It is widely agreed that asset allocation accounts for the vast bulk of returns for most global equity funds. Within asset allocation, it is often regional bets that either deliberately or inadvertently end up driving performance. In my past experience as an Investment Trust analyst I saw this first hand as I met many managers of global funds who came to see me to explain their performance. Outperforming through stock selection in Japan was never enough to mitigate the effects of being overweight Japan whilst the market was falling in the early 1990’s.
These kinds of regional allocation decisions frequently work to more than offset any effects from stock selection. In fact, for some funds one can question why they bother with stock selection at all when regional allocation dominates their returns so much. The performance of a global fund is often almost entirely attributable to one or two decisions at the regional allocation level. Fund managers who take this approach should spend 90% of their time on regional allocation though I am sceptical of the ability of anyone to consistently get these calls right. In addition to this, global equity funds are often not even as ‘global’ as one might expect. UK based fund managers are frequently biased to their home market and tend to have a much higher weighting to the UK than any global benchmark.
When I took over running global SRI funds in 2004 I resolved that we would set up a process in which stock selection would lead the performance of the funds. Hence the decision to keep regional asset allocation close to neutral relative to the MSCI World Index. We do not consider ourselves to be regional allocators and do not want the risk of the fund to be taken predominantly in an area which is not our key skill. By neutralising this risk we ensure that all the risk of the fund is accounted for by our theme and stock selection. This is where we are confident in adding value, and where we spend our time in analysis. It also prevents us from being biased to the UK or other regions and ensures that our fund has a genuinely global exposure. As a result stock selection becomes the key driver and the fund performance is impacted by c.70 stock decisions rather than just one or two regional allocation or currency bets.
This approach keeps us focused on stock selection and the themes, which is where we believe we have a robust and repeatable process, a measure of skill, and long experience. It also means that our major market and currency exposures are close to the MSCI World Index, eliminating the need for any hedging of exposures. We do not stick rigidly to absolute regional neutrality, but aim for broad neutrality as we allow some level of flexibility for the usual trading in and out of new ideas of fund management. This discipline also helps us to focus on longer-term stock selection as we are not buying and selling on the basis of increasing our weighting in Japan and decreasing Europe for example. This contributes to us keeping our average holding period at over three years – much higher than other comparable funds. We are not constrained by this policy; rather it is a useful discipline. Of course the theme exposures may be much larger in one region than another. Very often, for example, our Health exposure has been largely US companies, whereas more of our Water theme exposure is in European companies. We compare companies across geographic boundaries and pick the most attractive investment opportunities within our themes. Flexibility allows us to buy or sell without delay when we need to. Owners of the fund know they are getting a genuinely global exposure – not one that is biased away from the MSCI World.
I have managed funds in this way for over eight years in various different market conditions. The benefits have been clear in that time and contributed to our outperformance. For us it is stock selection that really matters.
1: Rmana Vardharaj & Frank J. Fabozzi “Sector, Style, Region: Explaining Stock Allocation Performance”, Financial Analysts Journal 63.3 (May/June 2007) http://www.cfainstitute.org/learning/products/publications/faj/Pages/faj.v63.n3.4691.aspx
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