North American equities have proved a long-term powerhouse. Few investors can afford to ignore what is, by some margin, the world’s largest and most liquid stock market, which enables them to tap into the world’s most prodigious, highly-developed, diverse and sophisticated economy. North American equities comprise 62% of the MSCI World Index, and over recent years have consistently outperformed it. Over the 10 years to the end of 2018, the MSCI North America Index’s total return was 231.4%, compared to 167.3% from the MSCI World Index. To be sure, in 2018, which was a highly unusual and difficult year for equity markets due to the end of quantitative easing, both indices suffered negative returns, but the MSCI North America Index performed relatively better (-5.2% versus -8.2% for the MSCI World Index).
On the global equities desk, we do not base our investment decisions on macroeconomic forecasts, but it is worth noting that the US economy is currently growing much faster than the Eurozone or the UK, and streets faster than Japan. Despite justifiable worries over the US-China trade war, American domestic business optimism and consumer confidence are high. US unemployment is low. The US Federal Reserve, having steadily raised interest rates during 2018, has recently softened its stance. It is indisputable that North American equities cannot be ignored; and, on any sensible long term view, this remains true, despite their down year in 2018.
THE DANGERS OF BEING TOO ‘STYLISH’
Although many asset allocators will therefore want to remain invested in North American equities for the long term, many are studying how best to achieve diversification within their allocations.
Many active fund managers in the North American equities sector have a pronounced investment style bias, such as towards value or towards growth. A value style emphasises stocks whose prices are low in relation to the companies’ earnings or book value, or whose dividend yield is high; a growth style is focused on companies that are growing quickly even if their share prices are relatively high. Other investment styles include quality and momentum, for example.
We believe that investment style bias can be a severe long term handicap, because the market environment changes over time, and a style that was successful in one market environment often proves unsuccessful in another. Our approach is to flex our investment style over time, specifically in response to our analysis of changing market conditions, and we believe this can enhance long term returns.
A concrete example of how our process led to a significant adjustment in positioning was in the final months of 2018. As the market environment (as measured by our proprietary analysis) became increasingly pessimistic and risk averse during the latter part of 2018, our process increased the significance of some of the more defensive elements within our stock selection criteria, while reducing those designed to capture growth. Our process is designed to work at the stock level rather than the sector level, but the adjustments had the end-effect of reducing our weighting to the information technology sector, for example. Such adjustments are a normal part of our long-term process.
One way of measuring how often funds switch styles between value and growth is Morningstar’s Value Growth Consistency Metric. The chart below shows the style consistency of the seven largest active funds in the IA North America sector based in the UK, for illustrative purposes. Funds with higher scores switch styles between value and growth more often, while those with lower scores are more consistent in style. The Merian North American Equity Fund has a much greater score than the other funds shown, because its process seeks to flex its style according to the market environment.
STANDING OUT FROM THE CROWD
We regularly measure the correlation between the alpha (excess returns over the peer group) generated by the Merian North American Equity Fund and the five largest North American Equity funds in its sector. As can be seen from the table, the correlations over three years were negative or close to zero. (Correlation is measured between -1, negative correlation, and +1, positive correlation, with zero representing no correlation.) The reason for the fund’s low or negative correlation, we believe, is the uniqueness of its systematic stockpicking process. Uncorrelated returns allow investors to achieve better diversification within their portfolios, and so to achieve a more optimal balance between return and risk.
Source: MGI, as at 31/12/2018. The returns were measured month by month from December 2015 to December 2018.
EVOLUTION NOT REVOLUTION
The Merian North American Equity Fund has outperformed its benchmark, the MSCI North America NR USD, in four of the last five calendar years. The exception was 2018, when it underperformed. Cumulatively, over the five years, the fund has returned 47.6%, compared to 41.0% by the benchmark. Over five years its sector ranking is first quartile.
The equity market in 2018 was notable for swift rotations, and this proved challenging for many investment strategies, including our own. The year was unusual for its numerous, and sharp, inflection points, as market uncertainty led investors to rethink their approaches and flip-flop in their decision making.
In periods of challenging performance, fund managers as well as fund selectors tend to face an increased danger of falling into behavioural traps, such as the temptation to overreact to short term performance. When faced with a period of underperformance, a very natural, but often flawed, psychological reaction can be to seek to change the investment process. Above we argued that it is advantageous to be flexible on investment style. When it comes to investment process, however, we firmly believe in the merits of consistency. For one thing, this allows investors better to judge what the fund offers and to assess it objectively. For another, we believe that our process has proved itself over the long term, and we see no lack of opportunities for it to outperform in the future, because of the prevalence of inefficiencies in market pricing.
Although we believe in remaining faithful to a consistent investment process, central to our philosophy is a continuous and disciplined research effort to ensure that our process improves over time. This involves research activity undertaken by our in-house team, as well as interactions with our external team of academic advisors and external researchers. We insist on a scientific, rigorous approach to introducing any enhancements to the process. Changes are not made without considerable in-depth testing and review, and are likely to be evolutionary, rather than revolutionary.
We shall continue to deploy our investment process diligently through varying market conditions. Our expectation is that this should continue to provide diversified excess returns in the future, as it has done over the long term.
Source: Bloomberg, as at 31/12/2018.
Source: FactSet, Morningstar, I USD Acc share class, bid to bid, net income reinvested, net returns, to 31/12/2018.