Value and growth come to Europe
A recent study that applied US style" investment criteria to the FTSE indices concludes that UK pension trustees may have been changing managers for the wrong reasons over the past 10 years.
The study which accompanied the launch by FTSE International and the investment consultants Frank Russell of new UK value and growth indices, give pension fund trustees and managers who do not incorporate style into their investment process considerable pause for thought.
A growth investor buys stocks that he believes will exceed the market's assessment of their future potential whereas a value investor generally buys stocks that are underpriced. The practice of dividing stocks and managers into these categories has long been accepted in the US. The new indices divide all individual stocks on the FTSE 100, 250 and 350 into style, growth or a proportion of the two. The shares are divided on the basis of their price to book ratio with high price to book representing value and low price to book representing growth.
Significantly Russell has plotted these indices back to 1986 and believes that this reveals a pattern of trustees changing managers, unaware that they may be doing so because of differences in the cycles of style and growth shares and as a result firing managers just when their performance is due to improve. Russell suggests that such seemingly inexplicable poor choices in the hiring of managers has recently led many trustees to adopt passive management.
The consultants acknowledge that there will be some opposition both to the methodology and to style investing itself. However, with independent research by another UK consultant John Morrell and Associates suggesting that half of UK managers have a consistent style, it could gain increasing acceptance.
The question remains to what extent developments in the UK will act as a halfway house on the journey to more widespread adoption in continental Europe.
Russell is not alone in the propagation of these ideas. Several USgroups already publish indices for world markets, while MSCI plans to launch a new set of indices for all significant developed and emerging markets in the autumn with the developed market data dating back to 1975.
The key to change in Europe, however, will be the single currency, according to Xavier Timmermans, senior portfolio manager with Generale Bank in Belgium. This will remove the salient difference between the US and Europe: market size. Timmermans highlights the current restrictions in many European markets, including Belgium, the Netherlands and even France, where certain stocks may dominate an index and where domestic holdings are at significant levels. However, he adds: "In Belgium, we have the tradition of being of being value oriented. Managers study equity mainly for the value aspects."
That said, because of the limited market, nearly every Belgian portfolio, according to Timmermans, has some domestic growth stocks, although there are as few as 10 on the market. For the future, he suggests that global managers, particularly the most aggressive, could adopt style characteristics and become growth managers, aided by the euro and the increasing number of IPOs across Europe.
But this does not mean that there are no pioneers at the moment. Deutscher Investment Trust (DIT) is the first German institution to offer style investing having launched a European value and a European growth fund this January. Senior fund manager Karl Heinz Thielmann is enthusiastic about the effect of EMU. He says: "EMU will not only bring macro-economic changes but also micro-economic ones: more competition, less possibility for ineffective companies, growth opportunities for growth companies and for restructuring. We reacted to this micro-economic change when we set up the new funds based on a pure stock selection approach."
Thielmann believes that the launch of these funds follows naturally from Germany's recently found enthusiasm for equity although, as yet, the majority of the investors are private clients. "On the institutional side, they are currently looking at the track record so I expect that in maybe one, two or three years, a lot more institutional money will come in."
The largest Dutch pension fund, ABP, also believes that style considerations follow other developments. Theo Jeurissen, managing director of strategic investment policies, explains that over the past five years the pension fund has undergone an extensive shift in asset allocation towards equity and foreign equity.
"As part of that development we have stressed the creation of core portfolios in major markets. Now we are the stage of going into details. In that respect we will put more emphasis on style as an investment consideration and also on style diversification," he says.
"On the basis of our own in-house research we may come to the conclusion that in a specific market a value style, for instance, will be structurally rewarded over time. We then look for managers who will provide such a style consistently. On the Japanese market, we have reached some key conclusions over what factors will be rewarded over time, so we have a style bias there."
Robbert Coomans, who manages all ABP's external equity managers adds: "Due to the approach of the EMU, you will see a tendency to put less emphasis on country weights and more emphasis on a sectoral approach. If you agree on that, then you can have a value or growth approach or maybe even a mixed one."
Larger pension funds appear to be the most willing to embrace change. Hans-Ruedi Mosberger of Frank Russell in Zurich says that only the larger Swiss pension funds have extensive knowledge of style investing, adding that he has worked with one of these funds to "implement an international equity investment, operating style diversification in a very systematic way."
In the UK, some managers have embraced the idea for a considerable time. GMO Woolley in London, a company with strong US links, has practised style investing for the last 10 years, but the company welcomes the Russell indices as an additional benchmark. Director Paul Bostock says that they invest as a value manager using their own index constructed on the same principles as those of Russell and MSCI. He adds: "Value investing is characterised as a style but it is actually a long-term approach."
However Bostock, echoing Timmermans, identifies the move from balanced management to specialist management as the most important trend, with style following on. "Style indices will become more important because specialist managers tend by their nature to have a more focused approach."
Rupert Carnegie, director of research and strategy at Henderson Investors in London, also welcomes the Russell initiative, while adding that, like Woolley, the company uses its own calculations.
"A lot of people treat style rotation as an act of God," he says, "but we think it has an element of predictability and this is incorporated into our investment process. We have a clear view on whether we expect growth or value to be more productive in a given country."
One restriction is that, in many markets, including the UK, managers have to hold certain stocks but he thinks that this will change with the euro. "Suddenly, rather than dealing with these small universes, it will be just like the US with 1,000 stocks to choose from, allowing a higher degree of selectivity. I suspect a move to the US pattern where people are much more emphatic about their style."
From those canvassed it is clear that there are few hard and fast predictions that can be made about style investing in Europe but there is some consensus that it will follow from other developments whether the move to specialist management, to a sector based approach, or from the pro-equity investment culture in general while EMU should prove the most significant spur of all.