The bigger picture

As pension schemes become more comfortable with the global approach to investing and the broader opportunities it offers, the choice of global equity investment strategies has increased. This was illustrated by Mercer research revealing nearly $29bn (£14.2bn) in global equity mandates were awarded in 2006, up from $16bn (£7.8bn) in 2005.

While the take-up differs across geographies and between institutions, the benefits are becoming progressively more received. Fund managers need to offer more than just equities to get them noticed and skilled managers are more likely to catch the eye of trustees. With all this on offer, how do trustees make the right decision for their scheme?

More choice
Hymans Robertson investment analyst William Marshall believes that having more choice in the global equity sphere is definitely a positive thing, despite the fact that it can increase confusion for trustees.

He explains: “There are an ever increasing number of investment managers entering the UK pension market, many of whom offer a range of global equity strategies. This increased choice can potentially cause trustees confusion when selecting a manager or even selecting a product within a manager. However, we believe having this larger opportunity set should be viewed as a positive.”

Mercer principal Debbie Clarke also thinks there is a greater choice and the extension into global mandates is a natural consequence of this.

She says: “Skilled managers are able to scour the world for interesting ideas and can go more broadly to find those that give the best value. The managers need to be able to find ways to either leverage-off their existing regional strategies or perhaps bring in specialist managers to address the world on that global basis. I think that is where we have seen some people migrate towards more global thinking.”

Clarke continues: “You probably have to look at a company’s global competitors to assess it anyway, so it is a natural extension for some people to broaden that out into global mandates.”

However, KPMG investment adviser Peter Gibson disagrees. Rather than there being an unprecedented choice of global equity strategies, he thinks that global equities funds fall into two broad categories.

Gibson explains: “Currently we would say global equities funds falls into two broad categories: traditional fund of funds and directly invested global equities.

“In general, there are currently no strong style biases for managers directly investing globally and regional style differences make up the only real distinguishing manager features.”

Lane Clark & Peacock partner and head of manager research Mark Nicoll thinks the choice of global equity strategies has exploded because of the impetus put on managers to perform well and meet continually-changing benchmarks.

He says: “Managers have to offer something different in terms of equities. In the past they have just had a single offering for global equities, but they now have to offer the ability to merge against different benchmarks and offer different outperformance objectives.

“There is also the unconstrained approach – where managers effectively invest without reference to indices and put all their best ideas into very concentrated portfolios – on top of the traditional approaches they are offering, so there are probably new entrants to the market, but existing managers are also offering variations to their existing products.”

When it comes to managing a global mandate, trustees should adapt a rigorous screening process.

Marshall explains: “Trustees should clearly define their key selection criteria, return goals and risk tolerance and carry out sufficient research to ensure that the manager has the appropriate credentials to achieve long-term success.”

Clarke adds: “It is important for trustees to understand the approach of managers and question whether they have operated in the global space for some time, if they can think more laterally across countries or if they are just bolting together a series of regional portfolios.”

Gissings Consultancy Services head of investment Alex Weiland also considers the importance of structure, when trustees make management decisions.

He says: “The starting point must be the investment objectives that the trustees have set for their scheme. The nature of the objectives and how specific they are in terms of the desired return and the risks that are considered acceptable will be the drivers of strategy and manager structure.

Weiland sets out the key decisions for trustees regarding strategy and structure:
• The proportion of equities to be allocated to overseas markets.
• Whether to allocate to individual regions.
• Whether to consider global equity mandates.
• Whether a particular style is sought.
• Whether to consider unconstrained mandates.
• How they view the separation of alpha and beta.

Weiland continues: “In summary, the trustees’ decisions about objectives, strategy and structure should determine the type or types of strategies that are appropriate for them. With the right kind of advice from their consultant, the task of selecting managers should not be unduly onerous.”

Quantitative vs qualitative
Both quantitative and qualitative approaches are used in today’s global investment universe and can offer different advantages. One of the main pros of the quantitative approach is the fact it takes emotion out of the stock selection process, as Weiland pinpoints.

He says: “The main pro of the quant process is that by taking emotion out of the stock selection process you hope to avoid decisions that are taken for the wrong reasons.”

Marshall reinforces the merits of this non-emotional element: “Quantitative approaches enable a manager to have a repeatable process that is not impacted by human behavioural weaknesses, such as falling in love with certain stocks and reacting to market rumour.”

This, however, does expose a weakness in quant, because quantitative relies heavily on historical market behaviour and can struggle when faced with erratic market conditions – as testified in recent months by the credit crunch.

Weiland elaborates: “If the modelling is based purely on statistical relationships, it is difficult to have confidence in the model’s ability to cope with the unexpected. The fallout from the US sub-prime market experienced in August is a case in point. A number of quant funds suffered badly because the models did not understand how markets were behaving, or could not predict market behaviour in unusual circumstances.”

Marshall adds: “The negatives often associated with quantitative approaches include the large reliance on history repeating itself and its reliance on accurate input of data, which may not always be possible, particularly in less developed markets.”

With the qualitative approach on the other hand, Gibson believes it is easier to decipher where returns have come from. Also, it is a good learning aid for trustees to understand the behaviour of equity markets, and there is greater opportunity to add value to the scheme because managers can invest more freely.

On the negative side, managers can suffer from greed and a fund can lose out if a star manager attracts vast sums of money and dilutes performance as a result.

Furthermore, there is the risk of the fund manager leaving – this is a key risk as often they will take their contacts and intellectual property elsewhere.

Marshall says: “Qualitative approaches enable investment managers with the relevant skills to either identify successful companies before the rest of the market has identified them or forecast the true value of a company more accurately than it is currently being priced in the market.

“Such approaches rely heavily on high-quality research and investment talent; both are fickle and need to be monitored over time to check for repeatability. The investment management fees associated with these approaches also tend to be higher than quantitative approaches due to the cost of this research.”

Combining quantitative and qualitative has become an increasingly common strategy for platforms and, as Nicoll believes, this crossover is evident in vehicles such as 130/30 funds.

Nicoll explains: “I think all fundamental qualitative approaches have a quantitative element. It can be almost entirely quantitative where it is a model and the manager looks for other signals to build into the model but effectively constructs portfolios that way and the fundamental approaches are steps back from that.

“So, even the most vague fundamental approach is not just a gut feeling, there is a quantitative element to a degree.
“The thing that particularly brings the two together is the 130/30 idea where there is the discipline that is necessary to run shorting positions that require some sort of quantitative element for them to be successful.”

Interestingly, Clarke has heard about what she terms “quantamental” strategies, but has not yet seen the two combined.

She says: “We have heard managers talking about this but haven’t seen people genuinely doing it yet. I see them as different skill sets, because quant managers have a certain way of thinking – quite systematic and trying to take some of the emotion out of the process – whereas qualitative managers are judgemental and think more laterally about putting pieces of the jigsaw together.

“Combining them could be an interesting experiment and I do know people have talked about it.”

Style-based investing
Marshall believes successful style-based managers tend to have clearly defined investment philosophies and processes.
He says: “They look for stocks that have specific attributes, whether it is a value manager looking for stocks that look cheap relative to their intrinsic value or a growth manager that is looking for stocks whose earnings are growing faster than the market expectations.

“By specialising on specific styles, managers’ research and portfolio management teams tend to have a clear and in-depth understanding of the criteria they are looking for, when researching and selecting stocks. This focus and clarity can help improve conviction in stock portfolios and avoid inefficient use of risk budgets.

Is style-based investing something trustees should be looking to add to global portfolios?

Marshall continues: “Trustees should consider introducing managers with clear investment styles and high conviction.

However, it is possible for certain investment styles to underperform the market as a whole for prolonged periods. In order to achieve an element of diversification, we typically encourage trustees to combine managers with different investment styles.”

Weiland believes it is definitely in the interests of the portfolio for trustees to embrace style-based investing.

He says: “If you are a long-term investor and believe that a particular style – for example, value – has achieved superior returns over time and is likely to continue to do so, you may choose to adopt this style and accept that there will be some periods when it is out of favour.

“Alternatively, you may take the view that different styles do better at different stages of the economic cycle and aim to move between styles accordingly – a process known as ‘style-rotation’. A third approach is to take the view that it is difficult to predict when different styles will be in favour and that it is better to combine different styles and to select managers who have demonstrated skill in each style – for example, combining a good value manager and a good growth manager.”

It is commonly held that the application of style-based investing is less developed in global investing than it is in regional investing. But is this true?

Gibson thinks it is: “Directly invested global equity funds are a relatively new concept to UK trustees. We believe it will take time for trustees to become comfortable with this type of product. Once this happens trustees could begin asking for more diversification from their global equity portfolio, which could lead to the introduction of more pronounced style-bias managers.

“Outside of the US, perhaps, that is the case; the US is the market where we have seen the biggest drivers of style-based investing and perhaps we have been surprised that we haven’t seen greater emergence of that outside the US, but there hasn’t been a demand for it.”

Thematic investing
Thematic investing involves positioning the portfolio to benefit from emerging trends, ethical or sustainable investing and activist investing – necessitating direct involvement by shareholders to influence company strategy and direction.

Weiland believes thematic investing can be of benefit for two reasons. He says: “Either it can demonstrate superior returns in its own right or it provides a useful degree of diversification from other styles. Thematic investing has the potential to score well on both counts. Track record is as important for this as for any style.

“But what is arguably more important with any style is the distinction between the perceived merits of the style itself and the manner in which it is implemented by the manager. This may be of particular concern with thematic investing if the themes themselves are likely to change over time. This style then becomes more akin to a rotational style, and its success depends on the manager’s ability to predict which themes are going to be rewarded.”

Marshall adds: “Thematic managers tend to identify global themes they believe will drive certain stocks and sectors in the markets – either in a good or bad way. A range of themes can help identify particular types of company that might be expected to under or outperform markets. The manager can then decide which of these companies are the most attractive.

“Typically this has the advantage of having a greater consideration for top-down influences on stocks – such as oil prices or climate change – as well as more typical bottom up stock specific considerations. This can be good for identifying market trends. It can also be useful in communicating why certain stocks appear in portfolios. However, in our view, this is just another style or approach to picking stocks that can outperform. We are just as likely to like a good thematic manager as a good value manager or any other style.”

Gibson adds: “Thematic investing takes away some of the emphasis on stock selection. A manager good at spotting themes early can follow these and, if right, can deliver strong performance. It follows the old adage: get the allocation correct and you are most of the way there.”