When U.S. investors pulled some $3 billion from European exchange-traded funds in October, the conventional wisdom was that the Continent's dampening macroeconomic picture coupled with intensifying geopolitical uncertainty had left investors unnerved — enough to drive record outflows from European ETFs. This sentiment was only reinforced in the ensuing months and into January, and the wallowing confidence of passive investors on the Continent has been reflected by continued redemptions from ETFs.
To a bottom-up value investor, however, these very factors often create the dislocations that distinguish the successful actively managed strategies from the passive approaches employed by ETFs, index funds or even low tracking-error equity strategies.
It's easy to understand why passive investors might be apprehensive about the opportunity in Europe, particularly from afar. It already has become clear that the European Central Bank's version of quantitative easing won't provide for the ECB as many strings to pull as the U.S. Fed had at its disposal. Moreover, the credit system in Europe remains impaired, some five years after the European credit crisis first took shape; that was evident when 25 banks failed the ECB's most recent stress test. Meanwhile, each country has its own cross to bear, which has only been underscored by renewed speculation regarding Greece's possible exit from the European Union, ongoing unemployment concerns in Spain and Italy, or France's daunting budget deficit. And all of this is occurring against the backdrop of falling oil and gas prices, EU sanctions against Russia, and reintensifying terrorism fears.
From the top down, it's hard to argue that Europe doesn't look dicey for 2015. From the bottom up, though, the view is quite different.
After an extended period in which we perceived a disconnect between lackluster earnings growth and bloated corporate valuations, we are once again beginning to see compelling opportunities in Europe for certain individual stocks (vs. large swaths of the market), opportunities that we define as being mutually inclusive of strong business fundamentals, positive earnings growth and attractive valuations.
The passive vs. active debate has been going since the early '70s, around the time Burton Malkiel became a household name. And to be sure, passive funds, for some, can be difficult to beat during rising-tide periods in which earnings and corporate balance sheets aren't properly reflected in company valuations. It's no wonder that many retail investors in Europe gravitated to passive strategies as the broader indexes climbed, with little let up, since a bottom in 2011. The reintroduction of volatility, however, has served as a painful reminder that passive strategies can yield white knuckles during sideways and descending markets or even ascending markets with an indirect path higher.
What often gets lost in the passive vs. active debate is that actively managed strategies often differ markedly from each other. For instance, while valuations have come down, the European market does not necessarily lend itself to a deep value strategy, in which considerations around quality might be secondary. Indeed, the strength of a company's balance sheet is even more critical in a capital-constrained market. Moreover, we're finding that investors are still willing to overpay for forward-looking performance expectations, which makes pure growth strategies tenuous after three years of multiple expansion in Europe. Let it be said that markets might be inefficient during the short term, but they're far from stupid in the intermediate or long term.
This is why success for active managers often rests in the investment process and how closely the process is followed in both bloated and depressed markets.
As a bottom-up investor, we believe it's simply easier to assess the idiosyncratic risks of individual assets vs. trying to make sense of and hazard a guess to the cross currents of macro threats confronting a broad market or index. Opportunities are again beginning to manifest themselves in Europe, although we still view Europe as a stock picker's market, particularly in the small and midcap space.
And unlike past years, disappointing earnings in select industries have not yet produced broad pockets of value, but have rather translated into isolated opportunities — one-off stocks within an out-of-favor sector.
While investors will still overpay for growth, more recently we've found that a lot of capital has gravitated to safer areas of the market as well, such as consumer staples and health care. But that has made areas such as industrials and insurance attractive, as price-earnings ratios in these sectors begin to settle in at levels that we find more appealing.
Beyond the respective strengths of a specific investment process, the benefits of an actively managed strategy often reside in the breadth of the opportunity.
The more expansive the coverage, we feel, the greater the opportunity to find overlooked assets. The MSCI World index, for instance, contains no exposure to small-cap stocks — a segment that among actively managed global funds that was among the best performers in 2013 through early 2014.
So as volatility continues to give passive investors pause, for actively managed value-oriented funds, Europe today provides an ideal landscape to again demonstrate the advantages of a research-oriented approach, one that can simultaneously manage risk, while uncovering the overlooked securities that can outperform the broader market.
Christopher K. Hart is an equity portfolio manager for Boston Partners global equity and international equity strategies.