Financial markets have anticipated the euro. This is most clearly shown by the convergence of interest rates during the past two years and the almost fixed exchange rates of most European currencies around the Deutschmark.

For European fixed income investors the consequences of the changes seem obvious. Life is more complicated for European equity investors.

Country allocation within Europe as a meaningful instrument for selecting investment opportunities and/or portfolio diversification is gradually losing its effectiveness. The main reason for this is the rising correlation between European stockmarkets, which can be seen in the figure.

In a more integrated Europe and given the fact that most leading companies have substantial cross-border European activities one would expect sector-allocation to be the logical alternative in managing European equity portfolios. Unfortunately this is not the case, at least not for now. Different research studies report the growing importance of the sector in determining stock returns but this is still outpaced by the country-allocation factor.

Considering that traditional country allocation is losing its effectiveness, sector allocation is not yet a useful alternative and that in a more integrated Europe only the strongest companies will survive, Robeco has opted for a pan-European bottom-up stock selection strategy.

To comply with this approach the traditional European equity team of specialised country managers was reorganised in such a way that each country specialist is also a member of one of the pan-European sector teams.

From the pan-European stock universe, the sector teams identify core stocks" within their sector. The criteria for assessing the attractiveness of "core stocks " include the following:

q growth prospects of the sector in which the company operates

q the competitive strength of the company within the sector

q cost-efficiency, judged on

productivity and cost rationalisation

q expected earnings growth.

Core stocks are selected with a longer time horizon in mind. Those investments mostly comprise larger capitalisation stocks of leading companies with strong track records. With the core part of the portfolio the long-term winnners are captured. This part of the portfolio will have relatively low turnover, while at the same time diversifying risk with respect to the benchmark.

Beside the core holdings, part of the pan-European portfolio is made up of so-called "tilt" stocks. These investments are made with a shorter time horizon and are selected on the basis of a proprietary multi-factor model. Using this model European stocks are ranked on the basis of value, momentum and earnings growth. The sector teams will select "tilt" stocks for their sector from the highest ranking names. The tilt stocks constitute the less stable part of the portfolio, the sole aim with "tilt" stocks is outperformance of the relevant benchmark.

In a typical pan-European equity portfolio with average risk (tracking error of 3.5), the weighting of core versus tilt stocks will be about 70%/ 30%.

From the initial selection of stocks (core and tilt together) constituting the raw portfolio, implicit country and sector bets result. These bets are reviewed for consistency with the top-down view of the investment policy committee.

Izaak Maartense is with Robeco in Rotterdam"

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