London versus Laos

Should allocators go with local talent they know—or talent local to what they own?

To be a long-term, unbiased investor, it helps to get out of the noise of the financial hubs of London and New York.

Just ask the big asset managers like Invesco Perpetual—one of the biggest and most successful firms in the UK—based in the quiet Oxfordshire town of Henley-on-Thames. Or Newport Beach, California-based bond giant PIMCO.

Both firms have enjoyed massive success over the course of many years—and both have endured the exit of their most successful and high profile manager in more recent times—but the unique nature of their locations is still an important part of their proposition to investors.

Even Warren Buffett cites the importance of his location in Omaha, Nebraska: In a 2012 interview, the veteran value investor said his hometown allowed him to “keep perspective” as he was “undisturbed by irrelevant factors and the noise generally of business investments.”

All this is “nonsense”, however, according to one man who has crunched the numbers.

“Obviously fund managers would say that,” says Professor Andrew Clare of Cass Business School (based in London). In 2013, he co-­authored a research paper with Dirk Nitzsche, senior lecturer in finance at Cass Business School, and then-PhD student Meadhbh Sherman, which ascertained that there is a relative performance advantage associated with a manager’s location—at least in some cases.

In the 21st century world of investment, in which Blackberrys and iPhones keep us all perpetually connected to markets, and video conferencing is becoming the norm, does the location of a fund manager’s office really matter? And, more importantly, does it add alpha?

CIOE-June-2015-London-Laos-Jillian-Tamaki-Portrait-Story.jpgArt by Jillian Tamaki“Compared with European managers of US equity mutual funds, US managers produce higher mean alpha, and display a greater tendency for positive performance persistence; indeed, Europe-based managers of US equity mutual funds show a marked proclivity for producing negative performance persistence.”

So write Clare, Nitzsche, and Sherman in their paper “Mutual Fund Performance and Manager Location,” laying out empirical evidence to show location is materially important to returns.

(A note: “Location” here means where the fund manager sits to do his or her day job. On most databases, a fund’s location is recorded as its legal domicile, which often has no relationship to the target market or the manager’s home.)

“Relatively little research has been done into this,” Clare tells CIO, when asked to return to this work. Clare and his colleagues studied more than 2,700 funds investing in US equities from locations in the US and Europe, and calculated the excess alpha produced on average by each group between 1970 and 2010.

US-based American equity managers added alpha of 0.06% a month on average during that 40-year period, while Europe-based competitors recorded a negative alpha—meaning a relative underperformance—of 0.18%. On their own the figures look small, but they soon add up to a meaningful impact.

“We did find that if you want to invest in US equities, you are better off with a US-based equity manager,” Clare confirms, supporting his initial hypothesis at the outset of the research that the nearer you are to your investment market, the better your returns are likely to be.

“There are certainly benefits for investors if the fund manager is able to sit down with the owner of the company,” Clare states, adding that “the smaller the companies you are buying, the closer you need to be”.

The benefits of a local manager can work both ways. Another research paper published a year earlier—“Local Investors and Corporate Governance”, by Vidhi Chhaochharia and Alok Kumar, of the University of Miami, and Alexandra Niessen-Ruenzi of the University of Mannheim—outlines how local ownership can improve a company’s governance and profitability.

The trio contends that listed companies with a high concentration of local institutional investors “have better internal governance and are more profitable,” and are also less likely to get sued by investors or be involved in “undesirable corporate activities.” Local investors are also more active owners and can keep a lid on excess compensation, the researchers claim.

“Taken together, our results indicate that local institutions are more effective monitors of corporate behaviour because monitoring costs vary inversely with distance,” they conclude.

Some of the most powerful asset owners in the US and Europe agree: The California Public Employees’ Retirement System had more than 9% of its $300 billion (€268 billion) portfolio invested in public and private equity—as well as real estate and infrastructure—in its home state at the end of last year. Meanwhile in Scotland, the £15.6 billion (€21.3 billion) Strathclyde Pension Fund has allocated millions to local assets through its “New Opportunities” portfolio, which has a target allocation of 5% of total assets—although this is predominantly aimed at real assets.

Investing locally is obviously attractive, makes sense, and can even add alpha—until, that is, you move away from US equities.

Clare, Nitzsche, and Sherman also ran the same analysis on roughly 1,800 funds investing in European equities, based in the US and in Europe. Their findings are very different: European investors still produced negative alpha on average even when investing in their home market, while US managers added even more, at 0.3% a month.

The researchers put this down to skill: “The results with regard to the management of European equities indicate, at least tentatively, that the source of outperformance may not be due to the exploitation of local information by local managers, but instead that, on average, US-based managers may be better than managers based in Europe.”

Take that, Europe.

Investing locally is obviously attractive, makes sense, and can even add alpha—until, that is, you move away from US equities.Nathan Gelber, CIO at London-based investment consultancy Stamford Associates, agrees with the findings. “In the US, we find it is very, very difficult for non-US based managers to add value,” he says. “It’s not impossible, but seriously challenging.”

In Europe, Stamford has found it difficult to identify a high-quality continental manager to run equities here. Instead, Gelber’s three European stock pickers are based in London, New York, and Toronto.

“The main reason is that the market is not as homogenous as other geographical areas,” he explains. “We tend to go where we are able to find exceptional talent that meets our qualitative investment criteria. There does not seem to be a ‘home advantage’ for European equities, irrespective of whether one is based for example in Zurich or Amsterdam.”

Despite the monetary union linking 19 countries and common policy across many sectors dictated by the European Union, stock markets remain disparate and often shallow, meaning the world of investment management is far more fragmented than it is across the Atlantic.

“As an investor, one still has to familiarise oneself with foreign accounting principles—being based in Madrid doesn’t necessarily give you a competitive advantage over being in New York,” Gelber points out. The US market is “vast”, he adds, but far more homogenous: Companies based in New York are bound by the same regulations and accounting principles as those 2,900 miles away in San Francisco.

What about other markets? In Asia, the market for single-country funds is dominated by Japan. Data company eVestment crunched performance numbers for more than 300 Japanese equity funds and discovered that the best average performance was generated by managers based in Singapore, across one-, three-, five-, and seven-year timeframes.

Managers based in Japan have performed better than those based in the US and the UK, but calendar-year data show returns to have been erratic: 2013 was the first year since 2007 in which Japan’s home investors compared favourably to those based offshore.

“We stopped looking in Japan approximately 10 years ago as we found it difficult to identify superior investment talent that suited our clients’ requirements,” Stamford’s Gelber says. A more recent “manager sweep” in the region again gave “disappointing” results.

While in China and other Asian markets a local knowledge and “cultural affinity” with the region has been shown to be essential, Japan appears to go against the grain.

“My personal view is that philosophy, process, and people trump location. Some specialty strategies may rely on location for the information edge but that is not the norm.” —David Villa“We believe the reasons are in the main cultural and to some extent structural,” Gelber says. “Finance and investments do not seem to be considered as a prestigious or promising career path in Japan compared with science or engineering, for example. We believe that fund management represents, in essence, an entrepreneurial endeavour, and Japan’s educational system and culture do not lend themselves to encouraging investment professionals to venture out and assume business as well as reputational risks in a boutique environment.”

As return forecasts decline, any new drivers of alpha should arguably be considered. However, as the CIO of one FTSE 100-listed company’s pension fund states, it’s still unlikely to factor high up the list of priorities when assessing a manager’s suitability.

“When we are looking at something straightforward like an equities portfolio, the manager doesn’t have to be home-grown in a certain market,” the CIO says. “They have to have people based there who have a very good Rolodex, and know the culture and the system, but it’s not essential for us for them to be from there.”

For “number-crunching” quantitative strategies, it “doesn’t matter at all where managers are based,” the CIO points out. In contrast, however, a frontier markets manager would require local expertise to convince a new investor: “I would be unlikely to commit to a fund investing in Mali if it were not from there,” the CIO adds.

This sentiment is echoed by others. “My personal view is that philosophy, process, and people trump location,” as State of Wisconsin Investment Board CIO David Villa puts it. “Some specialty strategies may rely on location for the information edge but that is not the norm.”

Location is by no means a black-and-white issue, especially given the fact that there is very little data or research outside of that mentioned above. The answer is, quite literally, neither here nor there.

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