ETFs gain ground as markets start moving

The strengthening of the global business cycle, led by developed economies, is leading to a normalisation of asset allocation as holdings first in cash, and then in bonds, have been switched into equities.

European equities, which had been massively undervalued, have been a prime beneficiary of the ‘great rotation’ widely predicted at the beginning of the year. The reallocation to Europe is also partly a result of profit-taking from Japanese and US equities after their strong first halves this year.

European stockmarkets have responded well to the US Federal Reserve’s commitment to keep borrowing costs low to support the global economy, implementing the taper process only if unemployment falls below 6.5 per cent and inflation hits 2.5 per cent. The eurozone’s manufacturing sector expanded for a third straight month in September and unemployment in the region also edged lower for a third straight month, although not by enough to change the overall unemployment rate, which has held steady at 12 per cent. 

Most northern Europe country-specific indexes have moved higher with banks posting some of the best gains, and confidence returning. Goldman Sachs Asset Management, for example, doubled its investments in European equities during the summer. Investors dared hope for a European Renaissance and conceivably, an export boom, as the Stoxx Europe 600 Index hit five-year highs in September and October.

Initially, the government shutdown in the US in October had surprisingly little impact. The markets were relieved when President Obama nominated Janet Yellen as the Fed’s new chairman, as she has been a  key architect of its unprecedented stimulus programme. But slowly, investors’ patience with US politicians changed and concern has steadily increased that the US could default, until it was averted at the eleventh hour.

 “We see some stabilisation in southern Europe, particularly in Italy and Spain,” says Oliver Kelton, European fund manager at JOHambro IM. “We’ve seen it on the ground and now in the macro-economic numbers –  Europe is in the very early phase of an economic recovery. Northern Europe is in robust shape, particularly Germany where the general election was very much a vote for a continuation of recent policies.”

But there is a dichotomy in the market with opportunities in northern European large caps and the Scandinavia index for example at a record high, while in southern Europe stocks are back to just 40-50 per cent of their previous peaks, he explains. “These stocks had been priced for destruction. Several individual areas have been oversold in Europe such as utilities and some of the infrastructure and motorway companies, and TV, for example in Spain where advertising is down 40 per cent from the peak. The huge internal devaluation in southern Europe, particularly in Italy and Spain, has helped.”

Market leaders

It is easy to forget how many world class companies there are in Europe. Many active Europe ex-UK funds have boosted returns by betting heavily on the continent’s banking sector, after Mario Draghi’s “whatever it takes” speech put a rocket under even the weakest of bank shares. Europe also has its share of big dividend payers which remain in strong demand, such as the large food producers Nestlé, Danone and Unilever.

Many investors, however, have been attracted to liquidity of exchange traded funds for equity exposure in this region and the opportunity ETFs afford to pick off countries, sectors and even styles. 

“By their nature and thanks to the breadth of strategies targeted, for example sub sectors, countries, maturities or bonds ratings, ETFs have historically been used for tactical exposure as they offer quick, liquid and cheap exposure,” says Valérie Baudson, global head of ETF and index solutions at Amundi Asset Management.

“In terms of flows, we are witnessing a demand for simple allocation ‘bricks’ from investors to implement a more selective approach to European equities as a result of the eurozone debt crisis. Indeed, this created a lot of difference among the eurozone equity market performances and therefore generated demand for a ‘pick and choose’ offer on country ETFs. This is also true on a sector basis, with sector or style ETFs used to seize market momentum changes,” adds Ms Baudson.

Growing confidence

“Wealth managers tend to focus on the standard indices, but there have been good inflows into the Euro 600 this year, with its representation of small and medium cap stocks, which shows a higher level of confidence,” says Thomas Meyer zu Drewer, managing director and global head of ComStage ETFs. “There has also been lots of interest in the PSI 20 Portuguese index from wealth managers this year, and even some interest in different sectors, in comparison to last year when that activity was not prevalent,” he explains.

“ETFs allow wealth managers to enter markets quickly and, besides, a wealth manager may not be allowed to use derivatives.”

One consideration is that ETFs generally outperform the benchmark, which is counterintuitive as one might expect them to lag the index by the TER.

“Most physically replicating EURO STOXX 50 ETFs tend to outperform the benchmark which is due to securities lending proceeds as well as fund management efficiencies coming from dividend payments from the underlying constituents in the index,” says Andrew Walsh, head of ETF sales UK at UBS Global Asset Management. “Going forward, it is a generally accepted view that securities lending revenues in Europe will continue to decline in the next few years.”

An ETF manager can for example take a scrip dividend instead of the cash dividend from high yield Spanish banking stock and enjoy a preferential tax treatment which could be worth 20 bspts. Although securities lending is declining, reflecting reduced demand from hedge funds for shorting activity, it still boosts performance by 15-20 bspts.

The European market has also seen growth in smart beta ETFs, but so far the inflows remain relatively modest. Ossium has two large smart beta funds in Europe: its Equal Weighting and it Minimum Variance funds.

“Equal value funds, which are relatively new for Europe, avoid the concentration and trend-following bias effects of exposure to a small number of large stocks,” says Isabelle Bourcier, head of business development at Ossiam.

“To give an example, the first 50 stocks in the S&P500 index account for 50 per cent of its market capitalisation. In the case of a large cap such as Apple, the stock’s weighting last year went through the roof, from less than 1 per cent in January 2009 to close to 5 per cent in September. Gains in the share price contributed approximately 30 per cent of the rise in the index in 2012. But this can go the other way as we saw when the stock price lost 36.4 per cent between September 2012 and March 2013, Apple contributed negatively to the performance of the S&P500 by 2.78 per cent.” This kind of impact is something investors would like to avoid, she says.

By equally weighting the holdings the portfolio is more tilted towards smaller stocks in terms of market capitalisation, with beta and volatility close to a traditional market cap-weighted index, explains Ms Bourcier.   The fund may also benefit from the strategy’s need to be periodically rebalanced by selling recent winners and buying recent losers.

“The minimum variance fund is working well as risk aversion has been high and investors want equity returns with less risk,” she adds. “When volatility recently increased, min variance strategies performed well and have shown a better Sharpe ratio than traditional strategies.”

Another recent trend worth mentioning in the European ETF market, has been the demand for currency hedged products, says Amundi’s Ms Baudson. “We have launched a range of ETFs integrating a daily currency hedging on Japanese and American equities markets for European-based investors. These funds had a great success with assets under management reaching more than €800m for the three exposures.”  

Choose wisely

European equity markets have rallied over 100 per cent  since 2009, with the MSCI Europe Index rising 16.1 per cent in September alone. Although further gains are expected, wealth managers caution that selectivity is vital as there could be further volatility.

“It appears that a lot of the risk we were so worried about last year in Europe has retreated,” says , head of European equities at RBC Wealth Management. “Macro economics have improved, forward guidance is optimistic, PMI (purchasing managers’ index) data is better, and companies in the US and UK say their European businesses have done better. A year ago the main risk was of a eurozone break up, so we might expect in this early part of the cycle some upgrades six months after the macro situation has changed.”

However, there has been some reining in of earnings expectations. While at the beginning of the year earnings growth of 12 per cent was forecast for European corporates, that has now been brought back to about 8 per cent, she says.  “That is a result of the notoriously volatile financial sector. If you strip out financials, earnings expectations contracted by about 2 per cent, and we expect the trend to start improving again.”

Ms Carrier stresses that in valuation terms, European stocks are not expensive. “Over 20 years the average has been 12.5-13 times earnings and that is where they are now. There are still good opportunities. In the emerging market sell-off, the shares of some large good quality companies with exposure to emerging markets corrected.”

Although valuations have risen considerably since the summer of 2012 when the macro picture looked bleak, historically valuations at around current levels have typically heralded a period of 10 per cent annualised returns over the following five years. That is very attractive against any other asset class. European special situations, recovery and value strategies have done particularly well as out-of-favour sectors, while financials have benefited most from the improved outlook. Automakers have rallied too, but remain cheap on valuations of 9 times earnings, for example.

Ms Carrier prefers active management to access this space as stock selection in the current environment is important. In particular she sees opportunities in industrials and consumer discretionary and some investment banks. RBC likes growth-oriented stocks but prefers to have something in addition to a pure cyclical recovery for example, a repositioning or restructuring story.

Wealth managers also warn that investors need to be careful about their exposures. Many mutual funds focused on the developed world already allocate a majority of their portfolio to Europe, while some  ETFs that track Europe exclude the UK and Switzerland. There is also the currency angle, which for example tripped many investors in Japanese markets this year.

VIEW FROM MORNINGSTAR

In line with peers

ETFs tracking European equity markets have performed well over the past 12 months compared to other broad markets. While the MSCI Europe Index and the STOXX Europe 600 Index generated returns of 18.07 per cent and 19.01 per cent to end September, respectively, the S&P 500 Index and the MSCI World Index returned only 12.67 per cent and 14.25 per cent. The bulk of this outperformance was mainly generated in the last quarter of 2012, when concerns about the ‘fiscal cliff’ weighed on US equity sentiment.

Measured against their Morningstar category, ETFs tracking the MSCI Europe Index and the Stoxx Europe 600 Index have only slightly outperformed the category average of 17.78 per cent. This can be explained by a rather similar sector allocation vs category. Indeed, only a few sectors, like consumer cyclicals, financial services, industrials, or IT, are over- or underweight by 1-2 per cent and as such have little impact on the ETFs’ performance relative to their peer group.

A key driver for European equities ETFs has been the financial sector, returning 27.88 per cent. As financials represent roughly 20 per cent of the Stoxx Europe 600 and MSCI Europe indices, this sector contributed about 5.6 per cent to overall performance.

Small and mid-caps outperformed large caps by about 5 per cent, as a pan-European recovery with improving fundamentals supported a risk-on investment environment. The Ossiam Stoxx Europe 600 Equal Weight ETF, tracks an index which overweighs small-caps relative to the market-cap weighted benchmark and returned 21.06 per cent over the period, putting it right at the top of the performance table.

Gordon Rose, fund analyst, Morningstar