Lazard Perspectives Capturing Structural Change A Guide to Thematic Investing How can investors 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 investor 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: stocks 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