Making equities work harder
In the late 1990s, double-digit annual returns were commonplace in many markets. Strong global economic and profits growth supported good returns from stocks in a wide range of sectors, but in particular technology stocks spiralled to unprecedented valuations and pushed average market returns higher.
When market returns are so high, simply buying a fund which mirrors the index is enough to provide good absolute returns, and many investors were satisfied with index-tracking funds.
We have now entered a period in which overall market returns are likely to be lower. The recent recovery in the rate of global growth has peaked, while interest rates are rising. Most of all, after strong sustained rises like that of the 1990s, equity markets tend to mark time for a while – although several years of modest performance from broad markets will be made up of good and bad years, and good and bad performance from individual stocks.
Active management is the key to better returns
In this environment, there is clearly little point in just accepting an approach which tracks an index. Investors need to be more discriminating by backing the winning stocks and avoiding the losing stocks, with the flexibility to manage portfolios dynamically in order to make the best of changes in prevailing market conditions.
All funds should aim to do this, but Alpha funds take this approach one stage further. Skilled fund managers are given the freedom to deviate from the benchmark and take large positions in stocks in which they have the highest conviction, or to take no position at all in a stock they believe will underperform, even if it is the largest company in the market.
Is Alpha higher risk?
This approach may lead to more volatility relative to a benchmark in the short-term, and is only suitable for investors looking for higher returns but who understand, and are comfortable with, this potential relative volatility.
However, while Alpha funds tend to take quite large ‘off-benchmark’ positions and therefore are considered more risky, it is worth noting that funds which closely ‘hug’ their benchmark can often be quite highly concentrated in a small number of the largest companies in the market. By simply tracking the index you could be exposing yourself to a high concentration of risk in an individual company. Alpha funds, on the other hand, give investors the opportunity to have exposure to companies which may not make up a large part of the index, but whose long-term prospects look first rate.
Fund manager flair…
Of course, the key to providing successful Alpha funds is finding the best managers and giving them freedom to back their best ideas and follow their own investment style. Some Alpha funds may be value-oriented, others focus on growth stocks and some are thematic. Different Alpha funds are more ‘focused’ than others.
… Supported by a robust framework
However, this flair must be backed up by sound research. We believe in the potential to generate competitive returns from independent research and 75% of the research we use is produced in-house, rather than relying on brokers’ reports. Regular contact with company managers is critical.
A flexible approach to different markets
Each of our Alpha managers takes a slightly different approach in their respective markets and one that is suited both to that market and the individual manager’s proven talents.
Crucial for German investors
‘Risikotragfähigkeit’, Asset Liability matching, solvency ratios, risk parameters set by the Financial Supervisor, minimum return requirements for insurance contracts or pension promises, etc have become the buzz words of the German plan sponsors. This demand aspect is nicely supported with the recently enlarged technical flexibility such as outsourcing, Master KAG, use of I-shares instead of Spezialfonds, which allows the sponsor to move away from the traditional Hausbank balanced mandate to the specialist Alpha manager.
Schroder ISF European Equity Alpha, managed by Zafar Ahmadullah, is entirely driven by bottom-up stock ideas, investing in companies on their own merits, rather than trying to predict the outlook for markets and sectors. Zafar’s proven investment style is identifying stocks with ‘hidden growth’ potential.
Hidden growth may mean there are strong elements to a company’s business not yet recognised by the market. For example, where one division of a company is growing rapidly, but the market focuses on other divisions that are low growth or that have fallen ‘out of fashion’. Over time, the share prices of these companies usually start to reflect their true potential as market inefficiencies are ironed out, or as positive change at the company brings it to investors’ attention.
This style is suited to European markets. European stocks are not as well researched by global investors as those in the US, which means there are many more ‘undiscovered’ opportunities. This particularly applies to smaller markets like Greece, Ireland and Belgium.
In addition, some very strong growth opportunities overlooked by other investors can be found among medium-sized and smaller companies. Schroder ISF European Equity Alpha has a mid and small cap bias at around 50% of the portfolio.
Translating superior Asian growth into real returns
Although the Asian region has generally delivered superior economic growth over the last decade, this has not been reflected in broad market returns. Factors including inefficient corporate management have meant that those investors holding a closely benchmarked portfolio of Asian equities have not participated in this economic success and many are demanding a higher octane approach.
One key factor in favour of the Alpha approach is that Asian equity markets are generally more inefficient than western markets. Share pricing anomalies are more common and more marked, especially for medium to smaller cap stocks, meaning that there are enticing investment opportunities for the more aggressive investor.
Schroder ISF Asian Equity Alpha, managed by Ng Soo Nam, generates alpha by identifying broad market themes and, within these themes, share price performance potential from a bottom-up perspective. The fund tends to have a bias to mid and small-cap stocks.
Themes can be economic, socio-demographic or related to industry or technological trends that are expected to enhance corporate earnings. For example, on a long-term view, we feel we can benefit from investing in stocks which are generating high and sustainable dividend yields, supported by secure earnings streams. The relative stability offered by companies that can pay high dividends should help drive superior returns.
Value the best approach in Japan in the long-term
Nathan Gibbs, who manages Schroder ISF Japanese Equity Alpha, aims at aggressive outperformance through a bottom up, value-driven approach. Value investment has been the most successful investment style in Japan over the long-term and there are good reasons to believe this will continue. Japan’s average market valuation is lower than other major markets and it is rich in value opportunities in individual companies. Furthermore, a very positive trend has been going on in corporate Japan for the last few years with more companies restructuring operations and cutting costs to become more competitive on a global playing field.
Japanese management teams are changing their attitude to shareholders and are beginning to focus on offering greater transparency and providing good rewards through dividend growth and share buybacks.
To generate alpha, Nathan looks for some kind of change present in the company or another catalyst that will bring the stock to the market’s attention, such as an improvement in management’s attitude to shareholders.
Our own research adds most value in areas which are not well-covered by other investment managers. For this reason the fund will frequently have no holdings in the largest companies in the market but instead tends to have a bias towards smaller companies.
As Nathan said recently: “We could be the 50th analyst that’s gone to see a big company but maybe the only one visiting a small cap.”
Martin Theisinger can be contacted on +49 69 975 7170 firstname.lastname@example.org