Investment Panel (July 2007) - Don’t lose your edge

CHAIRMAN
John Collins
Senior investment consultant
Watson Wyatt
Collins is a senior investment consultant in the investment manager research team, responsible for researching US equity, tactical asset allocation and currency managers. He is a chartered financial analyst.

Andrew Cole
Director, multi-asset group
Baring Asset Management
Cole is responsible for the management of global equity and multi-asset portfolios for clients located in both the UK and Europe.

Adrian Jarvis
Interim chief investment officer
Morley
Jarvis has overall responsibility for investment strategy, quantitative research and quant funds within Morley.

Angus Scrace
Head of global consultants & investment specialists
Threadneedle Investments
Scrace is responsible for building consultant relations across European markets and ensuring that Threadneedle’s main products are rated by key investment consulting firms.

George Walker
Global head of institutional business development
Standard Life
Investments
Walker is global head of institutional business development at Standard Life Investments. He joined SLI in 2001, after over 10 years at Friends Ivory & Sime, where he was UK investment director and head of North American business and client services.


COLLINS: Generally valuations have compressed across most asset classes, bringing relative valuations closer – how will you add value going forward?

COLE: The increasing numbers of investors using leverage to finance their investments, such as private equity firms, has resulted in greater linkages between fixed income and equity markets in recent years. Valuations across most asset classes have become increasingly correlated, and we believe this is leading to investor complacency over the benefit of asset allocation and the risks involved in investing in certain asset classes. Ultimately the return from equities over the long run is driven by earnings while inflation determines the course of fixed income returns, in our view.
In fact we expect a very different investment environment over the next ten years to what has happened in recent memory. We fundamentally believe that markets are returning to their long-term trend, where bonds and equities move, more often than not, in different directions.
Here at Barings we have a long and successful history in asset allocation. When other investment managers abandoned the discipline in the 1990s, we continued to invest in this area of our business. Fundamentally, we believe that asset allocation will once again be a key determinant of portfolio returns and this is where we intend to add value to our clients’ portfolios over the coming years.

JARVIS: Valuations have indeed compressed, with the recent sell-off in bonds moving yields back to attractive levels against equities for the first time in five years. However this should be seen as a healthy move, with risk premia now reasonable for both equities and government bonds rather than too high for one and too low for the other.
Going forward, active managers are going to have to work a little harder to add value, but opportunities remain. Property yields look low versus gilts, while the long end of the gilt market remains pricey versus the short end, as does the high yield credit market versus investment grade. International comparisons still show significant opportunities, e.g. the more attractive valuations available in European and Asian property, and the worse valuations on European versus UK credit.
Significantly, the last couple of months have seen volatility returning to markets that have been very well behaved for a few years. It is the lack of volatility that really stands out historically rather than the recent changes and we would expect more choppiness in markets to follow as investors grapple with changing economic conditions without the buffer of yields edging ever lower. This higher volatility environment will be a test of managers who are truly being active, balancing the risks and rewards for investment decisions rather than just loading up on credit, emerging equity and other risks and hoping the trends in markets continued.

SCRACE: It is true that valuations at an aggregate level have narrowed between markets over the past few years, but there are still differences and anomalies to be exploited. Moreover, at both the market and stock level there are investments that deserve different multiples, and focusing on the ones that can achieve a premium rating is how we seek to add value. For example, we have been consistently underweight US equities in recent times as the price-earnings (PE) premium enjoyed by the US has eroded. The US’s PE relative to the UK has gone from 1.5 in late 2002 to 1.1 today and we see no reason why it cannot trade at a discount to other markets in time, given that it no longer generates higher returns on equity.
At the stock level we are focused on long-term growth companies as we believe that these will be awarded premium ratings as aggregate earnings momentum slows. Making decisions like these is how we add value.

WALKER: It is the case that valuations have compressed across many assets. Examples would be the decline in PE dispersions between for example, mid cap and large cap stocks, or between developed and emerging equity markets. It is true that it is difficult to find many examples of cheap assets nowadays. However, it remains the case that a good fund management process can continue to find profitable opportunities.
Periodic bouts of market volatility mean that an investor with a longer term time horizon can pick up bargains. Standard Life Investments top down House View expects that global equities will generally rise in line with earnings into 2008, with potential upside from a significant re-rating of stock markets driven by such events as M&A. There should be benefits therefore, from an asset allocation that prefers riskier assets to cash.
From a bottom-up viewpoint, while sector dispersions are narrow, there are still many examples of individual stock picks which our ‘Focus on Change’ investment process can identify. As an investment manager who’s process is driven by stock selection across most asset classes, we firmly believe we will be able to add significant value for clients from the bottom up, even in a world where valuations are close across different asset classes.
In our recent publication Global Insight, June 2007, we highlighted how the top 10 UK stocks (accounting for 42pc of the market) were on a 2008 PE of 11x, some way below than of the next 90 FTSE100 and FTSE250 companies, which are on a PE closer to 16 times. This is an example of where relative value is still available to investors and where we believe “corporate self-help” or the threat of M&A will compel managers to do something to close this valuation gap.


COLLINS: With more managers and greater assets managed in the global markets strategies – how will you maintain your edge?

COLE: We are confident that we can maintain our edge through our asset allocation expertise and global research strength. We pride ourselves on having regional investment analysts researching the local markets in London, Hong Kong, Japan, and the US; feeding back the results of their analysis to our London-based portfolio construction group.
We have long held the view that asset allocation is a key driver of returns and maintained a “top-down” discipline to our global equity process. Whether it is through country or industry selection, we continue to believe and demonstrate that significant added value can come from asset allocation. Additionally, seeking added returns from both the “top-down” and “bottom-up” perspective should result in more efficient portfolios in our view.
Using an innovative method that calculates the relative influence of stock, sector and country specific factors for each individual stock, our clients’ portfolios are composed of holdings that integrate our views on sectors, countries and currencies at the stock level. Fundamentally, we employ a “growth at a reasonable price” philosophy that focuses on an all-cap universe along with sectors and countries with unrecognised growth and earnings surprise.

JARVIS: The trend towards global investing may well have played a part in compressing valuations. Global equity investors relying on convergence of cross-boarder stock valuations made the easy money in the early part of the decade whilst global bond markets have seen a more recent convergence. In time however the fundamental differences between drivers for different global securities will cause their performance to diverge again, and good long term managers should be adding value from this stock specific source of return.
Global asset allocation remains a rich source of anomalies however, as most capital remains invested within an asset class. Central banks actions and trade flows keep global currencies out of line with fair value, whilst interest rates will always reflect the current economic conditions of a single bloc rather than converging to a single global number.

SCRACE: We cannot know things before anyone else but we can understand them better and act on them more quickly. Employing highly talented people who understand the market and have the confidence to interpret information and take high conviction positions based on their conclusions is how we maintain our edge.

WALKER: There may be more competition amongst investment firms wishing to break into global funds, but the quality of their investment approach is key. Many fund managers rely on an overly rigid framework, which cannot accommodate major structural or even cyclical developments, Instead, our “focus on change” process at SLI has sufficient flexibility to add value over the course of an investment cycle. From a top down viewpoint, our analysis suggests that markets are moving out of a phase where earnings growth was key, into a phase where liquidity and sentiment will be the primary drivers, and also a phase of the investment cycle where asset class returns will become more volatile driven by growing economic and market imbalances. In these circumstances, we envisage that fund managers who invest in an ‘unconstrained’ approach will benefit most. We believe that we will maintain our edge through the bottom up application of our flexible approach in global equity portfolios.


COLLINS: Why are fees so high given there is typically a significant amount of capacity within these strategies?

COLE: Global market approaches usually encompass access to a wider range of specialist strategies than the more traditional, balanced institutional investment approach. The inclusion of alternatives such as fund of hedge funds and structured products can also add to costs, but equally, we believe these approaches offer investors the ability to diversify their investment returns properly.
Ultimately, investors need to judge the levels of fees in relation to the products and services provided, and decide whether the level of return after fees matches their expectations. As a manager of multi asset targeted solutions ourselves, our experience has been that clients do believe these advantages justify the slightly higher fee levels. This is demonstrated by the nine mandate wins totaling more than £220m pounds we have gained so far this year for portfolios in this area.

JARVIS: Whilst many factors other than capacity effect fees, the strong returns to many global strategies in the era of convergence may well have kept them higher than would have been the case. Its noticeable that global asset allocation and global currency strategies are already typically rewarded largely though performance related fees, so if the future rewards for global equity and bond strategies may well move to this model as the returns become more determined by individual manager skill rather than the trend towards convergence.

SCRACE: Managing global equity money properly is a resource intensive job. We are in the business of adding alpha and we believe that people are prepared to pay for products with a proven long-term track record of true alpha generation.

WALKER: Fees are typically determined by the marketplace, i.e. by what clients perceive is appropriate for the value added. It is certainly true to say that in the most part, complex strategies such as global absolute return or global equities may have higher fees than a bond fund or a single country equity fund such as UK equities. However, it is clear that in these cases often significantly more resource, input and skills from different parts of the firm is required to effectively implement these solutions and deliver the ouperformance that clients seek.