Switching styles

If large cap growth continues to outperform small cap and value, how will institutions find the right growth managers? Joseph Mariathasan reports

The last five years or so have seen similar trends in European equities to those prevailing in the US, with value and small cap stocks greatly outperforming large cap and growth. The dilemma for institutional investors is that whatever the outcome of the volatility seen at the beginning of 2008, it is clear that the dominance of small cap and value is very unlikely to continue over the next few years.

The question that needs to be asked is whether the current manager line-up, whatever the historic success may been, is appropriate for a very different environment in the years ahead.

The problem that institutional schemes face, according to Oscar Vermeulen, a director of multi-manager Altis Investment Management, is that large asset managers have almost single-mindedly focused on selling value and small cap managers for alpha in the past few years. “Now that the style climate has shifted it is obvious they have failed to build broad, style-diverse product lines,” he says.

Finding good growth managers in Europe has proved to be virtually impossible for Altis. “As opposed to the US, the European asset management industry does not have many good growth managers who have survived after all those years in which value and small cap dominated in performance,” says Vermeulen. “We have just completed a scan of the universe of European managers and found very few that can boast a true large cap growth alpha. Those that we did find all reside in boutique firms where they could survive the value epoch.

“At the same time, we notice that a lot of the large asset management companies are scrambling to set up growth products. There have been a few cases where bigger asset managers have attempted to poach boutique growth managers, but they seem hesitant to go.”

Vermeulen adds that value managers moving into growth have been noticeably unsuccessful so far, and says the reason is quite apparent: “Value-orientated stock picking in growth segments does not work. Buying a cheap tech stock does not capture the style rotation that is unfolding. Thus, it requires manager changes to gain exposure to growth.”

Altis reacted to the scarcity of true European growth managers by changing its categorisation of Europe. “We now have value, ‘opportunity’ and small cap [with] growth redefined to opportunity - managers that diversify versus the established value/small cap success stories of 2003-07,” says Vermeulen. “They are all high-alpha strategies with a blend or growth biased management style with a focus on the MSCI Europe universe.”

While Altis would claim to have an objective assessment of managers’ style preferences through analysis of the factors giving rise to their return profiles, many managers would disagree with its conclusions when they relate to their own view of their style biases. Indeed, some managers would disregard style in a conscious manner, adopting a very different philosophy to stock selection.

Charlotte Winther, head of equities at Nordea, says the firm tries to find themes or trends that are global, finding growth for the longer term. It sees itself as having a growth bias. This is a view that Altis would not necessarily share.

Nordea’s approach is more difficult to classify in strict style terms, and a manager’s perceptions of its own style can differ significantly from analysis of historical performance relative to style indices. That also reflects the limitations of adopting too doctrinaire an approach to the use of style measurement.

Many managers in Europe are far more reluctant to be constrained into style boxes than in the US, leading to an excess of managers claiming to be ‘GARP’ - growth at a reasonable price - rather than admitting to just an opportunistic approach and taking advantage of market conditions.

Of course, one way out of the dilemma of seeking suitable managers is to adopt an enhanced indexation approach.

The last few years have also seen an explosion in the numbers of quant firms in the marketplace, most having recently started as hedge funds rather than long only, and usually having no style or size preferences.

The events of July and August 2007 did raise serious concerns over how similar many of their approach-es are, and the enforced de-leveraging of quant market-neutral funds caused by the increased market volatility then resulted in short squeezes of many stocks that the quant funds found they were often simultaneously trying to buy back. While the market rebounded, many of the quant funds that had de-leveraged ended up never recouping the massive losses they had incurred.

The lesson to be gained from that experience is that it is important to be able to separate the men from the boys when it comes to quant firms. Nico Marais (pictured below) , head of active equities, BGI Europe, argues that its approach “is scientific, utilising forward looking analysis” rather than a quantitative purely historic analysis, and the market will increasingly distinguish “those managers with just an Excel spreadsheet and those with a scientific process”.

 

Defining Europe

One of the great contrasts between European and US mandates is that while it is clear what a broad US equities mandate represents, there is still a lot of confusion about what actually constitutes Europe. Marais finds that “pan-European” mandates “traditionally meant developed Europe, but there has been increasingly a move towards ‘greater Europe’, which includes emerging markets in Europe”.

But Vermeulen demurs. “Putting emerging Europe into a mainstream European equity mandate has often been a matter of selling emerging market beta for alpha. Only very few European managers have the ability to deliver real stock-picking alpha from both mainstream Europe and eastern Europe. The two are too different. So we prefer eastern Europe in the hands of a specialist or in an emerging markets mandate.”

But Vermeulen concedes that his arguments “will be wearing thin as central Europe gets integrated more and more”.

“The question does arise as to what is truly ‘emerging’ now we see that some eastern European countries are directly linked to the rest of Europe and their prospects are more aligned to Europe as a whole,” says Marais.

For Jonathan Cunningham, the head of international sales and business development at Baring Asset Management, “Emerging Europe is less correlated to the US now, closer to developed Europe and has more internal correlations. Russia, for example, is being driven by domestic consumer demand.”

What should investors be asking of their fund managers? Marais argues for a quant firm like BGI: “From a scientific viewpoint, we prefer the strategy with the greatest breadth. The demand we see is for including eastern Europe, which is very attractive from our perspective given the data sets, resources we have and so on that give us a huge advantage.”

But Altis’ view has validity for traditional managers. Barings, according to Cunningham, “has a separate eastern European strategy, which has found strong support from large European pension schemes”, while specialist emerging market firms, such as East Capital, have established strong reputations in the newly emerging markets of eastern Europe based on their exclusive focus on the region.

Many eastern European countries are very much frontier emerging markets, with both the potential for high gains and low correlations with the rest of Europe. But they are also characterised by illiquidity and issues of corporate governance and the protection of minority shareholders rights that local managers may sometimes be better placed to tackle than global firms.

 

Manager approaches

The complexity of the European marketplace and the sheer number of stocks, lends itself to a very divergent set of approaches. Marais sees the market trends as being “first, a shift from country-specific to pan-European, second a trend from long only to 130/30 and third, a trend to market-neutral hedge funds”.

Some firms try to ensure they can keep up with these trends by having many approaches under the same roof. Threadneedle, for example, has an “eclectic mix of fund managers” according to Francis Ellison, European equities specialist. It has a number of different European portfolios across the risk spectrum encompassing a core strategy, small cap, high alpha and hedge funds.

Barings has tried to differentiate itself in Europe by having a dedicated eastern European strategy together with a high alpha, 50-stock equally-weighted mainstream European portfolio, which reflects the demand for high alpha concentrated portfolios, according to Cunningham.

Richard Wiseman (pictured left), head of European equities at Insight Asset Management, sees “most interest for absolute return strategies from institutional schemes and funds of funds”.

Insight’s market-neutral hedge fund is unusual in not being a quant product, yet it claims to be genuinely market neutral, with a relatively low return target of cash plus 4%, and is an institutional product rather than an index plus 30% hedge fund, according to Wiseman. “The absolute return fund was created as an alpha kicker for an LDI product and the European product attracted interest in its own right,” he says.

More generally, there appears to be “demand for more focused products with higher tracking errors,” says Winther.

Threadneedle’s high alpha fund has just 30 stocks, according to Ellison. Such strategies, as Barings finds with its 50-stock portfolio, may be less correlated with the market as a whole and are often viewed as satellites to core indexed or enhanced indexed portfolios.

 

Valuation and the economy

Clearly, the turmoil at the beginning of the year does not bode well and the risk remains of a full-blown US recession that would have a very dramatic effect on global markets.

“Markets are pricing a recession and a close to 30% fall in earnings, which is around the average experienced in past recessions,” says Xavier Lagrandie, a European equity manager at Lombard Odier Darier Hentsch.

“Although markets are oversold, the risks related to a global economic slowdown remain. Rate cuts are the first step towards a more stable environment but there is a need for government intervention in the US to offer support for financial guarantee insurance companies.”

The last few months have also seen small cap stocks underperforming. “Small caps are actually trading again at a discount to large caps after reaching a premium above 30% in June 2007,” says Lagrandie.

“For some time we have not recommended that investors go into small cap because the valuations were stretched,” says Ellison. “But now that falls have occurred, better opportunities are available. We are now recommending small caps but there will be variations between sectors and companies.”

However, Lagrandie argues that “mid cap growth companies are faring better after five years of relative underperformance and should continue to do so in a more difficult environment”.

Despite the stock market setbacks in January, Lagrandie finds that “most of the companies we have met in the recent past remain fairly confident for 2008, which seems to be justified by good order books and the financial strength of their clients - cash levels are high. Some companies have raised concerns for 2009 only on the back of a loss in confidence following the current financial crisis.”

Lagrandie adds: “There are many implications of the current sell-offs. As always cash is king and good companies will remain good companies. Those in need of financing might face difficulties in the coming two years whereas cash-rich enterprises will have many opportunities to acquire. Investors should focus on those companies that do not need to rely on credit markets or on those funds that do not go out of their briefs and offer ample trading liquidity.”

The environment over the next few years is likely to be radically different from that of the last five, which favoured small cap and value stocks. While the turmoil of January may give rise to an overreaction in equity markets and a flight to perceived safer asset classes, Lagrandie notes that “in the end, the future belongs to the brave.

In January Warren Buffet took a 3% stake in Swiss Re, a first sign perhaps that there is value out there and that the main risk for investors would be to remain too cautious.”

If Vermeulen’s view that “the currently emerging market climate - pro-growth, anti-small cap value - will persist for some time” is to be believed, this should lead to a radical reappraisal by many schemes of their manager line-ups.

For conservative institutional investors this creates a dilemma. “They need to diversify their portfolios away from whatever did well in recent years, as the underperformance of quite a few popular low-tracking-error value managers fell through the floor,” says Vermeulen. “But to do so, they need the skills of people in smaller boutiques - not all institutional clients of ours are comfortable with that.”

The challenge for the larger fund managers is whether they can revamp their staff fast enough to meet the current and likely future demand from pension schemes for more growth managers.