Joseph Mariathasan finds that while modern portfolio theory and orthodox strategies can serve investors and fund managers well, there can be greater rewards for those willing to step away from convention

Karl Marx might not be the intellectual guru with the most influence on fund managers, but the epitaph on his grave in Highgate cemetery in North London should resonate with some: "The philosophers have only interpreted the world in various ways; the point is to change it."

Institutional fund management has evolved around a set of ideas, many predicated on the attempts by economists to develop a coherent intellectual structure akin to the physical sciences in its precision. Out of this has come modern portfolio theory incorporating the ideas of efficient markets and, from this, the use of capitalisation-weighted indices as benchmarks for both performance and risk measurement of equity and even bond portfolios.

Yet what the empirical evidence seems to indicate is that the best-performing global equity fund managers are those who have been prepared to demolish this intellectual edifice. Nevertheless, they risk being marginalised by institutional investors who often find it difficult to incorporate managers with unusual approaches within the confines of the governance framework that has been imposed on them.

Not surprisingly, it is the family offices and high net worth investors who are better placed to benefit from these firms. The much closer alignment of principals, in the form of the investors, and their agents, in the form of their advisers, means that they are more focused on achieving the objectives of the beneficiaries rather than minimising the business risks of the fund managers, which is often what index-based approaches tend to do.

Managers ‘outside the box'
The poor performance of equities over the past decade or so has certainly led to much soul searching by investors and consultants alike on the intellectual framework that underpins allocations to equities, the benchmarks that managers should be judged against and the selection of managers themselves. Managers who have more concentrated portfolios and are not characterised by strong style biases are inevitably more difficult to place within an institutional framework. Strategies may be more dependent on the intuition and skill of individuals rather than through the strength of processes that are less dependent on any single person. The concentration of stocks means tracking errors against index benchmarks can be so high as to make the indices themselves irrelevant for anything except keeping a scorecard of performance.

But does the framework that currently exists preclude managers with a process that cannot fit into one of the boxes deemed to be acceptable? It seems so. A good example is Wilkinson O'Grady, founded in 1972 and still only managing around $2bn, despite an excellent track record in global equities. The explanation lies in the fact that it looks very different from mainstream US-domiciled institutional fund managers.

"From 1972 to 1986-87 we only had two clients - both family foundations," explains Donald M Wilkinson III, president, CEO and son of the firm's founder. "Both had the objective of allocating capital across the globe with an absolute return objective."
Combining company-level security analysis with enduring macro themes enables the firm to construct focused portfolios of 25-50 stocks which, in contrast to most US managers, have never been US-centric. What makes Wilkinson O'Grady unusual and difficult to fit within an institutional context, however, is that the macro analysis combined with the absolute return objective can lead it to vary its cash weighting quite dramatically: in February 2008 only 20% of assets under management was invested in equities. At the moment it is at 60%.

Another example is Carmignac, with an excellent track record and €7.7bn of global equities under management - just 10% of which is institutional. The firm offers only pooled vehicles and no institutional share classes. "Each client should be treated in the same manner," says Eric le Coz, head of product development. "Our retail clients have been with us for a long time. Why should I treat someone else differently because they give me €50m rather than €50,000?" While there is certainly merit in that argument - not least in moral terms - it goes against the prevailing orthodoxies of the fund management industry.

Top-down, bottom-up
Effectively managing the trade-off between constructing portfolios based on pure fundamental stock research and taking account of macro-economic themes and trends is a common characteristic of the most successful fund managers. For Wilkinson O'Grady, it has been critically important and the balance between the two is a key driver of its own investment process.

"From 1972 to 1981-82, the macro-environment was much more important than the stock fundamentals," says Wilkinson. "Markets did not make much progress, apart from beneficiaries of inflation such as gold, and so on. From 1982-2000, the situation changed: while macro was still important - witness, for example the 1987 crash - a portfolio of good companies could consistently outperform. From 2000, the world changed again, with 10-15 years of P/E multiples contracting. So for the past 10 years, and continuing for the next 3-4 years, understanding the macro-environment will be critical. Price earnings ratios of 20-30 times were a secular high and the reduction will continue until equities trade at traditional secular bear market levels of 10 times or less, with dividend yields at 5-6%."

The shift in dividend yields that Wilkinson refers to represents a fundamental change in the relationship between bonds and equities. What is the logic in matching a liability stream that has large uncertainties associated with it with a precisely determined set of cashflows from a portfolio of risk-free government bonds with nominal yields sub 4%, when an equity portfolio can give essentially real yields that are significantly higher? Of course, equities deliver some short-term volatility, but that comes with a very high probability of matching inflation over the long term required by pension funds.

This is the logic behind the global income fund managed by Veritas, a variant of its main global equity strategy. Veritas uses a clear theme-driven approach to narrow down its universe before performing detailed analysis to arrive at a global portfolio of just 30-35 stocks. "We will only buy those we identify as good quality - possessing competitive advantage - at attractive valuations at the point of purchase," explains Andy Headley, head of global equities. The current themes are: "structural growth", covering sectors such as healthcare; "government spending", which is driving economic activity post-credit crunch (an infrastructure focus in developing markets, an energy-saving focus in developed markets); "security and supply contracts", which relates to companies operating with assets that are scarce or irreplaceable (for example, SES, which can take ownership of satellite orbit rights in perpetuity); and "dependable compounding", a more contextual theme that arose from the "resilience" theme that Veritas used in 2007. Taking the last theme as an example, the challenges articulated by Headley are the powerful forces pushing in opposing directions.

"The tail winds are the zero interest rates, the impact of government stimulus money, companies with fairly strong balance sheets and strong cashflows, while the cycle of cutting back on working capital and capital expenditure is ending," Headley explains. "The headwinds include the fact that zero interest rates will have to go up at some stage - is that going to be a managed rate rise or forced by markets? Deficit spending also has to cease. Given the deficits, tax rises are inevitable, which consumers will factor in reducing demand. Unemployment is high and companies are not recruiting and wage growth is not strong."

Headley looks for firms that can dependably compound earnings over 3-5 years and get re-rated by the market as a result. One example he sees is Transdigm, a US specialist supplier of aircraft parts. "All aircraft equipment and parts have to be certified and this accounts for 80% of Transdigm's business," he says. "They sell their products to manufacturers at zero margins and can then sell replacement parts to the users at much higher margins."

Focusing on macro-factors and themes and being prepared to move dramatically away from cap-weighted indices are common factors among many of the most successful managers in the peer group comparisons. Clearly, some of this could be due to luck or market timing - particularly if managers make large switches between macro themes or between equities and cash, as in the case of Wilkinson O'Grady.

Market timing is usually frowned upon by consultants and institutional schemes but Wilkinson maintains that all the approach implies is acknowledgment that there are certain times when the environment becomes more or less favourable for equity markets. "We are very respectful of the markets," he insists. "They are much smarter than we are!" Having said that, he explains that in 2007, the firm observed a fairly synchronised global economic expansion but then, one by one, large sections of the stock markets rolled over and started to underperform - first US financials, then consumer stocks, then housing.

"We have the view that if we observe something and no-one can give a reason, we should step outside," explains Wilkinson. "We sold all financials, then consumer stocks. We were under 80% invested." The clincher was 16 July 2008 when Bear Stearns' hedge funds were revealed to be worthless. "We knew that for a long time they were the smartest in the mortgage markets, so we felt there was too much instability in the financial markets to take an equity position, particularly as the Western world was overleveraged." As he argues, while security analysis is fundamental to the the firm, sometimes, although rarely, the macro analysis requires you to override the fundamentals: "In our history there have been only three of these kinds of moments, the last being the tech bubble."

Bottom-up stockpicker MFC's strategy is based on identifying companies selling at a discount to intrinsic value, using quantitative screening (which it finds more useful in developed than emerging markets) followed by more detailed fundamental research and company visits. As MFC's objective is to capture growth, emerging markets have plenty of potential - but the key for it is to find companies with good management teams and re-investment opportunities, stocks that may not be the cheapest, but which tend to be less volatile.

But even for MFC, macro-economic analysis plays a part. For example, it determines the avoidance of countries where currency exposure is difficult or impossible to hedge; some Eastern European countries with fiscal problems show attractive stock market growth prospects in local currency terms, but hedging that currency risk is tricky.

For Carmignac, top-down macroeconomic analysis drives stock selection, and its over-riding theme is the strength of emerging markets. "There were concerns from the spring of this year that emerging markets were over-heated and monetary tightening was likely," says Le Coz. "We do not share those concerns but there is a necessity for curtailing certain excesses and these together with equity valuations need to be monitored carefully. We prefer economies less dependent on export sectors and so less exposed to the health of developed market economies."

Not surprisingly India (11%) and China (10%) are its largest exposures. "The beauty about India is that it is pretty much uncorrelated economically with what is happening in the developed markets," says Le Coz. "The main concerns are inflation in the food sector and instability in the political structure. However, the last year has seen a significant improvement in the co-ordination between central and state governments."

While overall exposure to emerging markets is 31%, that does not represent the total exposure to emerging economies. "If you are positive about the domestic demand story for emerging markets and the trend towards increasing urbanisation, those are very commodity-intensive," says Le Coz. "Our allocation to commodity companies is 25%, so our total economic exposure to emerging markets is over 50%."

That kind of profile would give a benchmark-hugger palpitations. But the credit crunch has shown that that intellectual edifice underpinning institutional investment is highly unstable. Can investors adapt their corporate governance frameworks to encompass the managers who have decided not to fit their strategies within the conventional framework, but to change it? If they do not, they may continue to miss out on some of the industry's most rewarding returns.