Erik van Dijk looks at the issues in building portfolios
Institutional equity investors will be confronted with interesting op-portunities as the 'New' Europe un-folds with on the one hand the single currency in 11 or maybe 12 countries - if the Danes put in yet another 'Yes' vote - and on the other hand an important peripheral zone including countries such as Switzerland and the UK.
These two countries alone have a combined market capitalisation that is only marginally smaller than in 'Euro-land'. Beside these opportunities there are also dangers. The first major problem that confronts large investors is how to define Europe. Should one think in terms of 'Euroland' or use a broader definition which also incorporates countries such as the UK, Switzerland, Sweden, Norway, Greece and maybe even Turkey and Eastern Europe. With regard to currency risk, investors might initially be inclined to define Europe as 'Euroland' - the single currency area.
Investors based within this area will be able to reduce their traditional home bias (over weighting of the home market) because currency risk no longer exists for the other 'Euro-land' countries when matching assets to liabilities. However, this would result in a somewhat strange 'other' Europe that would need a separate mandate or several country mandates. We have not encountered many 'Euroland'-based pension funds that have opted for specialised country funds such as 'Swiss equities' or even 'Europe - non Euro'.
Structuring portfolios in such a fashion in order to differentiate between currencies does not take into account the advantages of a broader Europe definition. Firstly, the broader definition results in a doubling of the market (in capitalisation terms) and a widening of the spectrum of investment opportunities a fund manager has.
This widening is significant and im-portant as especially the UK and Switzerland tend to have a dominant role in certain sectors. Examples of such dominance are the chemicals/ pharmaceuticals sector, the financial sector and the publishing sector. As derived from research conducted by Palladyne, in all three cases these two countries account for more than 40% of the European market capitalisation on a free float basis. The correlations between different countries in Europe (whether they belong to 'Euroland' or not is unimportant) are such that it is important for fund managers to be able to process data from company X in country A when analysing company Y in country B. A clear example of this is the recent negative reaction of the Dutch stock KPN Telecom on the news of the international co-operation agreement between AT&T and Brit-ish Telecom (AT&T would step out of Unisource in which KPN Telecom is a member). Both AT&T and British Telecom are not domiciled in 'Euro-land' but their activities/news influence 'Euroland' stocks directly.
Splitting regions would make it more difficult to take these effects into account. Furthermore, risk control and co-ordination at the portfolio level is facilitated by a broader market place. A pan-European fund manager who manages Europe according to the broad definition is able to realise diversification advantages that would be difficult to achieve due to co-ordination problems if the region were to be split into a 'Euroland' mandate and a 'non-Euroland' mandate. Another advantage of a broad definition of Europe is the possibility of having a more stable and detailed sector allocation.
We recently introduced the Palladyne 2500 index in which more than 2,500 stocks are represented. These stocks have been split into 19 sectors with at least 75 stocks in each sector. By creating relatively homogenous groups of stocks, investors are able to make interesting, statistically relevant comparisons. A sector approach in-stead of the still-dominating country approach seems to be the way forward.
Does this mean that the country component will disappear? No not necessarily. There may be an increasing convergence within Europe, but the country factor has not yet become obsolete and it is unclear whether it may ever become so. We therefore advocate using substantial country differences within a sector approach. The Palladyne-index is not only a broad index with a Europe-coverage of 90% but also takes liquidity into account. Currently proposed indices either use market weighting (eg DJ Stoxx, MSCI, FTSE Eurotop 100) or are based on correlations (the Belgian Euro benchmark).
Large investors are interested in two things when constructing their European portfolio: I) Stable returns at or above the index; and II) risk control. When controlling risk, liquidity in the market plays an important role. Analysis of free-float and stock exchange turnover figures versus market capitalisation data shows that there are major differences within Europe. It is recommended to introduce weighting schemes that correct these liquidity differences.
Once the investor has found a solution for the country selection and the appropriate benchmark the problems really start. The transition from the current portfolio structure (with a relatively large domestic exposure and international portfolios) to a pan-European portfolio is not easy. At what pace should the transition be made? Should it be undertaken in a linear fashion? Should the transition take place by switching stocks or by first making use of futures before investing directly in the European benchmark once it becomes clear what that will be?
Nobel prize laureate Harry Mark-owitz, who is an associate researcher for Palladyne, helped develop a transition model for large investors that attempts to answer the above questions. The conclusions from this re-search are remarkable. For almost all large investors it is sub-optimal to transition very quickly. Rushed act-ions are costly. A too slow change-over is also not recommended. The late arrivals will be confronted with a similar phenomenon that confronts them when they are late in investing in a stock that has just been added to an index. This results in an unnecessary tracking error and relatively higher costs (lower returns) as large amounts of the stock needs to be purchased.
The solution is not just simply making the transition in a linear fashion over time. Markowitz's 'standard'' transition-pattern for the average institutional investor shows a relatively cautious change at the outset followed by a gradual acceleration. Surrounding this standard pattern there are differences that are a function of the home country, the relative over-weighting of the home country, the size of the portfolio and the level of transaction costs. A 'customised' optimal transition can save up to a few percentage points in return when compared to the naive approach (quick, linear or slow).
This is also the case when compared to using a so-called cost effective route with futures. Markowitz is extremely cautious in recommending the use of futures as he reminds us of the negative experiences during the 1987 crash. Portfolio-insurance which was based on work by the American Hayne Leland, did not function properly in practice when many investors wanted to move in the same direction. If these derivatives can even be obtained in such a period, the costs will be relatively high. Based on reports by Goldman Sachs, Morgan Stanley and Dean Witter, Markowitz concludes that extreme net demand or supply could occur during this European transition. Already volatilities are picking up. The higher the volatility the higher the relative price is for futures. We do not rule out the likelihood that volatility will increase during the period up to the introduction of the euro nor during the months or years thereafter. The relative cost advantage of a mainly futures approach will deteriorate.
This period of time will not be an easy one for asset managers or pension funds alike. However, it will be a challenging one that will result in a very interesting market place in Europe. Especially in the smaller European countries, investors are plagued by skewed indices that make the shifting of assets difficult. On a European scale this problem disappears. A situation is derived that is similar to that in the US where the largest stocks have a weight between 2% and 3%. Also the American example of splitting the market into specialty and style mandates is likely to be introduced. European 'large cap/value' or'small cap/ growth' etc. mandates are possible.
Also the newer phenomenon of the 'completion fund' manager will be widely introduced. The completion fund manager 'completes' a portfolio by 'filling in the gaps' a pension fund may have. Other managers would take care of specialised style mandates (value/growth and/or large/small). This completion approach has the advantage for a pension fund that when, for example, it is highly satisfied with asset manager A, who runs a large cap/value mandate, yet at the same time the fund feels that a shift toward small caps and/or growth is warranted, it is not forced to a) extract monies from this good performing manager or b) ask this manager to perform a service which he is not well equipped to do. The completion manager - often a quant manager - can act as a countervailing force that finally ensures that a portfolio's profile is according to a pension funds (new) wishes. It is logical that in the current European setting there were few completion fund managers. Because a completion fund manager - by definition - will have to take extreme style positions relatively quickly, the manager needs a broad spectrum of stocks to achieve these positions.
We believe that the New Europe will have many characteristics that prevail in the US equity market. This in turn will result in a heightened interest toward Europe from US investors. US pension funds have already stated their intention of reducing their 'home-bias' from 90% to 80% or less. This may not seem spectacular at first glance. However, a 10% shift in this market has meaningful repercussions for non US markets. With the Asian markets still in turmoil it is likely that a substantial part of these US assets will look toward Europe.
Erik van Dijk is CEO of Amsterdam-based Palladyne Asset Management, a UAM affilliate