An equity portfolio can be approached in various ways. There is a division between domestic shares and foreign shares, or a division based on market capitalisation with the three categories largecaps, midcaps and smallcaps. And there are distributions based on sectors, factors and, of course, regions.
Each classification has its advantages, but also disadvantages. This year, investors should look for shares that do not fit into any of these boxes.
Domestic, foreign
For the Dutch, international investing is quite normal. This applies to both institutional and private investors. There is no country in the world where the home bias of pension funds is as small as in the Netherlands. Occasionally, politicians call on pension funds to invest more in the Netherlands, but they are rightly reluctant to do so. Only in the area of Dutch mortgages have pension funds gained ground in recent years.
Especially after the Great Financial Crisis, more return was possible there than with government bonds. Risk management questions whether this is wise. Many of those mortgages belong to people who also have a claim on the pensions. Instead of spreading the risk, it is a matter of concentrating it.
Half of the Dutch real estate is now below sea level and in a more extreme scenario of sea level rise, this is unfortunately suddenly a greater risk than ever thought. In such a case, not only is your house under water, but also your pension. In general, the Dutch home bias is limited to a few percent. Americans find it already a problem if less than 70 percent is invested in American shares. In recent years, they have only been confirmed in this by superior returns on American shares.
Large caps, mid caps and smallcaps
The allocation based on largecaps, midcaps and smallcaps is also very common. This is reinforced by the fact that small caps are generally not included in even the broadest indices. A commonly used benchmark is the MSCI All Countries World index. This contains 2,976 companies and 85 percent of the world market capitalisation is covered. If you want to invest in 99 percent of the world market capitalisation, you must choose the MSCI ACWI IMI index, where IMI stands for investable market index. There are no fewer than 9,189 companies in this index.
Anyone who compares small caps with large caps in the long term will see that small caps perform better than large caps. Of course, all sorts of corrections can be made for this, for example for the sector composition or for the risk, but the outcome remains the same. Nevertheless, this has taken a turn for the worse in recent decades. Over the past 25 years, the structural outperformance of small caps is no longer self-evident.
At the end of the nineties, many institutional investors started to invest internationally and this was at the expense of domestic small caps. These were also not liquid enough to absorb the indices used for the index funds and the massive inflow into these index funds did the rest. Moreover, smallcaps are facing increasing competition from private equity, since, especially for small companies, the burden of a stock exchange listing is high.
The sector division
At the end of the nineties, the sector allocation was also standardised on the basis of the Global Industry Classification Standard (GICS), at the time a nice instrument to make a subdivision between the old economy and the new economy. The result was that TMT (technology, media and telecom) shares were pushed to record highs and there were more and more bargains to be found in the old economy. The GICS today has a breakdown of 11 sectors, 24 industry groups, 69 industries and 158 sub-industries. However, the IT revolution has made this division obsolete.
Today, there are companies in every sector that use IT to compete with existing companies. That makes for many disruptive innovations with a few winners and many losers. All in one sector. From the IT sector, several companies have also split off into other sectors. For example, Google and Facebook are part of the Telecom sector, which has now been renamed the Communications sector. So when you look at this sector in the past, you see a sector with a completely different composition.
Furthermore, business chains often span multiple sectors. With delivery problems increasing due to long delays in these chains, it is more difficult to identify how the portfolio is sensitive to these delays. Also, rotating in sectors based on the economic cycle does not appear to be an easy task. Sometimes there is no activity for a long time until suddenly several rotations succeed each other rapidly. The moment in the sun for the more cyclical shares, for example, is always relatively short. The GICS are therefore more suitable as a tool for risk management.
Allocation over factors
A relatively new feature is the allocation across factors. There are five now fairly widely recognised structural factor premiums, based on value, size, momentum, low volatility and quality. Quality is a relatively young factor. In 2012, Robert Novy-Marx published a paper in which profitability and stability could explain the so-called quality premium. At the same time, I published a column on so-called free firms, not yet aware of Novy-Marx. These were companies that were not dependent on banks and the government, a clear plus so soon after the Great Financial Crisis.
They were companies that could decide for themselves where to produce. At the time, the quality factor was not yet widely known, but in retrospect there is a great overlap between the idea of free companies and the quality factor. When there is structural outperformance, speculation about a new factor premium soon arises. A few years ago, it was seen that SRI would go mainstream and now, after a few years of outperformance, there is also discussion about whether there is an ESG factor premium. As far as I am concerned, this is the flavour of the week. Factor premiums are caused by incorrigible human behaviour or as compensation for specific risks.
It offers the possibility of collecting an additional premium on top of the general compensation for market risk. In recent years, factor premiums have been frustrated by the heavy weighting of the top ten largest companies in the world. These are usually underweighted in factor portfolios because of their weight. The index weighting would otherwise quickly result in too much specific risk, while everyone is looking for the purest possible factor premiums. The fact that a lot of money flows to those big companies is a direct consequence of index investing; then automatically more money goes to the bigger companies. Also, those big companies are seen as pseudo-bonds, as an alternative for too expensive treasuries.
Region distribution
Regional allocation is still very popular, but with a weighting of 63 per cent for the United States, it has become more of a discussion of the US versus the rest. In recent years, US equities have performed much better than equities in the rest of the world, caused by a complex of factors.
The iPhone revolution in 2007 allowed companies such as Google, Amazon and Facebook to grow big. Furthermore, American companies themselves were the biggest buyers of American shares. This purchase of own shares was fiscally favourable and, moreover, interest at zero offered a strong incentive to buy back own shares. The good news is that in time, there will probably be a more balanced three-way split in the world, with China alongside the US and Europe.
That country is now still part of emerging markets, but will soon make up more than half of the emerging market funds. Then it will be time for its own regional category. And that is just as well for the second largest economy in the world. Region divisions can still be corrected, for example, for purchasing power parity, and it can be decided not to weight on the basis of market capitalisation, but on the basis of the weight of GDP in the world economy. But the choice now is mainly whether the US should be over- or underweighted. A weak dollar, a rising oil price and rising interest rates are required to become more enthusiastic about the world outside the US.
Winners and losers from inflation
All these classifications are used to make choices and these choices must lead to an above-average return compared to the index. I always prefer more structural developments, which are less sensitive to the economic cycle or market mood. The advantage of structural developments is that they are often spread out over a longer period of time and are therefore less sensitive to the next rotation or the economic cycle.
One such structural development is rising inflation. My starting point is that, as far as inflation is concerned, for the time being we are in a different environment than in the past forty years pre-Covid. When inflation is higher, you want companies in your portfolio that are able to raise prices. Also, companies with a lot of staff are at a disadvantage due to sharply higher wage demands or a shortage of staff.
Companies that consume a lot of energy run the risk of having to temporarily stop production because the energy costs are simply too high. Otherwise, such companies are caught out by the carbon footprint being too large. Sustainable companies are also preferred to non-sustainable companies. So everyone should look for a sustainable company that is economical with energy, employs few staff and can easily raise prices. Unfortunately, these companies cannot be fitted into the existing divisions, but it is nevertheless useful to apply such an analysis to portfolios.
Han Dieperink is an independent investor, consultant and knowledge expert for Fondsnieuws. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. He is currently active as chief commercial officer at Auréus Asset Management. Dieperink provides his analysis and commentary on the economy and markets. His contributions appear in Dutch on Fondsnieuws on Tuesdays and Thursdays and in English on Investment Officer Luxembourg from time to time.