Back to basics: is it time equity managers step back to move forward?

Since the financial crisis broke there have been plenty of calls for the financial industry to go back to basics. Most of the attention has been focused on the banking sector but now there are similar criticisms of the equity fund management industry.

“We have identified a number of good companies trading at good valuations, but these have always been trumped by macro-economic concerns.”

Patrick Rudden

Aymeric Poizot, managing director in Fitch’s fund and asset manager rating group, says: “The fund management industry needs to slough off the habits of the last few decades. Equity portfolio managers need to go back to the practices of fund managers from the 1970s.”

In the past, managers spent a considerable amount of time looking carefully at the companies behind the share price but in recent years an increase in the amount of data available has ballooned and there is an increasing trend towards focusing solely on the financial metrics.

Poizot says: “Rather than asking whether the company’s business model is strong, managers have focused more on whether the share price is cheap or not. This becomes a self-fulfilling prophecy because there is always a company with a cheaper share price that then sees its price becoming inflated, irrelevant of whether it deserves that higher valuation or not.

“Fund managers need to spend much more time defining their investment universe. Managers need to think about finding those companies with a sustainable business model that can grow. They need to start thinking like shareholders rather than quant specialists.”

Quants are king

At first glance there seems little reason to change this focus on financial metrics. After all, it is the funds that focus on fairly narrow financial measures that have performed well. The unpalatable truth is that it has been a torrid time for longer-term managers while shorter-term strategies have performed well. Deb Clarke, global head of Mercer’s equity boutique, says: “For the last three years active managers have struggled because the top-down view has had a big impact and caused the market to flip-flop.”

Patrick Rudden, head of blend strategy at AllianceBernstein, says: “It is a much more uncertain world today and investors have responded to that by shortening their investment time horizons.”

Meanwhile, Nick Hamilton, head of global equity at Invesco Perpetual, believes less money is managed today by genuinely active managers than in the past. “Investors are allocating to different types of equity exposure including quant, low volatility, hedged and passive,” he says. “Active management is only one of many equity styles of investing.”

The strategies that have performed well in recent years have been those that target tangible rewards such equity dividend income, low volatility and defensive companies.

“Investors are simply not willing to look too far into the future. They don’t want jam tomorrow, they want it today,” says Rudden. “Everyone used to tell me that they were a long-term investor. But the lessons we’ve learnt over the past few years shows us that there are no truly long-term investors left and they need investment strategies that will pay off over the short to medium term.”

But Poizot believes that these shorter-term, quant-style strategies have limited potential and the current environment demands that managers take a more strategic approach to investment. “Research shows that companies with higher returns on investment capital deliver higher total shareholder returns,” he says.

Mark Tinker, fund manager at Axa Framlington, concurs: “When an investor buys an equity, the manager is effectively allocating capital to a business. The best guarantee to ensure the investor makes money is to ensure that the company generates return from your capital. If an investor loses sight of that basic fact, then all they are doing is speculating that another investor is willing to pay more for a share of those earnings.”

Clarke says: “There is a growing recognition that the fund management industry needs to go back to taking a longer term perspective, with low stock turnover, ensuring that they work closely with companies to ensure the best possible returns.”

That change, however, has to come from all the stakeholders in the investment industry. “That includes consultants, clients, trustees and fund managers. Everyone needs to think about things in a slightly different way,” adds Clarke.