Market with split personality
Investors in European equities enter this year with an even greater degree of uncertainty and foreboding than the last. Enormous risks overhang the market, not least the fear of war with Iraq, but also concerns over a double-dip recession and the need for structural reform in heavyweight markets like Germany.
Post-Economic and Monetary Union in January 1999, all Euro-zone-based institutions could legally invest in euro denominated equities as being equivalent to domestic equities and benchmarks switched to include all share classes traded in euros. Some European-based institutions are still transitioning money into the Euro-zone, whereas others have taken the next step and gone pan-European (see table 1). As Gary Dowsett, investment consultant at Watson Wyatt, comments: “Currency is the key determinant to the investment approach, with UK funds favouring UK assets and Euro-zone-based funds favouring euro assets.”
UK plans that invest along regional lines tend to invest in pan-European equities (ex UK). Others obtain their European exposure via global equity (ex UK). Divyesh Hindocha, investment consultant at Mercer, says some UK funds are adopting pan-European or global equity approaches and adding a domestic UK equity allocation to generate the required overall UK bias. The reason for this, says Hindocha, is to align the mandate with the managers’ approach to researching stocks, which is increasingly on a sector basis. In this way, some UK investors are leapfrogging the issue of Europe.
Dowsett points out that fixed-weight allocations outside the UK effectively overweight Europe versus the US, since the typical one third each allocation to Europe, the US and Asia, is out of sync with market proportions, to the advantage of Europe. The most recent figures on overseas investment by UK pension schemes, as gathered by CAPS Median, find that European investment is 43% of all overseas investment in equities.
Across the continent, individual countries are each taking a different approach. Says Hindocha: “Plans in Ireland and the Netherlands treat the Euro-zone as the domestic market, whereas a Portuguese investor is more likely to invest pan-European.” A partial transition to treating the Euro-zone as the domestic market can lead to some complex allocation structures, for example a combination of mandates taking in country of plan, Euro-zone excluding that country, the rest of Europe, excluding the Euro-zone, and the rest of the world. A more usual approach is to split into Euro-zone and the world excluding the Euro-zone or, in keeping with the trend above, a global mandate plus a top-up Euro-zone mandate. For non-Euro-zone investors outside the UK, pan-European mandates are more usual, for example in Switzerland and Scandinavia.
Entry of the UK into EMU would clearly have an impact on the allocations made by UK investors, but this insertion of the largest European stock market into the Euro-zone would probably sound the death-knell for solely Eurozone allocations, in favour of a pan-European approach. Comments Hindocha “if the UK were to join the euro, plans in countries such as Ireland and Holland, which have already embraced Euroland as the domestic market, could well move to a pan-European approach.” With individual countries in Europe still adopting disparate allocations to equities as a whole, differences in allocation of mandates are likely to persist, in Hindocha’s view. Some very conservative schemes can only invest 20% in equities and may not be permitted to invest outside the Euro-zone at all. Besides a lack of consensus in equity allocations across Europe, the split between foreign and domestic equities varies extremely widely (see table 2). France particularly retains a high exposure to the domestic market, whereas in the Netherlands, plans have the bulk of money in foreign markets.
Whereas highly structured regional and specialist allocations are more usual among the larger continental European pension funds, and all sizes of UK funds, balanced mandates are common among small- to medium-sized funds in the nucleus of Europe, often run by the house bank or a similar institution with which the fund has a long-standing relationship.
Fund managers are leading the trend away from a country to a sector focus, asserting that correlations between companies in a sector are much clearer than within stocks in the same market. Despite its main client base continuing to split out a UK allocation, most UK-based fund managers research stocks on a pan-European basis.
Wholesale selling in the middle part of 2002 has led to large segments of the European stock market trading at historically cheap valuations. However, Frederic Buzare, European fund manager with Axa in Paris, considers that, given the level of risks and uncertainties, it is reasonable and wise to stay cautious until clear signs of recovery materalise and the storm clouds lift. Stewart Armer, fund manager at Fortis Investment Management, reports that Fortis’ analysis of the implied growth rates, based on current stock valuations, reveals the market to be taking a very pessimistic view on earnings growth. However, Armer admits that catalysts to short-term performance are in short supply.
In the current environment, few fund managers are testing their risk limits and most are cautious on making aggressive sector bets. Buzare, however, favours telecoms companies as these are less exposed to US influence and their profits are not correlated to the economic cycle. As telcos reduce their gearing there is potential for increasing free cash flow. Some consumer stocks – for example, electronics firms like Philips and Thomson – are trading at valuations that discount a double-dip recession, in Buzare’s view. Unless advertising spend falls for a record-breaking third year this year, the media sector should perform well – although Buzare warns that debt-burdened advertising agencies will suffer poor free cash flow. Buzare prefers companies with strong cash flows and balance sheet and good earnings visibility, citing Nestlé, l’Oréal and Diageo, post the disposal of Burger King, as companies that merit a full allocation. “The capital goods sector could well suffer the double-whammy of a debt overhang and plunging cash flow” comments Buzare, “as these companies face declining margins and little earnings visibility.” Overall, Buzare’s stance is broadly neutral apart from overweight positions in telcos and oil stocks, and selected restructuring stories.
Axa runs E7bn of pure European equities funds, these being both defined institutional mandates and mutual funds, into which some smaller institutions also invest. Buzare reports that many French institutional mandates have moved from a French focus into the Euro-zone, but few have taken the step to go pan-European. The perception among French investors is that the UK, which would be a large constituent of a pan-European mandate, is a particularly difficult market in which to manage money. Buzare comments:“The magnitude of the reaction to any profit warning of a UK company is much more severe than a continental one.” French investors who diversified in the mid to late 1990s have had a painful experience, as German stocks, which would have been the main beneficiary of inflows, have fallen 33% in the past five years, whereas French stocks are up 5%. However, Buzare sees wider European investment by the French as an unstoppable trend, fostered by changes in the rules on Plans d’Epargnes en Actions (share savings plans) to categorise all Euro-zone investments as tax-free as well as French stocks and mutual funds.
A tracking error of 3–5% away from the benchmark is widespread in European mainstream mandates, and most managers report they are running portfolios with prospective tracking error at the low end of that range. Two trends are perceived in new mandates; funds that were previously passive are moving to enhanced index to obtain a small outperformance on a tracking error of 1% and there is very little demand for high-risk mandates, with tracking error of 5% or above.
Managing currency exposure is only an issue for mandates that take in countries outside the European zone. Fortis, in its management of pan-European mandates, does not hedge, nor does it take explicit country views, but attempts to maintain currency exposures within its model portfolios neutral to the benchmark. Fortis’ process involves taking views on both sectors and stocks to create building blocks for the construction of model portfolios. Long-term valuation models are run on the individual stocks within a sector, to determine stock rankings, and on the whole sector, to generate an implied growth rate for the sector as a whole. The same model can separately derive estimates of profitability and capital requirement. Where growth rates for a sector appear too low, the 14-strong analyst team will determine what catalysts could trigger a rerating.
As Armer explains: “Fortis has found that the shape of the yield curve can act as a proxy for a sector’s sensitivity to the economic cycle. Fortis also consider that, in the global sectors, the performance of US stocks influences European stock performance and can act as a catalyst for change. Historic correlations of more than 0.6 are deemed significant. General news flow may also be positive or negative to sentiment.”
A scoring exercise leads to a sector rating and this is combined with the stock rankings within the sector to construct portfolios. Attribution analysis has shown that 50% of Fortis’ performance arises from sector bets and 50% from stock selection. The same approach is used whether the mandate is Euroland or pan-European and the portfolio tuned to the tracking error target of the mandate. Fortis’ mandates range from 1–6% of tracking error, with the majority at 4% considered medium risk.
Fortis does not adhere to an investment style, and Armer is dismissive that styles shifts are a significant contributor to stock performance, commenting, “where there has been differential performance between styles, this has been primarily due to sector rotation”. Also Armer reflects that correlations between US and European stocks in the same sector are by no means stable.
Fidelity has some 70 people in total devoted to European equities management, these being 60 analysts and the remainder portfolio managers and business heads. Most are based in London with a few on the continent. Fidelity focuses on stock decisions rather than sector or country bets, and remain typically within plus or minus 3% of the industry weighting or country weighting versus the benchmark. On trends in European investment, Fidelity director of research and product development Anna Roads commented “new mandates are predominantly pan-European, although UK investors still award continental European mandates. We see a trend for pension plans to specifically allocate towards the small-cap area of the market in Europe, to generate additional alpha, and this requires specialist expertise.” Fidelity invests $45bn (e43bn) in European equities, including the UK, but a good proportion of that is in UK specialist mandates.
Gartmore has benefited from increasing equity allocations and the move to multi-country European benchmarks, through which it has received inflows both direct from pension funds and funds managed on behalf of domestic European banks, which distribute the funds under their own brand name. With its large historic base of UK clients, Gartmore runs a disproportionately large number of continental European mandates. Fund manager Adrian Darley however reports “an increasing number of UK funds are moving pan-European in the expectation of euro entry”.
Gartmore’s philosophy of investing on unexpected earnings growth in the past year has focused on avoiding earnings disappointments, as opposed to pleasant surprises. Comments Darley, “many stocks have fallen as a result of global themes, for example asbestos claims, and by taking a global approach we were able to spot problems such as these in advance.” But adverse sentiment is not restricted to troubled sectors, and Darley concludes that the loss of confidence sparked by accounting scandals disrupted the whole basis of investment, with the resultant selling leaving equities at unquestionably low valuations versus bonds.
“Probably half the European market is trading on yields of 3% or more and maybe quarter are yielding 4%, almost as much as the yield on European bonds at 4.5%,” says Darley. “Given that most European stocks pay a single dividend in the second quarter of the year, this has to be supportive to the market in the short term. Initial trading in the New Year has been strong and on good volumes, with some large stocks up as much as 10%.”
Irrespective of the outcome in the Middle East, Gartmore is positive on oil stocks, believing them to be undervalued versus predictions of the oil price. Gartmore’s largest underweight is the banking sector. If interest rates continue to fall, some European banks, particularly in Italy, will be under intense margin pressure. German banks are felt to be at risk of a worsening domestic bad loan situation, and are under-capitalised. Overall, Gartmore’s active risk is at historic lows, at around 2% tracking error, whereas it would typically run portfolios with 3.5–4.5% tracking error.
Market volatility is also shorting the timescale of investment, according to fund manager Harald Sporleder at DIT, part of the Allianz Dresdner group. Comments Sporleder: “although we maintain a bottom-up stock-picking approach, market volatility means that we have to adopt a trading mentality.” Sporleder considers a 12– 20-week view as the longest that can be justified in this uncertain environment. Downside potential has an impact on stock selection in key sectors. “Our portfolios are skewed towards the lowest-risk stocks in a sector.”
As a result of recent market turbulence, investors have become more conscious of defined investment processes and risk management in manager selection. Evaluation of the risk controls appears more important to the large state pension plans in Sweden, Ireland and Norway, for example, than corporate plans. Managers with a consistent bottom-up style are finding favour over managers that follow market trends and investors are more aware of the impact of style tilts in different market conditions.
Invesco European equities head Michael Fraikin concurs, suggesting that its structured approach to equity investment is finding favour in a more risk-conscious environment. “investors want to know where the risks are, whereas previously they were either not aware or conscious of risk”. Invesco maintains neutrality on a number of different risk factors, such as country, sector, style, market cap and beta, and constructs portfolios according to region, tracking error target and benchmark using optimisation techniques. More than 80% of the active risk taken by Invesco is stock-specific risk. Key parameters in stock selection are relative price trend, the direction of analysts’ earnings estimates, price-to-cash earnings and earnings consistency, is treated as a proxy of management quality. Each parameter is gauged and aggregated for each stock to obtain an overall indicator of its attractiveness. Within Europe, the above four factors are weighted equally, but the management quality factor has a higher weighting in the UK to reduce portfolio turnover.
Fraikin comments: “The combination of the above factors means that we are usually out of problem stocks before meltdown occurs, and we will typically be underinvested in ‘fallen angels’. Our approach is to overweight stable companies in the portfolio, believing that the opportunities missed through not investing in turnarounds are made up for by consistency of performance.”
Invesco runs E1bn in European equities, with mandates mostly in the E30m–40m range. Some European equity mandates are part of a larger balanced mandate and by placing the entire portfolio with Invesco, plans get the advantage of a managed accounts, even if the equity allocation is relatively small.
European and Euroland indices provided by MSCI, FT Actuaries and Dow Jones STOXX are used widely across Europe. MSCI has more of a hold on continental Europe, whereas Anglo-Saxon and Nordic investors are more likely to select the FT index series. The broader STOXX indices find some favour in Germany, and the narrower STOXX 50 is sometimes used as a benchmark for funds that use tactical asset allocation overlay to ensure congruence between the derivative and the underlying holdings.