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CONNECTIONS www.kl-communications.com - November 2014

Launch of new investment video update hub: www.alpha-sight.com

Argentina could top 2015 bond market returns

T. Rowe Price EMD portfolio

specialist Jeff Kalinowski believes

Argentina could emerge from its

default turmoil to be the top

performing emerging debt out-

post next year.

While Kalinowski accepts the

Argentinian bond market will

remain volatile in the near term,

he sees positive signs for the

troubled country. The T. Rowe

Price Global Emerging Markets

Bond Fund had a 5.9% exposure

to Argentina, at 31 October,

about four times the benchmark.

“We do see a recovery coming in

Argentina and the market is

pricing in an overly pessimistic

view,” Kalinowski says. “With

the expiring of the RUFO clause,

Argentina could make good on

its debt and we could see a sig-

nificant bond rally next year. This

is what predicates our over-

weight in the country.”

While Kalinowski accepts EMD

valuations are full in absolute

terms, he believes it still offers

compelling relative value.

“Technicals are positive, valua-

tions favourable, and the funda-

mentals are improving. This for

us is a clear buy signal,” he adds.

AlphaSight brings together the raw

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– such as Nordea Asset Manage-

ment, Henderson Global Investors,

pension consultant Redington and

fund rating service FundCalibre.

* The information in AlphaSight is

intended for (non-US) investment

professionals.

P2 ACTIVE VS PASSIVE:

COMPARISON CHALLENGES

Redington’s David Bennett

says utilising risk-adjusted

returns can help with active

vs passive comparisons.

P2 RETAINING CONVICTION

IN VOLATILE RUSSIA

T. Rowe Price’s Leigh Innes

and S. W. Mitchell’s Alexis

Mathieu discuss why they

remain optimistic on Russia.

P3 US MANUFACTURING

RENAISSANCE CONTINUES

Eagle AM’s Jeff Vancavage

explains why manufacturing

has been a growing bright

spot in the US economy.

P4 STOCK CONNECT: A

MILESTONE FOR CHINA

Views from top investors as

China begins the Stock Con-

nect, giving foreign investors

access to domestic A-shares.

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Active vs Passive: Beware of comparing apples to pears The Active vs Passive debate lingers

on. To understand which approach

delivers the ‘best’ results, it is vital

to compare on a like-for-like basis.

David Bennett, head of investment

consulting at Redington, says risk-

adjusted returns can help.

Are active equity managers worth

the fee-premium compared to

passive investing?

The focus on fees paid by institu-

tional investors has helped to fuel

the active versus passive debate. A

recent example is Hymans’ paper

and DCLG consultation for Local

Government Pension Schemes.

Also, active equity investments

typically bring a higher governance

burden at a time when resources

may be limited and higher priority

strategic matters need focus.

Comparing apples with apples

In order to help advise clients on

the merits of specific active equity

managers, valuable insights can be

obtained from quite simple analy-

sis. The table below provides an

example of how headline returns

may show outperformance against

the benchmark, but fail to tell the

whole story. In this example, the

manager has clearly outperformed

the benchmark and met outperfor-

mance target (+2.2% net of fees

versus +2%).

However, once the benchmark is

scaled up to have the same volatili-

ty, the manager underperforms the

benchmark. On a like-for-like basis,

accounting for the level of risk tak-

en, the manager would have had to

achieve an excess return above 14%

to meet its mandate.

The higher return appears to be a

function of using higher-risk strate-

gies, rather than manager skill

(‘alpha’). Further insights can be

obtained by using style factor analy-

sis. In this case, returns are re-

gressed against value, momentum

and style factor indices. This reveals

that the manager – whose mar-

keting refers to a value based in-

vestment philosophy – has in addi-

tion to a significant ‘long beta’ posi-

tion an underweight exposure to

‘defensive’ that was far bigger than

the long value position.

An alternative to active equity

allocations

So, how best to allocate to equities

if you do not want to use active

managers? Passive strategies which

include the use of volatility control,

with 90% put options, materially

improves the risk/return profile of

equities and are gaining wide ac-

ceptance.

If exposure is obtained by deriva-

tives, an additional benefit is the

freeing up of capital, greatly in-

creasing strategy freedom.

There is evidence to support long-

term successful active managers

deriving their success from a persis-

tent style tilt. Excellent examples

would be Neil Woodford and War-

ren Buffett.

Fortunately, credible offerings are

starting to appear from managers

offering systematic, diversified,

‘market neutral’ access to style

factors. Adding this exposure brings

additional benefits to a portfolio via

gaining low correlation exposure to

proven sources of outperformance.

twitter: @davidjbennett1

David Bennett - Redington

CONNECTIONS

Emerging Europe equity managers

remain cautiously optimistic on the

prospects for Russian stocks, de-

spite recent pressure on the econo-

my and rouble currency.

The rouble rout began during the

Ukraine conflict through to the

Western-imposed sanctions, while

it intensified during the recent oil

price slide. As for equities, the dol-

lar-denominated RTS Index is 26%

lower in 2014, to 19 November.

“It is important to look at the rou-

ble devaluation in conjunction with

the development of oil,” SWMC

Emerging European Fund manager

Alexis Mathieu says. “Energy consti-

tutes an important part of Russia’s

balances, both current account and

budget – as taxes on oil companies

represent a large portion of reve-

nues. As such, a weakening rouble

is shock absorber for oil prices.”

Mathieu believes a natural trade is

to favour exporters, which are sell-

ing in dollars but incurring local

currency costs, and shy away from

consumer discretionary companies.

“In specific cases, it is best to look

for the relative winners against

competition. For example, modern

food retailers are gaining market

share versus traditional trade play-

ers, as these companies are able to

leverage off their scale and strong

financial positions,” he adds.

T. Rowe Price Emerging Europe

Equity Fund manager Leigh Innes

says attractive opportunities can

still be found in Russia.

“Many investors look at stocks like

Magnit and simply say: ‘Russia,

macro, don’t touch’. However, the

stock has done incredibly well over

the last five years and we have

been adding to it during recent

bouts of weakness,” she says. “This

stock will do well even if the econo-

my continues to slow. The way to

make money is to be contrarian and

we can afford to be patient.

“While it is easy to write off Russia,

we are not going to run away be-

cause of turbulence. Given recent

volatility, there are some high quali-

ty companies trading at attractive

valuations. This is providing us with

great buying opportunities.”

Retaining conviction in volatile Russian stocks

Russian President Vladimir Putin

5yrs to 03/2014 Mandate/BM Investment target Annual net return Excess net return Volatility Sharpe Ratio Manager Global Benchmark +2% 14.0% 12.7% 19.3% 0.66

Benchmark (BM) MSCI World 11.8% 10.5% 14.5% 0.72

BM - scaled for volatility MSCI World 15.7% 14.0% 19.3% 0.72

3

CONNECTIONS

The US manufacturing renaissance can continue The industrial sector, manufactur-

ing in particular, has been a grow-

ing bright spot in the US economy.

The comparative advantage of US

manufacturing has progressed, with

energy costs declining and produc-

tivity improving. Additionally, Chi-

nese wages have increased, making

the relative cost of manufacturing

overseas less attractive.

There are a number of structural

changes allowing US manufacturers

to become progressively more com-

petitive globally, and at home.

Technology and innovation

Industrial activity continues to in-

corporate more software and auto-

mation, driving efficiencies and

increasing output. To get a sense

for how productivity has changed,

durable goods manufacturing grew

38% from mid-2009 through May

2014. Over that time the real value

added was 18%, compared to an

11% rise in overall GDP. US manu-

factures have employed automa-

tion and are reaping the benefits.

Through technology and innova-

tion, Ingersoll Rand has expanded

margins and increased capital effi-

ciency. It uses rigorous analytics to

ascertain the market’s need, drive

research and development, and

increase manufacturing efficiencies.

The shale revolution

Energy is a significant component of

manufacturing and distribution

costs. Technological breakthroughs,

such as drilling technology, have

been a game changer for energy

intensive manufacturing. In addi-

tion, success in exploiting shale

deposits has advanced US energy

independence. Natural gas produc-

tion has reduced domestic energy

prices, which are currently about a

quarter of those in Asia and Europe.

One of the direct beneficiaries of

the proliferation of shale gas is

chemical company LyondellBasell,

which has a low-cost advantage

against its global competitors.

Sustained shifts in labour costs

The recession has narrowed the

wage gap between US and EM

workers. While this has been pain-

ful, labour costs were a predomi-

nant factor in the move away from

US manufacturing. Reduced labour

costs and rising productivity are

improving the value added by each

worker, an increasingly important

factor in competitiveness.

Companies such as Honeywell have

benefited from reduced labour

costs by manufacturing equipment

near the end user. The benefits are

numerous, as a strong geographic

presence can deepen relationships

and increase speed to the market.

Increasing investment activity

US investment as a percent of GDP

is well below historical levels. How-

ever, capital spending is starting to

return. As this recovery continues,

uncertainty decreases. This, com-

bined with aging stock, should drive

replacement investments. Existing

equipment has not been this old for

nearly 20 years and efficiency gains

from existing stock are diminishing.

Businesses will likely resume invest-

ment in productivity-enhancing

capital expenditure.

This will benefit Eaton, which offers

energy-management solutions to

help deal with rising energy costs.

In summary…

US industry has changed dramati-

cally. The sector has transitioned

from low tech and labour intensive,

to technology intensive and high

productivity. Medical devices, clean

energy, nanotechnology and phar-

maceuticals are a few examples

showcasing US capabilities and

competitiveness in developing and

commercialising new technologies.

The US is unlikely to be the industri-

al leader it was in the 1950s and

1960s, but the US industrial sector

will likely continue to gain global

market share over the next decade.

Eagle AM’s Jeff Vancavage is a

portfolio manager on the Nordea 1

- North American All Cap Fund

Hermes Sourcecap buys into ‘misunderstood’ Nokia Hermes Sourcecap European Alpha

fund manager James Rutherford

has bought into Nokia, saying inves-

tors have misunderstood the Finn-

ish group’s transformation.

After selling its phone business to

Microsoft, Nokia is now made up of

three divisions – Nokia Networks, a

patent portfolio, and the ‘Here’

mapping operation.

“Market consensus is that the new

Nokia is distinctly dull, but is now

on a more stable footing than it was

before its recent merry-go-round of

sales and acquisitions,” Rutherford

says.

“Although Nokia shares might look

expensive at first glance – 28x 2014

consensus earnings – this does not

take into account the fact it had

€8bn of net cash and equivalents on

the balance sheet at the end of

June, after selling the handset busi-

ness to Microsoft.

“Adjusting for this cash, the shares

would only be on 14x P/E for this

year. Cash rich, well positioned and

with an enviable IP armoury, we

think the business has quite a long

way to go.”

Jeff Vancavage - Eagle AM

FundCalibre adds 6 more ‘Elite’ funds Leading UK fund ratings agency

FundCalibre has awarded an

Elite Rating to six further strat-

egies, taking its number of top

ranked portfolios to 109.

These are: Hermes Asia ex-

Japan, F&C Multi-Manager

Navigator Distribution, Invesco

Perpetual Hong Kong & China,

Smith & Williamson Enterprise,

Old Mutual Global Equity Ab-

solute Return and Rathbone

Strategic Growth.

To become Elite, a fund must

pass a quantitative process

designed to isolate a man-

ager’s ability to outperform

over at least three years. The

volatility of a manager’s ‘skill’

is then assessed to determine

the probability of repeating

outperformance. A qualitative

process is also made.

“We continue to search for

managers who are able to

generate alpha after fees. We

do not expect to add a signifi-

cant number of funds at each

quarterly meeting, but these

additions are all highly impres-

sive,” FundCalibre MD director

Darius McDermott says.

Revival of Finnish giant Nokia

4

CONNECTIONS

Stock Connect: A milestone in China’s development

T: +44 (0) 203 137 7823

www.kl-communications.com

info@kl-communications.com

Jorry Rask Nøddekær – Nordea The gradual opening up of China’s A-share market via the connect scheme is a milestone for China’s capital markets. It is a sign of the leadership’s commitment to reform, which is one of the reasons why we have a positive long-term view on Chi-na. This scheme broadens our investment universe to include a large number of shares listed on the Shanghai Stock Ex-change, which would otherwise not be accessible, including shares in the structurally growing auto, healthcare and media sectors. In addition, as this is a two-way scheme, mainland Chinese investors are likely to buy into Hong Kong-listed names in a number of sectors that remain underrepresented on the Shanghai exchange. The internet sector is a good example of this, and we could benefit from our holding in Tencent. Lastly, valuation gaps between A and H-shares can be exploited.

Anh Lu – T. Rowe Price We are optimistic about the Stock Connect, which allows foreign investors access to mainland A-shares. This is another important experiment in the opening of China’s capital markets and the internationalisation of the RMB. Our hope is that the limited quotas that the Connect begins with will be expanded over time, and its scope will eventually cover Shenzhen as well as Shanghai. If successful over the next few years, the QFII scheme for foreign access to A-Shares may become increas-ingly redundant. The Stock Connect could also hasten the inclusion of A-Shares into the broader MSCI indices – MSCI China is already the largest country component of MSCI AC Asia ex Japan and MSCI EM, and that weight may increase over time with increased A-Share inclusion. The A-Share market is home to a many companies in the consumer, healthcare and indus-trials sectors, for example, that are not available to investors in Hong Kong-listed China companies.

Jonathan Pines – Hermes In anticipation of this opening up, over the last few months I have significantly increased exposure to A-shares. The fact this trade is currently dominated by relatively unsophisticated domestic retail investors has resulted in significant inefficiencies. That does not mean most A-shares are cheap, even though the benchmark has declined for years. In fact, most A-shares are expensive relative to their quality, with well-governed companies generating free cash flow still a rarity. So why then have I been loading up on A-shares? This market presents two main sources of opportunity. Firstly, some issues are listed on both the A and H-share market, and sometimes A-shares trade at a discount. For example, our fund holds Ping An Insurance A-shares, which trades at a discount to its H-share. The limited opening up of the A-share market might result in the gap clos-ing, and if we are lucky, the gap will close by the A-share rising rather than the H-share falling.

Darius McDermott – Chelsea One of the major concerns is that both exchanges operate in different regulatory environments. Investors should be very aware of all of the potential risks around regulatory issues and tax implications before investing in any market. However, this development could be important for Chinese stock markets in the longer term. The principle of allowing free access to the country’s stocks is crucial to the sustained growth of China’s markets and economy. This is a clear signal from China’s

leadership that the stock market is at the centre of its future expansion plans and policies. twitter: @DariusMcDermott