Implementation: Points of entry
Investors have several ways of accessing European equities including passive, active and smart-beta strategies
At a glance
• Fundamental active management can, in theory, take advantage of global disruptions.
• Passive investment is the big potential loser from the growing popularity of factor-based approaches.
• Smart-beta strategies can be crude.
• Quant and smart beta managers cannot produce high-conviction portfolios.
“Whatever is going on in the world, we can usually find a way to take advantage through the European stock market because the revenues are so diversified, with half coming from outside Europe. If Europe is struggling and the rest of the world is doing fine, you invest in those companies that supply the rest of the world. If global growth is struggling and domestic growth is picking up, you downplay the globally oriented companies,” says Stephen Macklow-Smith, head of European equity strategy, JP Morgan Asset Management.
That is a strong argument for active management. But how many active managers are prepared to take a forward-looking view independent of their benchmark index weighting?
It is no surprise that passive management, smart beta strategies and quantitative active management are all making strong inroads in European equities. Nick Samuels, head of manager research at Redington, argues that each progressively more complex and less benchmark-constrained strategy has to be able to add value to lower-cost alternatives. “It is possible to improve on a passive market-capitalisation-weighted index,” he says. “Smart beta incrementally improves on passive because the tilts that such strategies introduced have proven over the long term to be effective. Factors such as value, quality, momentum, low volatility, all have roots in behavioural finance and they are all factors that you can back-test and show that they work over statistically significant long periods of time.”
He adds that the strength of such behavioural biases means they should persist. That gives confidence that the direction smart beta strategies are going is a sensible one: “The downside of smart beta strategies is if they become too popular you can get crowding in the factors chosen and they stop working, which, of course, can create opportunities elsewhere.”
Passive managers are the potential losers. Many studies show that virtually any kind of alternative weighting can beat passive market-capitalisation-weighted indices. Samuels also argues that the other losers are mediocre, low-conviction active managers. “People who are putting together 100-plus stock positions with plus or minus weights against a benchmark would have the view they have to own Shell, even though they don’t like it, because it is in the benchmark, so they go underweight by 1% relative to the benchmark weighting.”
But that accounts for the vast majority of active managers. “Our view is that a large proportion of those managers will find that their lunch has been eaten by the low-cost smart beta implementation of what it is they do,” says Samuels.
The pressure on active managers is increasing from the plethora of smart beta products on the marketplace. Amundi, for example, has launched a multi-smart beta European equity exchange traded fund composed of four universes based on four risk factors: value, size, momentum and volatility.
The worry about smart beta strategies is that they are created using naïve factors. “Value works, but the smart beta construction uses quite a crude way of finding out where value is in the market,” says Samuels. As he explains, smart beta approaches typically use price/book ratios and some may combine them with other metrics, but they tend to be simple constructs. What quant then does is to use that same philosophical backing but puts it together in a far more sophisticated manner.
“There is little point in using price/book to analyse an asset manager because what is the book value of an asset manager? Those businesses are all about the people in the firm,” Samuels says. “It would be far better to use, say, a price/earnings ratio. The quant manager is analysing all these issues, uses far more metrics and is constantly analysing, researching and innovating new ideas, thinking how to blend and time those factors.”
Quoniam Asset Management is a good example of a quant manager operating within European equities. The German-based manager has a strict risk-controlled quantitative approach based on 80 financial metrics identifying multiple factor premia (quality, sentiment, valuation) for alpha generation. The alpha and risk forecasts are combined in an optimisation process that constructs a fully invested portfolio with the focus on maximising alpha, says portfolio manager Sascha Mergner.
“The downside of smart beta strategies is if they become too popular you can get crowding in the factors chosen and they stop working, which of course can create opportunities elsewhere”
Taking account of transaction costs in a rigorous manner is also seen as critical in an illiquid marketplace such as small-caps. Like other quant managers, the methodology is subject to continuous development and adapted to specific industry segments. While the approach has been successful in the all-caps universe, with a realised information ratio of 0.9, it has really shown its worth in the European small-caps universe, where the strategy has a realised information ratio of 1.8. “In less efficient markets, the signals we get are stronger,” says Mergner.
For investors in European small-caps, the universe of 2,500 stocks is in an illiquid, poorly researched market difficult for fundamental managers to tackle – and few have tried. Lupus Alpha Asset Management is one that does operate in European small-caps. It reduces the investable universe to nearer 1,000 based on liquidity criteria, which are then split among the six-strong investment team for analysis, with about 60-80 stocks in their portfolio, says portfolio manager and partner Marcus Ratz.
In contrast, a quantitative approach such as Quoniam’s, which incorporates both the alpha signals and the transaction costs in the analysis, has no restrictions in the number of stocks that can be analysed in a consistent manner. But the portfolios will typically have many more stocks in them as the conviction associated with any specific bet is much less.
Given the increasing competition from passive, smart beta and quantitative approaches, a fundamental manager needs to be able to articulate why their process works and why it will continue to work in the future. “It is amazing how few managers can actually do that,” says Samuels. He finds that it is typically value, quality or momentum-oriented managers who can. “They are the ones who can point to a specific process. Value, quality and momentum do not require you to be smarter than anyone else. You have these tailwinds behind you that work.”
Institutional investors in European equities clearly have a choice. They can go for market capitalisation-weighted passive approaches or for more expensive smart beta, which arguably improve on pure passive; or for quant, which improves on smart beta. But, Samuels argues, if systematic alternatives can be bought very cheaply, how can a fundamental active manager improve returns?
Typically, a fundamental approach can discover problems in the balance sheet that a systematic approach might not be able to do. They may be able to have a forward-looking view that can, as Macklow-Smith argues, take advantage of macroeconomic factors.
What quant and smart beta cannot do is produce high-conviction portfolios. But for Samuels that means managers able to run portfolios of no more than 30-50 stocks. He says: “We will rule out any fundamental active manager with a 100-stock portfolio. How on earth can any manager really know them all well?” That does leave opportunities for some active fundamental managers but maybe not the majority.