AI is going to change the world, but which companies will benefit most from that trend? Investors who put money into trends and themes such as AI look for a solid benchmark to determine the purity of their investments. The goal is high purity. That does not always work out.
Many large defense mutual funds and ETFs give a prominent place to Boeing, but the stock has been struggling for months. The reason: although the Defense Space and Security division accounts for roughly 35 percent of the aircraft manufacturer’s revenue, the narrative around the stock is dictated by the performance of its commercial aviation business. And that performance has been poor, due in part to a series of technical incidents. Investors in Boeing may think they are investing in defense, but their returns depend on developments that have very little to do with that sector.
Thematic investors are vulnerable to this phenomenon. How vulnerable depends on the way asset managers translate themes or trends into concrete investments. How strong is the correlation between a company’s performance and the way a given trend develops? In other words: what is the company’s exposure to the selected theme?
Investors want to know how pure their thematic exposure really is. Investment Officer asked two fiduciary managers and Swiss asset manager Pictet which benchmark they use to measure this. According to Morningstar, Pictet is the world’s largest thematic investor, with more than 60 billion euro invested in thematic funds such as clean energy, robotics and environmental solutions. For each of these funds, the manager reports the average purity of the companies included, meaning their average exposure to the theme. Sometimes this is 70 percent or more (as with the well-known Pictet Water fund), but sometimes it is less than 50 percent.
‘Bread and butter’
How does Pictet determine purity? Marc-Olivier Buffle (photo), head of thematic research at Pictet, cannot help but smile at the question. “That is exactly our bread and butter,” he said. “We consider our method something of a trade secret.” Pictet does not only look at the share of revenue generated by “theme activities”, Buffle explained, or at the share of ebitda, but includes a wide range of additional variables in its research to determine the degree to which a company is aligned with a trend or theme.
“Only a handful of companies report on this themselves. This is also not information you can find on Bloomberg. We incorporate purity into our fundamental research on companies. Just as we form an opinion on valuation, management quality and the business model, we also assess the extent to which the organization is supported by the megatrend or the theme of the fund.”
Focus
Pictet prefers high purity, primarily for reasons of focus. “Focus in two senses,” said Buffle. “High purity allows investors to execute their strategy precisely. If you say you want to invest in clean energy, then you do not want companies that also derive half their revenue from fossil energy.” On the other hand, high purity gives a company itself more focus: “The strategy of those companies will also be more aligned with the theme or trend. With conglomerates it is the opposite: management attention must be divided among several business units. Across the organization, the overall objective will not align with a single theme. We therefore do not prefer such companies.”
High purity, however, is not always possible. “We also have to be pragmatic,” Buffle said. “Thematic investors typically already have a bias toward small and midcap companies, and in mutual funds we want to keep the universe broad. In some themes it is easier to find pure companies than in others. On the other hand, if you can find very few pure companies, this may also mean that you have chosen too narrow a theme. For example, we do not see value in a theme such as electric vehicles.”
Thematic indices
The examples already show that purity is especially relevant in the context of sustainable investing. Fiduciary managers Van Lanschot Kempen and PGGM emphasize this as well. 
Wilse Graveland (photo), head of Fiduciary Management at Van Lanschot Kempen: “Many pension funds have stopped active investing. In its place, thematic indices have emerged, linked to the United Nations Sustainable Development Goals (SDGs). Funds still want to choose what they invest in, and each fund has its own preferences. We design these indices tailored to their needs, and purity is extremely important.”
Several years ago, APG and PGGM helped develop a methodology to assess the degree of alignment with SDGs: the SDI Asset Owner Platform. The platform now maps for 10,000 publicly listed or bond-issuing companies which share of their revenue contributes to SDGs.
From 23 to 30 percent
Gert-Jan Sikking (photo), senior adviser for sustainable investing at PGGM: “PFZW aims for 30 percent of its investments in euro to be aligned with one or more SDGs by 2030. Right now that figure is 23 percent. So the investment teams must keep searching for SDG-related investments.” The extent to which business activities align with an SDG is determined based on revenue. For this methodology, that is sufficient. “If a company generates 10 percent or more of its revenue from such a sustainable activity, we consider it a Sustainable Development Investment. There can certainly be debate about this. Two years ago, for example, we decided that the production of hybrid cars would no longer be considered sustainable. Only electric vehicles are now the standard.”
To reach the 30 percent target, PFZW cannot invest too heavily in companies that generate only about 10 percent from a sustainable activity. Sikking: “Companies that generate 10 percent or more revenue from activities with a negative SDG contribution are excluded altogether, even if they have a higher positive contribution elsewhere.” As a result, after the first selection round only about a quarter of the 10,000 companies remain.
Optimization
Then it becomes a matter of further selection, Graveland (Van Lanschot Kempen) explained. “A pension fund often wants to focus on certain themes or SDGs, which already eliminates many companies. Then there may be an exclusion policy or an inclusion policy. Only after that comes asset allocation: which asset classes do you actually want to invest in? Then follow portfolio optimization, diversification and tracking error. You also want to remain as neutral as possible in terms of sectors and regions, which can have major consequences.”
In such a process, the degree of purity cannot come first. Graveland: “Risk and return also impose their own requirements.” Pictet finds those factors equally important, Buffle added: “A minimum level of purity is a first selection criterion, but ultimately valuation, management and business model are the factors that define the attractiveness of a company. Only when companies match across such characteristics do we let purity be the deciding factor.”