Why the sector approach is important for assessing the debt market as much as the equity is explained by Wouter Weijand and Henk Rozendaal of ABN AMRO Asset Management
In the Netherlands, almost every industrial sector has its own pension fund and the total amount of pension reserves is equivalent to 130% of national income, or more than NLG1,000bn. With such a highly developed pensions system, the question that begs answering is: What will EMU mean for Dutch pension funds?"
The answer - debtor policy, credit analysis and sector policy are set to become more important than ever.
The Netherlands ranks second in Europe in terms of accumulating pension reserves, both for total managed assets and for investments per person. Only the British have a larger savings total, and only the Swiss save more per person. It is a situation typical of a very Dutch philosophy; 'Security above all else'.
This safety conscious sentiment is further reflected in the way these assets are invested, with institutional investors employing strict guidelines aimed at minimising risk. Nevertheless, optimising performance still remains the overriding aim of the Dutch investment manager.
For these reasons, the Dutch market has built itself up on the founding pillars of security and performance and it is a particular priority at ABN AMRO Asset Management.
Although the arrival of the euro will not change these core principles, EMU will herald a number of other sweeping changes in the Netherlands.
Currently, many Dutch institutional investors have to invest in the same currency in which their commitments are denominated, obliging them to remain in the domestic market holding guilders. The arrival of the euro will open up a much larger field of operation.
Up until now the debtors an investment manager could choose for domestic institutional fixed income portfolios, ranged from government bonds to, well..., more government bonds, financial institutions, a few supranationals and a handful of corporates. The euro will broaden that debtor spectrum, with investors able to choose from debtors covering almost every European bond market, and with the additional bonus that Americans and Asians will increasingly issue debt in euros.
The credit scope of euro fixed income investment is also set to expand considerably. As a result, it will be necessary to reassess clients' investment guidelines, since investing solely in AAA and AA rated names will limit their fixed income returns.
These returns are already constrained by the low level of yields we are seeing today.
However, merely expanding the guidelines for debtor policy to include A and, perhaps even, BBB credits, which are still investment grade, will only serve to raise the risk/return profile of the portfolio.
Experience though has shown that the increased yield accompanying the lower credit quality more than compensates for this increased credit risk. Furthermore, credits rated BB and lower, ie non investment grade, or junk bonds, will most likely become a significant part of the 'Euroland' bond market, sooner, rather than later.
The launch of EMU will almost certainly place greater emphasis on debtor policy and credit analysis, since the performance and quality of the debtors and businesses in which money is invested will become the investor's key concern. Only reliable research can provide insight into how businesses score on these counts. Credit research will, therefore, become increasingly important in the success of fixed income managers.
One area in which credit research and equity research overlap, and where a natural co-operation develops, is sector research. Naturally, the performance and quality of a business do not develop by themselves.
One of the key factors influencing a company's success - for which read 'profitability' - is the sector in which it operates. Debtor strategy will occur along lines, which will increasingly assume a global nature. This is where we believe our global industry equity research analysts can benefit the investment group and consequently we include these analysts in the global credit committee of our fixed income teams.
In itself, such a sectoral approach is nothing new. During the 1980s, we realised through equity research that a business' performance depends greatly on the sector in which it operates. As a result currency risks were set aside and national borders treated as secondary, with the focus shifting to sectors within Europe and worldwide, provided, of course, that customers were in agreement.
At that time, however, the sector approach was new and special. The first investment fund based on this approach, the Trans Europe Fund, was launched in the mid 1980s. It continued an equity investment strategy that was pursued for institutional clients since the late 1970s. Now we are the only asset managers to have built up such a long track record based on the sector approach.
The euro is undoubtedly proving a new catalyst in this process. As borders disappear and the single currency becomes a reality, investors are asking themselves what they are going to do about it. A sectorial approach, not only in euroland but in the UK, Switzerland and beyond, is rapidly becoming one of the answers.
But in adopting this approach we follow and analyse sectors on a global basis, but with an emphasis on European and Dutch companies. In other words, we have a focus on Europe, but in a global way.
The sector approach means initially analysing the attractiveness of each sector, looking at the position within it regarding companies' pricing power, the barriers to entry and the scope market participants have to be different from one another. The global potential of a sector is the other main variable determining the attractiveness of a sector. Here the factors include the underlying demographics, the innovation levels and general technological developments.
There are also asset allocation decisions to be taken about sectors, such as whether to be over or underweight.
Then the analysis becomes one of stock-picking, where the aim must be quality investments in outperforming companies, with the selection determined by individual companies' market position, brand names, distribution strengths, production technology, strategy formulation among other management issues, including reporting procedures. This is in addition to the usual questions of financial position, covering ratios, cash flows and so on.
Investment committees have been created to cover the major regions: the U S, Europe and Asia. And increasingly, video/tele-conferences are becoming the tools for exchanging research, determining sector strategies and developing lists of expected outperformers. Above all, it is the sector, and then the particular attributes of companies within these sectors, rather than the country, which is being carefully analysed.
The sector approach is successful. But ABN AMRO Asset Management believes that to apply the approach properly an international branch network is a prerequisite, since the challenge is to identify local winners in a sector as early as possible. This requires an knowledge of and experience in the local situation. Many institutional investors do not have the people to set up such an international network as the group has done throughout Europe and around the world.
Wouter Weijand is vice president, euro fixed income team and Henk Rozendaal, is vice president, institutional services department at ABN AMRO Asset Management in Amsterdam"