Is your European equity exposure too concentrated?

One of the funds most commonly held by private investors is Jupiter European (GB00B5STJW84), managed by Alexander Darwall, which has a very strong performance record. However, the fund is very concentrated in a small number of stocks – it only had 37 holdings at the end of September – and only provides exposure to the largest growth companies in Europe, albeit some very good ones.

There’s also an argument for taking a much broader approach to European equities. This is not necessarily to get exposure to every stock, but rather to good growing companies other than the largest in the European index. And there are different styles to consider, such as value investing, which could be blended with some emerging markets exposure.

Taking a more blended and diversified approach to European equities is particularly vital in the current investment climate, according to Andrew Gilbert, senior investment manager at wealth manager Parmenion. He says that the changing monetary policy in Europe could induce more volatility in stock markets, because the European Central Bank might start raising interest rates as soon as inflation becomes stable. So relying on just one type of stock or manager may not be as beneficial as it has been recently. Large growth stocks have also had a tremendous run and while things may not change immediately, they will at some point.

To understand the benefits of a more blended approach to European equities it is useful to see what combining different strategies has achieved over a long period. Looking at the past 10 years, from the end of the market rout caused by the financial crisis to the present, is helpful because these markets have made good returns over this period, which included some very negative sentiment on European stocks, for example during currency and debt crises.

Over 10 years, MSCI Europe ex UK index has risen 144 per cent and MSCI Europe ex UK Large Cap index has risen 134 per cent. But if you start blending different indices together the return profile and volatility changes. We have constructed a number of portfolios based on different weightings to indices, which expose investors to different areas of the stock market.  

The largest weighting of the portfolios in Table 1 is large-cap stocks, although they also include some mid- and small-caps. And portfolios two, three and four also have have exposure to other areas or factors.

Table 1: Blended portfolios

Source: FE Analytics, as at 19/10/2018

Portfolio one makes the highest returns, which tells us that the returns from mid and small-cap stocks outweighed the benefits of diversifying further by tilting towards growth, value or emerging markets. A weighting to these areas at the expense of mid- and small-cap stocks meant lower returns. However, portfolio three only made 1 per cent less than portfolio one and it was slightly less volatile over the past decade, with a lower maximum drawdown.

It is also helpful to see how the blends of strategies performed in more difficult periods. There are three periods within the past 10 years during which MSCI Europe ex UK index fell more than 15 per cent.

Table 2: Bear market performance

Source: FE Analytics 

Table 2 shows something of a mixed bag. However, as these periods are short the return differentials are smaller. But what can be seen is that there is a difference in the actual and maximum losses. In some cases, such as in May 2011, holding value stocks would have resulted in greater losses, whereas in April 2015 holding value would have been more beneficial. In all the scenarios a weighting to growth stocks would have been beneficial, and emerging markets tended not to help overall portfolio returns while developed markets were falling.

Active funds in the mix

Index returns can show how blending company size, different markets and styles changes the return profile of investments. But most investors have their capital in actively managed funds where most investors have their capital.

The two most-held open-ended Europe funds on the three largest platforms used by fund investors – Hargreaves Lansdown, Interactive Investor and Fidelity Personal Investing – are Jupiter European and FP Crux European Special Situations (GB00BTJRQ064). Other popular choices include Barings Europe Select Trust (GB00B7NB1W76), and the most popular Europe investment trust on these platforms is Fidelity European Values (FEV).

Jupiter European is the best performing fund over the long and short term. It is useful to see how it can be blended into other strategies to gain a wider exposure to Europe, and how its inclusion affects performance and downside risk.

Jupiter European is heavily concentrated and has a low annual turnover of 31 per cent – a measure of how much its holdings are bought and sold. Over the past five years the fund has returned 96 per cent versus 37 per cent for MSCI Europe ex UK index, largely due to big weightings in Wirecard (GER:WDIX), Amadeus IT (MCE:AMS) and Adidas (BUD:ADIDAS). The fund has 60 per cent of its assets in what data company Morningstar classifies as large growth stocks, so it is clear what Mr Darwall is reliant on for returns. The fund has only 14 per cent in large 'blended stocks' – companies with elements of both growth and value – and 16 per cent in mid-cap growth stocks, .

FP Crux European Special Situations is very different, but has also been a standout performer. Its manager, Richard Pease, tends to take a more blended approach, favouring growth, core and value companies, and large, mid and small-caps. 31 per cent of the fund's holdings are large and 26 per cent are small, and 30 per cent are growth stocks and 48 per cent a blend of growth and value. FP Crux European Special Situations is also less concentrated and had 63 holdings at the end of September, making it more of a core holding for broad European equity exposure.

Portfolio five in Table 3 below is a 50/50 blend of Jupiter European and FP Crux European Special Situations. 

Table 3: Active blends

Source: FE Analytics, as at 19/10/2018

Chart 1 above shows that the funds and portfolio five were evenly matched over the first half of the nine years since FP Crux European Special Situations was launched, with some divergence around 2014 when Jupiter European's returns were ahead. This was a good period for European small-cap stocks, which benefited FP Crux European Special Situations up until the past two years, over which period Jupiter European made the strongest returns due to a good run for some of its largest holdings.

If investors had just held Jupiter European over this nine-year period, rather than both these funds, they would have made a greater return.

But a concentrated and growth-focused strategy, even run by an experienced manager such as Alexander Darwall, will struggle at times. When putting together an allocation to Europe it is important to factor in the effects of falling markets, and consider whether another fund would mitigate the downside of your Europe allocation if large growth stocks had a tough period.

It is difficult to pinpoint a time when growth has not been in favour, particularly over the past decade. However, the best period for European value stocks started around February 2016 and lasted for about a year.

During this period European value stocks returned 31 per cent versus 19 per cent for growth stocks. And Jupiter European made 11 per cent – below MSCI Europe ex UK index's return of 25 per cent and FP Crux European Special Situations' 26 per cent. Portfolio five, which has an allocation of 50 per cent to each of these funds, fell in the middle with a return of 18 per cent. This chart helps to show that no one fund does well all of the time, so it could be worth allocating to more than one, particularly as we don’t know what is around the corner.

Portfolio six (see Table 3 above) is a three-way split between these two funds and a deep value European equity fund, Neptune European Opportunities (GB00B8LF7310), run by Rob Burnett. Holding these three over the period in question would have resulted in a return of 25 per cent. Over nine years portfolio six returned 156 per cent versus 197 per cent for portfolio five, but with lower volatility and a lower maximum drawdown due to the inclusion of a different investment style and fundamentally different stocks. And, as table two shows, holding this fund also helped performance in two of the three down markets of the past 10 years.

A core holding in a passive fund held alongside concentrated or style-bias funds like Jupiter European and Neptune European Opportunities can make a portfolio more stable. Portfolio seven shows the effect of having a 50 per cent holding in MSCI Europe ex UK index, with 25 per cent in each of these two funds.

The impact of diversification is less as portfolio seven is not equally weighted and includes pure market exposure. But this has still resulted in better returns and slightly less downside than investing purely in MSCI Europe ex UK index.

There are numerous ways to blend Europe exposure and doing this probably makes sense with a region and opportunity set of this size. This is not a recommendation to sell Jupiter European, but a demonstration of the benefits of diversifying your European equity exposure – especially if there are more turbulent times ahead.