The elegance and beauty of efficient market theories mirror those of the physical sciences and, like many beauties, can captivate the unwary, creating an almost axiomatic belief that markets in general, or at least the most heavily researched markets, must be efficient to an extent that makes active management worthless. The US equity markets encompass around 50% of total global stock market capitalisation; within that, the 250 largest large capitalisation equities account for 70% or so.
In the global context, large cap US equities are therefore the largest single asset class and also the most heavily researched.
In the perennial debate on which, if any, equity markets can offer excess return through active management, US large cap equities are generally regarded as one of the most efficient equity markets in the world. It is no wonder therefore that pension funds such as Royal Mail, according to Gerry Degaute, would prefer using their risk budget in markets other than the US and allocate their exposure to US large cap to index funds.
Indexing might appear to be attractive; it can, though, lead to skewness in exposures to growth or value if one style outperforms for a period of years, as happened to the weighting of the S&P500 index during the late 1990s’ TMT bubble. Indeed, the danger of tracking a skewed index is a strong argument for taking an active approach to investment in large caps. But is there scope for outperformance of the index benchmark in the management of US large cap equities?
For institutional investors at least, the evidence does appear to indicate that this can be the case, but as Jonathan Price of JP Morgan Asset Management (JPMAM) argues: “Although inefficiencies exist across all capitalisations, for managers to be able to find opportunities for outperformance there is a recognition that you need breadth as well as skill.”
In this respect, mid and small cap markets with more stocks offer greater potential. However, historically, many US firms such as JPMAM have been weighted towards US large caps, according to Price.
Axa Rosenberg’s active quantitative fund management business, for example, was founded in 1985 on the management of US large cap equities. It, like other active US large cap managers, would argue that history has shown that the market can be highly inefficient. Bill Ricks, Axa Rosenberg’s Americas chief executive and chief investment officer, points out that despite the number of analysts covering US large caps, the height of the TMT bubble in 1999/2000 saw a staggering level of inefficiency that the firm was able to exploit.
Without taking a purely value stance, it was able to outperform the market during both the climb to the peak, and the value rebound afterwards. The bubble was the proof that human behaviour, both at the level of individual interactions and through the psychology of crowds, is a critical component of making investment decisions that make a mockery of the rational decision making axioms of efficient market theory. Indeed, behavioural finance guru Daniel Kahneman was awarded the Nobel Prize in 2002 for his insights into the applications of psychological research into economic decision-making.
In the context of US large cap equities, the overwhelming home country bias together with the segmentation of the US market into the in boxes of large, mid and small cap combined with core, growth and value is an obvious source of potential distortions, so much so that Scott Leiberton of Principal Global Investor (PGI) finds that even in the US “the pendulum is swinging the other way, with more discussion on style-agnostic strategies”.
und management firms offering traditional long-only active management for US large cap equities can offer not only the nine style and size buckets but also go through the risk spectrum of enhanced indexation, medium risk/return to high risk/high alpha strategies. JPMAM’s Price finds that it is the middle ground that is being squeezed, with demand instead shifting to enhanced index and high alpha products. European investors have always been wary of specialist style boxes, at most splitting portfolios into large and small cap.
The product offering of firms for the European market is therefore invariably focused on style neutral core products, with a combination of enhanced index and high alpha mandates often seen as more attractive than a single medium risk/return mandate.
After a few years of exceptional outperformance by small caps, perhaps it is not surprising that JPMAM’s house view, according to Price, is to now go overweight US large cap, both because of current valuations and also because large cap companies with more overseas earnings should hold up better in a macroeconomic environment of a weakening dollar. Corey Griffin, the CEO of The Boston Company Asset Management (TBCAM) sees absolute valuations as reasonably attractive, whilst he argues that relative to international equities the US large cap market is 10% undervalued, with large caps currently at a discount to small caps. Historically, they have traded at a premium.
What are the risks? JPMAM’s view is that “the US economy will make the transition from recovery to long-term sustainable growth, but the risk is with the Fed and its interpretation of inflation data.”
s T Rowe Price’s Ronald H Taylor points out “in the US inflation is showing up in the energy area, when you pump gasoline for example, but in terms of consumer items, airline tickets, PCs etc, there isn’t any inflation. So it shows up in the data that people talk a lot about but I am not convinced the inflation fears are real.” The danger is that the Fed’s rate changes, either upwards or downwards, will be an overreaction. He goes on to add that “two years ago, no one thought oil prices would be at $75. So for investors, be they value or growth, what your view is on energy, commodities and cyclical companies, and how you have invested there, will have had performance implications.
“One could argue that the environment today is the exact opposite
of what was seen in 1999/2000. Back then technology was in such a frenzied environment; everyone was jumping on board regardless of valuation.
“Today what we see in terms of oil prices and precious metals is that they are at cyclical peaks. So to the extent that you have been able to time that you will have had phenomenal performance. Exxon recently reported that its 2005 earnings were the best annual corporate earnings in the history of the world.
“So these companies have had earning growth over the last two years, but what about 2007 and 2008? Those kinds of companies aren’t growth companies but they have had phenomenal short-term earnings growth. So the challenge becomes, if we stay in this environment for another year or two, what are the performance implications?”
Fund manager approaches
Adding value requires high calibre research, whether quantitative or fundamental, or a mixture of the two. TBCAM’s Griffin finds that the quality and value of broker research is declining.
“Clearly, there is less investment spending at brokers on research”, he says, adding that whilst in the past “sell-side brokers used to have the first call from companies”, the regulatory environment in the US is now inhibiting such practices so that “if you need insights, you need to do it yourself”. As a result, firms such as TBCAM are expanding their research teams with new additional career analysts covering the large cap space. For example, one way that they can add real value, according to TBCAM’s Sean Fitzgibbon, is through channel checks. “Every month we call a franchisee of McDonald’s and he tells which way the trends are heading. So we try and get that information before everyone else.”
The boundary between quantitative and traditional processes is blurring as advanced risk control and stock screening processes have become increasingly prevalent even among firms with fundamental processes based on teams of career analysts. TBCAM’s process, which is based on teams of sector specialists, also incorporates “a quant model that highlights companies that are attractively valued and ranks them within each sector,” according to Fitzgibbon. He goes on to add that the “quant model helps us stay disciplined” and that TBCAM has incorporated the output from the quant models for over a decade. Its own experience has been that “the power of the models has declined over time. In the early 90s, quant models were strong so that the process was 60% quant, 40% fundamental. Now it is the other way round.”
Getting the right balance between finding cheap valuations and superior earnings growth is the critical issue that drives investors to seek value and growth specialists.
However, many firms with style neutral processes argue that it makes sense not to be constrained by a style box. Axa Rosenberg’s process, for example, focuses on both valuations and earnings growth according to Ricks. As well as a valuation model identifying where the best value is in each industry, the earnings forecasts are based on a proprietary model that compares the growth in earnings with current earnings, combining both statistical measures with fundamental accounting relationships that link, for example, inventory growth with sales changes and, in addition, utilise analysts’ forecasts weighted according to historical accuracy and by how recent they are.
JPMAM’s behavioural finance approach also looks at both momentum and valuation factors that can help identify pricing anomalies caused by irrational investor behaviour according to Price. GMO, with a purely quantitative process, separates its portfolios into independent sub portfolios with distinct value or momentum styles that produce an overall more or less style neutral product.
Many firms offer a number of strategies within the same organisation, or in some cases through affiliated organisations within the same group. PGI, for example, has a diversified enhanced index product and a high alpha product, which are style neutral, while its affiliate, Columbus Circle, offers growth products. JPMAM has three distinct processes within the same organisation, an approach they describe as “behavioural finance” driven, a fundamental research-driven approach based on their team of 20 large cap research analysts and more idiosyncratic manager-driven funds managed by long term incumbent managers, according to Price. T Rowe Price, which traces its origins to growth investing, also offers core and value products.
Enhanced index type strategies utilising the output from large in-house research teams with a very structured risk controlled portfolio construction process producing diversification with as much as 200 names is an obvious and successful route that firms such as JPMAM, T Rowe Price and PGI have gone down. Adding a fund manager able to take analysts’ recommendations to construct concentrated portfolios of as few as 45 stocks increases the volatility but also the potential for outperformance to meet the growing demand for high alpha strategies. T Rowe Price’s US Large-Cap Growth Strategy, which has 45-60 stocks, is the firm’s fastest growing strategy, according to Taylor.
Squeezing more alpha out of the intellectual capital within the firms without taking on more risk is an objective that many firms believe they can achieve through allowing a limited amount of short selling combined with overweight long positions to give an overall 100% long allocation.
Typically, the strategies would be short 30% and long 130% and such 130/30 strategies have become very popular in the US and are attracting increasing interest in Europe. As JPMAM’s Price points out, they are a “recognition that it is difficult for a long-only manager to gain alpha from analysts’ insights into stocks they do not like”.
However shorting a stock does require a very different set of skills to that of traditional long-only managers, who often only focus research on stocks they are likely to buy. In this respect, quantitative managers have a fundamental advantage since their processes invariably rank all the stocks in the universe. Axa Rosenberg, for example, has been running long/short hedge funds since 1989 and has moved easily into the 130/30 space which “is a hot topic in the US”. Having been completely accepted in Australia, they are now looking to launch a European qualified investment fund (QIF) product, according to Ricks. JPMAM unusually, offers a fundamental active approach in this area based on its existing Large Cap Core long-only model. Its 130/30 strategy was launched two years ago and it has seen at first hand the increase in interest in this space from institutional investors.
While there has been a reasonably held view widely prevalent in Europe that the US market has been overvalued for the last few years, the US large cap market, which, depending on the definition, might account for anything up to 35% of total global equity market capitalisation, is just too large to ignore completely.
The dilemma for European investors might be that a naïve indexation could actually be a high-risk approach to gaining exposure as the experience of the TMT bubble showed. It might be preferable to seek approaches that control absolute risk through ensuring that if large style bets are taken, it is because there is a strong relative valuation basis that drives them, rather than an artefact of index construction and market exuberance.