail to capture in concurrently. At any time companies Structural change is often non-linear: any meaningful way the real competitive may be subject to one or more drivers Adoption curves can be unexpectedly landscape, pricing dynamics, or regulatory of structural change, each representing steep, network effects can be exponential, environment, let alone anticipate exactly a unique opportunity for long-term exogenous shocks can act as catalysts. how technological disruption or shifts in value capture. Thus, our themes tend to One need not know exactly when and societal norms will affect how stakeholders encompass multiple drivers of structural how structural change will occur, only share economic gains. change. Lazard’s Global Thematic team that it is likely to happen. The inherent designs proprietary themes that precisely uncertainty of thematic equity investing For example, consider investing in the target the return opportunity comprising is precisely why a theme can produce solar energy industry during a prior period a number of structural changes, rather a differentiated return stream—it is a of peak optimism, around 2007. After an than a familiar but potentially incomplete feature, not a bug. Structural change may initial boom in demand due to European narrative. Theme construction requires a be accelerating even as macro events are subsidies, supply exploded in China, scalpel, not a sledgehammer. pulling down the overall market, a lesson structurally driving down investment investors will be familiar with in the wake returns (Exhibit 6). The “theme” played History has shown that the market of the COVID-19 pandemic. Structural out—solar became a significant industry— will eventually start to appreciate the change also proceeds whether or not but this was of little solace to investors sweeping nature of the structural forces certain styles or factors fall out of favor seduced by the simplistic investment driving a theme, at which point, equity with investors. proposition that solar would be a success. valuations are likely to reset higher or This was not an investment theme, it lower depending on whether a company The independence of thematic was storytelling, or as we would call it, a is positively or negatively exposed to performance from more closely tracked narrative fallacy.2 the change. As illustrated in the Sidebar market events may also increase ("Asset Efficiency: A Live Thematic conviction, an underappreciated True investment themes capture Example," see page 10), structural behavioral aspect of investing. Everyone significant, long-term structural changes that have the potential to drive materially higher investment returns than the Exhibit 6 market is currently discounting and Solar Investment: A Narrative Fallacy can directly contribute to our core Cumulative Investment Return (Rolling 10-year, %) objectives of return maximization, risk 200 mitigation, and sustainability integration. 150 Distinguishing genuine structural drivers 100 from noise is a non-trivial exercise that 50 we believe is best implemented by an 0 experienced team of specialists supported -50 by industry experts. -100 Creating a theme is not as simple as -150 Jan 2007 Jan 2009 Jan 2011 Jan 2013 Jan 2015 Jan 2017 Jan 2019 Jan 2021 identifying a single source of structural change and screening companies for As of 26 February 2021 The performance quoted represents past performance. Past performance does not guarantee future results. exposure to that change. In fact, we believe Source: JP Morgan, Bloomberg L.P. Index includes Solarworld, SMA Solar and SunPower. that various structural changes often occur 9

change over time, and picking the ultimate winner in an industry can be Creating a theme is not as simple as challenging. Idiosyncratic factors can be identifying a single source of structural change long term and unpredictable in nature. A and screening companies for exposure ... our product predicted to become a consumer favorite may not, an eagerly anticipated themes tend to encompass multiple drivers of idea may not work out once research structural change. and development work is complete, and reputational issues can surface seemingly from out of nowhere, to name just a few knows they should aim to buy low and in both the short term and long term. idiosyncratic risk outcomes. A basket of sell high, but a continual flood of news Expressing an idea about structural change companies associated with a given theme and price signals can severely test the as a theme rather than a single can allows for the reality that even a solid resolve of even the most disciplined mitigate these company-specific risks. investment thesis will encounter many investor. Knowing that this information unknown unknowns over the long term. The short-term risk for investors has little to do with long-term structural Spreading the risk among a select number picking stocks instead of themes is that change, investors may be more likely to of companies with similar exposure to volatility around near-term idiosyncratic have conviction in the thesis and allocate structural change drivers can help diversify factors could be difficult to handle in capital at what in the long run will prove away idiosyncratic risk, resulting in a purer a concentrated portfolio. Individual to be attractive entry points, such as expression of the thematic thesis. companies, even those with solid long- short-term, cyclically driven moves or term fundamentals, may undergo negative Portfolio theory can help determine the adverse idiosyncratic events. The ability to events such as cyclical challenges or right number of stocks in a theme. After rebalance among different themes when exogenous shocks. The expression of the all, a theme is ultimately a highly focused attractive entry points present themselves 3 structural thesis through a basket of related portfolio. A previous Lazard paper represents an additional potential source stocks may diversify away some of this demonstrated that the risk management of alpha. short-term volatility and reduce the risk of a benefits of diversification are subject to Genuinely long-term structural manager being forced to reduce positions in the law of diminishing returns, and that investment theses are rare, and if one order to manage volatility. the majority of benefits accrue before the is identified it makes sense to attempt addition of the tenth (Exhibit 7). Perhaps more critically, the long-term to exploit it as widely as possible by Similarly, our experience is that a theme risk for non-thematic investors is that searching globally and across sectors of approximately 10 securities reduces idiosyncratic factors could ultimately for places where the thesis might apply. idiosyncratic risk without diluting the outweigh the benefits of the structural An insight into a business model shift thematic insight. thesis. For example, competitive dynamics in the US may be highly relevant to that of similar European companies; technological developments in the Exhibit 7 consumer sector may give advance Number of Securities and Risk Reduction warning of potential changes in the Portfolio Standard Deviation (%) healthcare industry; and so on. A 50 portfolio unconstrained by geography or sector can maximize the value of these 40 insights. 30 Themes and Risk Mitigation 20 10 While long-term structural drivers can 1 10 20 30 40 50 explain a significant proportion of long- Number of Stocks term valuation, every individual stock This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. within a theme will have idiosyncratic Source: Lazard factors that can influence its performance SIDEBAR: 10 ASSET EFFICIENCY: A Live Thematic Example

One of our current themes, Asset Efficiency, offers an apt illustration of how a thematic thesis around structural change can significantly impact stock valuation.

The idea behind this theme is that the industrial complex is by this theme also align with sustainability digitizing, connecting, and managing physical assets with a objectives, which also raises the prospect of new set of industrial operating systems. These systems offer regulatory support, which in turn may further the potential for significant efficiency gains through the use increase growth rates. Leading companies may of sensors, real-time data analysis, and closer integration also be able to take market share through new between customers and suppliers. Efficiency gains mean new products and revenue models. Incremental digital profit pools to share between customers and suppliers. offerings are appearing as both new software line items in company P&Ls and a higher share of aftermarket services Some of the industrial sector’s quirks are relevant for as new offerings improve efficiency while products are in constructing the theme. Product cycles are long, which leads to operation. This has the potential to lead to a structural shift high switching costs, while domain expertise and direct industry higher in revenue growth. For the purposes of our example, knowledge are key to both developing solutions and winning we assume revenue growth accelerates from 4% per annum customers’ trust in order to adopt them. As a result, barriers to to 6% per annum over a 10-year horizon, resulting in a 17% entry are high, which makes it easier to pick winners, and change, increase in the value of our hypothetical company. while incremental to start, is likely to be highly durable. Second, new revenues from software and aftermarket services From a fundamental perspective, digitization in a sector with carry higher margins. For the purposes of our example, we these characteristics can create value in multiple ways for assume this mix improvement drives mid-cycle margins from companies. To make the point, we’ll track a highly simplified 12% to 15% over the course of a decade, driving a further 24% valuation measure, 10-year discounted flow (DCF), of increase in value. a hypothetical firm called Company A, which has certain commonalities with current holdings. The purpose of the Third, the relative stability of the new software and service example is to make the basic point that changes in long-term revenues could be perceived as a more secure and stable cash forecasts can have a significant impact on valuation. Prices flow stream by the market, giving rise to higher valuations via can move significantly as evidence builds to support shifts in a lower discount rate and overall cost of capital. A 50-basis- long-term expectations. Critically, the terminal multiple and point (bp) reduction in the weighted average cost of capital discount rate, even in a relatively long-duration 10-year DCF, drives a further 16% increase in value. are highly significant inputs into a valuation. Since the long Finally, expectations for persistent growth prospects term is inherently uncertain, shifts in perception powered by beyond the 10-year DCF may lead to an increase in the structural change of a thematic thesis can be powerful in expectations for terminal multiples and growth. Increasing creating value. the terminal multiple from 20x to 25x free cash flow, First, there is the potential for increased demand. A step which is equivalent to a 50-bp increase in terminal growth forward in technology has the potential to accelerate the expectations, drives a further 12% upside for a total growth of the entire market. The efficiency gains enabled increase in value of 68%.

Thematic Value Creation Example Indexed Valuation (100=base valuation) 200 +12% +68% Total +16% 150 +24% +17%

100

50

0 Base Valuation Acceleration in Sales Margin Expansion Improvement in Increase in Terminal Multiple New Valuation Growth from 4% to 6% p.a. WACC (50bps) (from 20x to 25x) For illustrative purposes only. 11

Themes and Sustainability Strategies with long-term time We believe that a properly implemented thematic approach should by definition horizons should, by definition, seek sustainable fully integrate sustainability considerations. investments. Societal norms change over time, whether due to sudden events or subtle shifts, and ideas that once seemed radical or impossibly idealistic become widely We note that there are a number of shifts narrative fallacy, a nice story driven accepted. Eventually, these norms become underway in the world that are often primarily by marketing considerations codified into policy by way of regulation specifically highlighted as sustainability rather than a robust theory grounded in the and legislation. Both policy changes and an themes. A thematic approach can evaluate potential for long-term returns and subject evolution in what society deems acceptable the fundamental case for these shifts and to rigorous analysis of potential spoilers. have potentially game-changing implications whether they represent valid investment We reiterate this critical point—a major for a company’s long-term fate. One need ideas in their own right or are merely part of thematic investing is distinguishing look no further than the impact of climate inputs to the design of other themes. between nice stories and genuine structural change policy on the coal industry for a Looking at any structural change in investment opportunities. recent example. isolation however, including those related Thematic specialists spend a great deal to sustainability, provides an incomplete of time thinking about theme selection, ESG issues are a key determinant of the thesis—recall the earlier example of particularly those who run multi-theme longevity of investment opportunities the solar industry in 2007. Rather than portfolios where the theme line-up can and therefore are ultimately linked to seeking out themes built around popular change. Ultimately, we believe that theme confidence in long-term financial forecasts. conceptions of sustainability, we seek selection is a specialized skill. Unless They are therefore particularly relevant for themes that offer genuine opportunities an asset owner has substantial in-house strategies with long-term time horizons. for investment returns and risk mitigation theme selection expertise, we believe Indeed, adding ESG and sustainability while fully integrating sustainability theme selection should fall to the portfolio considerations as further inputs at both the considerations.4 theme and stock level in a portfolio could manager and hence we generally advocate materially improve potential investment Putting It All Together—­ for a multi-theme structure that allows returns and reduce risk. Strategies with Building a Thematic the portfolio manager to select the most long-term time horizons should, by appropriate themes at any point in time. definition, seek sustainable investments. Portfolio The second key point is that long-term Having outlined how themes can improve It seems reasonable to us that any analysis investing does not mean buy and hold returns, risk, and sustainability objectives, we of structural change should incorporate forever. We believe true investment themes now consider how themes can be brought an analysis of non-financial externalities should have a finite lifespan and when fully together at a portfolio level. Just as we alongside more traditional areas of financial discounted by the market should either believe there are misconceptions about what research. All too often, investors hold policy evolve or be eliminated. Evolving themes, thematic investing is, we feel that the process as a comfortable constant until faced with an however, are more complicated to develop, of thematic portfolio construction is often imminent potential change. We believe that manage, and market. And the misunderstood. And just as we believe many this misses a large opportunity to add value and elimination of single theme strategies, so-called investment “themes” do not deserve through anticipating likely policy changes with subsequent dissolution and return the title, we also feel that many thematic over a long-term time horizon. As with of capital to clients, runs counter to asset portfolios are constructed without the key other sources of structural change, thematic manager incentives. ingredient we believe is needed for success: investing is well suited to the non-linear competition for capital across themes. One potential solution to this issue for nature of policy change, as it does not multi-theme managers is to allow themes require investors to identify precisely when Our portfolio construction process starts to evolve over time, mitigating the risk that and how policy shifts will occur. A thematic with a major decision: theme selection. an investment thesis becomes redundant. approach can both capture the potential Single-theme strategies outsource this This “dynamic” thematic approach requires benefits of structural shifts in policy and most critical investment question to the greater communication and transparency seek to avoid the risk of being on the wrong client and often offer little more than what than simple “static” thematic narratives side of history. we previously described as the thematic 12

In addition to properly aligning Many thematic portfolios are incentives, a multi-theme portfolio offers important diversification benefits. Our constructed without the key ingredient we analysis suggests that combining around believe is needed for success: competition for five themes into a portfolio offers the capital across themes. majority of cross-theme diversification benefits in terms of reducing overall portfolio standard deviation (Exhibit 8). Around five themes is the right but solves for the agency problems A key benefit of a multi-theme portfolio number for a return-seeking strategy above and arguably better reflects the is that it ensures competition for capital that also seeks to exploit the benefits inherent dynamism of the capitalist across themes. When the retirement of of diversification, our analysis suggests. system, a constant force for corporate a theme is not an existential crisis for a Extending the portfolio to around 10 structural change. Put another way: money manager, but rather an allocation themes can increase the level of certainty The world changes incrementally, so decision, it can be approached more around standard deviation outcomes, and why shouldn’t investment themes? We dispassionately. There is every incentive we believe it is therefore more suitable for often find that our themes become more to identify the themes that are truly a strategy seeking risk-adjusted returns. refined over time as facts emerge and our compelling at any given time and no Thematic strategies with other objectives understanding improves. penalty for an honest assessment that a are likely to find optimal implementation theme has run its course. with some 5–10 themes.

Exhibit 8 Number of Themes and Risk Reduction

Annualized Volatility (%) 28 Mean Volatility 26 Mean +1 std Mean -1 std 24

22

20

18

16

14

12

10 1 2 3 4 5 6 7 8 9 10 Number of Themes

As of 30 June 2020 Source: MSCI 13

Placing structural change at the heart of an appropriately constructed long-term equity portfolio immediately faces us forward. Structural change over the next decade may represent a differentiated and valuable source of returns. ­­­

Conclusion Return prospects should be improved by We believe that the significant benefits of themes that capture multiple structural thematic investing can only be realized if We conclude this paper where we began, changes. Idiosyncratic risks are mitigated implementation is robust. We have identified by paraphrasing Livermore—we must by populating themes with multiple many key implementation errors over the face forward, have conviction, and have stocks. The natural integration of years—and­ indeed have made a few of our patience. We believe that benchmark- ESG and sustainability considerations own—and observe that many of these errors centric approaches–backward-looking, provides additional support and are still in evidence today across the industry, risk-averse and short-term—are an conviction. with potentially negative consequences for impediment to all three of these objectives. unwitting investors. Readers interested in Instead, a portfolio anchored to themes We have discussed a number of common our views on implementation of a thematic can offer a forward-facing, robust, and thematic portfolio considerations and strategy are directed to our companion long-term alternative. conclude that, for most investors, white paper "The Seven Sins of Thematic a portfolio consisting of multiple, Placing structural change at the heart Investing: Common Implementation evolving themes, built with the help of an appropriately constructed long- Mistakes in Long-Term Equity Strategies." of both fundamental and quantitative term equity portfolio immediately faces tools, is the most robust approach. Our In conclusion, we believe that a robustly us forward. Structural change over the experience suggests that a portfolio of implemented thematic approach offers next decade will, in our view, represent around five themes should deliver strong, the means to truly capture the big waves a differentiated and valuable source of differentiated returns while offering some of structural change and access the best returns. At a minimum, investors can use simple diversification benefits. In keeping investment opportunities of the next an appropriately constructed long-term with the notion that diversifying exposure decade. Beyond that, the only other equity portfolio to diversify their asset to any one set of factors or events can prerequisite for both investors and money allocation alongside more traditional smooth returns, we believe a more managers is patience, a topic on which we approaches. diversified portfolio of around 10 themes have nothing to add to this observation We believe that a thematic approach to can reduce the level of uncertainty around from Livermore: “It was never my capturing structural change can anchor return levels. In both cases, competition thinking that made the big money for me. portfolios to core investor objectives. for capital is the key objective. It was always my sitting.”

We appreciate your interest in this paper and in Lazard’s Global Thematic Equity strategies. We believe our strategies offer the possibility of achieving a combination of a strong differentiated return stream, enhanced risk management, and integration of sustainability considerations. At this time of great structural change, we believe our strategies could offer a compelling opportunity for long-term investors willing to consider a thematic approach. 14

This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm.

Notes 1 All Jesse Livermore quotes from: Lefevre, Edwin. Reminiscences of a Stock Operator. (1923). 2 The term narrative fallacy was used in: Nassim Nicholas Taleb. Fooled by Randomness. (2001). 3 Lazard Investment Research. Less Is More: The Case for Concentrated Portfolios. As of 12 February 2015. 4 For more on the Lazard Global Thematic team’s approach to sustainability please see our paper, “A Sustainability Framework: Societal Shifts as Investment Risks.”

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