The events of the past three years have utterly changed the macro backdrop against which funds are investing. With this in mind, David Prosser asks a range of experts to name long-term themes that could reward patient investors.
Asset managers love the idea of a “super-trend”. The idea is that by investing in line with a powerful, long-term theme – and ignoring short-term market volatility – it should be possible to generate outsized returns over an extended period.
But what happens if an unexpected turn of events undermines your theme – a once-in-a-century global pandemic, say, or an outbreak of war in Europe? Maybe you need to rethink the theme you were committed to, or even find new areas to explore.
The events of the past three years have utterly changed the macro backdrop against which funds are investing, points out Dzmitry Lipski, head of funds research at interactive investor. He says: “We’re now in a period of high inflation and rising interest rates, as well as low growth and low returns. We’re seeing more volatility and dispersion in market leadership and valuations.”
As a result, investment themes that seemed like no-brainers prior to the Covid-19 crisis and war in the Ukraine have not delivered. The obvious example is the sell-off in the technology sector, where leading funds halved in value – or worse – over the course of 2022. Higher interest rates mean investors want more jam today, rather than promise of future cashflows.
Themes often chase what is hot
But there have been other shifts too. “Covid made companies question the wisdom of just-in-time strategies built on long supply lines,” observes Alex Stanić, co-manager of the Mid Wynd International Investment Trust (LSE:MWY) and the Artemis Global Select fund. He adds: “Throw in political friction over China and this is leading to a reversal of the globalisation trend that for many years encouraged companies to offshore production.” This is one reason why emerging markets – supposedly set to surge on demographic factors – have stuttered.
Such reversals should serve as a warning to investors, warns Peter Sleep, a senior portfolio manager at Seven Investment Management. “These themes often chase what is hot and front of mind in the stock market, but then go out of fashion – investors in areas such as medical cannabis, online gaming and the future of food have recently incurred significant losses. In the light of the Ukraine war, the latest thematic ETF to hit my email box is a ‘future of defence’ fund.”
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And yet, it still feels intuitively right to many investors that there are certain themes and ideas that are so strong, they must be worth backing for the long term, even if they go off course in the short term. The challenge, then, is to spot the secular growth stories and avoid the hyped-up and overblown investment fads.
Ways to play the shift to low-carbon world transition
Inevitably, such judgements are subjective, but there are some themes that just seem undeniable. The battle to mitigate climate change could be one such example.
“I think we are at the start of a super-trend for battery and alternative energy tech companies,” says James Henderson, co-manager of Henderson Opportunities (LSE:HOT) trust and Lowland (LSE:LWI) Investment Company.
“These companies could have a major part to play in the transition to a low-carbon world and some may become international giants in years to come if their technology takes root,” he adds.
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Examples in his portfolio include ITM Power (LSE:ITM), AFC Energy (LSE:AFC) and Ceres Power (LSE:CWR). “The pandemic added to the volatility for these companies, but climate change is a far more pressing crisis weighing on us. And that will give powerful momentum to these businesses if they can prove their technology works,” says Henderson.
At Mid Wynd, meanwhile, Stanić points to his warnings about a shift away from onshoring as giving rise to a shift of thematic enterprise.
“The problem with onshoring back to economies with low unemployment is that you face higher labour costs and wage inflation. In that scenario, investment in automation becomes a good way to protect profit margins, so we expect companies in this sector to have a tailwind for some time.”
Indeed, almost 20% of Mid Wynd’s portfolio is currently invested in automation stocks of one flavour or another. Examples include Keyence, a Japanese business that makes sensors, and Rockwell Automation Inc (NYSE:ROK), a US company that specialises in controls for industrial automation.
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“Automated systems can generate lots of data that may be used to optimise productivity and quality control, which can reduce waste and energy consumption,” Stanić explains.
These are examples of active fund managers weighting their portfolios towards themes they expect to dominate the years to come. The alternative, for investors looking to pursue a thematic approach, is to look at an exchange-traded fund (ETF) that tracks a basket of stocks selected to represent the theme in question.
This is not passive investment in the traditional sense, in that at launch, the ETF will typically create a new benchmark of stocks to hold, according to the theme that is being pursued. But thereafter the fund simply follows this benchmark, rather than actively trading in and out of positions.
Thematic passive plays
This can be a useful way to take a strong position on a particular theme, says Tom Bailey, head of research at HANetf, which offers access to a broad range of thematic funds constructed in this way. He points to two areas in particular that are currently attracting attention.
“Russia’s invasion of Ukraine brought back into sharp focus the importance of reliable, secure energy supplies, and nuclear is an increasingly favoured option in this regard,” Bailey says. With around 60 new nuclear reactors under construction worldwide and a further 100 at the planning stage, this could be an enduring theme given the long-term approach required in the energy and power sectors.
“The Sprott Uranium Miners ETF USD Acc (LSE:URNM) provides exposure to both a basket of uranium miners and the spot price of uranium,” says Bailey of potential funds to back the nuclear theme.
The alternative play on energy, he suggests, is to focus on renewables and storage, and the minerals required accordingly, including lithium, nickel, manganese, cobalt, silver and graphite. “Sprott Energy Transition Materials ETF GBP (LSE:null) provides exposure to the mining companies that are providing these in-demand critical materials,” he says.
Bailey’s second area of interest is space exploration. “In the 1960s, government spending represented almost all space spending in the US, but today it only accounts for 20%,” he says.
“As a result, we see more private sector firms partnering with NASA to help develop the space capabilities of the US, making this new space race an investible area.”
Procure Space ETF (LSE:YODA) is one possible play on his theme, Bailey suggests, with its focus on companies that derive significant revenue from pure-play space exposure.
Artificial intelligence and blockchain
Where else might investors on the look out for strong themes explore? Interactive investor’s Lipski expects “the adoption of artificial intelligence and blockchain to accelerate”. This year’s explosion of interest in generative AI – courtesy of ChatGPT – is just the latest illustration of the power of such technology. In which case, Polar Capital Technology (LSE:PCT) is an interesting way to the play the theme, Lipski points out.
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Just be on the look out for managers who understand the market, rather than simply talking a good game, advises Seven Investment Management’s Peter Sleep. “There is not much differentiation between fund managers and ETF themes,” he warns. “A fund manager should have an idea of a companies’ future growth regardless of whether they are participating in a theme or trend.”
In other words, it’s not necessarily a mistake to buy into the idea of a powerful narrative about change and disruption, but there also needs to be some hard-headed analysis too. Make sure the numbers add up, particularly as the unexpected may be just around the next corner.
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