Rattray says this is based on the fact that recommendations will deliver alpha on average but his team also uses pattern spotting to enhance this, looking for changes in consensus or the market falling in love with a stock.
“If three brokers have a buy recommendation on a stock and a sell comes through, we will close that position based on signs of a breaking consensus,” he says. “Likewise, if we get five straight buy recommendations on a stock, we will stop purchasing and begin to sell if the buys keep coming through, wanting to get out of companies early.”
You snooze, you lose
A further key element of the process is the holding period: Rattray says while analysts might claim to be giving 12-18 month views, most of the alpha comes in the first two or three months of holding the position.
“Traditional funds are often in stocks far too long whereas we want to be out when the outperformance flattens,” he adds. “Otherwise, we are under-employing capital for our clients. In basic terms, you want to buy stocks as soon as analyst recommendations come in to get the full benefits of performance.”
This first-mover benefit gives the GLG product a clear advantage over many peers.
“For a typical fund manager, if a broker comes in with a recommendation, they will want to meet the analyst – which could take a few weeks – adjust their models and then potentially test the idea at investment committee before actually buying,” says Rattray.
“This process potentially takes a month and if we say average analyst ideas generate 1.1% over the benchmark, our estimates suggest 0.7% of that is lost by delaying. In contrast, acting immediately on best ideas has generated 1.7% above the benchmark per idea.”
While buy recommendations have a long track record of adding alpha, sell notices have been far less consistent – and in line with human nature, there are always more buys than sells coming out of brokers, typically two for every one. Rattray says there are technical reasons for this but the basic explanation is that human beings naturally prefer giving good news rather than bad.
With much of the value in the fund’s stock picks realised in the first three months, turnover is higher than competitors – typically five or six times a year against just one from a typical long-only manager.
But Rattray stresses his belief that it pays to trade like this and the fund is actually fairly low-risk compared with the benchmark and sector, largely down to its very broad diversification. “We are seeking slow and steady returns on the fund without any huge drama,” he adds.
Looking at potential weaknesses in the process, the manager dismisses concerns that broker research will fade out.
“I started investing 20 years ago and people were talking about analysts as a dying breed and fund managers doing all their own research back then, just as they are now,” he adds.
Reducing macro risk
A further problem comes in periods where the market is driven by macro events, such as the Lehman Brothers default in 2008 or in July/August 2011 when it looked like the eurozone could collapse.
“We had a weaker year in 2011 but I would question how successful funds that employ macro hedging have actually been,” says Rattray. “These periods are very difficult for stockpickers but we are protected to some extent by our diversification. Most macro events that really hurt the market are impossible to forecast – no one could have predicted the Lehman default or the global impact of a struggling Greece for example.”
With such a stock-specific process, Rattray uses various methods to reduce macro risk, keeping the portfolio broadly market cap neutral for example as he feels many European funds have too much invested in smaller companies.
He also remains largely sector neutral, with two-thirds of excess returns coming from stock selection, although notes some thematic positions in recent years. “Banks has been the hardest sector to be positive about and over the last five years, being underweight has largely been the right call,” adds the manager.
“In terms of overweights, we would highlight capital goods companies, with names in Germany and Scandinavia making machine tools for export to the fast-growing emerging markets.
“Overall, these themes are not permanent and it has been best to move around – this year, banks are leading the market for example.” With many peers currently highlighting now as an opportunity to get back into Europe, Rattray says the best entry point was actually last year but investors have been sluggish to recognise the attractions the continent presented.
“People have been slow to acknowledge the worst of the macro problems are likely behind us and also that many of Europe’s companies are exporters so can thrive despite local concerns,” he adds.
“A company like Siemens for example does sell in Germany but also does business around the world and investors have overestimated the impact of eurozone woes on these businesses.
“Taking a long-run view, European equities still look cheap but they are clearly not as good value as they were last year after solid performance in 2012.”
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