Morningstar analysis: Artemis European Growth

Morningstar, a leading provider of independent investment research and data, has issued fund analysis on the Artemis European Growth fund.

Tom Whitelaw, Analyst at Morningstar: Artemis European Growth's recent struggles point to a clear weakness of quant models, but we still believe it's a good pick for the long haul.

It was in this fund that Artemis's SmartGARP quant process got its first public airing. Fund manager Phillip Wolstencroft initially developed the strategy in the early 1990s during his time at Merrill Lynch and put it into practice at Artemis when this fund was launched in March 2001. Wolstencroft had sole responsibility until he was joined by former Merrill Lynch colleague Peter Saacke in late 2002.

SmartGARP is Artemis's proprietary software tool that aims to quantitatively identify good and bad stocks. The system ranks stocks based on seven independent factors which consider fundamental growth and value data, behavioural finance theory and macroeconomics. It will then churn out a score of between zero (terrible) and 100 (outstanding) for each of the 1,500 stocks in the fund's European universe. Stocks which score above 90 are included in the portfolio, with position size being a function of their score as well as persistency of score. However, this is where Wolstencroft and Saacke come in; using their combined 32 years of industry experience the pair systematically sifts through SmartGARP's picks to double-check its assumptions.

The SmartGARP process had an enviable start to its life and performance was strong even during the declining markets of 2001 and 2002. During the first five years of the strategy's life it returned 18% - an impressive 12% more than its Morningstar Europe Ex-UK Equity Large Cap peers on an annualised basis. The strategy continued to outperform in Europe until 2007 when increased market volatility, something quant funds struggle with due to their inability to deal with inflection points, and a mistimed foray into financials on the back of positive SmartGARP scores proved costly. Between June and October 2007 financials exposure increased from 27% to over 40% and, although this was reduced in mid-2008 back to nearer 20%, the damage was done and performance over the last 18 months has erased some of the positives achieved earlier in its life. The fund now ranks in the 98th percentile over 3 years, but to its credit just manages to cling onto a second quartile showing over five years.

The magnitude of underperformance of late is surprising when compared with Artemis Global Growth, which uses the exact same strategy. Although the global fund has struggled year-to-date it is still comfortably first quartile over three and five years. The explanation lies in the size of the two funds' universes: whereas European Growth is restricted to just 1,500 stocks, SmartGARP gets to pick from 6,000 for the Global Growth offering, thus providing access to a more diverse and potentially stronger list of companies.

This fund benefits from an experienced management team which uses a well thought out quantitative process. However, investors should beware of its volatile nature and propensity to underperform in volatile markets like those of late. As a result the fund is best suited to more aggressive investors whose time horizons are long enough to ride out substantial downdrafts, but we continue to believe the process and personnel here are capable of adding significant value over time.

Strategy

Wolstencroft and Saacke use a quantitative model known as SmartGARP to pick stocks and construct the portfolio. The SmartGARP model takes in a multitude of data based on a series of bottom-up and top-down factors .The top-down factors capture macro trends such as changes in GDP, inflation, interest rates and bond yields, as well as investor sentiment in the markets and whether a stock is under- or over-owned. The bottom-up factors include growth, value, analyst revisions, momentum and accruals, including directors' dealing. The earnings revisions factor carries a double weight because the data quality is high and Artemis sees that factor as particularly effective in predicting investment trends and investor sentiment. The accruals factor was added in the second quarter of 2007 and takes into account earnings quality, balance sheet strength, insider buying and directors' dealings. We think the addition of this factor has improved the quality of the model's output. Moreover, we approve of the managers not adding new factors frequently (the accruals factor being the only major addition since the creation of SmartGARP at Artemis) and that they only tweak the model around the fringes where needed to keep it ahead of the markets. This instils a level of confidence in the depth of their understanding of stock analysis.

The model ranks stocks based on its scores in each factor and those stocks that score the highest make it into the portfolio. Consequently, the fund's sector weightings are allowed to deviate significantly from those of the benchmark. At the start of 2008 the managers made the stock position size a function of the SmartGARP score, so those stocks with the highest scores will be given larger weights in the portfolio. We now expect the fund to hold around 100 names, having previously comprised 60. The top 50 stocks will make up around 80% of the fund with the remaining 20% comprising stocks with volatile and/or deteriorating scores. The manager has an element of discretion over stock picks, he may exclude a stock if there is news that the model will not pick up on, such as merger and acquisition activity.

Management

Phillip Wolstencroft joined Artemis in early 2001 from Merrill Lynch where he was head of the group's Pan-European equities strategy. During his time at Merrill's Wolstencroft developed a quantitative research tool aimed at identifying good and bad stocks. When he moved to Artemis he was able to put the strategy into action and SmartGARP was born. Wolstencroft has run the fund through SmartGARP since launch in March 2001. In total he has 23 years of industry experience, seven of which are at Artemis.

In December 2002 he was joined on the fund by former colleague Peter Saacke. In total Saacke has nine years of industry experience, with five of these spent at Artemis. In addition to European Growth, Saacke is lead manager on Artemis Global Growth and has sole responsibility for one global institutional pooled fund, one global hedge fund, one global SICAV and two segregated mandates. He and Wolstencroft are also jointly responsible for one hedge fund, one SICAV and seven segregated mandates.

Although the fund managers' responsibilities appear numerous we are not concerned as the investment process used across the board is roughly 90% SmartGARP and 10% fund manager.