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The Cinderella sector

Unloved European funds often suffer the most in rough markets, bearing the brunt of investor outflows, and with returns from the region expected to be harder to achieve, it looks likely this sector will remain the worst-selling area of the market for some time yet. But should this be the case?

In 2008 and 2009, while corporate bonds was the best-selling sector, Europe excluding UK fared the worst both years. Over the second quarter of 2010, cautious managed sold best, highlighting the nervousness of equity investors. Again, Europe ex UK funds featured the poorest net retail sales, according to IMA sales data.

Why is this sector the first port of call when investors sell out of funds? It is not about performance. If that were the case, then the Japan sector would end up bottom of the sales table. Financial Express data shows that not one fund in the Japanese sector has made a gain after charges over the cumulative 10 years to September 16, 2010. In the Europe ex-UK peer group 38 funds out of 58 would have made investors money over 10 years. Yet Japan has only been the worst-selling market once over the past nine years, in 2001. Europe ex UK has been the poorest seller four times since 2000.

Whether or not the sector’s unpopularity is always justified remains to be seen. What does appear more certain is that those sticking with the asset class may not have an easy time in the coming period. That is not to say there are no opportunities to be found and even greater diversity than is perhaps present in other markets but Liontrust European manager James Inglis-Jones believes any easy gains made in 2009 are behind investors now and the focus should be on the post-recovery story, which could last for three to four years.

Like most economies, the EU has suffered increased volatility and constant swings between positive and negative investor sentiment but the biggest drawback has been the situation in Greece and then Spain.

According to managers at Alliance Trust, the divergences across Europe continue to build and are clearly illustrated by the comparison of second-quarter GDP growth rates across the region. “Germany’s growth of 2.2 per cent, or almost 9 per cent on an annualised basis, puts it in the same class as major Bric economies such as China and India. Germany’s large export sector is clearly benefiting from weakness in the euro caused by concerns over the sovereign debt crisis in Europe,” they say.

Meanwhile, economies where fiscal austerity packages are being implemented, Greece and Spain, for example, are more reliant on domestic demand and have suffered.

This divergence in geographic opportunities has led to a similar trend in European portfolios, with many managers heavily weighted to just France and Germany.

Around 45 funds in the IMA’s Europe ex UK sector have more than 15 per cent in each country, 71 have more than 10 per cent in each. Individual weightings are higher to France at the moment, nine of the portfolios in this sector have more than a quarter of their assets in the country while five have a similar amount in Germany.

The numbers are much lower for countries such as Portugal, Spain, Greece and Italy. There are a few managers who see some select value in Greece despite its difficulties. Eight portfolios in the IMA sector have minimal holdings of less than 5 per cent in this country .

Jupiter European special situations manager Cedric de Fonclare says he does have a high degree of his fund in Germany and France at the moment, 17 and 19 per cent respectively, but a 1 per cent position in a Portuguese holding constitutes his Southern Europe exposure.

He believes the focus on France and Germany is likely to continue for some time yet and that there is still a case to be made for companies within these two economies. “There is a big differentiation in valuations between Southern Europe and places such as Greece. Germany is at a premium but only when compared with Southern Europe. Germany is not that expensive on a historic basis.”

Like Inglis-Jones, De Fonclare thinks that the easy gains seen as cyclicals recovered last year are at an end and investors should expect lower growth. He has been switching his portfolio towards core Europe and defensive, quality names as well as those more internationally exposed.

Calling cheaply rated domestic European companies a value trap, De Fonclare prefers more international plays. He points out that about 40 per cent of sales from the biggest German companies are from noneuro-denominated economies.

Inglis-Jones and co-manager Gary West are significantly underweight Germany relative to their peers but this is more due to their process rather than an active decision to be light on the country. The duo hold less than 10 per cent of their fund’s assets in Germany, instead favouring Belgium, Norway and Finland. Like De Fonclare, the pair are underexposed to Southern Europe and have only a small position in Spain.

Volatility has plagued portfolios invested across the geographic spectrum, not just Europe but De Fonclare and Inglis-Jones believe that is lessening somewhat. Both note that the turnover levels in their portfolios have been high but are now stabilising.

In Jupiter’s fund, De Fonclare says his turnover between 2008-09 increased substantially but it is now trending downwards as he leans away from cyclicals and concentrates more on structural ideas.

In June, Inglis-Jones and West revamped their portfolios to a much higher degree than is typical for their funds.

Inglis-Jones says that around 60 per cent of Liontrust continental European was changed and while their absolute return fund saw a 40 per cent change, he says that figure is almost double when you consider it accounts for both the long and short books.

Both De Fonclare and Inglis-Jones are upbeat about Europe’s prospects but with a focus towards quality companies.

The region is unlikely to wow investors in the short term but there are plenty of reasons why it should not end up being the worst-selling area of the market – again.


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