How to order the world
The ability to offer a truly competitive global equity product is what many would argue differentiates the men from the boys among fund managers.
Whether you are a follower of efficient markets or a seeker of the highest alpha, global equity mandates make the most theoretical sense
but also exhibit the most practical difficulties.
Followers of modern portfolio theory are led to the conclusion that they should be investing in the market portfolio, which in the equity-only context is a portfolio of equities reflecting the global capitalisation weightings.
Those who see markets as having numerous inefficiencies that skilful managers are able to exploit should be allowing as much freedom for managers to search for opportunities, which again leads to a global mandate. Indeed, many investment consultants, such as Kerrin Rosenberg of Hewitt Bacon and Woodrow, argue strongly that the burden of investment decision-making should be placed on the fund manager and not the trustee.
The narrower the mandate, the more burden is placed on the trustees to make asset allocation decisions, which they are ill equipped to do. The subdivision of mandates into more and more boxes for managers to stick to means that a US small-cap value manager cannot buy a Japanese large-cap growth stock even if he feels it offers better value. As a result, there is less arbitrage within markets and markets are becoming less efficient, giving scope for managers with wide mandates such as a global equity mandate to outperform.
The years of double-digit returns in equities may have disappeared with figures of high single-figure returns for global equities as a whole seen as a reasonable estimate by most managers. Global equity mandates can range from portfolios having thousands of stocks attempting to stick closely to a global index, to those with a focused stance of 50 or less.
Both global firms and niche boutiques can have the ability to offer competitive and indeed outstanding global equity products, but based on very different philosophies and methodologies. Exceptional managers offering high-alpha products may be able to generate excess returns above the index returns of 4% or more and the issue for trustees is whether it is possible to identify those managers likely to do so in the future, and what are the characteristics to look for.
The economic backdrop
The TMT bubble that climaxed in 2001 was characterised by a huge outperformance of growth stocks over value stocks, although both categories rose in absolute terms. The subsequent market crash resulted in firms with a very strong value bias spectacularly outperforming the markets for the next couple of years although, in a rapidly falling market, this did not leave their investors with much to be happy about.
Value and growth are now more evenly balanced, which leaves equity strategy far more dependent on good stock-picking skills than the last six, style-driven years. Meanwhile, the global economy is on the cusp between deflation and inflation, with Japan in particular, as Alison Hamilton of Martin Currie points out, benefiting from an end of deflation providing a “real positive for real assets such as land” and “where the macro recovery is providing strong underpinning for earnings recovery”.
The general view among fund managers is that the US looks expensive, even against long-term trend values, Europe is at fair value and the UK slightly more attractive. Japan, now recovering from a decade in the doldrums, is looking cheap as are emerging markets.
The consensus view is that the global economy is slowing, although some observers, such as Leon Pedersen, the CIO of Norde,a think that this is very unlikely. “Lots of factors have high volatility, the US economy is on steroids, there is loose monetary policy in Europe, whilst the Chinese economy is definitely not a western-based market economy but is on a full go or full stop cycle,” he says.
On top of this are the current political risk and uncertainties over oil prices, with some, such as Hamilton believing that the oil price will remain high for the relatively long term, and that this is not factored into valuations. Others, such as Schroders, argue that in real terms prices are not that high compared with previous shocks such as 1979, and that they will fall back to $28 a barrel in 2005.
Structure of the market
Global equities can be classified and subdivided in numerous ways, with the most obvious way, although not necessarily always the best, being by country of listing. The FTSE All-World Index had a market capitalisation of about e17 trillion as of June this year, including about 2,800 securities covering large and mid-cap stocks and covering 90% of the investable universe.
Within this, the US and Canada accounted for 53%, the UK and the rest of Europe for 26%, with Japan making up 10%. Of the remaining 11%, emerging markets as a whole made up 5.2%, and Australia and Canada 2% and 2.3% respectively. Adding in global small stocks produces an index covering 98% of the investable universe, the FTSE Global Equity Index, with 7,000 stocks, with North America accounting for 59% of the total market capitalisation.
Whether country weightings are relevant, and in what context, is the key issue that any investor in global equities needs to consider carefully. Large stocks in developed countries tend to be more influenced by sector factors than by country or region, whereas emerging market stocks are characterised by being driven by country and regional factors such as sovereign risk levels.
Any attempt to track a world index at all closely would imply a heavy exposure to an expensive-looking US. An interesting question to ask is whether most fund managers would allocate over 50% of their personal equity portfolios to the US market? I suspect not, but the business risk of not tracking a benchmark closely will often outweigh the investment view.
This dichotomy in thinking is inherent in the current structure the pension industry. Although some, such as Rosenberg, argue that fund managers should be thinking of risk in terms of something that is meaningful to the pension schemes - absolute losses or the inability to meet liabilities, not the tracking error against an arbitrary index - this
has still not gained widespread acceptance.
Rosenberg sees traditional fund management houses as keen to change but, he says: “They see this approach as just another product – they look at how big the market for this is likely to be and still question whether it is worth directing their brightest people to it.”
He finds this disappointing, noting that “schemes should tell managers that they do not want to buy things that the managers don’t want to have”. Some managers do accept this logic, such as David Boal of Bank of Ireland Asset Management, who points out: “We do not compose the portfolio in order to minimise variation against the benchmark. So no matter how big a stock’s weight in the benchmark, if we don’t like it, we won’t hold it. Investors who buy ‘underweight’ positions in stocks they don’t like are effectively leaving value on the table for us”.
Rosenberg favours general mandates that do not encourage index-hugging approaches. He “prefers managers to think like private equity managers”.
Fund management approaches
The key issue for any manager running a global equity mandate is how to organise the massive amount of information covering thousands of stocks. Running an index fund is clearly one approach that avoids the issue altogether by sampling or, ideally, replicating a suitable index. The large index players such as BGI and State Street have established huge asset bases on this philosophy and the fees charged are low, with both firms heavily pushing higher-fee products wherever possible.
Moving up the alpha scale of excess returns, enhanced indexation products are essentially based on technical ways of taking advantage of index construction rules to offer extra returns by, for example, arbitraging ADRs and actual stock. They can offer very attractive fees for excess return targets of around 1% or so.
Active management of global equities requires a different set of skills altogether, although as Lucy Macdonald, CIO of RCM says: “I don’t think you can do it without a quant filtering process. We don’t make a big deal about it and use the usual sort of screens – value, and earnings momentum and so on.”
Firms such as GMO and Axa Rosenberg have adopted a completely quantitative approach, eschewing company visits on the grounds that by adopting a completely rigorous approach to analysis with no room for subjective input, they can avoid emotional biases. However, such approaches rely on models that themselves have to incorporate subjective assessments of the factors that are important and, ultimately, modelling the economic world is as much an art as a science.
Using quantitative screens to select a universe of stocks worthy of more detailed analysis is the more common approach and the issue then becomes how the additional qualitative information gets processed and organised to provide real insight. To generate the highest alpha products usually implies having a small number of stocks, often fewer than 50.
Incorporating qualitative information is crucial to this and very difficult to organise consistently on a global basis. As Roger Miners of RCM outlines, there are three approaches to managing such an effort.
q Investment could be centralised at one location: Under this structure, any other offices would be sales and service centres. This centralisation enables a holistic view to be taken, with one closely integrated team making investment decisions, the drawback being lack of localised expertise.
q Firms can have different offices that manage money allocated to them: Under this common set-up, each office acts independently. The problem here is that the US and Asia could each independently be overweight tech stocks, giving the total portfolio a strong bias. Another problem is that each portfolio will be risk controlled against its own local market benchmark, which means it will be having a lot of the local large stocks to control risk rather than for any other reason.
q A network of offices around the world: These office s attempt to communicate with each other on a continuous basis – the structure that RCM itself uses. As Miners puts it, this gives the ability, for example, “to invest in the best car companies wherever they are in the world”.
This, of course, presupposes that there is a mechanism for applying consistent valuation methodologies on a global basis and a key element of this is the organisation of research within a particular firm.
Many firms, such as Schroders, split the fund management role from research, and see a competitive advantage in their organisation of the research function using global research databases and localised expertise. The fund managers’ role is then, as Schroders would describe it, “to exercise flair and judgement within a controlled portfolio construction framework”.
Schroders, like many of the largest players, would argue that the same methodology can be used to manage portfolios across the risk spectrum from enhanced index mandates to high alpha unconstrained portfolios.
Firms with strong style biases have seen their fortunes fluctuate dramatically during the past six years, predominantly as a result of the extraordinary rise of the TMT bubble favouring growth managers, followed by its collapse giving one-off extraordinary returns to deep value managers. With growth and value more evenly balanced now, combined with single digit returns for the market as a whole, generating exceptional absolute performance in the next five years is going to rely on exceptional ways of stock-picking and focus on absolute rather than relative returns.
Global mandates do offer scope for adopting visionary thinking in the search for the highest alpha and despite the massive resources available to the largest global firms, some of the smaller boutiques and retail driven firms have been more successful than the mainstream houses in fulfilling the characteristics that Watson Wyatt was looking for in the 10-year mandates they were seeking to fill.
Nordea is an interesting example of an effective investment philosophy that is strikingly different from the mainstream. Its fund management team is centralised in Denmark and its mechanism for handling information and the processing of it into knowledge is by adopting a highly structured thematic approach to analysis.
It sees a theme as a long-term trend that drives the cash flow of a company that can be used as a tool to identify companies that benefit from the implications of structural change. A large amount of analysis is devoted to identifying 15 or so themes that will be in play for periods of three to five years that can then be applied to the total investable universe of stocks to produce a thematic universe. Companies benefit from two to three themes with a primary theme and two to three secondary themes.
Company visits play an essential if somewhat unusual role for Nordea’s process since it uses meetings with CEOs to explore the way they see Nordea’s themes affecting their own competitive landscape and use the feedback to refine the themes themselves. Visiting about 1,000 companies a year, Nordea has about 100 in a portfolio with detailed cashflow models for 200 to 300 alternatives. There may be 10 companies benefiting from a theme but only two or three that are undervalued. With such an approach, Nordea’s focussed high alpha has 50 stocks with a 5-10% tracking error and an alpha target of 400 basis points.
Selecting managers for a global equity mandate should be one of the most important decisions a trustee has to make. Removing all country constraints and tracking error targets offers the greatest potential for high absolute returns but also the greatest potential for underperforming a global index benchmark.
Before the manager selection can be tackled there needs to be a true understanding of what the relevance is of capitalisation-weighted benchmarks to a scheme’s longer term liabilities and how best to encourage managers to do what they are actually being paid for: exercising skill and judgement to select stocks likely to generate exceptional positive returns over the long-term.