If enough well researched information is available, and is properly analysed, a multi-manager is able to use thematic forecasts to add to the performance of their portfolios without taking on excessive risk
Multi-managers who undertake tactical allocation are constantly required to identify trends, valuation discrepancies, and growth potential across different regions and styles of stock. A scientific and systematic approach to this search is without doubt the most successful way to tactically allocate funds within a multi-manager portfolio. Within each potential theme considered, the following factors should be applied in order to formulate the multi-manager's view in a systematic manner:
Macroeconomic factors: Including interest rates, inflation, GDP growth, industrial production, employment numbers and the wealth effect.
Fundamental factors: Relating to the various growth potential and valuation characteristics of different asset classes in both relative and absolute terms. These include earnings growth and p/e (price to earnings ratio) for equities, government bond yields and corporate bond spreads (the difference between the yield of corporate and government bonds).
Momentum factors: Concerning short to medium-term price momentum at the asset class level, as well as the effect of earnings revisions on equities.
For 2005, the key themes which have the potential to drive superior returns are:
• Asset class mix - equities, bonds or cash?
• Value versus growth.
• Large caps versus small caps.
• Regional and currency allocation.
These themes will now be subjected to the macroeconomic, fundamental and momentum criteria described above. In doing this, the most important investment decisions facing multi-manager portfolios in 2005 can be more care- fully considered.
Asset class mix - equities, bonds or cash?
Getting the equity decision right from the outset is probably the most important call a multi-manager can make, as the direction of the equity markets will determine if they outperform the less risky asset classes.
Macroeconomic factors: Equities have enjoyed a relatively supportive economic environment in recent years. Most developed markets have benefited from healthy and sustained growth, although Germany and Japan fell into a technical recession at the end of 2004. Multi-managers will need to determine for themselves whether this a statistical aberration or something more fundamental to be concerned about.
Overall, however, investors might reasonably expect a comfortable scenario of global growth which will be not too fast, thus avoiding inflation risks and possible rapid interest rate increases, and not too slow, which would cause unemployment and profit concerns. If economic growth were indeed to be steady in 2005, this could help underpin increased corporate profitability, allowing a measured approach to interest rate increases.
Economists are, of course, notorious for their tendency to herd like sheep, but when an investment stance away from the macroeconomic consensus in either direction poses risks, multi-managers need to carefully consider how much risk they are prepared to expose their portfolios to.
Fundamental factors: Considering the table below, equities appear reasonably priced on traditional valuation measures such as p/e, price to book, EV (enterprise value) and EBIT (earnings before interest and tax). Furthermore, growth is forecast at nearly 10% for the MSCI World Index this year, which would be a very healthy return indeed. However, the effective multi-manager needs to ascertain whether such growth really can be achieved or whether the analysts are being too optimistic.
Momentum factors: The risk to equities is probably to the downside in the short term. The valuations which make them look attractive are based on very optimistic forecasts of blockbuster margins. However, an even more significant risk comes not so much from predicting fundamental factors, but the emotional aspect of the market. Investors may continue to push equities higher in 2005 simply because of the last two years' solid performance. Alternatively, they could waver at the prospect of slowing profit growth.
Value versus growth
"A bird in the hand is worth two in the bush", so the saying goes. Investors appear to share this sentiment, because since 2000 they have preferred cheaper and higher yielding stocks to those that provide the less tangible feature of future growth potential. Value funds have drastically outperformed growth funds in all major markets since the peak of growth stocks in 2000. However, these two themes are cyclical and can undergo protracted periods of strong relative performance. The question for multi-managers is whether value funds will continue their run, or whether the market will rotate towards growth funds. This will be a crucial theme across all regions this year.
Macroeconomic factors: Value versus growth as a theme has little correlation to macro-economic trends, including the stage of the economic cycle.
Fundamental factors: The sustained relative outperformance of value funds relative to growth funds has dramatically reduced the discount the former trade at versus the latter, on a p/e, price to book and dividend yield basis. It could, therefore, be argued that the higher earnings appreciation from growth stocks should warrant a small valuation premium over value stocks.
Momentum factors: On the momentum front, value stocks are still very much in favour, having outperformed growth stocks not only in the 2000-2004 period, but also every calendar year within it.
As indicated above, a defensive equity stance would appear sensible, due to over-ambitious growth forecasts. This defensiveness would imply a preference for value versus growth. If forecast earnings are indeed reduced, this will lead to better performance from cheap value stocks. However, as the market comes to more realistic expectations for earnings growth, it is likely that growth stocks will lead performance in a 'virtuous spiral', as their very growth will attract more investors.
Large caps versus small caps
While value stocks have enjoyed a sustained rally relative to growth stocks, so have small companies consistently outperformed large companies over the past three years. This was to be expected, because small-cap performance usually occurs during an early cycle recovery, often accompanied by rising expectations.
Macroeconomic factors: At this stage of an economic recovery, large-cap stocks often outperform. In the US, there is already evidence emerging for this, with the S&P 500 outperforming the Russell 2000 index in the first two months of 2005. As the economy gains strength and interest rates rise, larger companies with healthier balance sheets and more stable cash flows will be better positioned to succeed than their small-cap counterparts.
Fundamental factors: Large companies are trading at lower earnings multiples than small and mid-caps in Europe and the US, despite better returns on equity. The strong rally in small caps over the past two years has made them expensive relative to large caps.
Momentum factors: Momentum appears to be moving towards large caps in the US, but has stayed with small and mid-caps in Europe. This may be partly due to the weak dollar, as US large caps receive a large proportion of their revenues in the stronger European currency. The reverse is true for European multinationals, which receive much of their revenues from the US.
The market would, therefore, appear set to rotate to larger caps, for both macroeconomic and fundamental reasons, and one might reasonably expect the equity markets to be led by large caps during the last three quarters of 2005.
Regional and currency allocation
Macroeconomic factors: As many investors will be acutely aware, the US dollar has suffered relative to European currencies for the last three years running. The much publicised twin deficits in the US have placed the dollar under tremendous pressure, while central bank diversification away from US dollar assets has been another key trend in the currency markets for several months. The question for multi-managers is how much depreciation is too much? The consensus view is for continued US dollar weakness. However, the bull case for the dollar rests on value and relative performance. It could be argued that there is now a risk premium associated with the currency given all the well publicised issues it faces. For those willing to manage the risks of significant US dollar exposure, there could be significant rewards.
Fundamental factors: The regional valuation table below has shown the UK and Europe standing out as offering the best combination of value, yield and growth.
Momentum factors: As equity markets have performed well in local currencies across all regions, there is no clear momentum in favour of any one region over another. Last year's best performing regions, the UK and Europe, appear most likely to deliver the best returns in 2005. Attractive valuation, yield and good balance sheets should all support their relative outperformance in 2005.
2005 is likely to see a significant divergence in performance across all the themes discussed here. The excitement of the investment markets stems from their volatility, and no matter how much analysis a multi-manager undertakes to forecast the relative direction of different regions, styles, market caps, it is hard to be sure of 100% accurate predictions. That said, if enough quality information exists and it is analysed expertly, a multi-manager's thematic forecasts can successfully drive investment decisions. Investors in multi-manager funds should use only those managers who are able to make informed views on multiple themes, thereby adding to performance without taking on excessive risk.
A scientific and systematic approach is the most successful way to tactically allocate funds within a multi-manager portfolio.
If enough quality information exists and it is analysed expertly, a multi-manager's thematic forecasts can successfully drive investment decisions.
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