Macro-economic obsession
One of the most important changes is obsession among all types of investors with the macro-economic environment. This concern is hardly surprising given the low economic output of the developed world and the European sovereign debt crisis. In addition to the depressed growth of Western economies, the world is becoming a much more competitive place, as globalisation marches onwards and technology lowers barriers to entry.
Poizot says: “In a low-growth, competitive environment it is even more important for investors to assess the robustness of a company’s business model. That cannot be achieved by simply looking at financial metrics; it requires detailed strategic analysis and a thorough understanding of the company’s operations and products.”
Investors’ obsession with all things macroeconomic poses another very difficult challenge for stock pickers. Conventional equity investment wisdom says that the economic environment is almost irrelevant: no matter whether economic conditions are good or bad, some companies will succeed while others fail. The manager’s skill is about choosing the companies that will succeed.
But overarching concerns about the macroeconomic environment make it difficult for stock pickers to see returns on this strategy. Many fundamental managers will point out, for example, that Spanish equities deep discount to German equities is ill-deserved when the fundamentals of the companies are taken into consideration. But this analysis is falling on deaf ears. Investors do not care if Spanish equities are trading at historically low levels: concerns about the outlook for the eurozone trump everything else.
Rudden says: “For a company like us whose calling card has been the bottom-up stock picking approach this is a very real challenge. In recent years, we have identified a number of good companies trading at good valuations, but these have always been trumped by macro-economic concerns.
“I don’t think that we should fundamentally change our investment strategy. We have to stick to our belief that over the long term the market is weighing, not a voting, machine. But one of our biggest problems is that investors always focus on what has worked in the past.”
Hamilton says: “The right culture is critical to performing well as an active manager. Volatility and extreme market conditions have meant many European value strategies have underperformed.”
If a manager is put under pressure to change their style or portfolio radically in the middle of period of underperformance that just means the losses are permanently crystallised. If a manager feels they can never underperform the market without the threat of losing their job, then the risk is that fund management house will never make higher than market returns over the long term.
But Poizot thinks that in this macro-driven world, fund managers should incorporate thematic, sector and country views so that they can identify new opportunities and avoid value traps: when a deeply discounted stock stays permanently discounted because the company is no longer competitive.
But others do not believe that managers should change their investment style. Clarke says: “Fund managers need to be clear about the anomalies they are exploiting in markets and the investment consultant and client needs to ensure that the scheme’s portfolio is invested in a diverse range of investment strategies to minimise correlation.”
As well as incorporating macro-economic views into an investment decision, fund managers can also benefit from taking a close look at the shareholder register.
Tinker says: “There’s no point at looking at the fundamentals of the company if it is owned by a distressed seller: they will simply push the price down.”
Trading patterns
Macro-economic obsession and increased competition are not the only new factors affecting the fund management industry. The rapid development of programme and high frequency trading along with investors’ current love affair with passive investment vehicles such as exchange traded funds (ETFs) has fundamentally changed the trading environment.
Poizot says: “A significant proportion of the daily volume on the New York Stock Exchange can be attributed to ETF trades. The combination of high levels of algorithmic trading and the growth of ETFs has led to correlations between stocks and sector reaching historic highs while valuation discrepancies are limited.”
Managers need to pay more attention to these patterns and appreciate that this is a new risk factor that needs to be taken into account before investing in a company. Tinker says: “We learnt in 2008 that how a share price performed was less about the company and more about which investors owned this stock.”
Fund managers need to take a close look at the volatility and trading patterns of a stock that they are thinking of buying for fundamental reasons.
“It may be that the fund manager might prefer another stock which isn’t quite as attractive because many of the mega-cap stocks have effectively become a proxy for a market or a sector that’s used by hedge funds to express a view. That’s a big positive force for small and mid-cap investors,” adds Tinker.
Clarke says: “The skill of the traders and how they implement client portfolios is something we take into account when we assess fund managers. Not all fund managers have a good understanding of new trading techniques and the impact of trading on markets: it is vital they employ traders that do understand the trends.”
There are undoubtedly benefits to equity managers taking a page from the book of the 1970s investor and returning to a more fundamental style. But this approach behoves the consultants and trustees to take the same view and to have a longer-term investment horizon. Nor is it as simple as rolling the clock back because there are new risks that need to be taken into account, such as the growing obsession with the macro-economic environment, increased competition, as well as extreme and unpredictable trading patterns.
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