A changing marketplace
While it may be natural for European institutional investors to see European equities as a core asset class, what is not so clear is what should be included within that definition, and on what basis managers should be selected. The US market has a culture of much more specialisation of managers into specific styles and size bands, which, while creating potential anomalies through that rigid segmentation, does enable managers to focus on areas such as small cap value, where they can develop deep knowledge of a more narrowly defined segment.
When it comes to geographical coverage, the rise of interest in eastern Europe has added a new dimension to the possibilities. Ann Steele of Pictet Asset management explains that while they have a few different European product regions, they believe that by investing across greater Europe “which stretches from Ireland to Russia and Iceland to Turkey with 27,000 quoted companies”, they can maximise opportunities for investment.
Stability of European equity teams and processes has been a fundamental problem in the last few years. The tremendous growth of assets under management by hedge funds and the high fees payable to managers have lured many of the best managers away from large institutions.
Russell Investment Management’s Andrew Harradine monitors around 150 European equity fund managers and finds that “at the organisational level of the European fund management industry, we are continuing to see individuals leave big institutions and set up on their own. I think that there is now a much greater entrepreneurial spirit in the market, and big organisations are having to respond to that and provide incentives to keep key people.”
Merrill Lynch Investment Manager, whose European team has fallen from more than 20 to half that number, has responded to these trends by, as Wolfram Roddewig says: “Moving from an integrated research approach to a boutique approach, implemented over the last two years. Every team now has its own resources, and our European equities team has its own business plan.”
As Harradine points out, such an approach “makes incentivisation much more transparent as it’s a function of the quantum of assets being run by the team. If they don’t have the performance it will be tough to sell the product and similarly, if they grow assets too aggressively they will no longer be able to delivery performance and so lose the assets. So there is a much tighter linkage between the success of their product and their compensation.”
European long-short hedge funds are a very popular hedge fund strategy and likely to continue to lure talented European equity managers. Is it possible to have both hedge funds and long funds under the same roof? As Harradine points out: “Hedge fund managers are much more tuned into the market, they have better access to the best analysts on the sell side because of the commissions they generate. The key danger is that the long only product plays second fiddle to the hedge funds because of the different profitability dynamics of the two, and we are very mindful of monitoring that all the good stocks aren’t going into the hedge fund and all the rubbish into the long product.”
He goes on to add that “it also depends upon whether the same individual does both hedge and long only. While Roger Guy at Gartmore has been very successful running a long only European fund and a hedge fund at the same time, our preference would be for different individuals to do different products.”
Are style mandates likely to become of greater importance in the European marketplace? JP Morgan AM, according to Michael Hughes, “has won a number of style mandates. We have seen demand particularly from German pension funds asking us to run pure growth mandates. Often these pension funds structure their exposure to Europe through a growth and value manager and we have been very successful winning particularly growth mandates structured against the MSCI growth or Dow Jones TMI Growth index.”
However, when it comes to a wider acceptance of style specialisation “there are certain institutional consultants who think it is a good way to go but not all”. MLIM’s Roddewig argues that: “Some institutional investors are nervous about committing themselves to a style for five years. Mutual fund and fund of funds investors on the other hand find it easier to switch between styles as required.” He adds that: “Some of the very large institutions segment European equities, they can afford the luxury of splitting their assets between a number of managers, a European value manager, a European growth manager. However, many cannot afford that luxury.” MLIM’s European equity team therefore offers both style and flexible strategies, with the latter enabling them to “switch between styles over time depending on what the fund manager believes to be the right course”.
Russell’s approach as a multi-manager is one of being style neutral in their fund. They divide their universe of managers into “quant, value, market orientated and growth. Market orientated is GARP, a combination of earnings and valuation orientation,” explains Harradine, who goes on to add that they “are aware of market conditions, so if we decide to make a change to our fund now we would be quite cautious about bringing in a small cap value manager as they have been very profitable parts of the market over the last few years”.
Their current line up also includes BlackRock as a growth manager and Fidelity, “who plays a market orientated growth role in the structure. In terms of the approach, BlackRock versus Fidelity, there are some similarities but in reality they are pretty different. With Fidelity you have 45 pan-European research analysts looking to generate an informational advantage in stocks. BlackRock takes a combination of top down and bottom up influences, the BlackRock portfolio will be much more concentrated with 30-35 stocks against Fidelity’s 80.”
Continental European economies have not been noted in recent years for their dynamic growth yet, as JP Morgan’s Michael Hughes points out: “Since the bull market began in March 2003, European equities have outperformed other developed market blocks despite poor underlying economic performance – why? Because of the globalisation process. For example, Continental, the German tyre manufacturer, had no non-German workers in 1998, whereas today 60% of their employees are outside Germany, primarily in eastern Europe. Corporates don’t make much noise about it but they are moving production to low cost countries. Global trade growth has been about 5.5% annually in recent years that bears no resemblance to the rate of domestic economic growth in Germany or France.”
Hughs continues: “We think that this process is at a relatively early stage and that returns on capital will continue to improve for years to come. The other really good thing about European equities is that they are much cheaper than other developed markets.
Roddewig argues in the same vein: “People have been sceptical about Europe for some time, there has been very little economic growth at the centre while there has been very strong growth at the periphery, in Ireland, Sweden and Norway. But if you look at Germany, the stock exchange listed companies have done very well. German companies have benefited from the 4% real GDP growth around the world.”
At the periphery of Europe, Steele comments: “We can go up to 25% in eastern Europe, but are currently at 8%. We are overweight Turkey and have reasonable weightings in Russia, which we find more attractive than central Europe where we only hold a couple of stocks.”
Overall, prospects according to MLIM are good. “We think that 2006 will be another good year, eight-10% returns. We think there will be a little more economic growth in 2006. We are currently in a fantastically favourable lending environment. That said there are clearly risks in terms of, for example, energy prices.”
With the sheer number of companies available for investment within greater Europe, it is not surprising that virtually all firms use some form of quant screen to reduce the universe to a set of manageable opportunities worth exploring further. What differentiates the firms labelled ‘quant’ is the extent and sophistication of their screening, valuation and portfolio construction models, and the rigour they take in excluding qualitative and hence more subjective information.
Russell, for example, has two managers regarded as quantitative in their approach: Axa Rosenberg and Numeric Investors in their pan-European multi-manager strategy. Harridine points out that “they have fundamentally different types of processes. Axa Rosenberg breaks a company down by component parts and builds it back up again. I would say that the valuation part of their model dominates the process. At Numeric Investors valuation is important, but earnings per share (EPS) revisions play a much more significant role and additionally, the qualitative overlay is quite important. When you look at all the data which is thrown out by these strategies, some of it will give a false signal (eg, an earnings upgrade for tax reasons), and if the portfolio manager can recognise it as a false signal, well that is the best of both worlds.”
MLIM, although certainly not a quant manager, “uses a mixture of quantitative screening and bottom up investment ideas”, according to Roddewig, who adds that “over the last few years we have moved away from a blanket research coverage model in terms of how the analysts work, and use the quant screening to target the research. We use the quant to highlight stocks which are attractively valued and have good earnings growth momentum.
This approach does not require an extensive in-house quantitative team. Roddewig says: “Rather than building an in-house quant screening model we have brought in ones sourced from third parties. We look at valuations, identifying stocks which look cheap and have good earnings momentum and evidence of operational improvements.”
The qualitative input is critical to their approach as well, and “as a large investor in European equities, we can get access to companies and their senior managers. We tend to have hundreds of contacts over the year, which is particularly useful with complex companies.”
In contrast, Michael Hughes at JP Morgan is adamant that “we do not make company visits. We do not believe that company visits will tell us if a stock has the specific characteristics we associate with outperformance. In addition, you can fall into the trap of ‘liking’ management, or obtaining too much irrelevant information about the company. Of course small cap mandates are different, there you have to supplement the publicly available data with your own research.”
The manager’s process is a combination of value and momentum, which they see as based upon behavioural finance. “People tend to seek pride and try to avoid regret when making investment decisions. If the price of a stock rises from $50 (€41.7) to $75 it is easy to sell because the investor has made a profit. However, if the price drops to $30, it becomes harder to sell since selling would involve an irrevocable acceptance that a mistake has been made. If a stock announces
positive news, efficient market theory suggests it will immediately rise to a new price which fully reflects the impact of all that news. However, behavioural finance studies indicate that as the stock rises people will tend to take profits and the reverse will happen if the news is negative and the stock falls (people tend to hold on or even buy some more).
“The implication of this is that people tend to slow down the movement of a stock in one direction or the other. So if you buy an outperforming stock or sell an underperforming stock you will outperform yourself. Furthermore, stockbrokers don’t predict all the bad news in one go, instead they make a series of downgrades or upgrades as they react to the news coming in. This means that seven out of 10 times one upgrade is followed by another so, if you buy stocks which already have upgrades you will outperform.
“In our core portfolio we look at four characteristics: value, growth, price momentum and value momentum. We buy stocks with the best combination of these factors. We rank each stock in terms of these four factors
and then have a combined ranking.
We ensure that in aggregate the portfolio has a better combination of all four of these factors than the overall market, unless it’s a growth or value mandate, in which case we ensure that we are very overweight value or growth factors.”
Hughes sees the quantitative analysis and the fundamental research they do are both means to the same end: “Creating portfolios that are comprised, on average, of faster growing, cheaper stocks with better news flow than the market. Reason suggests that a portfolio with those characteristics is likely to outperform.”
JP MorgAn also has a higher alpha variant of the same process where, according to Hughes “we do not use a benchmark for construction purposes, just the very best ideas that the investment process generates with 50-150 stocks. The number varies according to how great is the opportunity the manager sees, and also whether there are more opportunities in small than large caps.”
Given the structural changes in the European marketplace recently, it
is clear that one of the most important criteria for selection of managers for long-term mandates is going to
be the stability of the teams, regardless of their short-term performance record.
A major factor in the success seen by quantitative managers in recent years can be attributed to the repeatability and sustainability of their investment processes, which do not depend upon the retention of ‘stars’ likely to be tempted by the possibilities of generating immense personal wealth very quickly through the insatiable hunger for higher alpha European equity hedge funds. Determining how much of an investment process is dependent on an individual’s skill, how much on the team’s unique analytical approach and how much on the quant screening undertaken beforehand, may be the key to determining which managers to trust with a long-term mandate.