Investment Panel (September 2007) - Search for value

The panel
CHAIRMAN: Peter Keutgens, senior investment consultant, Watson Wyatt
Keutgens is a member of Watson Wyatt’s manager research team where he is mainly responsible for enhancing quantitative investment management expertise in the investment practice. This includes the areas of portfolio analysis and the use of quantitative analysis in general in its investment manager research.

Andrew Cole, multi-asset group director, 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.

Nina Harris, institutional relationship manager, Morley Fund Management
Harris joined Morley in March 2006 as institutional relationship manager to promote the firm’s investment expertise to UK corporate pension schemes and their investment consultants. Prior to this, Harris held various marketing manager positions with ABN Amro Mellon and Beaumont Capital.

David Oliphant, fund manager, Threadneedle
Oliphant is a member of Threadneedle’s fixed interest asset allocation committee and is joint head of investment grade credit.

George Walker, global head of 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.


Keutgens: Given generally compressed valuation spreads across markets, how has this affected your ability to add value?

COLE: Given the compressed valuation spre ad across markets, it is our view the market is not charging a sufficient premium for superior growth. If one can correctly identify those markets, be they countries, sectors or indeed stocks, investors will be rewarded as those assets should ultimately trade at a premium to the balance of the market.
We employ our growth at a reasonable price (GARP) investment philosophy which focuses on an all-cap universe along with sectors and countries, and seeks to identify unrecognised growth and earnings surprise.

HARRIS: The spread compression and low volatility that have characterised bond markets in recent years have made it increasingly difficult to unearth sources of value and achieve consistent above-benchmark performance.
As active fund managers, we responded by increasing position sizes, trading more actively and exploring off-benchmark opportunities but the rewards for doing so in those markets were increasingly diminished. We view the more recent widening of spreads and pick-up in volatility as providing a better environment in which to add value consistently without taking on unnecessarily high levels of risk.

OLIPHANT: While generally compressed spreads had been the case for some time, volatility on the back of rising defaults in the US sub-prime market resulted in a dramatic widening of credit spreads at the end of June. In fact, this widening has created a lot of opportunities to enter or re-enter the market. Ignoring recent volatility within the bond market, credit spreads had tightened as a result of improving fundamentals and near insatiable demand from investors. In some cases this demand was driven purely by a search for yield.
As a result both good and poorer quality issuers rose in value, making it difficult for managers to differentiate themselves solely by an expertise in credit research. However, having such an expertise enables managers such as Threadneedle to identify and exploit opportunities within a single issuers capital structure, it provides us with the means to identify opportunities in non-traditional fixed income markets and the focus on downside risk that characterises credit research places us in a good position to identify short-selling opportunities. While tight spreads reduce a managers’ ability to add value in credit markets, they do not limit our ability to add value.

WALKER: It is the case that the valuations of most equity markets have become more similar during the de-rating and re-rating process of the past five years. Looking at a simple metric, such as price to earnings ratios, then we have a narrow band, with the US, Japan and some emerging market economies at the top and Europe, the UK and other emerging markets clustered at the lower end. This does suggest at this point in the investment cycle, valuations are not a strong driver for investors.
Nevertheless, I would emphasise that good fund managers can still find considerable scope to add value. A key question in our “focus on change” philosophy is: what is priced into the market? For example, it is understandable that most emerging economy stock markets have performed well, reflecting such factors as stronger domestic demand growth, improved corporate governance, better balance of payments positions and so forth. However, we do question whether too much good news has been priced in to certain emerging markets.
The final point is that valuation spreads between markets are still considerable. The view of the world priced into, say, US bonds, European credit, or Japanese equities is rather different. The turmoil of the past few weeks has seen distressed selling taking place across a range of stocks, especially financials. Long-term investors with a sophisticated investment process can identify when to add to portfolios.


Keutgens: How has investment strategy performed during the recent ‘quant’ de-leveraging and what, if anything, have recent market movement’s show about your process?
COLE: Since the beginning of this year we have been concerned with the excessive use of leverage in the financial system, whether it is by the private equity industry, hedge funds, investment banks or just the level of consumer indebtedness. As a result, we have been cautiously positioned, particularly in our multi-asset portfolios, having sizable cash positions as a hedge against the expected rise in equity market volatility and rising credit spreads.
Our blend of return-seeking and risk-reducing assets employed in our multi-asset portfolios has meant that downside risk has been mitigated. Indeed our position of holding cash as the diversifying asset has proved particularly helpful. A number of previously marketed diversifying asset classes and structures have proved to be not quite as risk-reducing as had been hoped for, particularly over such short periods of increased volatility.
Global equity markets have weakened over the last few months because of the specific concerns surrounding US mortgage-backed debt and its impact on the wider availability of credit to fund economic growth. In this environment, the FTSE All-Share Index declined by almost 12pc on a total return basis before recovering as August progressed; our multi-asset Extended Risk Fund declined by just 5pc over the same period. Our asset allocation strategy has played an important role in reducing portfolio risk. This has allowed us to maintain positions in what have been some of the higher return and riskier markets, such as those in the Far East.

HARRIS: We questioned the fundamentals of the financials sector over the potential peak in earnings and overconfidence in the prolonged nature of the lending cycle. While an obvious area for concern, we do not think many could have predicted the level of correction witnessed.
The apparent failure of some quant-driven funds presented long-term investors with opportunities to take advantage and build upon positions at discounted prices where the long-term fundamentals are supportive. This type of environment should re-focus investor’s minds on the merits of identifying companies that demonstrate long-term investment conviction and not to react to very short-term events.
While we are always mindful of the risks in any given market environment, our investment process remains robust and is driven by fundamental, bottom-up consideration with typically longer-term views. Quant-driven funds have received a lot of popularity and attention lately and while they are a valid option, they do highlight that no amount of investment modelling can provide 100pc of the answers.

OLIPHANT: Our investment approach relies very heavily on bottom-up fundamental company analysis and has not been impacted by the recent ‘quant’ deleveraging. As such, we are very happy with the performance of our bond funds. As mentioned, credit spreads had been low for an extended period of time and importantly so had volatility.
The models employed by many quant strategies assumed volatility would remain low indefinitely and commonly employed leverage to bolster performance. As such, they suffered significantly as a result of the recent increase in volatility and widening of credit spreads. Our investment decisions are based upon issues of fundamental credit quality and fundamentals are unaffected by volatility.

WALKER: Our “Focus on Change” process identified problems in the credit markets as a major issue back in 2006. This meant we had taken a variety of steps to protect our portfolios before the storm burst in August. For example, our exposure to credit derivative instruments linked to the US sub-prime mortgage market is minimal. Our corporate bond funds had been orientated towards higher quality credits, while our fund managers had limited the holdings of US house builders or mortgage related financial stocks in our equity funds.
We continue to expect positive earnings surprises from a range of sectors, such as raw materials. Of course, our funds have been affected by the weightings in mainstream equity markets and the holdings of banks.


Keutgens:How may the rise of fundamental indexing products affect your marketing position over time?

COLE: Fundamental indexing is one of a number of “quantitative” approaches to managing portfolios. This approach, in its own right, consists of a range of strategies which either encompasses one or two company earnings measures to up to 24 different combined calculations.
Our GARP philosophy examines many of these fundamental variables. However, our approach seeks to address whether the fundamentals of a company are reflected in the price of that company, and whether the company is over or under-valued as a result. Therefore, we believe our approach is both different and more flexible than fundamental indexing products.

HARRIS: We believe there is a place for indexation within the pensions fund market. We fully recognise the current trend for schemes to implement their beta exposures cheaply – even more so when you consider they can generate additional income through entering into schemes like stock-lending for example.
However, we also believe that demand remains for products that can offer sustainable and consistent sources of alpha. The trend to separate alpha from beta is likely to stay with us but active management still has a lot to offer pension schemes in helping to reduce scheme benefits as well as contribute to capital preservation.

OLIPHANT: The rise of fundamental indexing products is more likely to affect equity managers than fixed income managers.
However, given fundamental indices assign weight or importance based on financial characteristics rather than market capitalisation, we believe bottom up managers such as Threadneedle are in a good position to identify mis-pricing within such indices.
We certainly feel that from a marketing perspective the evolution of such indices will play to the strengths of investment houses with good research capabilities.

WALKER: At various points in the investment cycle, indexed products are more attractive, for example in the middle stages of a bull market where investor confidence is recovering strongly. However, at other points in the cycle, more active fund management does come to the fore.
One example would be the trough, when risk aversion and distress have led to significant bargains at a stock, sector or market level.
At the other end of the investment cycle, as volatility picks up, then cash positions in a portfolio become more important, to provide balance, and also to enable a fund manager to take advantage of specific opportunities as they appear.