Hitting over 30 all-time highs in U.S. equity markets this year may get you a bit closer to your funding, spending or plain happiness goals, but they may also invite an asset allocation problem, as the U.S. and other equity markets considerably outperformed European equities. MSCI World ex Europe has given investors a 32.2% cumulative return advantage over the MSCI Europe Index in just the last three years (Figure 1).
Has your European equity allocation changed?
Rebalancing for Opportunity
It's no secret that Intech advocates diversification and rebalancing, but it's not just for risk management. Rebalancing offers you an opportunity as well. It’s always essential to keep your policy allocation on track, and thoughtfully rebalancing to European equities offers upside potential for reasons overlooked by conventional managers.
Traditional fundamental arguments may point to relative valuations, earnings growth, and improving pandemic conditions across Europe, but these might miss what we see as a structural opportunity for the right active management approach: long-term diversification, lower capital concentration, and better market breadth. We believe these factors lay an excellent foundation for alpha potential.
Long-term Diversification
Many European investors have found the benefits of international diversification elusive over the last ten years. Over the long term, however, regional markets do not always move together and have provided diversification benefits.
A 5-year rolling return comparison between the MSCI World ex Europe and MSCI Europe indexes gently illustrates the point (Figure 2; please note, Figure 2 presented in USD to lengthen history). Regional market performance advantages can last for years, especially when accounting for currency exposure. The current advantage of international equity market performance over European equities is unprecedented, and many pundits have rationalized a new normal. But as long-time market observers, we contend that markets usually succumb to their historical patterns.
More Stable Capital Distribution
Capital distribution in global equity markets has been remarkably stable over the long-term. Smaller-cap companies may become larger and larger-cap companies may become smaller. Still, over the long-term, no stock or group of stocks persistently dominates, given the collective stability in capital distribution across markets.
More recently, however, investors in U.S. equities in particular have been allocating capital to the largest stocks, making the environment challenging for risk-aware, diversified active managers. For example, over the last several years, global active equity managers likely trailed the index if they underweighted the largest U.S. technology names.
Conversely, investors in European equity markets have distributed capital consistent with historical allocations. The European equity markets present an opportunity for investment processes that seek to diversify risk systematically. The differences in capital distribution couldn't be starker.
More Consistent Market Breadth
Many consider market breadth the first cousin to capital concentration. It represents the percentage of stocks outperforming the index in a given period over time. And it's been remarkably narrow in U.S. equity markets. For example, despite the new all-time market highs in the U.S. markets, only 29% of U.S. stocks in the Russell 1000 Index outperformed the benchmark in Q2 2021 – a significant drop from the prior two quarters (Figure 4).
Again, the opposite is true for the MSCI Europe index, where investors have experienced more consistent and broader market breadth. Such an environment offers a favorable opportunity for active managers to generate excess returns for clients.
Stable capital concentration and greater market breadth offers opportunity for conventional active management to generate excess returns through stock selection, as the range of stocks outperforming the index increases.
But these factors are also favorable for diversification, which is alpha potential in Intech parlance. How do you get alpha from diversification? It’s easiest to understand by breaking down compound returns.
It might surprise you to know that an index’s compound return is more than the weighted compound returns of its underlying stocks. The difference comes from portfolio effects, derived from the volatilities and correlations of its stocks – aka diversification (Figure 5).
With cap-weighted indexes, there's quite a bit of diversification opportunity left on the table because they don't explicitly consider volatilities and correlations in their construction methodology. Intech seeks alpha simply by re-weighting index stocks more efficiently and rebalancing them systematically. The opportunity is ever-present, but the MSCI Europe Index, in particular, and the current market regime increase that potential.
Many active managers have found success against the MSCI Europe benchmark recently; therefore, researching this space may not seem like a high priority right now, but inferences about favorable performance often arise from universe misspecification. And there is plenty of that going on in this popular category.
Apply Three Prudent Screens
eVestment makes correcting this problem easy by using a few simple screens (Figure 6). First, find the group of strategies designed to fit your policy allocation by using these manager-stated data points:
Boom. You shrink the universe of strategies by almost half, from 47 strategies to 30.
Now, you can examine performance. For relative return strategies, positive information ratios help you cut to the chase because they tell you two important things:
But make sure they have a long track record by screening for a positive information ratio on 3-, 5- and 10-year trailing periods. That cuts the universe down to 11 strategies overseen by just 9 managers.
Pick Your Pleasure: Similar Success, Yet Different Paths
The best thing about this group of successful strategies is that they don’t all “fish in the same pond.” In other words, you can get uncorrelated sources of alpha by combining two or more of these strategies.
We’ve already described Intech’s unique alpha source, but don’t depend on investment process narratives. Look at the data. Again, using eVestment, we can easily examine the excess return correlations for these elite strategies over multiple time periods. Below is a table for their 10-year excess correlations (Figure 7).
Yes, Intech’s in This Group
Intech has been navigating European equity markets for over 11 years with the same lead portfolio managers and the same investment process. And we believe all that sameness has contributed to consistent results, giving our clients less governance anxiety.
Respecting Your “Time is Money”
We expect Intech European Large Cap Core to have periods of underperformance in the short- and medium-term, but we also expect that underperformance to average away over longer time-horizons. Historically, patient investors have been rewarded with higher probabilities of excess returns. 92% of 3-year rolling excess returns have been positive since inception; 100% of 5-year rolling excess returns have been positive since inception (Figure 8). And these figures are NET of fees.
Performing in Up and Down Markets
Five-years can be a reasonable proxy for a market cycle, so let’s break down the 5-year rolling net-of-fees returns above to see WHEN Intech European Large Cap Core outperformed its benchmark (Figure 9). Consistent with the chart above, our strategy outperformed the MSCI European Index 100% of the time, but now you can see that it occurred in BOTH up and down markets.
Intech European Large Cap Core does not rely on high active risk to generate these results. While higher tracking error is sometimes associated with higher excess returns, it typically increases the range of outcomes as well. In other words, your results are less predictable. Instead, Intech European Large Cap Core assumes moderate active risk relative to peers, attempting to deliver consistent excess returns.
Ultimately, Intech European Large Cap Core focuses on information ratio because it demonstrates excess returns per unit of active risk which, over long periods, is evidence of skill in outperforming and the efficacy of our investment approach (Figure 11).
Conclusion
We believe a rebalancing opportunity toward European equity markets is at hand, and supported by favorable structural market conditions, such as a potential rotation in regional returns, a normal capital distribution curve, and steadier market breadth. But few active managers have proven, long-term track records and consistent, disciplined processes to capitalize on these opportunities. We encourage you to discover how Intech European Large Cap Core is prepared to do just that.
Learn More
We invite you to learn more about Intech European Large Cap Core and the diversification potential in non-U.S. equity markets.
The information expressed herein is subject to change based on market and other conditions. The views presented are for general informational purposes only and do not purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This information should not be used as the sole basis for investment decisions. All content is presented by the date(s) published or indicated only, and may be superseded by subsequent market events or other reasons.
Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value. Information that is based on past results or observations is not necessarily a guide to future results, and no representation or warranty, express or implied, is made regarding future results.
Intech performance results shown reflect the reinvestment of dividends and other earnings, are time-weighted rates of return using daily valuation, include the effect of transaction costs (commissions, exchange fees, etc.), and are gross of non-reclaimable withholding taxes, if any. For periods of less than one year, performance is not annualized. Reporting currency is EUR.
Net performance results presented reflect the deduction of model investment advisory fees, and not the advisory fees actually charged to the accounts in the strategy. The model advisory fees deducted reflect the standard fee schedule in effect during the periods shown, applied to each account in the strategy on a monthly basis. Standard fee schedules are available upon request by contacting Intech at Finance@intechinvestments.com. Actual advisory fees paid may vary among clients invested in the same strategy, which may be higher or lower than the model advisory fees. Some accounts may utilize a performance-based fee.
Prior to May 21, 2010, with respect to non-U.S. securities traded on non-U.S. exchanges, Intech used fair value prices that reflected current market conditions at the end of regular trading hours of the NYSE, normally 4:00 PM ET, rather than unadjusted closing prices in local markets. Therefore, the prices as well as foreign exchange rates used to calculate the U.S. dollar market values of securities may have differed from those used by an index. Indices generally use the unadjusted closing price in local markets instead of fair value pricing. As of May 21, 2010, prices for non-U.S. securities traded on non-U.S. exchanges are typically valued as of the close of their respective local markets. However, if a significant event takes place between the close of the local market and the close of the U.S. domestic market, a security may be fair valued. Non U.S. securities are translated into U.S. dollars using the 4:00 P.M. London spot rate.
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