During times of uncertainty and market volatility, it is especially important for investors to manage their asset and geographical allocation carefully as it has been shown to be one of the most significant determinants of performance
As we move into the final quarter of 2004, we look back on yet another turbulent year for fund investors. As the war in Iraq ended, continuing terrorist activity led to markets being dominated by concern over rising oil prices and interest rates. In fact, the past three years have been particularly chaotic following 11 September and the resulting war on terror that led to the invasion of Iraq in March 2003.
Uncertainty and volatility are never good news for investors as they lead to indecision. During these times, it becomes especially important for investors to manage their asset and geographical allocation carefully, as it has been shown to be one of the most significant determinants of performance in an investor's overall portfolio.
Lipper conducts a monthly asset allocation survey with many leading fund providers in the UK. Through this we are able to understand where managers view the strengths and weaknesses across the various markets.
The resultant indices that are constructed from the surveys are used by product providers to more accurately benchmark their own funds against their peer group and, in many circumstances, adjust their portfolio allocation to reflect the sector itself rather than an external index. Using this data, and in order to understand fund managers' views on the major global equity markets, we look back over the past three turbulent years at the IMA Global Growth sector.
Starting with standard performance, the Global Growth sector has underperformed many of the IMA categories, falling 13.36% over the three years, placing it 25th out of 29 IMA categories. Only the recently-introduced UK Zeros sector, North America, North American Smaller Companies and Technology/Telecoms sectors saw poorer returns, down 15.25%, 17.67%, 22.75% and 35.38% respectively.
Looking at table one, we can see how the major equity regions have performed since the end of August 2001. We have added the Global Growth sector to the table, excluding initial charges. We can see that despite the S&P 500 index being in positive territory, the poor performance of the Nasdaq, being strongly technology weighted, heavily influenced the poor returns of Global Growth funds.
What does come across is the stellar returns seen by both Latin American and Asian Excluding Japan region over the period. The MSCI EMF Latin America Growth index gained 77.45% over the period and the FTSE AW Asia Pacific Excluding Japan (USD) gained 49.59%. Thailand, Korea and Indonesia all showed significant gains, with FTSE Thailand up 74.61%, MSCI Korea Growth rising 63.04% and the FTSE Indonesia index up 51.5%.
Obviously, the absolute performance of the sector is poor in comparison to other IMA categories but this is only one part of the story. Since early 2000, Lipper has looked into many aspects of fund performance and this has resulted in the development of the Lipper Leader fund rating toolkit. Lipper Leader fund ratings allow advisers to take a view of the sector not just in terms of absolute percentage performance but also in terms of its capital or downside risk. This shows a very different picture for Global Growth funds.
Those investors who have shorter investment periods, and may be moving towards retirement, will be more interested in protecting their hard-earned capital than gaining the best absolute returns. For this report, we use the Lipper Leader Preservation rating, which measures a fund's ability to maintain its initial capital investment, or a measure of downside risk. Funds are rated against others in their asset class and are scored 1 to 5, where 1 (or Lipper Leader) shows the fund is better at maintaining its initial capital and 5 shows the fund is at least able to maintain the initial capital investment. The results show the Global Growth sector delivers an average preservation rating of 2.4 and this compares well against many other IMA equity categories.
Table two shows the global growth average preservation rating versus the other equity sectors. What is unsurprising is that despite the stellar returns from Latin America, the two Latin American funds in the Specialist sector are both rated 5.0 for preservation, showing therefore far greater capital risk.
Moving onto geographical weightings in the sector, Global Growth funds have traditionally been biased towards the US, UK and Continental Europe as these have provided stable returns and less volatility historically. Although this weighting trend continues, we have seen some interesting movements over the past three years. Chart one shows these major region weightings in the sector.
What seems most interesting from the chart is the trend of movement away from the UK since the end of 2002. At end of December 2002, the sector was weighted 28.14% in the UK, falling steadily to 20.89% by the end of August 2004.
It seems from these numbers that since the invasion of Iraq, managers have taken a view that UK equities have been somewhat overvalued and looked to other markets for investment opportunities. In particular, fund managers have steadily increased their weightings in both Japan and Emerging Market regions and, to some extent, the US market.
What does this tell us? For Japan, the economic rebound certainly raised sentiment in the market and managers took the opportunity to move more assets into the market. For other Asian markets, managers perhaps saw buying opportunities as exports to China began to increase. Managers also took the view that Western markets were overvalued and looked elsewhere for buying opportunities.
What is also interesting is that managers actively allocate cash and fixed income holdings during times of uncertainty in markets. While there are both regulatory restrictions on the limit of a cash holding in a non-cash fund and sector restrictions for using cash in the Global Growth IMA sector, fund managers do actively adjust their cash/fixed income holding according to market movements, often as a defence against market downturns during market turmoil.
Chart two demonstrates the movement in average cash and fixed income weightings in Global Growth funds. We show the FTSE All Share as a line on the chart for comparative purposes. Looking at the chart, we can see that immediately after 11 September 2001, fund managers raised their holding in this asset class as a direct result of the sharp fall in global equity markets.
We saw a similar trend in the run-up to the invasion of Iraq. As with some previous conflicts, we did see an upturn in markets immediately after the commencement of hostilities.
So what does this tell investors and should they look to adjust their portfolio during periods of heady market volatility? The answer depends on what investors' overall portfolios contain and their view on asset or geographical risk. They should also take into account their investment time horizons.
The lesson we can learn from this analysis is that if they hold other equity funds, cash exposures in these funds may increase during these periods. It should also be remembered that chasing performance usually results in missing out on upturns. However, understanding your cash/fixed income exposure inside equity or mixed funds could never be more important during these uncertain times.
So, does this demonstrate a more urgent case to have a more balanced asset portfolio, holding a mixture of equity and fixed income funds in defence of volatile periods? Perhaps it does and the recent trend of managed and multi-manager funds does show fund companies are identifying the need for more actively asset managed funds rather than asset-specific products. These may well become more popular as advisers and investors show more interest in active asset allocation in the future.
Finally a note looking to the end of 2004. For the remainder of the year, we can see the recent falls in European markets have provided some buying opportunities for diligent fund managers. As the major market volatility continues, the focus on oil prices, interest rates and consumer spending will drive sentiment in equity markets. Fund managers will continue to actively allocate their cash and fixed income exposure to maintain a defensive strategy if markets fall.
Funds exposed to a balance of defensive equity sectors and high-quality cyclical growth stocks may well outperform equity funds with a more aggressive growth strategy for the remainder of the year.
