Dealing with volatility

Finding global equity managers likely to thrive in the current market environment will be difficult. Joseph Mariathasan asks which approaches are likely to do most well

The near destruction of the equity value of US investment bank Bear Stearns in March illustrates the dangers in the post-credit crunch world facing global equity investors who adopt a capitalisation-weighted approach to investment. Financial stocks account for 25% of the MSCI World index, which itself is dominated by the US equity market.

Moreover, many of the best-performing global equity strategies of the past few years have benefited from taking 20% or higher weightings in emerging markets. “One of the most significant stories over the last few years is the rising level of wealth in the emerging markets,” says Christopher Orndorff, the managing principal responsible for Payden & Rygel’s global equity strategy. “So they will naturally consume more resources just as the UK and US did, and this is a long-term phenomenon.”

The weightings to the US, emerging markets and the financial sector are key drivers of global equity market performance, and finding global equity managers that are likely to thrive in the new environment may mean a willingness to move far away from the index.

Information overload

A systematic approach to tackling the problem of ‘information overload’ is a critical component of any global equity strategy. Quantitative fund managers, facing no constraints on analysis based on the size of the universe, see global equities as a prime area where they can gain a competitive advantage. Not surprisingly, a few long-only quantitative firms have established long track records and large funds under management. Their approaches are invariably predicated on avoiding sector and country bets which require something more than a purely quantitative analysis, which leads many to the enhanced indexation rather than the high alpha space.

More recently established quantitative fund management firms, of which there have been many in the last few years, have generally immediately gone down the more lucrative hedge fund route. However, the market volatility seen in last August had a disproportionate effect on these, and many made substantial losses as they deleveraged their positions to close out short positions that were losing money.

This raised concerns that their correlated behaviour implied that they were using very similar models and methodologies, which may not bode well for quantitative firms more generally in a future scenario of increased market volatility.

While the distinctions between quantitative fund managers and traditional managers are blurring, undertaking in-depth qualitative as well as quantitative fundamental research is something that no manager, no matter how large, can hope to do on the total global universe of listed stocks. Even those that do manage to cover a major portion are still left with the problem of how to extract alpha producing decisions from the mass of data and analysis that has been produced.

Successful managers are those able to maximise their strengths in what may be quite specific areas that can lead to weaknesses in others becoming totally irrelevant. For example, Nordea Investment Management has a long established thematic approach to global equities. Yet, as Leon Pedersen, its CIO explains: “Our approach came out of necessity. Prior to starting our approach in the early 1990s most of our investors were locally based and there were only a few global investors. But then a lot of our institutional clients went from domestic to international equities in a short time and we had to cover European and global equities with few resources. So we had to manage them in the most efficient manner.

“We did not have the resources to do typical country coverage, which was the natural thing to do then. We discovered that by transferring information across areas we were able to catch important factors earlier than local investors. Early on, we started to use the phrase ‘investment themes’ and ‘thematic research’ to describe the approach, which has followed us today.”

Payden & Rygel, by contrast, is primarily a bond manager yet has managed to produce a successful global equity product with an 11-year track record without any stock selection skills at all, using purely global country sector and currency views. At the other extreme are absolute return oriented strategies such as those of Bedlam Asset Management or Janus that have concentrated portfolios of as low as 25 stocks where risk is seen as the potential to lose money as against underperform an index that has no inherent relevance to an institutional pension fund.

The game here is not to analyse the complete universe or even to screen out subsets of stocks with quantitative screens, but to identify what are exceptional opportunities using methodologies that are reminiscent of the approaches taken by private equity firms in the unlisted marketplace.

“The credit crunch we are seeing will be the biggest thing in our lifetimes, the first global property and financial crash,” says managing director of Bedlam, Jonathan Compton (pictured left). Indexation and enhanced indexation are clearly standard options for any institutional investor. But whether or not Compton’s doom mongering proves to be an exaggeration, with future returns likely to be heavily dependent on taking the right bets on exposures to financial stocks and the US, having a default indexed or closet indexed approach may be naïve.

Many equity managers include some elements of top-down macro thinking. But not all agree. “Looking at macro themes is mostly waffle,” says Compton. “Basically what matters is where you are in the credit cycle.”

But top-down analysis can add value if done well, and an extreme example of this is Payden & Rygel’s approach to managing global equities, which involves no individual stock selection at all. Specialist bond managers can, and often do, also have high levels of expertise in macroeconomics and global industry sector trends. With expertise in using derivative markets this enables them to translate country and sector analyses into active management of equity portfolios. Payden & Rygel’s approach, Orndorff explains, “relies on using futures, ETFs and currency derivatives to translate views on countries, sectors and currencies into a portfolio that is benchmarked against the MSCI World index”.

Orndorff adds: “One of the responses we got from consultants and also from one or two sovereign wealth funds and more complex institutional investors is ‘because this is a top-down process, we have not developed resources or skills to evaluate you’.” Despite this, Orndorff continues: “Some consultants who are more sophisticated are caught up in the fact that the product is an excellent diversifier to a portfolio of bottom-up global managers or bottom-up regional managers. The correlation of alpha is low. Obviously correlation of returns is high. We have had a lot of success with fund of funds, multi-managers and those institutions with four or five managers for a sector.”

Payden & Rygel’s strategy illustrates that top-down analysis can be useful, but completely bottom-up stock selection approaches are very much more mainstream. The key differentiating factor between firms is often how well resourced they are and how cleverly and efficiently they can translate fundamental research into live portfolios.

“What we do is manufacture portfolios based on good bottom-up research,” says Lucy Macdonald (pictured right) CIO global equities at RCM. “This is based on research from a global team of 80 analysts. Stock selection provides 70% of the alpha. There is not a top-down asset allocation.”

RCM represents a good example of a conscious effort to utilise all the resources available to a very well resourced global organisation in trying to produce, as the firm’s motto proclaims, an information advantage.

“The research is 85% of what is behind a portfolio,” says Macdonald. “The analysts are career analysts and that is the key. A former analyst, Claude Rosenberg, founded RCM in 1970. The analysts are divided by global sectors. They produce ratings of between one and five of everything in their universe while broker research is used to just fill in the gaps and to challenge the views of the internal analysts.”

The value of the analysts’ own recommendations is analysed and monitored in a very disciplined manner using StarMine software designed to measure the value of research. According to Macdonald, using this package “has really transformed the quality of research and the interaction between researchers and fund managers and the analysts can get greater visibility”.

RCM has also gone a step further in the analysis of a company by setting up a division, Grassroots Research, that uses a global network of freelance journalists and researchers to look at consumer trends that have an impact on the prospects of companies of interest to RCM’s analysts and portfolio managers. “It is a key element that is integrated into our research,” says Macdonald. “Qualitatively it is a cost but we are investing more and doing more surveys [and] it is used throughout the organisation.”

About 40% of the stocks in the global portfolio have Grassroots backing. Not surprisingly, RCM finds it is more relevant to consumer-oriented areas such as consumer products, healthcare and technology.

“It can give great colour and depth,” says Macdonald. “For example, take the Disney resorts in the US. The view of analysts in their ivory towers is that it is a typical cyclical consumer business with operational gearing, so one should be cautious as the economy goes into a downturn. But travel agents tell us through Grassroots Research that Disney gets lower cancellations than other resorts because the last thing people want to do is to disappoint their children. That insight into the quality of the business is something that analysts can’t easily get. The January figures were stronger than expected and we will do the survey every quarter for a stock like this during this environment to ensure the dynamics are up to date.”

Thematic approaches

Firms without the resources of an RCM, which is owned by Allianz Global Investors, can still be competitive through finding approaches that can cut down the universe to a manageable size. Like Nordea, Newton Investment Management espouses a thematic approach. “All processes have to screen the universe in some way,” says Newton’s director of global funds Iain Stewart (pictured left). “We were concerned that economic variables were not predictive and neither did we think that modelling the past was worthwhile. Somewhere in-between that, you can tease out the themes that describe how the world is changing. So it helps us to focus the research effort and be aware of the risks. These are the global ideas.”

For Pedersen, the thematic approach is driven by the fact that Nordea believes the market is inefficient at transferring information. “Buy and sell-side analysts are organised according to sectors,” Pedersen says. “The problem for them is that if there is new important information outside the telecoms industry that has an impact on the industry, it will be a long time for it to be recognised. For example, internet telephony took a long time to be recognised as having an impact.”

Both Nordea and Newton have located their complete teams in one place. “We have specialists but everyone sits pretty much in the same area,” says Stewart. “The process requires everyone to interact and thus all specialists get exposed to other asset classes and the ‘big picture’. We think that you can benefit both from the knowledge imbedded in the group and also from the synergies resulting from combining the full range of individual perspectives. Perspective is hugely important; arguably the fixed interest specialists who created complex CDOs had lost their perspective. We could not have a global thematic process if we had a devolved, geographically dispersed, approach.”

Nordea’s thematic process is very disciplined, starting with a seeding stage, followed by conviction building and finally execution. “In the seeding stage, we have an open mindset,” says Pedersen. “We have a long list of ideas and the hurdle rate is low. Anyone can come in with ideas. Our overall investment philosophy is that ideas need to be supported by long-term structural changes. These are demographics, globalisation and technology. If the structural changes drive the investment themes, then they will be longer lasting so we avoid fashion fads.”

The second stage of conviction building is project based. “Two or three people from various sectors - for example, Asian, consumer products and IT - could be responsible for looking at a theme and seeing companies, building models and so on,” says Pedersen. “We have a testing phase when the team reports and discusses with colleagues. We may have had a good feeling in the stomach but then we need a to get a good feeling in the head.”

The third stage of execution phase means identifying 10-15 companies that would benefit from the themes, which are then analysed more deeply using conventional discounted cashflow analysis.

While both Nordea and Newton have strategies that can include emerging markets, neither has been overweight emerging market stock directly. “Emerging market weightings have been anything from 0 to 10%,” says Pedersen. “We have never had situations where we had a massive contribution from taking an emerging market bet. The most contribution is from stock selection.”

However, they have constructed themes that are driven by the tremendous growth in wealth seen in emerging economies that now is clearly the driving force in global GDP growth. Nordea, for example, has an ‘emerging consumer’ investment theme which, Pedersen explains, “is driven by urbanisation process in each country. Below that there are ‘new urban consumer’ strategies in luxury goods, meaning basic goods such as toothpaste.”

Stewart explains that one of Newton’s 13 themes is that of ‘global realignment’. “The western world dominates GDP wealth consumption, stock market capitalisation and so on,” he says. “In the longer term, all that will change. This is partly a currency effect, so that developing world currencies are likely to be strong vis-à-vis the dollar, euro and sterling. Future levels of consumption will be different to even out the disparities. We are not so keen to buy exporters in the developing world because of their appreciating currencies. We prefer exposure to consumption and the financial sector in the developing world. In the developed world we have done the reverse, with very large underweight in consumer discretionary and credit related sectors.”

Focused portfolios

Even boutiques like Bedlam can manage global equity portfolios if they are not constrained by a global index. “The fund management business became perverted in 1992,” says Compton, describing the move towards closet index tracking. “There was an unholy alliance between fund managers and actuaries where the least important interests catered for were [those of] the clients.”

“Investment is about getting more back over time than you put in,” notes Jason Yee,  global equities portfolio manager at Janus (pictured right). “So over time you need to get absolute returns, and this is sometimes forgotten in our industry.”

Both Bedlam and Janus are running strategies that are focussed on absolute return objectives rather than index benchmarks. As Compton explains: “A benchmarked process means huge allocations to, say, the US and banks irrespective of value. The premise is to extrapolate that what was big in the past will be big in the future.

“We have never held a bank in the English-speaking world as their own finance directors would candidly admit they couldn’t produce meaningful two-year forecasts - our key parameter - thus they were not analysable. This conservative approach has a radical outcome; we could not buy banks even though they are a large part of all major indices. They had gross derivative exposures from their own prop desks alone more than 10x their equity. That meant at some stage they had to fall over, even before the far greater risk to a wide range of counterparties that they didn’t even know were solvent or otherwise.”

Running absolute return portfolios means that risk is not defined as tracking errors against a benchmark index, but as losing capital. “We are aware of the usual risk reports in terms of country and sectors but we are relatively unconstrained against the benchmark,” says Yee. “We would not allow the benchmark to define what the best risk rewards were. We are more interested in correlations and having sufficient diversification. For example, two names that we own, Berkshire Hathaway and a Japanese property-casualty insurer, are both in the insurance sector but have little correlation to each other, so saying that we have x% in financials is not useful in terms of the absolute risk of losing money. So for minimising tracking error these portfolios are not attractive. We have pragmatic risk controls so the largest position in the concentred fund would be 7-8% and 5% in the 70-stock fund.”

The focussed approach is reminiscent of private equity deals and while Yee does not see himself as having any input into company management, Compton is keener to have at least some input. “We will always be a focussed investor so as we grow we will have large stakes in some companies,” he says. “We are interested in fixing the parameters for management in terms of debt levels, incentives, alignment of interests and sticking to their knitting. However, we are wholly unqualified to interfere at all in the running of the actual business.

The future

The credit crunch has clearly been a turning point in the global equity markets and has occurred at a time when the long value bull run appears to have run out of steam. For many managers, this is a welcome relief. “Value has been in favour for a long time and it has been a difficult environment for any growth manager,” says Pedersen. “The thematic approach has a growth bias and now growth is coming back into favour. But can we find the right kind of growth?”

“The whole of the past three-to-four years have been a bull market,” says Yee. “Our strategies do better when there is lots of volatility and we try to position ourselves for turns in the market. We are extremely busy now and it has been the most target-rich environment for years. We have more ideas than cash.”

Managers willing to take large off-market positions will do well if they can find a rational approach to behaviour in markets that may become driven by panic. For Pedersen the fear is “that suddenly for whatever reason, the financial stocks start performing well again as I have very little exposure”. The problem for institutional investors is that sticking to the index does not necessarily reduce the risks.