May 2008

UNCONSTRAINED INVESTING: Betting against the Benchmark

Unconstrained investing might have helped investors avoid the worst of the sub-prime damage, Nick Fitzpatrick hears ... (photo displayed: Stephen Docherty of Aberdeen) Pension funds in the UK and Europe have been moving away from index-constrained investment mandates for some time now. Had they not done, then the damage caused by sub-prime could have been worse. Investors who constructed portfolios to match the MSCI World Index in the years before the US sub-prime crisis will now be suffering, due to the decline of financials. According to Stephen Docherty, head of global equities at Aberdeen Asset Management, in the first few years of the current century, a boom in US and UK banking profits boosted the sector, as investors ignored the opaqueness of off-balance-sheet funding and falling lending criteria. By late 2006, the sector represented about 26% of the index, but now represents around 22%. Aberdeen Asset Managers’ global equities team has warned of the backward-looking nature of investmenT benchmarks, Docherty says. Aberdeen has always advised investors to ignore indices in portfolio construction, and focus only on investing in quality companies with positive prospects. He says that although UK and US banks have loomed large in global equity investment benchmarks, the global equities team have had no exposure to them for the past four years, preferring to avoid the overleveraged UK and US consumer. “Benchmarks are inherently backward-looking. When it comes to portfolio construction, investors should ignore indices and concentrate on using first-hand research to find good quality companies with long-term prospects. It is only by knowing an investment intimately that a manager can have the confidence to take a decisive bet against a benchmark – and it is only by deviating from a benchmark that an investment manager can hope to outperform it,” says Docherty. In the past few years, UK pension funds have been observed to drift away slightly from index-aware investing. In 2006 Watson Wyatt noted that generating returns to reduce deficits and implementing risk reduction strategies were top priorities for the majority of UK pension funds. This had resulted in many funds moving some of their assets away from benchmark-sensitive instruments to make meaningful allocations to alternative assets and absolute-return products. Aberdeen still has some financials in its portfolio because fund managers feel that despite share price weakness among big-brand financial companies, there are still some opportunities elsewhere in the world for managers with a mandate to invest globally. Aberdeen’s current holdings include Italy’s Intesa Sanpaolo, which is set to reap considerable synergies from a recent merger, and German retail bank Deutsche Postbank. In emerging markets Aberdeen favours local players such as Indian private bank ICICI, while in Japan, domestic banks such as Bank of Kyoto and Bank of Yokohama are at the opposite end of the cycle from banks in the US and the UK.   A comparison of stocks within other sectors further illustrates the argument that big is not always best. Within the energy sector, Petrobras in Brazil has much stronger production growth than BP in the UK and Total in Europe, and also repays investors with high dividend growth, Aberdeen says. The same principal of unconstrained investing applies elsewhere. The Aberdeen World Equity Fund is currently overweight in telecommunications because of the value available within the sector. In recent years, the team has added to its telecoms holdings, as companies with strong free cashflow, such as the UK’s Vodafone, began to look attractive. More domestic-oriented companies within the portfolio are Belgacom and Portugal Telecom. Docherty says: “Despite widespread pessimism about the world’s economy, well managed companies should continue to deliver good long-term performance. Meanwhile, recent market volatility is providing opportunities to invest in these companies at attractive valuations, particularly in Europe and emerging markets.” © 2008 funds europe 

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