Too much information
There is no doubt that running a global equity portfolio is a macho activity that any red-blooded CIO would like to put their name to. It is also a good fallback in the event that a merger takes place and the loser in the battle for CIO has to be able either to update their credentials as a fund manager, or else update their curriculum vitae. Of course, with all their other responsibilities, it is often the case that they may not be able to spend much time on actually managing a global equity portfolio, relying instead on a committee of their regional fund managers. The drawback with that approach is that it is very difficult for any of them to confess their mistakes to eight of their colleagues and potential rivals with obvious implications for performance!
What is fascinating about looking at approaches to investing in a global equity portfolio is the different strategies that one can use to overcome the key issue of sheer information overload. Using a committee of regional specialists can appear to be an obvious way forward, but the practical implementation is fraught with deep organisational and behavioural problems. Yet philosophically at least, global mandates make far more sense than the home country bias that still dominates equity investment.
US managers are geared to a domestic market that is 50% or more of the global marketplace and often have a range of specialised US equity products alongside a single EAFE product covering the rest of the world, occasionally supplemented by a specialist emerging markets capability.
The UK market accounts for around 10% of the global market capitalisation yet until a few years ago, UK pension schemes had an average weighting of 70% of their total equity exposure in the UK and only 30% in global. Buying sterling assets to match sterling denominated liabilities has traditionally been the rationale for the imbalance but with the top 10 stocks in the FTSE All Share accounting for 45% of the index post the Royal Dutch/Shell merger (up from an already high 28% in 1997) the concentration is unacceptably high for any pension scheme to have, given the nature of their liabilities.
For the last few years at least, investment consultants have been advocating that pension funds increase their exposure to global equities and this has been reflected in an increase in the global component to 50% in the UK.
The approaches taken to deal with the sheer size and complexity of the global equity markets can be divided into four main categories: passive index funds, enhanced index/active quantitative approaches, traditional large research-based teams and finally small boutiques. As Gary Dowsett, the senior investment consultant at Watson Wyatt responsible for manager research in global equities points out, there is also an issue about how you gain exposure to small cap on a global basis. “Most products on offer are bolt-together regional products, there are few true global small cap products. How do you cover thousands of companies around the world?”
While the most complete exposure of mid and larger cap global equities is through index funds, enhanced index or active quant approaches are becoming increasingly popular. More recently, according to Dowsett, “there has been a trend towards enhanced indexation and active quantitative strategies in the UK, continental European and US equity mandates because active managers have not been able to consistently deliver in the +1% to +2% outperformance range. Over the last two years we have seen quantitative houses develop global products, and we have started to see allocations being made to them.”
Firms such as BGI and GMO rely on processes that have less detailed but consistent information on all stocks in their benchmark index, and apply relatively simple measures of comparative value. Whilst there may not be a high confidence level in any individual bet, by having a global portfolio of upwards of 300 stocks, they would aim to be able to identify sufficient anomalies whilst controlling the tracking error against the index to generate outperformance.
Large asset managers with dedicated research teams that cover sectors on a global basis have been the traditional mainstream choice for global equity mandates. Dowsett sees the success of the large US managers at picking up global mandates in the UK as “largely due to the depth of resources they have devoted to research and their greater knowledge of the US market”. A common initial approach by many US houses seeking products for the European market has been to staple an existing US equity product with an EAFE product to produce a global product. Whilst this gives a quick entry point to European investors seeking global managers, it precludes the manager from making a choice between Ford and Renault, for example, in selecting the best global car companies. Many US houses have been running integrated global portfolios for many years such as OppenheimerFunds with $20bn in global funds, the majority retail, run out of New York since 1969 against an MSCI World benchmark.
Other firms such as T Rowe Price are finding ways to create new dedicated global products that can satisfy the demand in the European institutional marketplace for higher alpha global products. The manager has adopted the approach of capitalising on its strength in global sector funds to set up a new global diversified equity product run by its former IT and telecom sector specialist Rob Gensler, who has the view that “unless you have a fully integrated approach you are just wasting your time”.
The very success of many of the larger US global equity managers also limits their future growth since, according to Dowsett, “a number of these managers have run into liquidity problems, which has pushed them up into the large cap area and away from better performing mid and small caps and consequently performance has suffered”. With a general view in Europe that the US market is too expensive, the home country bias of US managers does not help their case.
Boutiques, as Dowsett sees it, are “able to digest information from a number of different sources which leads them to focus on an area of the market at an early stage. This would combine some top-down macro sector views and bottom-up company research. Over the last year to 18 months these smaller fund managers, say with $5bn-$20bn under management, have been winning global equity mandates. They have tended to have less exposure to the US and more to Asia and Europe. They have also been less constrained in regional allocations when compared with some of the larger houses.
“These smaller teams have been more lateral thinking. For example, they have been able to make comparisons between emerging market banks vis a vis US banks. They have also been able to devote more resources to the interesting areas of the market, which recently has been Asia rather than the US. He adds: “So these smaller teams have been showing their greater flexibility by taking bigger positions in Asia and Japan compared to the large US research-driven teams.”
Most investors would agree with Dowsett’s view that “there is a lot more opportunity for good alpha generators to find outperformance in the small cap space”. Given the liquidity constraints, “you need to look for a good small cap alpha generator in whatever region. You look to gain in making a specific allocation to small cap in the same way as you would in emerging markets”. Finding good US small cap managers that still have capacity may not be so easy, however.
For all active approaches, a key issue is the basic philosophy guiding the construction of a global portfolio: Is it meant to be taking exposure to as much of the global opportunity set as possible, or a mechanism for enabling the most talented managers to seek high outperformance in a focussed manner without any geographic constraints? This debate can take place in many forms – from a discussion on the size of the tracking error against a global index, to whether a bottom-up stock selection or a top-down macro-economic approach is more attractive.
Adopting a global sector approach fits very well into the philosophy of a well-resourced research-driven fund management house where analysts may be typically organised along global sector lines. As T Rowe Price’s Gensler, points out, “whilst in terms of industries maybe only a third are truly global: technology, healthcare services, energy and materials, most other things are local with global issues like newspapers: Baltimore newspapers don’t compete with Sydney newspapers but they are all facing the issue of digital migration, classifieds going online etc”.
The successful firms are likely to be those that can strike the right balance between ensuring clear responsibility for decision making, and making use of the depth of expertise that may be present within the firm. For Gensler, the solution is clear, “while there is a team that runs this product, at the end of the day it is a dictatorial rule, there is one decision maker” although backed by 70 or so analysts around the world, each covering 60 or so stocks with 20-25 ‘Buy’ and ‘Strong Buy’ names. “I am going to own 100 names in the fund so I will be only choosing a couple of names per analyst; they are a wonderful first filter.”
“There are very few managers who are purely thematic, ie, who start by identifying broad themes and generate stock ideas from those,” according to Watson Wyatt’s Dowsett. However, this can be a potentially attractive route if it can be implemented successfully.
Nordea Investment Management has run a thematic process from Copenhagen since the early 1990s and according to Klaus Godiksen, head of global sales, they “process information into knowledge differently from 95% of the market investors”. This approach can narrow down the total universe of stocks to “a thematic stock universe of roughly 700-800 companies”, a far more manageable number that can then be analysed further through company visits which are a “critical step in our stock selection process”, Godiksen goes on to say, and he adds “interaction with management is also vital in testing and evaluating our thematic research”.
OppenheimerFunds are also a keen exponent of a theme-based philosophy and according to Adrian Gordon, the new European head of their European institutional subsidiary, OFI Institutional Asset Management, they use four themes that were finalised in the mid-1990s summarised by the acronym MANTRA – mass affluence, new technology, restructuring and aging. “They are long-term socio-economic themes. What changes frequently are the sub-themes, with the technology sub-themes changing more frequently. A recent example is satellite radio, which is taking off in the US.”
If the global universe is regarded as an opportunity set that has no direct relationship to liabilities, then the idea of imposing tight tracking errors against a global equity index makes little sense for an institutional investor. The alternative is to remove all constraints on tracking errors and aim for outperformance over the long term against a benchmark related to liabilities.
Watson Wyatt, according to Dowsett favours what it calls ‘long term long only’ mandates with a RPI +5% benchmark, ie, the real return on equities over the last 100 years. “With this type of manager you would look at the performance on a minimum five-year basis and adopt a balanced scorecard approach to monitoring. This would check the consistency of the people doing the managing, the consistency in the stocks they buy and so on.” Such an approach it sees as generating tightly focused portfolios that “generally hold 30-50 stocks with an average holding period of three to five years, so are very concentrated with low turnover”. To run such portfolios requires a commitment that can be difficult to maintain within large organisations and for Watson Wyatt, the view is that “often managers will be privately owned and invest in their own fund, so ensuring long-term continuity”.
Watson Wyatt, according to Dowsett, has advised on a few billion sterling in more than 20 mandates structured this way, with an “aspirational target benchmark” of around RPI + 5%. These mandates have severe capacity constraints and “of the original group identified, a number are now closed to new investment”. As Dowsett admits, “there are very few asset managers managing money on this basis. We had to go to the US to find organisations who had been managing money for high net worth individuals and then introduce them to the institutional market.”
The challenge for mainstream managers is whether they can evolve their processes to be able to satisfy the demands of consultants such as Watson Wyatt. Dowsett’s view is that they can “but they would have to create a specific team to do it and that team would have to convince the client that they genuinely believed in managing money that way when they hadn’t before. The managers we have contacted have been doing this for a number of years. So it would be a big sea-change for large institutions”. A key issue here is the requirement to have a proper alignment of interest and for Dowsett “there would need to be some sort of ownership of the business by the people managing the money as staff retention is critical – the vast majority of the managers we are talking about are privately owned”.
If Watson Wyatt’s approach to long-term mandates really does catch on, it will raise many difficult challenges for the larger institutional fund managers. Whilst Gensler at T Rowe Price is happy to admit that “I have 100% of my 401K in my product – sometimes I joke that I manage my own money and everyone else gets to go along for the ride!” the emphasis on alignment of long-term interests between managers and clients may require more fund management teams to lock in significant amounts of their own personal wealth in the funds they actually manage. It may sound revolutionary but in private equity it is mandatory.