The car is probably the invention that has changed people's lives most dramatically in recent history. It has greatly enhanced mobility, revolutionised logistics and sparked a multi-trillion-dollar industry worldwide.

For investors, the opportunities at the birth of the automotive industry must have seemed dazzling, but since the beginning of the industry in the United States about 2000 car companies were formed, of which only three have survived, and only just.

On the other hand, the US horse population dropped from 17 million in 1900 to 5 million in 1998, a reduction of 70 per cent. With the benefit of hindsight, the best investment to make was to go short on horses.

This illustration was used by investment guru Warren Buffett at the 1999 Sun Valley gathering of top executives to point out that even if innovations are successful, pouring money into new technologies will not necessarily make you any money. This illustration also neatly sums up the challenges of thematic investing.

If you are clever enough to get the theme right, in this case the rise of the automobile industry, you will still need to pick the appropriate investment vehicles to achieve the best returns.

"Many of our clients are thinking about these things, but it is the implementation that is the hardest part," JANA Investment Advisers head of consulting in Sydney John Coombe says.

"If funds go down every theme that you can identify, you end up with a hundred different investments. You would own farms, agricultural companies, and it just gets too unwieldy in their portfolios. It is about how many investments you want to have, because you can split a pie in a million ways."

AMIST chief executive John Livanas says: "Thematic investing, very specifically, looks for big themes or trends in the way that the world works. Of course, this is not new and yet just as it's easy to misread a company's performance, it is just as easy to miss the big themes. [Microsoft chairman] Bill Gates, of course, famously dismissed the Internet."

The bigger picture

And yet, it is easy to see how thematic investing is gaining more enthusiasts. The global financial crisis (GFC) made many investors realise a bottom-up stock-picking strategy alone was not enough. You need to have a view on the structural shifts in the world; the bigger picture.

"Being able to access and identity themes will become more important to long-term returns and identifying risk," Pengana head of distribution Denis Carroll says.

"Don't bet the bank on any individual theme, but you should have a wide exposure to a number of themes. People that don't recognise the existence of these issues do it at their own peril."

Livanas agrees that investing is in part about making assumptions about the future. "When anyone invests for the long term, the changes that occur are a result of macro factors, and while in the short term these factors may have small effects, ultimately they will shape the success of one's investment," he says.

But having a view on the bigger picture does not make you a thematic investor. "I suspect that most analysts do take account of themes," Livanas says.

"If an analyst is studying BHP, Rio Tinto or Qantas, I expect he or she is also trying to understand the major factors that will impact that particular industry over the long term. These factors will set the limits for the long-term performance of each company within an industry, even while there is a divergence of performance between companies."

Thematic managers differ in their approach because they start with a theme that often cuts across various sectors and then find the most appropriate companies for this theme, while most managers start with looking at companies and then place them in a wider context.

"Thematic investors try to identify long-term structural changes in the way that the world operates so as to invest in the sectors that are going to benefit the most and avoid those sectors that are going to be hurt the most," Coombe says.

"Most of these managers won't put all of their money into one theme. They will generally have 10 to 12 themes and at any time one or two themes seem to be working."

Gaining traction

Super funds have started to take thematic investing more seriously, but they have adopted different ways of integrating the method into their portfolios. "Some of our funds have gone into agricultural funds because they have identified it as a particular theme. It is about how many investments you want to have because you can split a pie in a million ways," Coombe says.

To avoid the pitfalls of thematic investing, most investors simply hire a manager that specialises in this style of investing. AMIST has a small allocation to Global Thematic Partners, a firm that has been recently been spun out off Deutsche Bank's asset management arm. "It is less than 5 per cent of our portfolio, but it is an important component because it allows us to look at the future in the long term," Livanas said.

"[But] it doesn't necessarily mean you get it right."

Global Thematic Partners is led by chief executive and portfolio manager Oliver Kratz. He is considered one of the smartest and more original thinkers among thematic investors. Kratz emphasises that thematic investing is not a new fad.

"We don't just buy something, because it is thematically interesting, it has a nice name and the CEO of the company wears a colourful tie," he says.

Every decision is made based on careful research and is continuously debated on its appropriateness for the portfolio, he says.

Kratz and his team have identified about a dozen themes that could drive growth, including the further unravelling of human genetics, the shift from cheap disposable products to quality product and the global demand for engineering services.

He is unafraid to take an unpopular position, if he believes the idea has merit. At a recent presentation in Sydney, Kratz pointed out the opportunities thrown up by the arms race involving countries around the Indian Ocean.

"The militarisation story of the region we like, because . you know it is not very SRI (socially responsible investing), but we think it is M-A-D," he says.

"Looking forward, you've got India going from a defence budget of about $10 billion to $100 billion over the next fiveyears. China has a defence budget that we don't really know, [but] it is about 3 or 4 per cent of GDP (gross domestic product), and it is growing really fast. The Saudis have a defence budget going to $48 billion. These are the numbers which we have measured.

"These companies are very cheap. People are valuing these companies as whether the West has cut their budgets forever. It is mutually ensured destruction that has kept the West pretty peaceful for the past 50 years or 100 years even."

He says he believes the world is in an era of frequent but minor conflicts and crises. "In 2001, all hell broke loose. We have gone from the tech bubble to the global financial crisis to the sovereign crisis, and I think it is okay. We will have a world where we will have serial conflicts and serial crises," he says.

"The 'goldilocks scenario' that we used to have was probably more of an aberration. The 'new normal', as people call it, has a higher number of low intensity conflicts and crises and you can make money in this environment. You just have to think a bit more with the left side of your brain."

Scottish fund manager Aubrey Capital, which is distributed in Australia by Treasury Group, has somewhat less controversial ideas. This firm has identified five themes that explain growth in all its forms. The themes include behavioural change, prosperity, innovation, maturity and sophistication.

"Behavioural change is one of the key drivers. Ten years ago there was nobody using the Internet in China, now there are 400 million users. Last year, 140 million of those purchased something online," Aubrey fund manager Lynne Thornton says.

"So companies that are geared into that space are going to be benefiting from the tailwind of that growth."

To leverage off this growth, the firm has made investments in companies like Baidu and Alibaba in China.

The conditions in which these themes play out change all the time, Thornton says. "Seven years ago, we did not have an Internet exposure to China. It was too early. The behavioural change wasn't happening such that the companies were materially growing," she says.

"A lot of the thematic investors sit around and brainstorm and say: 'Oh, now we've got this new theme running through the portfolio. [But] when we are talking about these themes, the themes are not changing, but the sectors or companies that we are playing change all the time."

The main reason Aubrey uses its five themes is to structure its research efforts, she says. "If you say 'we are just going to look at everything', then it is easier to fall into a lot of traps. We are very much squarely focused on companies that are played into the five themes that we have. And then we identify the best companies within that sector," she says.

Many managers would argue China and the rise of the emerging markets is a theme in itself, and Investec Asset Management global strategist Michael Power says thematic investing can help investors make better use of existing opportunities in the emerging markets as more generic investment strategies tend to underestimate the contribution these markets make to global economic growth.

"The main investment indices are badly lagging reality. Typically, emerging markets have a 15 per cent weight, but will be providing the world with 85 per cent GDP growth over the next decade. Thematic investing allows you to short-circuit the delay and jump to the front of the investment queue," Power says.

Investec has a number of thematic funds, and according to Power they have attracted much interest in recent time, especially the firm's Emerging Market Debt and Resources Fund.

"The demand for thematic investing will be driven by a recognition that normal indices are systematically, materially and repeatedly falling behind the fast-changing world we live in, especially as the secular changes driven by Asia's rise overwhelm the cyclicality of the developed world," he says.

Global Thematic Investors also recognises the emerging markets as an important growth driver and, when prompted, Kratz calls his Chinese analyst without irony his "secret weapon". Yet, he also points to the immense difficulties in obtaining data that has not been tampered with. "China, it's an off-balance sheet story. I have nothing intelligent to say, because really you can't look inside the corporations and understand how their earning practices are done. I find it risky," he says.

A returning theme

Thematic investing is not without risks. Apart from having to identify the right themes, you need to make the right assumptions about who will benefit from these structural developments. However, the method certainly has its merits and it is likely there will be a wider adoption of some of the methods these investors apply.
"I think what will happen is the same thing that has happened with the Internet or with other innovations. What starts off as a new way of thinking, perhaps limited to a few experts and converts, gradually becomes incorporated into the mainstream way of thinking," Livanas says.

"In the case of thematic investing, I suspect that this will quickly become part of the suite of ideas used by fund managers."

Coombe says he believes the success of this method is also dependent on how many managers are willing to tie their name to this style of investing. "It depends more on how many managers will put their hand up and say 'I'm a thematic manager', and whether they can add value over time," he says.