A robust investment process should accept that higher volatility is normal, and that style bias must be overcome, argues Ian Heslop, head of global equities and manager of the Merian European Equity Fund
European equities cannot be ignored when considering how best to diversify. Western Europe is a colossal economy, with almost as great a share (14%) of world GDP as the US (15%), on a purchasing power parity basis1. Yet many investors remain far more weighted to US than to European equities.
The European market is deep and liquid. Less homogeneous than the US, it embraces a variety of national markets. This diversity means that there is greater scope for generating alpha through systematic, research-based investment in European equities than in the homogeneous and highly competitive US market, in my view. Most academic investment research has focused on the US, giving an opportunity in European equities for a research-based, systematic approach like ours.
Europe, like all world economies, faces risks. A disorderly, no-deal Brexit could cause an economic shock, especially for the UK and Ireland. A financial crisis might assail Italy, which suffers from high debt. Global trade tensions have already dampened European growth, and there is a risk that the US, having increased tariffs on China, could erect fresh trade barriers against Europe.
When facing uncertainty and risk, it is essential to adopt an objective, bias-free approach, based on thorough and objective research. Central to our philosophy on the Merian Global Investors global equities team is a continuous and disciplined research effort, testing hypotheses against specific, concrete data.
Higher volatility is normal
European equities, like world equities, have been more volatile recently. The Vstoxx Index, a measure of volatility in European equities, rose to 21.1 on 5 August 2019. However, this was still below its long-term average2. The fall in volatility during 2016 and 2017 may have lulled investors into a false sense of security, ill-preparing them for the spikes in volatility of February 2018, December 2018, May 2019, and August 2019.
Like world markets, European equities lost ground toward the end of 2018, but recovered3 in 2019. Yet the rally of 2019 was cautious, most of the gains coming from quality and growth, rather than value factors. Investors have been risk off rather than risk on, according to our analysis, and value tends to do well in risk on environments. Over recent decades, value and growth have contended to hold sway in Europe (see graph).
Many traditional European equity funds are prone to style bias. They may be wedded to a rigid investment style, such as a value style or a growth style. Our process avoids style bias. We believe that better risk-adjusted returns can be achieved by flexing the fund’s investment style according to our proprietary analysis of the market environment.
1 Source: IMF estimates for 2019.
2 The average was 23.9, based on data 4/01/1999-2/08/2019.
3 The MSCI Europe Index had a price return of 8.9% year-to-date, as at 5 August 2019. Source: Bloomberg as at 5/08/2019.