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Global Equity Strategies

Tactical strategies dominate investor interest right now.

Cara Esser and Andrew Gogerty, 03/25/2013

ETF managed portfolios are investment strategies that typically invest more than 50% of portfolio assets in exchange-traded funds. Primarily available as separate accounts, they represent one of the fastest-growing segments of the managed account universe. Morningstar has developed a proprietary classification system for ETF managed portfolios that identifies the investments’ portfolio attributes. The new structure consists of four main attributes: universe, asset breadth, portfolio implementation, and primary ETF exposure type. This system helps investors better understand the philosophies underlying these investment strategies. The latest Morningstar ETF Managed Portfolios Landscape Report (which can be found here) is a comprehensive industry review of strategies that report information to Morningstar’s separate account database.

In this series we’re taking an inside look at the industry using the combination of universe and asset breadth attributes as a starting filter. This commentary is focused on global (universe) equity (asset breadth) strategies, and upcoming commentaries will discuss other attribute combinations.

Accessing the Global Economy
Benefiting from an investor base that is growing increasingly comfortable with investment options beyond their own borders and enticing growth prospects in some developing and emerging economies, global investment strategies have been gaining interest. During 2012, World-stock ETFs had net inflows of more than $2 billion, an increase of nearly 50%.  Morningstar currently tracks more than 120 global equity strategies, with 14 new strategies launched since the start of 2011.

While global equity strategies are the third-largest universe and attribute combination, its total assets are less than half of the top two combinations (global all-asset and U.S. equity) as of the end of 2012. The group is not particularly large, but, given that some of the largest ETFs in existence provide access to global equities (such as Vanguard FTSE Emerging Markets ETF VWO and iShares MSCI EAFE Index EFA), it’s not surprising that global equity strategies land toward the top of the list. 

Collectively, equity strategies have kept pace with the industry’s growth, holding steady at approximately 42% of assets. But domestic strategies remain a focal point, with assets up 86% in 2012 and accounting for 60% of the assets in equity strategies. Global equity strategies logged a 30% growth in assets during 2012. 

Kings Among Men
While the top five strategies account for 52% of assets, overall, this group is less concentrated than the global all-asset and U.S. equity strategies where the top five players account for 75% and 60% of assets, respectively.

The largest strategy as of Dec. 31, Stadion Managed Strategy, had nearly $1.5 billion in assets, adding nearly 17% last year. This tactical offering uses technical and fundamental indicators to determine market risk levels and sizes of individual holdings. Management can use a variety of ETFs and is not afraid to stash a portion of assets in cash. As of year-end 2012, it had 24% in cash as well as a sizable allocation to SPDR’s financials- and industrials-sector ETFs.

Although its tenure is relatively short, the Windham Portfolio 70/30 Strategy snapped up $312 million in assets last year, a growth rate of 41%. A relatively wide-open portfolio allocation process, with an emphasis on equities, focuses on expectations of risk and reward. Management is not afraid to use its discretion in allocation. For example, the strategy shifted from a 38% allocation to bonds in 2011 to a 9% allocation as of Dec. 31, 2012. It also doubled its non-U.S. stock exposure to 42% from 21% over the same period.

The only top player to experience a net decline in assets over the year was Riverfront Global Growth, which saw a 5% decline in total assets last year. The firm’s suite of five global equity strategies follows a hybrid implementation approach, investing both tactically and strategically in a variety of ETFs. Riverfront Global Allocation holds both ETFs and common stocks, though the latter accounts for only about 10% of the portfolio.

Portfolios Without Borders
Like the broader ETF managed portfolio universe, global equity strategies typically employ a combination of technical and quantitative factors. Statistics such as momentum, moving average, relative value, relative volatility, and various yield-curve scenarios often form the basis of model inputs. Other factors such as mean reversion or mean variance optimization can also play a role in determining portfolio holding weightings. More than half of the strategies fit the “All-Inclusive” primary ETF exposure type label, providing relative freedom to managers in choosing underlying funds. As a result, investors should expect to see regional, single-country, and broad-market ETFs inside the strategies’ portfolios.

Because these strategies focus not only on equities but also look across market economies, macroeconomic data plays a larger role here than with most other universe and asset breadth combinations. Individual country, and even small regional, gross domestic product consumption and export data are often key factors in the strategies’ models, sitting alongside the data mentioned above. The managers are aiming to minimize relative risk or even anticipate price momentum appreciation. In addition to the quantitative signals, the strategists may inject a qualitative idea from an investment committee or portfolio manager. In these cases the portfolio manager should be able to clearly demonstrate how such qualitative inputs have improved the strategy and the structure that allows for consistent application of these views going forward, and this should be a key discussion point for potential investors.

Understanding the strategy’s scope and objective is crucial to using it correctly within a broader portfolio. Decision-makers must have a clear view of the importance of factors such as upside participation, downside-capture, and correlation. A strategy’s portfolio may quickly and extremely move in and out of sectors, industries, regions, or countries, while some products may have concentration limits. Be sure to ask whether a strategy has set allocation bands related to regions or sectors to better understand any limitations. Potential attribution and performance analysis versus broad-based, passive ETFs should also focus on the allocation of satellite regions such as emerging markets compared with the historical allocation in the portfolios. For tactical funds, it’s also important to understand how an investment in “cash” is handled—how exactly is a cash portion invested? By clearly understand these aspects, investors are able to picture what a strategy actually does (rotates into better pockets or offers a degree of downside protection, for example) as well as what is unusual or atypical compared with peers (slight or extreme tactical changes, or leveraged or inverse ETF holdings, for instance). 

Under the Hood
For sector exposure, SPDR Select Sector ETFs are popular, as is the PowerShares Dynamic sector lineup. Few, if any exposures, were noted using global equity sector ETFs. Not surprisingly, Vanguard FTSE Emerging Markets ETF, iShares MSCI EAFE Index, and iShares MSCI Emerging Markets Index EEM are widely used ETFs by these strategies. 3D ETF Global portfolios, on the other hand, rely on a handful of Schwab and WisdomTree ETFs.

How They Can be Used
Global equity strategies can be used in a variety of ways—especially if decision-makers consider the characteristics of the return stream rather than the portfolio holdings. Advisors may invest the core portion of clients’ portfolios in these strategies. Institutions and other large investors can also consider them for an alpha satellite holding or risk-diversifying allocation, depending on their drawn-down and volatility-consistency goals. Below we highlight the top strategies based on risk-adjusted return, core/alpha characteristics, and diversification.

To Infinity and Beyond
Similar to U.S. equity strategies, global equity offerings are likely to keep pace with the general growth of the broader ETF managed portfolio universe. We don’t expect their utility as a core equity offering to diminish. The rate of growth will likely be more influenced by the performance of the broad domestic-equity market as a whole in relation to its world and regional counterparts.

We expect wider use of leverage and volatility-linked ETFs and exchange-traded notes. A key focus on managing risk isn’t going away anytime soon, and these products may allow for cost-effective execution by strategists. We also expect the adoption of ETFs that cut the market by a specific factor (such as low volatility) to gain further traction within both tactical and strategic offerings.

Cara Esser is a closed-end fund analyst at Morningstar.

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