Past performance alone not enough to assess European fund managers

NOTWITHSTANDING the continued uncertainty over Greece, Europe's macroeconomic environment is continuing to improve. Since the eurozone crisis, we are starting to see upgrades in corporate earnings, thanks also to a weaker euro and lower energy prices.

While there remains market headwinds because of the impending rate hike by the US Federal Reserve and the continued Greek saga, investment opportunities have opened up. The question is how to choose the superior investment fund among the many funds available in the market.

Key is in selecting the investment manager

We advocate a core-satellite approach to portfolio management in order to optimise return versus risk of the underlying portfolio. Investment in core portfolios would be oriented on a long term time horizon and stay fully invested. Satellite investments are largely opportunistic and shorter term in orientation.

How should one construct such portfolios? While some clients may have their preferred choice of buying individual bonds and stocks, we would suggest leaving the selection and management in the hands of professionals particularly in areas where the client has low level of expertise or experience in. Outsourcing to professional portfolio managers with good track records would also deter "emotional" investing.

While funds or unit trusts are an integral part of this process, questions on a fund manager's ability to add value have always been the focal point and strong emphasis should be placed on the manager selection process. Why would it be the case? Selecting a manager with the right investment philosophy is both art and science, unlike valuing a stock or bond which is more of the latter.

Choosing a manager with a strong team and investment process and, at the same time, one who will perform well in current market conditions, is not just about looking at his past performance versus the underlying benchmark or competitor funds.

The consistency of performance as well as the reasons for the outperformance are central to the manager evaluation process. This emphasis is particularly important with respect to European managers today - on the back of the complex market dynamics at play in recent times, such as the impact of Greece on the eurozone at large, the weakening of the currency coupled as well as the negative interest rate environment in some European countries.

The science is all about number crunching. The process is formal, structured and repeatable as it creates comparative data points to explain results. This quantitative part of the selection process helps weed out the "closet benchmark" huggers. We look at various ratios such as tracking error and active share. We also measure the relative performance of the manager across various market cycles to ensure that the manager sticks to the investment style.

However, recent past performance can be particularly less meaningful when it comes to selecting European managers. Since early 2014, the euro has weakened sharply, providing for an environment for exporters to do well. This was not the case in the prior period when the euro was stable to strong, and this renders any data on past performance less relevant.

This is where the art of evaluation comes in. This qualitative part of the selection process allows us to interrogate good performance. The "why" of good performance can be broadly attributable to three key factors - idea generation, portfolio construction and management team.

Questions to ensure that drivers of good performance are in place include - "How is the research coverage done? Who are the people? How does the investment process ensure ideas generated by the analysts are incorporated into the portfolio? How stable is the management company? How are analysts and portfolio managers compensated? Is the fund management company investing in tools that enable the manager with efficient portfolio construction and monitoring?"

Adopting a three-pronged investment strategy on European funds

Since the start of the year, investors have started favouring European stocks. This was on the back of improvement in economic growth, weakness in the euro as well as low to negative rates in some areas of the continent. Managers who employ core strategies oriented towards identifying companies with globally diversified sources of revenue with free cash flows are sought.

Low to negative interest rates also provide strong tailwind for funds whose managers are focused on stock dividend themes, both in companies that pay generous dividends as well as those that consistently grow their dividend pay outs. In fact, on the back of persistently low to negative rates, we have been seeing fund flows out of bonds into such dividend-focused funds by both retail and institutional investors.

Along with European exporters and dividend payers, investors could also consider a third leg to the investment strategy. The positive changes in the balance sheet of core European banks have opened up opportunities to invest in the various tiers of capital securities of these banks.

This three-pronged approach, while maintaining a hedge on the FX exposure has worked very well for client portfolios. Select European equity funds have posted mid-teen returns in US dollar terms over the first half of the year.