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Magazine Issues » October 2014

ETFs: Starting with the big picture

GemsWith the rise of dynamic asset allocators who use index funds to hunt returns, Nick Fitzpatrick asks two ETF strategists about their approach to investment.

They are a group of investment managers who epitomise the swing towards passive investment, albeit in a form driven by active decision-making. They reflect an argument, made by academics since the 1970s, that asset allocation is more important than stock selection. And they are a boon for Europe’s exchange-traded fund (ETF) providers, because ETFs are their vehicle of choice.

The rise of the ETF strategist, a wealth or investment manager that invests purely through ETFs, is a phenomenon of our times.

Charles Stanley Pan Asset, a UK investment manager and part of Charles Stanley & Co, says it was a forerunner among investment managers that marry passive investing wholesale with dynamic asset allocation. It started doing this in 2007.

Nutmeg, a London-based online wealth manager, is one of the most recent to launch. 

Others include SCM Private, which is also based in London. Its founding partner and chief executive officer, Gina Miller, has vociferously criticised active management for, in numerous cases, failing to deliver value for investors.

These ETF strategists are prepared to forgo the alpha from individual stock picking and, instead, try and deliver good performance based on passive allocations to regional, country and sector indices that are tracked by ETFs.

For ETF dynamic asset allocators like these, the big picture is the vital starting point for an investment strategy.

“We are very much a top-down investor,” says Brad Holland at Nutmeg when asked to explain the ETF investment process. 

“We think about forces that will make a sector or factor work. A bottom-up manager will ask which stocks within a sector are likely to outperform – but top-down is about what is going to make countries and industries perform,” he adds.

Taking the FTSE 100 as an example, one of the questions Nutmeg would ask is what, if any, technical factors were driving the index. This might include the small-cap factor, which is historically treated as a source of alpha, though is increasingly seen as a “smart” beta. Another factor is momentum.

But the process does not begin with this technical analysis. Perhaps logically for any ETF house, as a top-down investor Nutmeg starts with weighty macroeconomic issues when deciding its portfolio design.

“Country and sector holdings implied by indices are your natural starting points. You then want to map a macro view across that, so if you think stocks are on an up trend, you ought to be overweight equities and underweight government bonds.”

Right now, Nutmeg is “risk-on” – and that means equities over bonds. The firm has small- and large-cap holdings in Europe. Holland highlights Italy and Germany in particular and he gives an insight into the macroeconomic analysis behind this broad European view.

Much of it is to do with “economic slack” – a key gauge for company earnings as well as the outlook for a country’s economic performance. Economic slack is concerned with how much spare capacity there is in a company or economy. If capacity utilisation is not at 100%, then a company can increase capacity without a significant increase in costs.

The present level of slack, coupled with a supportive economic environment, bodes well for equities. Holland says: “It is a fertile time for company earnings. European policy is spearheading growth and slack could close down in this market. Policy will work eventually, and is working now.”

After the macro picture is formed, quant tools are employed. This includes data such as bond prices to get a clearer picture about valuations and economic variables.

“There is a whole world of capital markets that seems like it is operating in a parallel universe to macro data. Capital market data may not be mapping very well onto economic data.”

Then technical analysis comes into play. This ranges from mean-reversion models, to price-to-book measures.

How technical analysis and macro analysis dovetail is illustrated by Nutmeg’s negative attitude to bonds. China, and other countries with very large trade surpluses, recycles its surplus into bonds, such as US treasuries, depressing yields and pushing up prices. There is also a wide structural demand from insurance companies to meet solvency requirements. “Should we be chasing bonds? We think it’s not worth it,” says Holland.

Nutmeg has been cautious on emerging market equities for some time, but Holland says the firm recently bought Indonesia as its general election unfolded.

He acknowledges that emerging markets have done better than expected, though he says scepticism about China has been justified because a driver for growth is difficult to find.

Nutmeg’s post-fee 12-month returns until June 30 ranged from 9.9% for its most risky portfolio, to 2.3% for its lowest risk. Nutmeg employs 10 portfolios based on risk tolerance.

Charles Stanley Pan Asset is also risk-on in its outlook. It uses a “quant matrix” as a starting point for deciding between asset classes, including property. 

A starting point is the yield on all investments, says Christopher Aldous, managing director at the firm. “If an asset has a faster growing yield than cash, then it’s probably going to appreciate versus cash over the next year.” 

To this extent, the firm’s preferred benchmark is the UK Retail Price Index (RPI), plus an agreed percentage above it. A medium risk benchmark would be UK RPI +3%, for example.

So, in looking for outperformance from passive allocations, how similar is the approach to that of an active stock picker using fundamental analysis to find alpha in a stock?

“You can think of each country like a company but there are differences. Good active management is about taking long-term views on aspects like innovation, market share and holdings of management, which is an approach that can be applied to America Inc to some extent,” Aldous says. “However, the past couple of years have seen emerging markets scuppered by US central bank action, which is something that probably would not happen to a company.”

Charles Stanley Pan Asset, like Nutmeg, is also broadly negative for bonds at present especially in contrast to equities.

“Right now, the environment is extremely supportive of equities due to central bank action and other factors. Fundamentally, we are not very keen on bonds,” Aldous says.

Broadly, the firm has favoured developed market equities over the emerging markets in recent months. The main reason for this is stronger earnings growth in developed markets. 

“Corporate earnings have recently grown faster in the developed markets than in the emerging markets and that is an unusual trend,” says Aldous. 

“We see relative earnings growth as an important indicator in terms of tactical allocation between developed and emerging markets.”

US earnings growth has been “very good” and Aldous wants to increase exposure to US equities without a dollar hedge.  

This un-hedged dollar position is relevant against the policy backdrop of the European Central Bank (ECB), led by Mario Draghi, president. Trying to foster growth in the Eurozone economy has seen the bank most recently announce a bond-buying stimulus, albeit not fully blown quantitative easing, as in the US or UK.

“We have hedged our fully weighted Eurozone positions and invested in indices that will benefit most from the stimulus.  We want to avoid currency risk because we see a weaker euro as the associated outcome of any easing of ECB policy.” 

Aldous acknowledges the bearish attitude towards China shared by many investors. Nevertheless, over the past four months Charles Stanley Pan Asset has increased exposure to Asia and emerging markets from a low base, though generally the firm still favours the developed world.

“China has scored well with economic growth, valuations and earnings, but ultimately, if we know people won’t invest there until the bears are proven wrong then there is no point in going too far down that track.”

Year-to-date (at August 31) performance of the PanDynamic range of seven funds has all been positive, ranging between 2.7% for the PanDynamic Defensive fund, to 5.8% for the Aggressive fund, net of the 0.25% management fee, though platform fees may alter the returns.

The sway that economics carries for ETF investors may be glimpsed in fund flow figures. Lyxor, an ETF provider, notes that record flows were seen into US equities in August on the back of positive economic data, while deflation fears that seem to be driving markets recently could be behind record flows into European and US government bonds, too.

Deborah Fuhr, managing partner at ETFGI, notes that geopolitical concerns may have influenced ETF investors in August when they invested net new money into an array of equity, fixed income and commodity exposures “due to concerns over the situations in Ukraine and Gaza”.

Dynamic asset allocators may miss pockets of alpha given by particular stocks or bonds, but the importance of asset allocation over stock picking is a theory with academic support and one they are putting into practice.

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