By Anthony Lawler
For European equity long/short hedge funds it has been a challenging year, with those funds up 4.8% through the end of October even as the MSCI Europe index returned 12.8% (both returns in U.S. dollar terms). In Europe the risks of structural core versus periphery imbalance, policy actions, political rhetoric and fragile sentiment continue to prompt violent swings in expectations and equity prices. This has proved a challenging backdrop, but strong risk-adjusted returns have remained achievable. This year many of the equity long-short winners have been those who have been nimble in adjusting positioning while at times holding firm with constructive equity views through the noise of almost daily chatter of how the European crisis will continue to unfold. But going forward which is more likely to outperform, the nimble traders or the fundamental investor? We see indications that fundamental investors could be the winners. But the better of these fundamental investors will be hybrids: fundamentally focused but nimble enough to reposition quickly if Eurozone stability weakens materially.
Through ongoing discussions with European hedge fund managers, it is clear that for many their trading strategies have been forced to adjust during the past few years. The frequent shocks to markets--whether from policy, fear or sentiment--have proved particularly challenging for fundamental bottom-up managers. Long positions taken based on rigorous financial analysis have oft been dropped in the face of highly correlated risk-off moves. Similarly, weak companies which some managers were short have rallied steeply along with the broader markets when positive sentiment has come flooding back. This correlated bumpy price activity has taken its toll on fundamentals-focused managers, who have tended to respond by de-risking their portfolios and running a lower neutral gross exposure. Managers have also responded by shortening their typical holdings periods, and implementing tighter stop losses.
Given the frequent reversals in market direction, and the regular bouts of volatility, the environment has been suited to more tactical managers, and those with a greater emphasis on top-down analysis. Indeed, many bottom-up managers have made a conscious effort to develop these new skills, with varied degrees of success. The increased importance of top-down analysis, particularly in relation to political developments, has been obvious in recent years. The most successful Europe-focused managers have shown flexibility in their views and not been wedded to either company fundamentals or to perma-bull/bear views. This hybrid approach has proved more effective than most buy-and-hold fundamentals-driven portfolios.
However, there is an argument to suggest that the out-performance of the nimble traders over the fundament traders could reverse from here in the medium to long term amid a rise in global market stability. The ECB now appears to have taken up the mantle of buyer of last resort for European sovereign bonds, while core Europe seems closer to accepting an open-ended burden sharing of peripheral debt. With the addition of QE3 from the Federal Reserve in the US, the probability of a more stable macro policy backdrop seems to have improved markedly. Note that for the fundamental investors it is this policy framework stability that matters, rather than the level of growth rates.
On top of this more stable outlook for the global policy framework and macro backdrop, European equity valuations appear relatively attractive. On a cyclically adjusted price-to-earnings basis, for example, Europe trades at 13.6x and 1.5 standard deviations below its long term mean while the U.S. trades at 20.8x which is near its long-term mean. Said differently, Europe is about as cheap as it has been for thirty years while the U.S. is arguably fairly valued (Source: "UBS European Equity Strategy Thematic" published November 20; and JP Morgan Equity Strategy briefing from November 28). A proportion of these European-listed equities are industry leaders with revenues sourced globally yet they trade at a steep discount to similar global competitors listed in the U.S. The magnitude of recent European equity underperformance is so significant that if a reversal or mean reversion were to happen, it could result in a substantial rally. The outlook for European equities is also attractive from a technical perspective, with the market relatively under-owned by global investors following European equity outflows this year totalling more than $20 billion versus only $2.4 billion in outflows for U.S. equities.
While the growth outlook will likely be challenging in Europe for the foreseeable future, the opportunity set appears to be changing for equity hedge managers. From here, fundamentals-based, in particular value-focused, managers may start to outperform their more tactical peers. Given attractive valuations and lower left-tail policy risk to the sovereign debt crisis, European equities could be less susceptible to political shocks and short-term reversals. The winds are changing and we see this as positive for fundamental European equity hedge managers.
Anthony Lawler is a London-based portfolio manager for the fund of funds division of global asset management firm GAM.