“Rumours of the demise of country influences on asset returns are greatly exaggerated,” say Anton V Puchkov, Dan Stefek and Mark Davis, paraphrasing Mark Twain in a 2005 paper exploring the relative importance of global, country and sector-specific factors on share price performance.

It is common knowledge that a key characteristic of emerging markets is that stocks tend to be more correlated to their local stock index than their global sector. So it is therefore not surprising to see that Ashmore, a specialist emerging market debt manager, has also been running an emerging market equity fund successfully for a number of years, based on a top down country view and investments in liquid securities that enable rapid country reallocations to be undertaken cheaply and quickly.

But the paper does give academic credibility to the idea that there is the potential for outperformance even for developed markets just through focusing on the macro-economic and sector specific factors that impact share prices. Many equity managers would agree with this and incorporate macro and sector views into their investment processes that are typically focused on stock selection.

But specialist bond managers can and often do also have high levels of expertise in macro-economics and global industry sector trends, as well as the expertise in using derivative markets that enables them to translate country and sector analyses into active management of equity portfolios. But few have ventured into this realm. For a bond manager wishing to launch an equity product with no specific stock selection skills, building credibility among potential investors is clearly a hurdle that only the brave, or perhaps the foolhardy, would dare contemplate.

Moreover, bond subsidiaries of multi-asset investment firms may find themselves firmly positioned within a debt silo, and actively discouraged from straying into someone else’s patch. Payden & Rygel as an independent privately-owned bond specialist, does not face such issues and, having been asked in the 1990s by a major global financial services company to advise on how they could most efficiently gain active global equity exposures for their pension fund, ended up developing a process that a decade later is still going strong, and which is now attracting increasing interest in the European marketplace.

The derivative-based strategy uses a tracking error-based performance target that enables institutions to set their own risk and return objectives for a global equity portfolio. “Institutions typically target a tracking error of 300-500 basis points which, with a historical information ratio of one, has enabled institutions to meet their risk return objectives,” says Robin Creswell, managing principal and the London-based CEO of the firm’s European operations.

 

hristopher Orndorff, the managing principal responsible for Payden & Rygel’s global equity strategy explains that the core of their process “relies on using futures, exchange traded funds (ETFs) and currency derivatives to translate views on countries, sectors and currencies into a portfolio that is benchmarked against the MSCI World Index. Over a 10-year period, the contribution of each of the three sources of outperformance has varied but the combination provides diversification of alpha sources, while playing to the strengths of the firm’s broad investment research process.”

Creswell makes an analogy with the development of the internal combustion engine and the motor car: “Before the construction of the first automobile, all the essential working parts had been invented by different people at different times, but they needed to be combined for the development of the motor car to begin. If you were a bond house in the past and had thought of taking your country and sector analysis and applying it to the equity markets, you would not have been able to do so until the growth of futures markets and ETFs throughout world markets.”

Currently, only 2.3% of the MSCI World Index is not investable via futures contracts, according to Orndorff. “A large amount of equity exposure can be added or taken away in seconds with stock index futures compared with hours or even days, depending on the market and position size, if the underlying shares are used,” he adds.

Transaction costs are also many times lower both in terms of commissions and also the bid/offer spreads of futures versus trading the equivalent index weighted basket of stocks.

Country selection is based on both fundamental macro-economic factors that any international bond manager could be expected to have mastered, as well as a variety of more equity-specific variables. Key fundamental factors include the level and trend of economic growth and corporate earnings growth within each country.

Other factors taken into account can include government policy, labour conditions, inflation and central bank policy. Investor sentiment towards a country is also important as this regulates the flow of funds to that market and provides insight as to how much support the equity market is likely to receive from new investor inflows.

Equity specific variables include the price/cashflow ratio which, due to different tax and accounting conventions between countries, Payden & Rygel feels is the most comparable indicator. Other variables are the earnings yield when compared to bond yields, which is obtained by looking at the earnings/stock price ratio compared to the yield on the 10-year bond in each market and the current relationship relative to its recent trend and historical range.

Given that technical analysis drives many investor cashflows, this is also borne in mind, while the composition of the index underlying the futures contract and the underlying MSCI benchmark also needs to be examined to see which companies and sectors dominate the indices. These can then be analysed in terms of the respective country and sector outlooks.

“We established an overweighting to the German market at the end of May 2005. Fundamental economic factors were the primary reason, as well as valuations, since Germany was slightly cheaper than other markets on a price/cashflow comparison, although this was offset by relative expensiveness on an earnings yield/bond comparison,” as Orndorff relates. “The German corporate sector has adjusted in recent years to the changing environment by sharply cutting back spending on capital and labour. As a result, Germany had high productivity growth in recent years and lower unit labour costs, thus positioning German companies for higher earnings growth. We continue to favour the German market where we are optimistic that a reformist agenda is now in place.”

 

ector allocations are driven by some of the same set of equity specific variables that are used in the country analysis. “For a traditional manager, good sector analysis is often outweighed by unforeseeable stock specific risks,” says Creswell. “If you take oil and energy the sector has clearly done well, but choosing Shell prior to the management’s mishandling of reserve estimates or BP ahead of the environmental and safety issues relating to their Prudhoe Bay pipeline or their Texas City refinery catastrophe, would have led to underperformance.”

Payden & Rygel’s approach in contrast, relies on using global sector specific ETFs to take sector views without having any specific stock bets. The initial country allocations for a portfolio result in a default set of sector overweights and underweights relative to the index, each of which then needs to be actively adjusted to reflect the manager’s analysis and viewpoint. The firm’s analysts undertake research looking at factors that characterise each sector such as margins, growth relative to CPI, current state of legislation and market position, which are then passed on to Orndorff’s equity team who can make the judgmental decisions on relative weightings.

For example, in 2004, Orndorff projected a price of $40 (€29.8) a barrel for oil in the coming year, which at the time was consider an extreme view. Based on the analysis, the decision was taken to overweight the energy sector through the purchase of a global energy ETF. The benefit of this was that the strategy had a pure exposure to increases in energy prices. Had the exposure been to selected individual companies it could easily have led to buying either Shell or BP, or indeed both, prior to the subsequent very specific adverse news events. “The $40 a barrel figure subsequently proved to be an underestimate and the overweight energy position was a significant driver of performance during that period,” says Creswell.

In portfolios with an open currency exposure, Payden & Rygel also actively manages positions with the objective of protecting asset values from depreciating currencies and enhancing returns when they see an opportunity for appreciation. As Creswell explains: “While there are many factors that influence currency direction, for each discrete pair of currencies there are a few that have greater explanatory power for their subsequent relative valuations. For example, our research has identified that the greatest explanatory variable between the US dollar and the euro and the deutschmark prior to the euro, is the yield spread between two-year government bonds.”

As both investors and fund managers attune themselves to the use of derivatives, the boundaries are blurring between the capabilities of a bond manager and those of an equity manager. Many bond managers do have the capability to emulate the Payden & Rygel approach, providing they can overcome potential internal business conflicts.

However, as Payden & Rygel has found, global equity strategies of this type are likely to find more favour in Europe and Asia than the US, where the emphasis is still very much on dividing the globe into US and ‘international’ non-US exposure.

But perhaps of more significance in terms of the growth of such approaches is that Payden & Rygel’s global equity strategy is somewhat reminiscent of a macro hedge fund in its reliance on derivative markets, although it does not have the leveraged exposures or leveraged fees typical of hedge funds.