Re-organising a fund management operation to support a global equity product involves enormous effort in changing analytical practice, and integrating teams across geographical boundaries. Upon joining AIG in 1998, Danielsson inherited 70 analysts sited in Canada, US, Latin America, London, Zurich, Tokyo and a number of South East Asian countries, which appeared to operate in isolation. Danielsson initiated a project to harmonise both philosophy and process to promote high- quality regional investment management that was supportive of a global product. He introduced regular discussions and meetings and combined industry projects to encourage team members to work together. Specialist insight on local markets is pooled and access to research is the same in each office. Comments Danielsson, “the process is strict enough to ensure there is a common denominator, but varied enough to work within different markets”. AIG categorises companies by their rate of growth, with different valuation measures applied to each classification. Spreadsheets are ready-formatted, so that analytical work is specified and performed to the same rigour in each region. Danielsson expects to obtain 80% of the alpha generated from stock selection using these techniques.
Old-style valuation measures like price/earnings ratios are not comparable when there are differences in accounting standards and the treatment of certain accounting items between countries. Global investment managers more often use free cash flow as the key variable in valuation, employing discounted cash flow analysis, or ratios such as price/cashflow as a primary valuation screen.
UBS Asset Management, which recently won part of an £850m (e1,355m) global equity mandate from BAA, the UK airports operator, takes the outputs from its discounted cash flow model, supported by specific industry criteria and a qualitative assessment of management, and applies them in portfolio construction. UBS determines its forward projections of free cash flow as a function of certain critical milestones or achievements, for example the development of new products or increases in market share, and divests if these criteria are not met or if the market valuation fully reflects the company’s potential. UBS claims to consider country, industry and stock specific factors simultaneously, as opposed to one after the other, as was the historic norm.
Stocks are weighted in accordance with the extent of the valuation anomaly, with the aim of ensuring that at least 80% of the client’s portfolio is composed of the top third of analysts’ recommendations. UBS typically manage to between 3% and 5% tracking error, suggesting that some 75% of added value comes from industry and stock decisions, with the remainder from asset allocation and currency. A typical mandate for UBS would be a performance target of 225 basis points over MSCI World, with constraints on the divergence of stock, region, currency, country and industry sector from the index weightings resulting in a portfolio of between 125 and 175 stocks. Raising and lowering bet sizes to fit the performance objective allows UBS to fulfil more or less aggressive mandates.
A similar core product is offered by Morgan Stanley Asset Management, which seeks to outperform by 200bps with a prospective tracking error of 3–5%. Whereas the UBS offering has a value bias, the Morgan Stanley product uses both value and growth signals in stock selection and is appealing to trustees who have no view on manager style. Kate Cornish-Bowden, Morgan Stanley fund manager, explains, “our ethos is to use the most efficient methodology for judging a stock in the context of cyclicality and the secular growth rate of its industry. With some industries, like chemicals or engineering, value investing is most appropriate. Aggressive growth companies at the other end of the spectrum require measures like earnings revisions and momentum.” Some companies do not correspond to either, resulting in a combination of measures and Cornish-Bowden recognises that companies will change their character over time. After qualitative assessment of stocks arising from this primary screen, portfolio construction is decided using rules on stock, industry and country exposures to ensure that tracking error targets are not breached. The result is a fairly concentrated portfolio of 100 stocks, which covers probably 90% of the index capitalisation.
An advantage of using a core style-neutral strategy is that a plan can introduce satellite managers at the regional or global level with some style bias. The Morgan Stanley global value product, run in London by Frances Campion and Paul Boyne, aims to access the sustained outperformance that Boyne asserts is demonstrated by its value style of management. Boyne suggests that cash flow and book value ratios are readily applicable across markets, whereas profit is a subjective concept susceptible to interpretation. Once stocks are ranked according to these valuation measures, analysis is performed on the company’s financial strength, management and franchise and catalysts that might unlock the company’s value identified. The process is pure bottom-up, with no reference to country or sector outlook, although broad exposure guidelines ensure the fund does not deviate too far from index proportions. The global portfolio contains between 90 and 110 stocks, with typically no more than 3% in any one stock, and stocks are held for, on average, three years. The average market capitalisation of stocks held within the portfolio is $29bn. The programme’s target is 250bps annualised average outperformance on a rolling five-year basis, whereas the Morgan Stanley Global Value Equity Fund has outperformed the MSCI World index by 450bps a year over its 10-year life.
The Russell ethos is that no style outperforms any other over the long term. To mitigate manager, research and style risk, Russell recommends a multi-manager approach to global equity investing. Barnes points out that style underperformance can persist for upwards of four years, which is longer than most pension fund trustees could stand. Russell prefers regional allocations to a global approach, as Barnes explains, “in global equity mandates, the assumption is that the manager is equally good across all regions, which is asking a lot of a single manager. But not all funds are large enough to split their overseas exposure. For smaller funds, a broad mandate may be appropriate where the manager’s brief is to pick the best stocks globally.” Russell would however still recommend two or even three managers operating different styles and processes to diversify sources of return and improve the information ratio.
Barclays Global Investors, which runs approximately £50bn of global mandates, suggests that even using standardised valuation measures, the danger in adopting a global sector approach is that companies are not directly comparable, because of local market influences. BGI downplays sector bets as a source of return, and suggests that picking stocks correctly within a region and making market asset allocation decisions is still the best way to run global portfolios. BGI has outperformed global indices by almost 2% a year consistently since adopting its scientific investment style. BGI reduces transaction costs by using futures to exploit its country views and segments its currency allocations, broadening the range of decisions taken as a means of stacking the dice in its favour. Its stock selection process takes a number of ‘leading indicators’ – for example, directors’ purchases, earnings revisions and cash flow generation – and after testing to ensure that these signals lead to outperformance, uses them to grade companies, so prioritising stocks for inclusion in portfolios.
However, Dresdner RCM’s survey suggests that structural inefficiencies arise when an investment manager creates a global portfolio from regional products. But if a specialist global team is maintained separately from regional fund managers, tensions can result. Mark Archer, head of sales for Dresdner RCM, contends that a truly global approach requires a different type of investment manager from the traditional top-down manager relying on regional inputs, and a single team. Whereas there is some consensus on a market cap-weighted global benchmark outside the UK, Archer comments that UK consultants more often impose fixed weights, giving rise to customised benchmarks. Smaller funds may wish to follow their consultant’s advice, but may not be large enough to justify a segregated account. With this in mind Dresdner RCM has created a number of pooled products for use by smaller funds, benchmarked to the assortment of different global mandates recommended by UK investment consultants.