September 2008

BRIGHT IDEAS: the latest investment schemes

Equity turmoil over the past year has forced asset managers to review the sector. Not surprisingly, they tell investors to keep the faith. Nick Fitzpatrick looks at some of the latest investment schemes ... What investors do with the bulk of their equities in the foreseeable future depends very much on who they ask. Various ideas for equity investing are beginning to surface as fund managers try to offer guidance to nervous investors after dramatic outflows from equity funds in recent months.

Baring Asset Management, for example, says there are good opportunities to be had in European small caps. ING Investment Management is looking to the US and is less favourable about Europe.

Newton Investment Management, part of BNY Mellon, urges people to hold on to their UK shares if they want decent long-term returns in their pension plans, while MSCI Barra, a maker of indices, says commodity equities can be used to hedge against inflation.

The global credit crunch, earnings downgrades and rising inflation mean that 2008 is likely to be one of the most volatile years for global equities since 1970, according to analysts. Every fund manager has a view about what investors should do next with their shares.

Research by Newton suggests that holding UK equities for a period of more than eight years during the last 108 years, has not only produced higher real returns than gilts, but also with lower deviation.

Even during periods of short-term volatility in equities, such as the stockmarket crash of 1929, or the bursting of the tech bubble in 2000, equity market performance has tended to even out over time.

Jeff Munroe, chief investment officer at Newton, is urging investors to think about investing through market cycles rather than trying to pick the best time to invest.

“As hard as it is at certain times, it is advisable to avoid the herd mentality, which inevitably sees investors piling in at the top of the market and selling at the bottom.”

Munroe adds: “While we are currently witnessing important changes in the contours of
financial markets, it is important for investors to consider a long-term investment horizon, particularly where their savings and pension plans are concerned.”

US vs Europe
The US might intuitively feel like one of the least attractive regions at the moment, but for some fund managers US equities are making a comeback. ING Investment Management has moved from a neutral position to overweight on the US using a top-down strategy. The firm says it prefers US equities over Euroland because of looser monetary conditions in the US, including a more competitive exchange rate, and an expansionary fiscal policy, which has seen tax cuts to boost spending. These conditions are not present in Europe.

On top of this, the US is at a more advanced stage of the cycle and its market is more defensive.

However, analysts at Citi take an opposite view. In a global equity report they favour European equity markets over the US, saying Europe is the cheapest in the world and with the best combination of relative earnings momentum and exposure to growth. Although the US has been defensive this year, it still looks overvalued, they say.

For investors that want to focus on Europe, Baring Asset Management argues the case for small-cap companies. Nick Williams, manager of Baring’s Europe Select Trust, believes that a combination of continued corporate activity, structural change and attractive valuations all make the sector an attractive long-term proposition.

“European equity valuations – both small and large cap – are relatively cheap compared with bonds and historic averages. Despite some profit warnings, selected companies, in particular in the healthcare and industrial sectors, continue to see strong growth,” he says.

He adds that low share prices are also providing support in some areas, with some companies being taken private by their major shareholders.

Smaller companies have outperformed larger companies in 2008 year to date and Williams notes that, historically, small cap stocks have often outperformed in bear markets.

Specific stocks favoured by Williams include Lonza, a pharmaceutical ingredients company based in Switzerland, and Andritz, the Austria-based engineering company. In terms of sectors, 23.6% of The Baring Europe Select Trust is accounted for by business service providers, including employment agencies, office supply companies and transport companies. Also, 16.3% is focused on the consumer goods sectors. A further 11.9% is invested in basic materials and 11.3% is in industrial goods.

The £267.6m Baring Europe Select Trust has returned 61.9% over the past three years and 192.3% over the past five years.

Inflation protection
MSCI Barra is trying a different tack by encouraging investors to think about the inflation-hedging properties of equities. The index provider says that its MSCI Commodity Producers Indices “possess some interesting properties that could potentially be used by investors as an inflation hedge”.

It is important to think about the relationship between equities and inflation because, says MSCI Barra, while equities have traditionally been associated with inflation hedging characteristics, anecdotal evidence has shown that equity returns sometimes fail to provide protection against inflation over shorter horizons. Given the importance of equities in a typical multi-asset-class portfolio, insulating an equity portfolio from inflation is therefore a key consideration for investors in the current environment.

Equities are seen as a good hedge because a company’s revenues and earnings should rise with inflation over the course of time. For example, US equities, as measured by the MSCI USA Index, have demonstrated an average annualised return of 7.6%, compared to the annualised
inflation rate of around 4% a year since 1970.

From a long-term perspective, equities may therefore be considered an inflation hedge, but not necessarily over a shorter period.

Taking three periods of high inflation in the US, a study by the firm shows that three categories of industry with exposure to certain commodities seem to have reacted positively to headline inflation. The first category consists of companies with gold and oil-related exposures. Equities with exposures to these factors have been resilient during periods of rising inflation – although energy reserves and oil refining less frequently so.

Companies with exposure to these factors are typically precious metals producers and energy companies.

Other categories that performed well during the second inflationary period in this analysis (December 1976-April 1980) are medical services, drugs, defence and aerospace, hotels and tobacco companies.

A possible explanation for this is that demand for products and services in these industries are relatively inelastic and these companies could therefore provide an earnings hedge when inflation
is high.

Ideas about what to do with the asset class is one thing. But the first challenge is for managers to halt equity outflows by nervous customers in the first place. Munroe, of Newton, is trying, and he reminds investors of an old maxim – that equities deliver over the longer term, but with risk.

“In times of high volatility many investors may consider whether equities remain an appropriate investment vehicle for their savings and pension plans. However, it’s a fundamental principle of long-term investing that if you want to achieve higher returns, you must be able to accept higher risk and volatility along the way." ©  2008 funds europe

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