Following the introduction of the euro in January 1999, pan-European industry investing has rapidly become standard practice among institutional investors. Although the euro is making the integration of Europe highly visible, it is surprising that the majority of investors only started to adapt their investment processes after the formal announcement in May 1998 – and even now not all have done so.
Obviously, the euro is a big step in the European integration process, but it is only one step in more than 50 years of hard work on the lowering of trade barriers and the limitation of individual nations’ freedom to take protectionist actions. The process was started by the French–German initiative to the European Coal and Steel Community in 1951, which was subsequently joined by four other countries – Italy, the Netherlands, Belgium and Luxembourg. These six countries moved on to found the EEC in 1957. Through enlargements in 1973 and later, and a name change in 1993 it has become the current 15-country EU.
At least as important as these formal milestones – and possibly even more pervasive – is the underlying internationalisation of the global corporate sector, which has been going on for about the same length of time. Ahead of the formal developments, companies have been developing their positions away from their home markets, gradually raising the international content of their business mixes. As a result, the coincidental location of the head office has been losing its relevance for portfolio allocation policies and the currency of quotation has become a mere translation of the underlying multi-currency business portfolio.
The combination of this internationalisation, an environment of lower trade barriers and less freedom for governments to support their national champions, is creating an international level playing field in which companies compete almost unhindered and in which the return gap between winners and losers within an industry will widen. Weaker companies will benefit less from the shelter of national trade barriers or from the partisan broad shoulders of their national governments. Consequently, the effect of these developments has been a gradual, but inevitable reduction of the country effect in equity investing. Instead, the effect of industry allocations and in particular company choices in an equity portfolio is becoming larger than ever before.
Although this entire process has been going on for half a century, major changes in the investment industry have only occurred in the past few years. Among the reasons for this is that before the relatively recent trend for extensive privatisations by European governments, large differences existed in the industry weights between countries, resulting in the perception of a considerable country effect in their relative performance. In equity market statistics, the industry factor did not begin to rise markedly until the end of the 1990s. Ourchange from traditional top-down country investing, to industry- and company-driven allocation in the mid-1980s was therefore a matter of vision, rather than statistics. Our view that the internationalisation process had progressed so far that it had become irreversible and that the country effect would have to start fading made us go ‘pan-European’ well before anyone outside the Netherlands had ever heard of Maastricht. This may have been the benefit of being an originally Dutch firm, from a small country with large pension savings, which were being invested globally and with a very internationally orientated corporate sector. In such an environment, the guilder denomination of pension assets and corporate equity was already quite unimportant .
Another reason for the slow pace of change in the investment industry is the totally different set of demands to the investment process, skills of people and the structure of the organisation that emanates from industry- and company-driven allocation, compared to those needed for top-down country allocation.
Country allocation could be done by developing a view on a relatively limited number of variables for a relatively limited number of countries. Value could be added – given the right choices – with a small team.
The rising importance of industries and in particular the almost unlimited number of companies calls for much more detailed specialist knowledge and a process that enables the portfolio managers to mould all the fragmented pieces of knowledge into one coherent portfolio. As a result, it has become much more difficult for smaller investment firms to add value with small teams. Larger organisations have had to go through a painful process of retraining or even replacing people and changing responsibilities. In many cases, a country-based structure of managing (sub) portfolios was a major impediment to change, and in some cases it still is. Much of the same struggle taking place in asset management companies is also highly visible in the broker industry, where local research establishments are extremely reluctant to give way to a more centralised industry approach.
Does all this make the concept of adding value from country asset allocating obsolete? Certainly within Euroland the difference between countries has shrunk to the level of politics and politically driven factors such as taxation and the structure of the local economy. Nevertheless, there still may be (at times quite strong) country effects based on changes in these factors. With politics and therefore politicians as the main driver of change, the predictability of that change has become very low. Consequently, in our view countries are becoming useless for allocation purposes, with the outcome driven more by luck than skill, although it must be recognized that they still constitute a short-term risk factor. A way of dealing with this in an equity portfolio could be to refrain from deliberate country allocation but maintain maximum deviation limits from country benchmark weights.
An element that could be lost in the change from assessing countries to international sectors is the local knowledge advantage that arguably still exists. Being close to a company’s headquarters does have a positive effect on the level and timeliness of information flows. The main challenge for investors who change to industry allocation is to combine their centralised sector vision with some of this ‘local colour’.
The next step from Euroland-wide or pan-European sector investing is likely to be in the direction of global sectors, or at least combining Europe, the US and maybe Japan into a central sector vision. Investors and brokers that have now organised their research along regional lines are likely to have to go through a similar process of change once more in the foreseeable future. Considering the acceleration of the corporate internationalisation process in recent years, the strongly increased correlation between stock markets and the synchronisation of global sector movements (for example, the TMT bubble) in recent years, this globalisation effect may develop a lot more quickly than many people expect. Based on our experience of over 15 years of industry-driven investing, we believe strongly that a global industry structure, combined with a strong element of local input, is the best way of adding value to future equity portfolios. That may also be the last window of opportunity to catch up for investors and brokers that have held on to a country structure for too long.
Felix Lanters is head of European equity investments at ABN Amro Asset Management in Amsterdam