Fog shrouds route to best returns

Fund managers’ views on American investments are shrouded in a fog of uncertainty as the market turmoil persists – but looking at industry weightings alone will not provide any clarity.

Last year was characterised by overperformance and volatility in emerging markets and punctuated by credit worries in developed markets. Much discussion dwelt on how to get a piece of the action and profit from the striding confidence in East Asia, the Indian subcontinent and Latin America.

Some profited from direct investment in shares of local firms and others by investment in the raw materials produced and consumed by these firms. Investors saw titans rising in far-flung lands that excited with their growth prospects and supposed ability to sustain the global economy.

Nevertheless, the evidence surrounding China’s dependence on exports is genuinely contradictory and soundly supports both the pessimists and optimists. Will Indian technology firms ride out any slump in global capital expenditure? Will high oil prices be sustained by emerging market demand, or will they stumble and give breathing space to the oil-addicted regions of the world?

Equity returns will become less uniform across emerging markets and investors will learn which questions they should be asking, to finesse their choices between emerging markets, rather than taking a broad brush approach.

Such uncertainty is part of the financial markets. So what is everyone worried about? Is it not just business as usual? What marks the best investment returns this time around, compared with those of the last significant bull market, is that previous returns came from the developed world dotcom experiment. Being human and somewhat more at ease with creating risks for ourselves, the investing and working populations are again getting used to the idea of a new dynamic from overseas. The last time this happened was the rise and plunge of Japan’s markets.

This breeds unknowns that are real and concerns about inflation – witness the American Congress’ protectionist attacks on the value of the Chinese renminbi, for example. They were rebuffed by Alan Greenspan, the then chairman of the Federal Reserve as based on “no credible evidence”. But in the face of this uncertainty of outcomes, there are still important pointers to keep an eye on.

All eyes are on how corporate America and the country’s consuming public hold up. However much the relative balance of power has changed in the world, there is no dispute about the continued importance of America to equity returns globally.

British funds in the IMA North America sector returned 4.46% on average in 2007, with the sector holding 12th place in the IMA sector rankings. This was on the back of a 3.53% return for the S&P 500 and the Nasdaq 100 witnessing a renaissance of the tech sector, with a 18.7% gain over the year. The increase in market volatility in the last part of the year did keep investors on their toes.

Three consecutive Federal Reserve rate cuts propelled the dollar to record lows and supported the view of many that America may have already entered a recession. The jumps in inflation and increases in oil prices during the year complicated the picture regarding rate cuts. Moreover, a potentially sharp slowdown in a malignant credit environment would not sit well if geopolitical concerns exacerbate existing worries.

Two phenomena have been true in financial markets from their origins to modern electronic markets – credit availability moves in cycles and investor sentiment fluctuates between hope and fear. The credit situation is summed up by the word “crunch”. Most investors in America range from less than hopeful to glum, even before considering the falling value of their homes.

So how are British fund managers managing their American investments? A powerful point is made by the deterioration of the worst performers in the IMA North America sector during the latter half of the year.

Over 12 months, the bottom decile of funds in this sector lost between 3.7% and 10.8%. If we examine the bottom decile over the final six months of 2007, the figures show that they lost between 7.9% and 15.4% in what were challenging conditions.

Data on the IMA North America sector from the December Lipper Portfolio Holdings Analysis Report shows the average fund held just under 17% of its portfolio in financial stocks. Exposure to consumer services and goods stocks was more than 20% (see pie chart).

The impact on fund returns of subprime mortgage problems causing write-downs by banks over the past six months has therefore been an unsurprising drag on returns.

These allocations are also rather close to industry weightings in the S&P 500 index. With this index being one of the most common fund benchmarks, many managers stick as closely as possible to portfolios that are similar to the S&P 500.

Market capitalisation weighted indices, such as this, reward higher market valuations with higher index weightings. Financials had been an increasing proportion of American market capitalisation for some time as a result.

The higher the valuation the more dangerous the prospect of bad news, and there has been enough to go around. Out of all the industries, it was financials that faced the drastic earnings estimate revisions by analysts for the fourth quarter of 2007.

What is the investor to do? Consider funds whose industry weightings differ from benchmarks aiming for strategic outperformance, or fund managers who have a solid reputation for bottom-up stock analysis? Looking at industry weightings alone will not reveal the answer.