An important innovation of modern portfolio theory is that the return on a portfolio is viewed in relation to the risk exposure when evaluating performance. Lowering risk through diversification has become the dogma of portfolio managers.
Aside from pure security diversification, international diversification traditionally involves a country approach. It has been empirically demonstrated time and again that the top-down decision with respect to country weighting has a significantly more lasting influence on performance than stock selection. This has pushed the traditional investment style of pure stock picking into the background. The dominance of top-down (macro-oriented) investing has led, after all, to an improved control of risks. But it also moved performance close to that of the benchmarks, thus resulting in a holy war" between active managers and passive indexers.
At the same time, investors have changed their behaviour considerably. Continental European investors are generally considered risk-averse in comparison with investors from English-speaking countries. Yet this "conservatism" is overestimated and continues to fade. One example of this is the current change in allocation with respect to mutual fund subscriptions. Whereas Americans hold 49% of their mutual fund investments in stock funds, Europeans have already reached a level of 38%.
In contrast, various reasons such as market size have traditionally made Europeans more open to global diversification. The investment approach briefly outl ined below was inspired by the creation of the European Common Market and the elimination of monetary borders. Using a pragmatic approach, we have investigated how the advantages of the various approaches may be optimally employed. We first assumed that so-called global "megatrends" display the greatest growth potential. This is demonstrated clearly by examples such as the technology trend, with its implications for communication (eg, the Internet), as well as the demographic trend and its resulting implications for pharmaceuticals, leisure or investment behaviour (eg, pension financing). This investment style represents a combination of the risk-inclined, pure stock-picking approach and the risk-averse, pure top-down approach.
The outlined investment styles overlap each other, resulting in intersections that we define as the attractive industries and sector leaders, as shown in Figure 1.
The next stage of the selection process (ie, the intersection of the three circles) leads to a small list of securities whose characteristics are surprising at first if we assume that all three processes are carried out independently. This independence can only be theoretical, however, since the fundamental set of possible stocks is always identical. Nevertheless, we have simultaneously determined that this results in a more disciplined investment process and enhances the consistency of the argumentation.
Interestingly enough, and for us the principal revelation, when implemented systematically each process leads to fundamentally similar portfolios with respect to security selection, sector allocation and country allocation. This logically has to be reflected in the risk-return figures. In other words, a portfolio that is structured according to our sector approach criteria has a country allocation (as an output, not an input) that indeed deviates (active style), but it does not deviate wildly from the given benchmark.
As an example, we now briefly present an excerpt from the risk analysis of a "world sector portfolio". The inputs with respect to the client are as follows: FT World as the benchmark, with a tracking error of 6-7%. At the same time, the number of assets should be significantly reduced with respect to the benchmark (1,500) due to the size of the portfolio.
Figure 2 shows that Europe is clearly overweighted, whereas the US is slightly underweighted, and Japan is substantially underweighted. Once again we emphasise that this country allocation represents an output, not an input. Whether coincidental or not, in view of the current turmoil in the stock markets the portfolio makes a tactical impression, not a strategic impression.
The industry selection, as indicated in Figure 3, presents a similarly "logical" picture.
We are now interested in the contribution to tracking error. It is not surprising that the stock specific risk and the market selection together account for approximately 80% of the tracking error. The contributions from the currency selection (5%) and the industry selection (7%) are very small. The tests regarding the contribution of management style (risk indices) to tracking error correlate most closely with large caps (versus small and mid caps), to securities with a high price momentum, and somewhat less closely with but still clearly to growth (versus value). Given the very small number of securities in the portfolio, it may be somewhat surprising that in the style analysis the component "indexing versus stock picking" is not significantly pronounced and correlates greater with the passive side. In the above-mentioned context, however, this is easy to explain.
These observations should not be taken fully at face value. It is necessary to consider the investment style of our company, which naturally also affected the study and which style we intend to retain in view of our good performance (active, long-term oriented, multiple risk exposure, strictly risk controlled, etc). So there is a clear bias towards the existing portfolio construction. For our clients, who allow us to manage the "new products", this has the advantage that the actual portfolio does not look completely different, that a gentle transition is possible, and last but not least, that the high visibility (ie, transparency) is assured all the way down to the individual security level. Our active management style makes it possible to avoid the problem of a lack of widely recognised and well-known sector benchmarks, and it allows us to measure ourselves against traditional benchmarks.
Leo Th Schrutt and Manfred Wolfensberger are with Julius Baer Asset Management in Zurich"