European institutions have little choice but to invest in European equities, be it via a domestic or foreign equity allocation, structured as a euro or pan-European mandate, or the European element of a global mandate. Four years after the birth of the euro, the means by which institutions achieve European equity exposure still vary widely.
For institutions within EMU, Euro-zone equities have largely replaced home-country equities as the domestic allocation. This leaves the tricky question of how to allocate to the rest of Europe, the UK, Sweden, Denmark, Norway, and Switzerland not being a natural combination of country exposures. The alternative is to go straight to a global mandate, excluding the Euro-zone. For institutions in countries outside the Euro-zone, the emergence of the euro has made little difference to portfolio structure. The home bias remains, justified largely by the argument that the currency of assets should match that of liabilities. Foreign exposure may be allocated regionally or globally, and European mandates will usually be pan-European, excluding the home country. Either way, the fortunes of Europe dominate every European pension fund’s equity returns.
Volker Koester, head of equity portfolio management at UBS Global Asset Management in Zurich, which runs e14bn in pan-European equity mandates, comments that small to medium-sized Swiss pension funds split their equity allocation into Swiss and global ex-Switzerland, whereas larger funds take more of a regional approach, awarding pan-European ex-Switzerland mandates. Günther Baum, actuary at Heubeck, suggests that most German pension funds have switched from a DAX to a broader European benchmark, most preferring a Euro-zone index. According to Rob Visser, European equities product specialist at Fortis Investments, which manages e5.4bn in European equities, its mainly French and Belgian clients are looking to put more money into equities, but are increasingly seeking absolute return vehicles, such as convertibles or hedge funds, with which to increase their European allocations.
Of the e13bn that BNP Paribas Asset Management, with its mainly French client base, runs in European equities, some 40% is pan-European with the same percentage in Euro-zone mandates, the remainder being in single countries. By contrast, Storebrand Investments runs Nkr7bn (e875m) in Norwegian domestic equity mandates, versus Nkr4bn in specific pan-European equity mandates, and a further Nkr1.6bn in Europe within its global mandates. According to Bernt Sagard, portfolio manager at Storebrand, none of its clients has requested a Euro-zone mandate, and most Norwegian institutions choose to go global rather than pan-European for their overseas allocation.
But the emergence of the euro has had a significant impact on the approach that investment managers take to European equities. Within the sphere of institutional money management, country indices and exposures are of little importance, the sector being the perceived main driver of profits and share price returns. To this some exception is made for the FTSE100 index, the barometer of the UK, the second largest equity market in the world, because of its independence from the rest of Europe. But aside from hedge funds, which mainly trade volatility, rather than direction, and the retail investor, who prefers to play in his own backyard, country of domicile has largely disappeared as a reason to invest. This has led to a re-alignment of equity analysts along sector lines, resulting in global teams, although within certain sectors particular countries or regions predominate. According to JP Morgan European equity strategist Walter Kemmsies, only four sectors can be considered truly global, in that industry factors alone drive returns. These are materials, energy, technology and industrials, which feature European giants such as Rio Tinto, Shell, SAP and Siemens. Certain global sectors reveal regional influence, for example pharmaceuticals, where the US and Europe are to the fore, and within Europe mainly UK and Swiss companies. But other sectors have a distinctly regional or domestic feel, such as utilities, even though large companies such as National Grid and E.On have significant assets outside their home countries.
Managers in the region stress the importance of bottom-up fundamental analysis over country views. The focus is upon return on capital employed, the discounted value of future cash flows, potential company rerating, company visits and industry news flow. Some managers also use quantitative analysis as an additional screen – BNP Paribas, for example, ranks stocks according to various qualitative and momentum criteria.
Managers take views on sectors to a greater or lesser extent. Fortis Investments considers as part of its decision process the shape of the yield curve and whether this favours cyclicals over defensives, taking into account implied industry growth rates obtained from current market valuations. MEAG uses its economic views to decide sector allocations, leaving the portfolio manager to decide on the stocks to fill the sector allocation. Different valuation measures are used for different industries and sectors are typically no more than 3.5% under or overweight. Although Storebrand prefers to expend the majority of its risk budget on stock-specific risk, its sector weightings are currently quite divergent from its benchmark, with overweights of 4% to telecoms and 3% to raw materials. Sagard explains that country weightings may deviate from the benchmark as a result of stock or sector views.
Managers differ in their response to resulting country over or underweights. Julius Baer Asset Management CIO equity René Schneider remarks, “against a concentrated benchmark like Stoxx 50, deviations at the country level have a higher contribution to risk, compared to a broad benchmark like MSCI Europe. Our investment process is primarily driven by stock selection and sector bets whereas country deviations are treated more like a residual that needs to be risk-controlled.”
For BNP Paribas, single-stock alpha is paramount and top-down and sector views secondary. However, the portfolio managers each have a country responsibility, and feedback into the portfolio construction their assessment of fund flows in each market. As Oliver Rudigoz, portfolio manager at BNP Paribas, comments, “in the abstract there is a strong rationale to compare stocks within a sector, but one has to be aware that markets exhibit different behaviours. At the margin we may emphasise or de-emphasise a share on a country view”.
The benchmarks against which performance is measured are typically MSCI Europe, and sometimes Stoxx 50, Stoxx 600, or Eurotop 300. For Euro-zone mandates Dow Jones Euro Stoxx 50, Euro Stoxx Large or Euro Stoxx 300 are preferred. Specialist mid-cap mandates would use the Dow Jones Stoxx Mid.
Fortis’ Visser suggests that an MSCI pan-Europe mandate combined with a separate small cap mandate provides better exposure to European equities than a single mandate based on the MSCI Europe benchmark. This is because the small cap element of the MSCI Europe is difficult for a large-cap focused manager to provide. Visser comments, “this is a problem common to small and larger investment managers, possibly more so the large managers because of the smaller free float of small-cap stocks”. Most of MEAG’s mandates are large cap, but senior portfolio manager Alfred Wasserle comments that it will invest opportunistically in smaller cap stocks, preselecting using quant techniques. A typical tracking error for the managers interviewed was 3–6%, with mandates in the 6–7% range deemed high risk, and those in the 3–4% providing core exposure.
The resources devoted to pan-European research vary widely by manager. UBS Asset Management has 26 of its 88 analysts devoted to European equities, split between London and Zurich. Its analysts are split into 12 global sector teams each of which creates a sector neutral portfolio. A team of six, based in Zurich, London, Frankfurt and Paris, undertakes portfolio construction. The same approach is applied to mandates, irrespective of the country in which the client is based. In Koester’s view, this integrated European platform is a key differentiation of the UBS offering.
In contrast, Storebrand has two portfolio managers dedicated to Europe and rely heavily on brokers forecasts in their assessment of companies. Fortis Investments has 13 European equity sector analysts in Paris and access to its Boston global sector research. Six European equity portfolio managers create model portfolios, which portfolio constructors then tailor to individual client guidelines. BNP Paribas has a European equity team of 28, based in Paris, split between 13 analysts, six quant researchers and nine portfolio managers. Daily dialogue ensures communication among the team members. Each group assigns alpha scores that are aggregated in a database to create the model portfolio, with which all client portfolios have at least a 70% commonality. MEAG has 15 portfolio managers focused on Europe and a research team of 10, all based in Munich. The portfolio managers are directly responsible for stock specific research and sector trends, whilst five out of the 10 analysts contribute to the economic scenarios, the longer-term market forecasts and quantitative indicators for the sectors.
Cyclical outperformance and the advance of low quality, debt-laden companies of 2003 may well continue into 2004, but many fund managers expect to take a more defensive stance. Furthermore, last year’s supremacy of small-cap stocks is likely to go into reverse. A counter would be an upturn in takeover activity, which is forecast by UBS’ Koester, provided that interest rates stay low. Julius Baer’s Schneider questions the sustainability of the recovery, commenting, “initially earnings growth was driven by cost cutting but now we need to see some top-line revenue growth. Also the strong euro is not yet fully reflected in earnings forecasts. Against this background the 25% expected earnings growth for the next 12 months looks challenging, thus posing a risk for the market in the second half of 2004.” Schneider cites convergence of Eastern Europe as an important theme and includes selected Czech, Polish and Hungarian stocks in some of the portfolios. Taking a contrarian view, Schneider expects initial Fed tightening in the first half of 2004, followed by a series of interest rate increases after the US presidential election in November. Rudigoz, however, sees positive earnings momentum and expects markets to remain buoyant. Following the sharp rebound in the market in mid 2003, which was led by the tech sector, Rudigoz expects performance to broaden out across other sectors, which to him look undervalued. MEAG estimates moderate performance from the Euro STOXX 50 in 2004, with an end year forecast of 2850, going against the consensus in anticipating a stronger dollar in 2004, primarily because of the US election. At the turn of the year, Wasserle reduced MEAG’s exposure to cyclicals and trimmed its underweight position in defensives in reflection of its subdued market outlook. It is underweight the tech sector on valuation grounds and because of the dollar, considering that valuation will be a key driver in 2004, rather than momentum.
Far from seeing the tech sector as overpriced, Kemmsies argues that the greatest multiple expansion in 2003 was seen in the more defensive sectors. “Analysts’ expectations in the tech sector were too low, so that as the sector rose analysts were adjusting their figures upwards. In contrast materials analysts, who generally have more industry experience, had priced in some earnings improvement. These shares rose 20–25%, whereas earnings growth expectations were 10–15% so arguably this is the sector that has traded ahead of expectations.” Kemmsies notes a trend among asset managers to employ a ‘barbell’ sector strategy, combining heavy defensive exposure with some high beta stocks, so as not to miss out on any market rally. As regards current levels of valuation, Kemmsies suggests that Europe has simply undergone the normal pricing cycle. “Share prices fall to a level where there was yield support, then profits recover, at first quickly, because cost are cut at the same time as revenues rise, then flattening off to the rate at which the economy grows. Only at this point does a market become valuation-driven,” asserts Kemmsies, “Providing that profits keep pace with rising share prices, the equity market is not overshooting. However, the market needs to halt briefly to gauge whether profits growth is indeed sufficient, which it did only once in the last year.”
In textbook beta rallies, such as was experienced in 2003, Europe will inevitably underperform, whereas its bias towards defensives like consumer staples, healthcare and financials will stand it in good stead in bear markets. In 2003, Europe underperformed the US and Japan, due both to its underweighting in cyclical sectors and its lagging economic growth. This gave rise to differentials in country performance intra-Europe, with more cyclical markets like Germany and Sweden outperforming the more defensive markets of UK, Switzerland, France, Italy and Spain. But it is not just countries that have sector bias; there is also bias within sectors. For instance, chemicals companies dominate the continental European materials sector, whereas in the UK the tilt is towards metals and mining. An aggregate exposure to pan-European equities will be more balanced, but against the US, the largest and most diverse stock market in the world, some imbalances remain. The most obvious one is the size of the technology sector in Europe, which is one third that of the US.
Kemmsies considers it no accident that the market capitalisation of European companies is biased towards defensives. “The technology sector is basically a play on innovation. For the European technology sector to grow there has to be an incentive to be entrepreneurial. Europeans are less comfortable taking risks, as is clearly evidenced by the slower rate of company formation. This is not to say that start-ups have always had it easy in the US; the NASDAQ had a similar difficulty to the Neuer Markt in the 1960s. The difference between the US and Europe is that people get laid off in the states and find new jobs, often in new companies. Until access to finance is improved and the stigma of business failure recedes, Europe will continue to suffer a long-term performance drag.”
Assigning US industry weights to European share price returns does bridge some of the gap between US and European equity market returns. But some differential remains because of lower productivity. Comments Kemmsies, “Existing European businesses need to improve worker productivity up to the levels of the US and UK. Being unable to fire unproductive workers means that a company cannot invest where it can profitably use labour. And European capital investment tends to increase the amount of capital spent per worker, whereas US capital investment is aimed at increasing productivity by maintaining capital spend per worker.”
This is the reason for the 10–15% ratings discount suffered by the European markets in comparison with the US. In the past this was concealed by interest rate differentials across Europe, which made comparison difficult and the flattering of Europe’s growth rate as a result of post second world war restructuring. Europe’s slower growth in the past 10 years demonstrates the constraining influence of inflexible labour markets. Without government action to address the issue, Western European equity markets will become ever more defensive, as companies divert their capital investment towards the cheap labour of Eastern Europe and elsewhere. European governments do however appear to have labour and pensions reform on the political agenda, which suggests this trend will abate in the future.