ING breaks with the herd

Another funds manager is taking a significant step away from index benchmarking into the realm of “conviction” investment '” going for the best return for investors instead of trying to just nudge a little above some arbitrary index benchmark.

ING Investment Management’s chief investment officer, David McClatchy, doesn’t quite put it like that, but that seems to be the gist of ING’s move to change the way it runs its international equities offering. Management of the international strategy will be driven from Sydney, the local investment team picking the best 125 options from the several hundred recommendations of ING’s investment offices around the world, and giving each stock an equal rating in the portfolio regardless of that company’s market capitalisation.

The result will be a move away from a portfolio that is top-heavy with the biggest international companies '” reflecting some index-hugging '” and more into mid to small-cap stocks. The thinking behind the move is instructive for anyone managing a portfolio because it’s a break with the standard investment theory that still dominates the industry, albeit with decreasing strength.

It’s also fair to say that ING probably had to do something to lift the performance of its international share offering. International shares have grossly underperformed Australian equities '” a recurring theme in Eureka Report commentary over our first year. As you can see from ING’s own performance figures the wholesale international share superannuation fund has averaged a negative return over the past five and seven-year periods, while the equivalent Australian share fund averaged 12.86% and 12.41% annual growth.

Despite, or perhaps because of the Australian market’s out-performance, there’s been a regular and building chorus among local fund managers over the past couple of years about the need to diversify into international stocks. As you can see in the attached video interview, McClatchy thinks his team has found a way to do it that suits Australian investors.

McClatchy says the big super funds are demanding more from their international investments '” and so should individuals.

The interview

Michael Pascoe: The move to greater conviction investing, as you’re doing with your global investment offering '” is that an admission that index hugging doesn’t work?

David McClatchy: I think there’s a number of questions in that, or a number of points that I can draw upon. I mean, indices or where we find ourselves with indices, are really conventions of convenience. They’ve come around because of financial theory and subsequent to that they’ve come around because the capital markets have engineered a whole lot of synthetic products around these indices that at no time or probably less questioning was made of those indices about whether they’ve got any validity or not with regards to value.

And as we look more and more at them, the foundation that they’ve got any value at all is diminishing and when we look at the total investment universe, too much time in the past has been spent in saying, well, if I’ve got 1800 or 1900 companies that I can invest in around the world, people look at that and they say to themselves, well how am I best to look at that universe and manage my risk and they say, oh, I should own 300 or 400 stocks and then they say, well, if I’ve managed my risk what return am I going to get for that risk? That’s the wrong way of looking at engineering returns for investors.

The first thing you want to look at is how can I maximise my return and then ask the question, am I willing to tolerate the risk that I have to take to get that return? And what that does is it say that I’m not actually interested in an index any more? I’m not interested how big a company is relative to another company. I’m not interested in diversifying my risk against that index. I’m more interested in getting the return so I only want to own those things which are really going to give me a powerful payoff and I have a high conviction that they’re going to give me a powerful payoff. Then I ask the question: am I willing to tolerate that return? And that’s what drives you down into owning less stocks but the quality of the stocks that you do own, you have a higher conviction '” a higher expectation that they will deliver a return.

So you’re effectively saying that index hugging is more about funds managers not being embarrassed by doing worse than their peers than getting a good result for their clients?

It’s interesting. I don’t know if it’s the fund managers themselves that are driving that determination or whether it’s the expectation of the investors which are driving that expectation, because ultimately '¦

They just don’t want to do worse than other people but they don’t necessarily want to do better than them?

It’s easier to stand around the barbecue and say, 'I actually did quite well relative to the universe, relative to the index and relative to all the people around the barbecue’, than it is to start to enter into a discussion of discomfort about the level of risk that you might have taken or the experience that you might have had over the short term. I think what’s happened is because people look at the management of money on risk first and return second, there has been this enormous diminishing risk profile, or tolerance from investing in the international market in particular, and what comes with the reduction in risk is a reduction in return.

Australian investors are very mature investors. They’re very smart investors and their investing awareness is very high relative to the risks of the international environment so simply following an index type configuration, which is very much the international convention, is not something that suits the Australian investors and therefore they’re now demanding a higher level of return, which is taking them away from that thesis of how good our return is relative to the universe. more how well did I return relative to perhaps some money that I could have put in the bank or put in other locations.

Is part of this about the fact that international equities haven’t performed very well over the past few years compared with Australian equities?

I think there’s been an enormous home bias to people’s investment decisions over the last 10 to 15 years but increasingly that’s diminishing and the funny thing is that while there’s been a reluctance for Australian investors to put their money overseas, there hasn’t been a reluctance for the companies that they’re investing in domestically to put their money overseas and so they’re getting '¦ 30–40% of Australian companies have earnings or assets offshore in some form or way.

So Australian investors in the local market are getting international exposure by default and I think they’re suddenly recognising that. As more and more money is going into savings and there’s the recognition of more and more need for diversification, there’s now the willingness because again, as I said, they’re sophisticated investors here, there’s the recognition that they can discretely identify opportunities internationally rather than just relying on the companies they invest in in Australia to make those decisions for them.

But Australian investors are looking for something quite discrete from the type of proposition that a US investor looks for when they look at international, or a European investor looks at when they look for international equities. If you’re in the US, their idea of international equities is EAFE '” Europe, Asia, the Far East. When you look at Europe, their idea of international equities is the US. When you’re in Australia, our assessment is that we want some Japan, we want some emerging markets, we want Europe and we want the US. Our expectations and our bundling needs are quite different than the rest of the world’s needs. Therefore, you need to package up something which is unique for Australia as opposed to just simply buying something off-the-shelf out of an international business.

What sort of prospects do you like overseas? Where are you putting your money?

Overall the composition of our books sees us that we are underweight in the financial sector at the moment. We’re underweight in the IT sector, which is a positive position to be in while everyone’s a little bit hysterical around the world and we’ve got this extra higher risk premium. We are overweight the consumer staple part of the market. We still believe that the strong growth that we are seeing around the world is going to play very well to that particular part. We’re in the energy sector, which is leaning itself very favourably to returns, and we’re holding some utilities and some health care; but in isolation or at the individual name, we don’t favour one individual name better than any other name in the portfolio. Size to us is irrelevant. Just because you’re Exxon Mobil and you’re 1.64% of the total universe doesn’t tell us whether you’ve got any value or not compared to the stock at the bottom end of the index or the universe, and so every stock in our portfolio we expect to contribute individually and collectively to the outcomes.

And you weight your stocks equally? If you’ve got 120 stocks and $120 million fund, each one would have $1 million in it?

You’ve got it. Very simple.

That’s a bit unusual too isn’t it?

Well one of the big issues that you have with this whole convention of indices and that capitalisation is some sort of foundation for value is as a stock price goes up you own more and more of that stock so as it gets more and more expensive you own more and more of it, and as the stock price goes down you own less of it and what happens is you get caught in the mean reversion trap so when these stocks do mean revert to their long-term true value you end up owning a hell of a stock that’s sort of high-priced and you end up owning bugger all of the stocks which revert back upwards.

Having a regular system of rebalancing your portfolio back to an equally weighted position continually takes profits off the stocks that have performed well and continually invests in the ones that haven’t performed so well over the short term, which is the old thesis of dollar-cost averaging. And it’s pretty sound.