What is the alternative to actively managed investments?

2010 looks set to be a challenging year for European equity investors. The environment is changing as central banks start to initiate exit strategies from quantitative easing. Whilst it’s true that European equities are, on average, attractively priced and poised for recovery, the risk is that stimulus withdrawal could threaten economic stability – if tightening measures begin too early, we could see a further dip during 2010.

So what does this mean for European equity investors? With such an uncertain outlook, and muted growth predicted for the year ahead, it’s difficult to determine which countries or sectors are positioned to outperform. Instead, many strategists are suggesting that stock picking will be essential for investors looking to generate decent returns in 2010. Of course, actively managed funds are one way that investors can access top stock picking expertise, but what other options are there for investors?

The Case for Stock Selection

For much of late 2008 and 2009, the market was driven very much by macro factors. We saw big swings as equity markets responded to the changing economic environment. Now, as European equity markets appear to be stabilising, it’s a good time for investors to look at where the winners and losers of the future could emerge. Analysts are highlighting an abundance of stocks that represent real opportunities – those stocks that are undervalued and underowned.

Furthermore, given the recovery in credit markets, borrowing is cheaper and easier than it has been for some time. If we see a pick up in M&A activity as a result, this too could be supportive for stock selection strategies: sometimes a takeover, or even just the rumour of a takeover, can act as a catalyst that drives a resurgence in an individual stock’s price.

Different Investment Styles

Equity investors are faced with a multitude of metrics that they can analyse in order to select stocks they believe will outperform the broader European equity market. Classical style investing – selecting stocks for their value or growth potential – is a well known way to try to beat the market. Growth investors will seek out stocks with a superior track record of earnings growth, in the hope that this trend continues. Value investors instead look for stocks that may be out of favour, and therefore seem cheap relative to company assets or future prospects. Historically, both approaches have been successful over different parts of the investment cycle.

Regardless of whether they belong in the growth or value camp, there are other factors that an equity investor needs to consider – is there sufficient liquidity in the individual stocks? Should they implement concentration limits on single stocks, sectors or countries? How frequently does the portfolio need to be reviewed? Constructing a robust, reliable screening process can involve more than cherry picking the highest ranking stocks, and can be a complex process. Rather than manage an individual portfolio on their own, it seems it would make sense for an equity investor to look to one of the solutions available via the market that suits their individual needs – either an actively managed portfolio that relies on the individual managers stock picking skill, or an algorithmic strategy that relies on a strong set of investment rules.

‘Off the Shelf’ Stock Picking Solutions

One solution would be one of the many actively managed European Equity funds. Active managers can follow a well-defined investment process, but many allow themselves a lot of flexibility. It’s this discretion (and the stock picking skill of the manger) that allows them to select any opportunity that appears interesting.

Of course an investor will need to pay fees to access the stock picking abilities of these managers, and they will be expecting the fund to outperform the broader market by a sufficient amount to cover these fees. The track record for many of these managers is very impressive, demonstrating the skills of certain managers and the discretion they have in selecting investments. But what about investors who might be concerned about manager underperformance risk, or those who want access to a more formalised strategy? What is the alternative?

Most investment banks now offer a range of custom or proprietary indices. Many of these are as transparent as well-known market benchmarks, have good liquidity and use simple, logical criteria to screen and select stocks. Sometimes the index might be based on a well-known investment process, such as value or growth screening. Other times they might be more specialised, or based on specific investment research.

For example, our Europe Target Equity Index is based on research by our European Equity Strategy Team. They analysed how private equity firms and corporate buyers identify takeover targets, with the purpose of identifying the metrics underlying those selections. Their study suggested that the characteristics that could attract a corporate buyer might also be attractive to long-term investors and could be developed into an investible index. Lots of ‘value’ strategies simply look at what’s cheap. Europe Target Equity is an interesting alternative: not only does it look for undervalued assets, but aims to identify quality companies – those with favourable cash flow and strong balance sheets.

Choosing Between Different Stock Picking Strategies

When looking at any stock picking strategy, there are questions investors need to ask about how the strategy is constructed. In particular:

• Is the methodology well-defined? Does it follow clear rules? Whereas active managers publish broad investment objectives, custom index providers should offer a detailed description explaining the methodology behind the index.

• Have the stocks been screened for liquidity? A strategy is liquid where its constituent stocks are liquid and the more liquid the strategy, the more options there will be to access the strategy, including via structured products with capital protection.

• Have any sectors/regions been excluded? Understanding whether specific market segments have been excluded can help to understand performance biases and also to select an appropriate benchmark for comparison.

• How frequently does the screening take place? As the past 12 months exemplify, market conditions can change quickly, and stocks with favourable characteristics now may not have favourable characteristics in 6 months time. So it is important that the strategy is dynamic and rebalanced regularly.

• How does the historical performance look, and how much of this performance is live vs simulated? How has the strategy performed over different market cycles, and are there any periods of extreme underperformance/overperformance that need further explanation? It’s also important to look at the overall risk / reward of a strategy, rather than just the return. Sharpe Ratios and other information ratios are useful tools for comparison, since they take into account volatility as well as performance.

Of course, investors also need to consider how the strategy fits within their overall portfolio. What is its correlation with existing investments? Should it be used to replace existing benchmark exposure, or more as an overlay?

For European equity investors expecting lacklustre benchmark growth in 2010, stock picking could be the solution to generating decent returns. Investing via custom indices can offer the potential for attractive returns, often without compromising on liquidity and transparency. There is a huge choice of indices and strategies in the market, so investors should ensure that they have received the right information and advice to make an informed decision. Ideally, they should seek out strategies that have a strong rationale in line with their objectives, a transparent methodology and a strong track record.

The views expressed in this article are those of its author and do not necessarily represent those of the company he represents