Waiting for flight to quality
With a rise of 32% in the S&P500 from market lows it is fair to say that investor appetite for US equities has gone up since IPE’s last report on this market. But the overall market return figure disguises wide disparity in performance between sector, style and capitalisation bands. Whereas the late 1990s favoured growth managers, the bursting of the tech bubble signalled a pronounced shift that until late 2002 served value managers well. A key feature of the beta rally that commenced in March 2003 was the leadership of small caps and poorer quality stocks. Continued performance from these companies will depend on the reality of earnings numbers matching the market’s high expectations. Should these disappoint, a flight back to quality may well result, to the benefit of US large and mega caps.
Besides market inflection points, there are other reasons why investors might reconsider the inhabitants of their manager stable. The latter stages of 2003 were conspicuous for damage done to the reputations of a number of leading US mutual fund managers, found to have been involved in mutual fund timing. Against this backdrop, investors are reviewing their choice of manager and questioning managers harder on factors such as corporate culture and risk management. Allocations to the US are broadly increasing however, as continental European investors increase allocations to global equities, of which the US is 55%, and UK investors allocate in line with market cap weightings, whereas before they used fixed weights, implicitly underweighting the US. The weakness of the dollar is also tending to make the US market look cheaper, compensating for the normally higher US market p/e ratio.
The broader Russell 1000 is gaining ground as a benchmark for core allocations, although the S&P500 remains most widely used. US institutional investors by now are comfortable with diversifying alpha sources, and given that the bulk of their equity allocation will be in US stocks, there is more than enough money to divide up by style. European investors are less comfortable with style benchmarks, since managers in their home market are less easily demarcated by style. Where they have taken style decisions, it has been a pretty even money bet as to whether it has worked or not, with dramatic differences in performance at each end of the spectrum.
Enhanced indexation has been a beneficiary of the wide swings in performance between managers of opposing style. Investors may not necessarily have suffered disappointment; but might be alarmed by extraordinarily good performance, indicating unforeseen risk. Totally passive mandates are losing out, as investors react to declining market returns by attempting to extract small additional returns from a little active risk. Rather than apportioning risk like a barbell, with no risk passive combined with high risk active, investors are seeking to capture small amounts of alpha in the core allocation. Pricing inefficiencies that occur between index constituents mean that firms in this space can achieve 1% performance for a 1% tracking error, a relatively impressive information ratio of one. Firms like BGI, SSGA, Invesco and Janus’s subsidiary Intech have been winning money on this basis.
BGI’s distinctive philosophy is to incorporate all three aspects of risk, return and cost control into the investment process. BGI attempts to identify those characteristics of stocks that are consistently rewarded, whether these be fundamental, such as profits or cashflow, valuation measures, or other factors, such as stock issues or buybacks. No characteristic is used unless testing has proved it to be a sensible indicator for investing. BGI’s portfolios typically hold over 200 stocks to minimise sources of risk such as capitalisation bias, with tracking errors of the order of 2%. Investment decisions are taken on an after costs basis, so as to manage implementation shortfall. BGI US portfolio manager Martin White estimates that this saves 50bps per year on unnecessary transaction costs, meaningful given the conservative performance target of 1-2% pa excess return.
BGI initiated its approach in US large caps in the late 1970s and it now accounts for $75bn (E59bn) of its $169bn of active equity assets. As White explains, “although one could argue that all stock characteristics are important, some do better than others at different points in the cycle. Last year excess returns were found in struggling companies that started to generate cash strongly as demand improved. Earnings forecasts were less useful, as the market did not distinguish between companies with real earnings prospects and those with poorer quality earnings. This year I anticipate a better balance between the various return drivers and more rational market behaviour.”
SSGA’s enhanced index proposition similarly takes in traditional fundamental indicators, trading factors and corporate signals, and exploits defects in the benchmark to generate 0.5-1% outperformance on 1.25% tracking error. Enhanced indexed portfolios contain more names than active quant portfolios, whose tracking error is somewhat larger, at 3.5-5%. SSGA runs the bulk of its $17bn in large cap enhanced US equities against an S&P500 benchmark. As SSGA portfolio manager Alistair Lowe relates, “SSGA forecasts of return on US equities are lower this year than last, with a 7% return target for the end of the year. Valuations are a little stretched, with a forward p/e ratio of 19, versus 16 a year ago. Against this there is tremendous momentum and flows, and more risky assets are in favour. Inventories are low, labour productivity is very high, and companies have little pricing power. Because the inflation risk is fairly insignificant, we feel that rates will rise later than expectations, but this favours large caps over small in the second half of the year.”
Invesco has been operating risk-controlled mandates within its structured product group for the last 20 years. The approach is used not only for US large caps but also in a number of other markets and subsets. Head of product management for Structured Products in New York, Russ Kamp, explains, “we seek to avoid taking unintended bets in industries, sectors, styles and capitalisation bands, focusing simply on the one skill that we have, which is stock selection.”
Invesco’s US large cap portfolio typically numbers 100 or so stocks, against an index of 500. Stocks are selected on the basis of four investment criteria: the direction and pace of earnings change, management signals, exemplified by issuance or repurchase of stock, its relative strength versus the peer group, and the earnings yield, as a measure of valuation. Stocks that score positively on these factors will be held, subject to the risk limit that no stock weighting can be more than 2% above or below its index weight. The portfolio is reoptimised every month, and the higher the permitted tracking error, the more trading activity there will be on the fund. Invesco now has $2bn under management in this strategy from outside of the US, against a total of $13bn.
Intech’s radical approach, launched in Europe last year, is to dismiss any fundamental stock assessment and focus entirely on two measures of price behaviour, volatility and correlation. The strategy has been employed on US stocks for 16 and a half years, and is based on stochastic portfolio theory. It is best suited to markets that are efficient in the theoretical sense, meaning that trading is liquid and deep and that no one has an information advantage. These assumptions are broadly met in the large cap arena, because of the volumes dealt and extensive Wall Street coverage. The portfolio contains index stocks whose volatilities are higher than the index, and whose prices are least correlated to each other.
Because the portfolio is constructued taking correlation into consdieration, the portfolio volatility is equal to or lower than the benchmark. Intech extracts additional performance from the higher stock volatility by finding a more efficient combination of stocks than the benchmark index; additional performance comes from rebalancing portfolios frequently, diverting money away from stocks that have had good short-term performance towards those that have not.
Intech’s most aggressive portfolios, on 5-7% tracking error, have generated historically excess return of 6.5% over the benchmark. Its conservative mandates operate on 1.5% tracking error, with narrower deviations from index weight at the stock level. The portfolio will contain between 50-90% of the names in the index and in more volatile markets, portfolios contain more names, because there is more opportunity but also more risk. The Intech approach can be applied to any subset of the large cap universe. It is equally applicable to value or growth stocks, by simply restricting the universe of stocks analysed to the constituents of the index. However, due to the higher relative volatility and lower intra-stock correlation, growth is a better universe for the strategy. Currently Intech only offers a US product but is testing its approach on the MSCI World index with a view to launching a global product in the next six to eight months.
A historic information ratio of more than one implies outperforming the benchmark four years out of five. These modest excess performances compound so that, with tight risk control, the portfolio is extremely unlikely to suffer a deficit that would bring performance back to the index. In European, Intech finds the most interest from the larger, more sophisticated pension funds. Comments David Schofield, Janus European sales head, “Intech challenges the orthodoxy that it is impossible to add value, with its theoretical approach that is not based on fundamental stock research.” The firm recently won a $250m mandate from Blue Sky, managers of the KLM pension fund.
All the managers reported demand from US investors for portfolios measured against style benchmarks. European investors have yet to adopt this mentality and are more likely to want a core portfolio, measured against an S&P500 or Russell 1000 benchmark. They may, however, be prepared to accept a style tilt, provided the tracking error is tightly controlled. Purely by virtue of the higher standard deviation of growth stocks versus value stocks, a growth orientation has higher potential excess returns, and managers in this space have more opportunities to take advantage of active risk. T Rowe Price large cap growth manager, Larry Puglia, considers, following recent meetings, that UK investors are wary of the US given the performance of the market and of particular sectors, but are prepared to accept a growth tilt, if it is pursued prudently.
T Rowe Price is the great grand-daddy of growth managers, its founder being the first to promulgate the philosophy in 1937. T Rowe Price’s approach is to seek out quality growth, and strong free cash flow. The top five holdings are a roll call of American’s finest, Citigroup, Microsoft, Pfizer, United Health and GE, with dominant market share and seasoned management used to allocating capital. Puglia, manager of $11bn of retail and institutional growth mandates, dispels the notion that it is impossible to add value in the mega cap space. Puglia trades these positions dependent on the results of global research and runs more heavyweight portfolios than the benchmark, with 26% of the portfolio in the top 10 holdings.
Examples of smaller stocks held by Puglia for T Rowe Price are Maxim Integrated Products, a semiconductor company, International Game Technology, a supplier of gaming machines to casinos, custody group State Street Bank, and Harley Davidson, the motorcycle manufacturer. These stocks, in the area of $10-15bn market cap, have strong free cash flow and financial ratios, dominant market share, high margins and consistent double-digit earnings growth. The core growth portfolio is measured against both the S&P500 and the Russell Growth indices, the manager steering a more conservative middle path and avoiding the excesses of momentum-driven markets. Puglia’s portfolios are overweight financials, an area where Puglia has specialist knowledge.
Puglia is less bullish for 2004 than 2003, but he is positive on quality consistent growth companies that have historically performed well in the second year of economic expansion. Explains Puglia, “the exclusion of tax from 85% of dividends will support large cap stocks, which tend be dividend-payers. Conversely, there will be some disappointment in the tech sector if earnings do not support the run-up in stock prices.”
RCM (formerly Dresdner RCM Global Investors) runs just under half of its £26.67bn (E39bn) assets under management in US large caps. The firm, organised by global sector since the early 1990s, looks for companies with sustainable earnings growth at above market rates, which is not discounted in the share price. These companies are identified by their competitive advantages, be it franchise, product or technical strength. RCM’s core growth product operates with a 3-5% tracking error versus the S&P 500 index. Performance slipped a little in the last year because of the rise in poor quality companies, but is anticipated to improve this year, as the market adopts a more rational attitude. RCM UK deputy chief executive Mark Archer warns that the sudden resumption of growth does not signal the start of a new bull market, and that the next few years will involve a working off of bull market excesses, like consumer and corporate debt and overcapacity.
“In this scenario, companies that can produce a reliable 10% earnings growth are more valuable than those that throws off 20% followed by 6%.” What differentiates RCM’s research is its subsidiary Grassroots, set up in 1985, which comprises a network of independent researchers charged with quantifying marketplace demand for products and services. Its reports are particularly useful in the fields of pharmaceutical sales and consumer products. Grassroots researchers interview doctors on their prescribing of a new drug and can quickly gauge whether the drug is likely to meet sales targets, dependent on the readiness of doctors to prescribe it. Market research into goods like clothes, toys and fashion items can alert RCM analysts to likely positive sales surprise, or disappointment. This focus on top line improvements is particularly important for growth stocks, whose performance rests on consistently meeting or beating market expectations.
Nicholas Applegate also seeks to identify turning points in a company’s fortunes, but through systematically measuring factors for evidence of change. Its systematic strategies account for $3.8bn of the firm’s total assets of $18.1bn, and $3bn of that is in US large cap growth. As lead portfolio manager of US systematic large cap core growth, David Pavan, explains, “if one is looking at static data, market inflection points can be difficult to spot; a number of small changes may turn a good company into a bad investment. Last year in the tech sector, the first evidence of change was at the balance sheet level, with falling inventories and accruals and a sharp slowing in the rate of cashflow decline. Once sales improved the earnings gain was dramatic, because of all the cost-cutting.” Nicholas Applegate’s data comes from both published sources and internal calculations, and it combines accounting information with statistics relating to market price activity, such as short selling, to arrive at an explicit score for each company in the benchmark. Tracking is held within a 4-6% range and since its inception in May 1994 the composite for US systematic large cap core growth is 1% ahead of the S&P500 index (as at end December 2003).
Whereas portfolios last year were heavily weighted towards technology, Pavan comments that exposure has moved towards other sectors, like industrials and retailers in reflection of anticipated broader market growth. “This year most of the excess return will come from stock selection within a group. Within retailers in particular there is disparity between inventory levels.” This discipline must be evident when it comes to selling and Pavan is sensitive to signals that growth is slowing. “Trading activity, and particularly an acceleration of shorting, can be an indicator of incipient change,” highlights Pavan.
Credit Suisse Asset Management (CSAM) exemplifies the more traditional approach to large cap growth, although CSAM also consider valuation in stock selection. CSAM focuses on the classic growth sectors of radio, TV, healthcare, technology and consumer products and watches for opportunities to buy recognised market leaders at points of weakness, or when growth has paused. Marian Pardo, large cap growth portfolio manager, comments, “Within the traditional growth arena, some companies have better growth characteristics than other, healthcare being a prime example of this. Incorporating short term value tools within a growth universe forces us to be price-aware growth investors.” Pardo highlights TV companies, financials and medical device companies as favoured sectors, citing companies like Viacom, which owns Nickolodeon and Paramount, Capital One Financial and St Jude as most of interest.
Co-manager Jeffrey Rose remarks, “Technology is a cyclical growth sector, misdefined as a secular growth story in the late 1990s. Following last year’s run, many valuations look too high and holdings will be trimmed. This year’s earnings may be saved by the bringing forward of IT spend from 2005 to before September 2004 to take advantage of tax breaks. But this spending is more replacement rather than business transforming. In the absence of a ‘killer-app’ an over-commitment to technology is unjustified.” CSAM runs $800m in the strategy, pursuing a tracking error of 4-8% against the Russell 1000 Growth index, with on average 70bps per year outperformance since inception.
Pension funds struggling to get to grips with the panoply of manager offerings and wanting to exploit manager expertise in growth or value without a resulting portfolio tilt might consider a multi-manager approach. Andrew Hutton, portfolio manager at Coutts multi-manager division, reveals that in US large caps the argument for multi-manager is more obvious because there is such a clear distinction between managers, by style, capitalisation bias and investment philosophy, whether this be top-down or bottom-up, qualitative or quantitative. Hutton comments, “a key question to ask the manager is in what market environment he is likely to underperform. If he is not clear on this point, then he is not qualified to manage money.” Rather than seek to fill specific holes, Coutts focuses on identifying intelligent managers, which it can then blend to avoid any extreme style bias. Says Hutton, “the main job post-selection is risk management. The portfolio, which contains managers that deviate between 2% and 10% from benchmark, has a 2% tracking error overall, because the managers selected are each taking very different approaches. Deciding manager allocations is not something that can be done by computer; adjustments need to be made for behavioural elements.”