Challenging Conventional Wisdom in Global Equities Schroder Educational Series Stephen Kwa Senior Client Portfolio Manager March 2013 For Broker/Dealer Use Only. Schroder Fund Advisors LLC, Member FINRA, SIPC Not for use with the general public or clients under any circumstances. 875 Third Avenue, New York, NY 10022-6225 (800) 730-2932 www.schroderfunds.com
Agenda For passive investors 1. Challenging the conventional wisdom of cap weighted indices and ETFs And for active investors 2. Challenging the conventional wisdom of concentrated portfolios 3. Importance of Quality in portfolios 1
Challenging the conventional wisdom of cap weighting Source: newslettercartoons.com 2
What is cap weighting? Stock weights proportional to market cap of company S&P 500 stock weights Dec 31, 2012 MSCI EAFE stock weights Dec 31, 2012 Stock Stock Company Weight Company Weight rank rank APPLE INC 3.94% NESTLE SA 1.92% 1 1 EXXON MOBIL CORP 3.10% HSBC HLDGS 1.76% 2 2 GENERAL ELECTRIC CO 1.73% NOVARTIS AG 1.32% 3 3 CHEVRON CORP NEW 1.66% 4 ROCHE HLDGS AG 1.29% 4 INTL BUSINESS MACHINES 1.60% 5 BP 1.20% 5 MICROSOFT CORP 1.59% 6 ROYAL DUTCH SHELL 1.17% 6 JOHNSON & JOHNSON 1.52% 7 TOYOTA MOTOR CORP 1.17% 408 X 7 345 X AT&T INC 1.50% 8 BHP BILLITON LTD 1.14% 8 GOOGLE INC 1.48% 9 VODAFONE GROUP 1.13% 9 PROCTOR & GAMBLE 1.46% 10 SANOFI 1.03% 10 FIRST SOLAR 0.01% 496 KINDEN CORP 0.01% 900 BIG LOTS 0.01% 497 SQUARE ENIX HOLDINGS 0.01% 901 THE WASHINGTON POST 0.01% 498 TOYOTA BOSHOKU CP 0.01% 902 AUTONATION INC 0.01% SYDNEY AIRPORT 0.01% 903 499 BANKIA SA 0.005% ADVANCED MICRO DEVICES 0.01% 904 500 3 Source: Schroders. Companies mentioned are shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell .
The issues with cap weighting Leaves unexploited opportunities behind 1. Buy and hold strategy – can detract from returns 2. Stock diversification issues 3. Concentrated to mega/large caps which underperform over time 4. Restricts universe of opportunities Source: Schroders 4
Issue 1: Cap weighting is a buy & hold strategy Akin to momentum investing – unable to take profits and rebalance Technology/Telecoms bubble of 1999/2000 40% 30% 36% of MSCI World is comprised of tech stocks here 20% 10% 0% 1994 1996 1998 2000 2002 2004 2006 2008 IT sector weight in MSCI World Source: Schroders, MSCI. These views and opinions are of the QEP Team and are subject to change. 5
Issue 2: Stock diversification issues Concentration primarily to market leaders – “Top Dogs” % weight in country Weight of largest 3 companies by country total market cap 80% Largest stock "National Top Dog" 60% 2nd + 3rd BHP Commonwealth Bank 40% Westpac Apple Exxon 20% GE 0% UNITED STATES JAPAN HONG KONG CANADA UK GERMANY FRANCE SINGAPORE AUSTRALIA BRAZIL TAIWAN SWITZERLAND ITALY SPAIN SOUTH KOREA Source: Schroders as of December 31, 2012 based on stocks within the MSCI AC World Index. Countries mentioned are for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The percentages shown represent the weights, as measured by market capitalization, of the indicated stocks of each country within the MSCI AC World Index. These weights are subject to change and should not be viewed as an investment recommendation. Top Dogs” is defined as the single largest company in the sector-country combination. 6
Issue 2: Top Dogs dominate exposure Top Dog concentration within sectors by country The Relative Cap Weight Market Share of Top Dogs (1982-2010) Average United New United Australia Canada France Italy Germany Japan Across States Zealand Kingdom Countries Non Durables 15% 28% 42% 39% 32% 26% 13% 36% 18% 28% Durables 43% 59% 46% 49% 78% 49% 25% 88% 34% 52% Manufacturing 7% 33% 18% 19% 29% 14% 5% 71% 20% 24% 31% 31% 21% 57% 91% 77% 31% 78% 49% Energy 52% 24% 63% 49% 60% 54% 48% 11% 65% 45% Chemicals 47% Business Equipment 20% 21% 25% 28% 47% 58% 12% 59% 30% 33% Telecommunication 29% 70% 40% 40% 40% 76% 64% 78% 60% 55% Utilities 5% 63% 30% 70% 44% 34% 27% 45% 30% 39% 16% 36% 18% 24% 43% 32% 10% 43% 20% Shops 27% HealthCare 13% 47% 39% 50% 60% 42% 19% 76% 45% 44% Finance 6% 20% 14% 18% 24% 20% 9% 25% 14% 17% Other 8% 25% 13% 13% 34% 23% 7% 36% 11% 19% Average Across 18% 41% 30% 39% 48% 42% 19% 58% 31% 36% Sector Top Dogs Source: Research Affiliates; Source: Arnott, Wu (2012): “The Winner’s Curse: Too Big to Succeed?” The authors use SIC codes to define the 12 sectors. These definitions may vary from GIC definitions. Countries/sectors shown are for illustrative purposes only and should not be viewed as a recommendation to buy/sell. “Top Dogs” is defined as the single largest company 7 in the sector-country combination.
Issue 2: Top Dogs lag in performance US equities Source: Arnott, Wu (2012): “The Winner’s Curse: Too Big to Succeed?” Graph shown are for illustrative purposes only and should not be viewed as a recommendation to buy/sell. Past performance is no guarantee of future results. The value of an investment can go down as well as up and is not guaranteed. “Top Dogs” is defined as the single 8 largest company in the sector-country combination.
Issue 2: Top Dogs lag in performance Global equities Source: Arnott, Wu (2012): “The Winner’s Curse: Too Big to Succeed?” Graph shown are for illustrative purposes only and should not be viewed as a recommendation to buy/sell. Past performance is no guarantee of future results. The value of an investment can go down as well as up and is not guaranteed. “Top Dogs” is defined as the single 9 largest company in the sector-country combination.
Issue 3: Concentration to mega/large cap stocks Crowds out small and mid caps MSCI World by size as of December 31, 2012 Schroders global universe by number as of December 31, 2012 Mid, 4.2% Mega/Large Micro 18% 24% Mega/Large, Mid 95.8% 28% Small 30% Source: Schroders, MSCI. MSCI World as of December 31, 2012 Capitalizations mentioned are for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The percentages shown represent the weights of stocks in the indicated ranges within the MSCI or the Schroder global universe. These weights are subject to change and should not be viewed as an investment recommendation. 10
Benchmark issues Significant new landscapes exist beyond the benchmark All global stocks > 15,000 global stocks > 12,000 international stocks MSCI All Country World Significant opportunities >2,400 stocks from emerging markets, MSCI World small and mid caps >1,600 stocks S&P 500 Exploit breadth – small and mid caps fertile hunting ground Source: Schroders, MSCI as of December 31, 2012 11
Conclusion 1. ‘Passive’ investing is an active decision 2. Understand the exposures you get from an index fund or ETF 3. Cap weighting issues > Buy & hold > Concentrations to market leaders and ‘Top Dogs’ which underperform > Restricts universe Source: Schroders 12
Concentration versus diversification New eyes on generating alpha Source: newslettercartoons.com 13 13
How to build a highly active fund? Don’t need to be concentrated How to be highly active - Not looking like the index Concentration New sources of alpha Drop constraints – Reduce number of stocks – Take off index bets – Non market cap stock and increase bet size weights – Emerging markets – Allow greater flexibility in – Small and Micro caps stock, sector, region and currencies Source: Schroders 14
Active Share measures the active bets in a fund Not tracking error or number of stocks, ultimately it’s Active Share Example Fund Benchmark 4 1% Stock weight (%) 3 0% 2 2% 3% 1 0 Stock A Stock B Stock C Stock D Source: Schroders. This is a stylized example is does not represent actual stock weights of the companies mentioned in any specific benchmark. 15
Active share vs. number of holdings Diversified but still very active 100.00 Schroder International Multi-Cap Value Fund 90.00 80.00 70.00 60.00 Active Share (%) 50.00 40.00 30.00 20.00 10.00 0.00 0 200 400 600 800 1000 1200 1400 1600 # of Holdings Source: eVestment. Portfolio holdings for Schroder International Multi-Cap Value Fund as of December 31, 2012 versus eVestment EAFE large/all cap managers. Active share is calculated versus MSCI EAFE. 16
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