january, 2014 2013 european equity investment … · in 1602, the world’s first formal stock...

JANUARY, 2014

2013 EUROPEAN EQUITY INVESTMENT LANDSCAPE: A GUIDE FOR ASIAN INVESTORS By Angelika Eibl, CFA, senior market development manager, STOXX Ltd.

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1. INTRODUCTION

“To understand Europe, you have to be a genius - or French.” Madeleine Albright

The “old world” has the world’s longest standing tradition of stock market trading. While equity market like structures existed as early as in ancient Roman times, the first documented European securities market was set up in Venice in the late 12

th century, when local rulers explored new ways to finance their wars against their

neighbors. In 1602, the world’s first formal stock exchange was founded in the Netherlands, two centuries before the first US stock exchange was established in Philadelphia. Today the tradable European equity universe is over USD10 trillion and represents some of the most innovative industries and iconic brands.

Despite the significant investment opportunities available in Europe, the region has not been a focal point for

Asian investors, who have traditionally divided the world along two dimensions in their equity policy allocations:

primarily their home region of Asia and secondarily the US. The evidence for this practice is seen in the prevalent

use of international benchmarks by institutional investors in Asia. We observe this attitude changing, however, as

investors move toward an all-country view of the world. We believe this trend is positive since it allows investors to

take a more focused view on countries and regions and make more incisive asset allocation decisions.

In this research piece, we will attempt to provide a clear view on the current stock market investment landscape in Europe. The first section of this paper will shed light on the macroeconomic situation in Europe. In the second part, we will describe the European stock market, its fundamentals, performance and particularities. We will compare the European equity market to the US equity market, offering Asian investors a detailed view of their differences. The last section will give an overview on STOXX’s offering in the European market.

TRANSPARENCY AND FLEXIBILITY STAND OUT IN IN THE FLOOD OF “SUSTAINABLE“ PRODUCTS

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VOLATILITY INDICES FORECAST MARKET RISKS THE CASE FOR EUROPE – SEEN FROM A US PERSPECTIVE 2013 EUROPEAN EQUITY INVESTMENT LANDSCAPE: A GUIDE FOR ASIAN INVESTORS

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2013 EUROPEAN EQUITY INVESTMENT LANDSCAPE: A GUIDE FOR ASIAN INVESTORS

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2. MACROECONOMIC PICTURE

The term “Europe” means different things to different people. Throughout this piece we shall define Europe as

those European Union (“EU”) member countries and those European Free Trade Association (“EFTA”) states

combined that qualify as developed markets from the perspective of a public equity market investor1). This

definition covers all developed European countries as well as all developed countries in Europe that have entered

free trade agreements with each other such that together they can be regarded as a contiguous economic entity.

We further define the Eurozone as the subset of European countries which have adopted the Euro as a currency.

As of 2013, Europe thus defined covers 18 countries with more than 420 million inhabitants and the Eurozone

covers 12 countries with more than 320 million inhabitants2)

.

Figure 1: Map of Europe

Illustration: STOXX

1) Using STOXX definition of developed markets, see STOXX Index Methodology Guide. The underlying methodology is fully

transparent and rules based and exclusively uses input data that stems from globally recognized independent organizations

such as the International Monetary Fund (“IMF”) and the World Bank. 2) IMF World Economic Outlook. Data as of Oct. 2013

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2.1 ECONOMIC OUTPUT Gross domestic product (“GDP”), which measures a region’s total output in a given year, is a natural starting point

to understand Europe’s economy. Figure 2a compares Europe’s GDP in USD with the GDP of the rest of the world.

We find that Europe forms one of the world’s largest economic entities. With 17.2 trillion US dollars, the region’s

combined output is slightly higher than that of the US. Asia’s GDP at 20.3 trillion US dollars is higher than both

the US and Europe.

Figure 2a: GDP 2013 by country/region in USD trillion and as % of total

Figure 2b: GDP PPP 2013 by country/region in USD trillion and as % of total

Eurozone12.5

17.0%

Europe, other4.7

6.4%

US16.7

22.8%

Canada1.8

2.5%

Japan5.0

6.8%

Australia1.5

2.0%

Other31.2

42.5%

Europe17.2

23.4%

Eurozone11.1

12.8%

Europe, other3.9

4.5%

US16.7

19.3%

Canada1.5

1.8%Japan4.7

5.5%Australia

1.0 1.2%

Other47.7

55.0%

Europe15.0

17.3%

Source: IMF World Economic Outlook. Data as of Oct. 2013.

Since cost of living differences can be substantial, we also compare output based on purchasing power parity

(“PPP”). This way, we account for the fact that, for instance, a McDonald’s Big Mac cost a consumer 4.56 US

dollars in the US, 2.61 US dollars in China and 4.66 US dollars in the Eurozone3)

in July 2013. Using this second

measure of economic output (see Figure 2b), Europe still forms one of the world’s largest economies.

3) The Economist, Jul. 2013

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Though Europe has been in a recession for the past two years, the region is expected to return to positive growth

and experience rising wealth in 2014. Over the coming five years, the IMF projects European countries to grow by

1.7% and Eurozone countries by 1.6% (see Figure 3). This is important for an investor because stock market

performance mirrors trends in the underlying economies in the mid- and long-term.

Figure 3: Average annual real GDP growth forecast for 2014-2018

2.8 2.4 2.3 2.2 2.1 2.0

1.9 1.8 1.7 1.6 1.6 1.6 1.5 1.5 1.4 1.3

1.2

0.7

1.7 1.6

0.0

1.0

2.0

3.0

Source: IMF World Economic Outlook. Data as of Oct. 2013. Computation: STOXX *Median

2.2 DRIVERS OF GROWTH The World Economic Forum’s (“WEF”) Global Competitiveness Report, which annually assesses the global

competitive landscape across currently 148 countries (see Figure 4), finds that as of 2013/2014 a majority of the

world’s most competitive countries are situated in Europe: Switzerland (1st), Finland (3

rd), Germany (4

th), Sweden

(6th

), the Netherlands (8th

) and the UK (10th

) make it into the world’s top 10. The US is ranked 5th

. Singapore and

Hong Kong are ranked 2nd

and 7th

respectively. Japan ranks 9th

on the list.

Figure 4: Heat map competitiveness around the globe

Rank [range of GCI scores*]

Rank 51-75 :

Rank 26-50:

Rank 1-10:

Rank 11-25:

Rank 76-148 & not covered

[4.13, 4.41[

[4.41, 5.00[

[5.37, 5.67]

[5.00, 5.37[

Source: WEF Global Competitiveness Report 2013-2014. *Global Competitiveness Index score; higher scores indicate higher competitiveness

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The WEF finds that Europe remains committed to maintaining and further improving its competitiveness through

a focus on drivers of productivity, such as technical innovation, good governance, price stability, competitive tax

rates, free trade and the integration of the neighboring growth regions in Eastern Europe.

Technological innovation

Europe is home to more researchers than any other region of the world with over 1.5 million. In addition, with 347

billion US dollars in research and development (“R&D”) spending, it accounts for 24% of total global spending on

R&D. In relation to GDP, the Nordics and the German-speaking countries outspend even the US in R&D4)

.

Good governance

The turmoil in Europe has spawned a strong commitment to tackle the roots of the continent’s economic issues.

This, at least, is the conclusion of studies such as the 2013 edition of the Ease of Doing Business survey by the

International Bank for Reconstruction and Development and the World Bank. Southern European governments, in

particular, are found to have embarked on efforts at large-scale reform, starting with fiscal consolidation, financial

sector restructuring and steps toward improving the functioning of key goods and services markets. Along with

these reforms, there exists a major effort to strengthen their governance of innovation policy.

Price stability

There is a clear consensus among European leaders and the European public that, in the longer term, the stability

of the euro is of paramount importance for the region. This belief is reflected in the objective of the European

Central Bank (“ECB”), one of the six institutions besides the European Parliament that jointly govern the EU.

Modeled after the German central bank and situated in Frankfurt, Germany, the ECB says in its mission statement:

“The main objective of the Eurosystem is to maintain price stability: safeguarding the value of the euro.” Unlike in

the US, where the Federal Reserve System must balance the competing goals of price stability and maximum

employment, price stability is the explicit first priority of the guardian of the European monetary system. And

indeed, despite initial concerns that inflation would pick up, inflation has remained near long-term lows since the

beginning of 2009 and is expected to remain below 2% over the coming five years5)

.

4) R&D Magazine, Dec. 2012. Data as of 2012 5) IMF World Economic Outlook. Data as of Oct. 2013

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Competitive tax environment

In recent years, there have been big shifts in corporate tax rates globally, which have generally tended to drop.

With a median total corporate tax rate of 42% (see Figure 5), Europe offers a more favorable tax environment, on

average, than other major developed markets including the US, where high levels of corporate income taxes drive

up the aggregate corporate tax load. Particularly some of the smaller European economies such as Luxembourg,

Ireland or Switzerland offer rates that are highly competitive. While the fact that lower corporate tax burdens can

generally be associated with higher investment and higher growth is intuitive, another finding may surprise:

research by PricewaterhouseCoopers (”PwC”) and the World Bank6)

, which since 2004 have annually evaluated the

global corporate tax environment, finds that low administrative burdens on businesses through efficient tax

systems contribute even more to economic growth than tax cuts do. PwC and the World Bank further find that

some of the world’s most efficient tax systems are located in Europe. In fact, a majority of European countries’ tax

payment systems ranks within the top quartile of countries worldwide. Canada makes into the world’s top 10 (8th

),

the US comes in as 69th

of 185 countries ranked.

Figure 5: Total tax rate as percentage of commercial profits

7) in major developed markets globally

21 26 28 30 36

39 40 41 42 43 45 47 49 53 53

58

66 68

27

47 48 50

-40

-20

0

20

40

60

80

-40

-20

-

20

40

60

80

Tota

l cor

por

ate

tax

rate

in %

2005 2012 Change

Median Europe 2012: 42

21 26 28 30 36

39 40 41 42 43 45 47 49 53 53

58

66 68

27

47 48 50

-40

-20

0

20

40

60

80

-40

-20

-

20

40

60

80

Tota

l cor

por

ate

tax

rate

in %

2005 2012 Change

Median Europe 2012: 42

Source: World Bank, Doing Business Project. Data as of Aug. 2013

6) Paying Taxes 2013: The global picture, A joint PwC and World Bank report, 2013 7) Total tax rate measures the amount of taxes and mandatory contributions payable by businesses after accounting for

allowable deductions and exemptions as a share of commercial profits. Taxes withheld (such as personal income tax) or

collected and remitted to tax authorities (such as value-added taxes, sales taxes or goods and service taxes) are excluded.

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Exports

Europe is home to some of the world’s most iconic brands and most successful export nations, (see Figure 6 and

Figure 7). Led by Germany, the UK and France, EU member states export higher values of goods and services to

non-EU states than either the US or China.

Figure 6: Selected European brands by industry

AerospaceVehiclesFashion Food products Pharmaceuticals Industrials

Figure 7: Exports of goods and services

741

378 313

2'731

282

592 437

2'167

2'196

988

380 449

0

500

1'000

1'500

2'000

2'500

3'000

Germany UK France EU Brazil Russia India* China US

Brindled bars:Exports within EU

US

D b

illio

n

Sources: World Bank (exports of goods and services in USD); Eurostat (percentage allocation of EU exports within and outside of EU). Data as of year-end 2012. *Data as of year-end 2011

Efforts to further promote free trade and thus exports between Europe and outside parties continue. A European

Union – United States Free Trade Agreement was proposed by President Obama in his February 2013 State of the

Union address and was openly received by European representatives. If successfully concluded in 2014/15, it can

reasonably be expected to substantially boost growth on both sides of the Atlantic.

Continuing integration of Eastern Europe

Encouraged by rising exports among its member states coupled with reduction of trade barriers and the

harmonization of standards, Europe is working on further integrating its neighbor states in the east and south,

namely much of Eastern Europe as well as Turkey. Owing to this policy, Europe benefits from its massively growing

periphery which, on aggregate, consumed a staggering 2.8 trillion US dollars in goods imports in 2011, more than

either China or the US. The IMF estimates this area to grow at twice the speed of the EU over the next five years8)

.

8) Per IMF World Economic Outlook Oct. 2013, central and eastern Europe is expected to grow by 3.4% annually from 2014-

2018

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Eurozone6'290 12%

Europe, other5'174 10%

US18'668 35%Canada

2'016 4%

Japan3'681 7%

Australia1'286 2%

BRICs7'065 13%

Other8'982 17%

Europe11'46422%

France1'823 29%

Germany1'486 23%

Spain995 16%

Netherlands651

10%

Italy480 8%

Belgium300 5%

Other554 9%UK

3'019 26%

France1'823 16%

Germany1'486 13%

Switzerland1'079 9%

Spain995 9%

Netherlands651 6%

Sweden561 5%

Italy480 4%

Other 1'369 12%

3. THE EUROPEAN STOCK MARKET

3.1 OVERVIEW With a total capitalization of 11.5 trillion US dollars, stocks in the European market account for approximately 22%

of aggregate listed equity values globally, with a majority of these values stemming from Eurozone stocks (see

Figure 8). Understanding the capitalizations of regional markets (on a relative basis) is important since they

determine the base-case allocations for those global stock investors whose strategic asset allocation is

determined by relative market sizes. A likely strategic target allocation for market-cap investors to European

equities, for instance, would thus be about 22% of total equity allocation.

Figure 8: Total stock market cap by country and region in USD billion

Source: World Bank. Data as of Dec. 31, 2012

It is noteworthy that while European economies jointly have a slightly larger GDP than the US, (see section 2.1),

their combined stock market values are over a third lower. Two major factors contribute to this apparent

mismatch, which is shown in further detail in Figure 9.

World Total: USD53.2 bn

Eurozone Total: USD6.3 bn

Europe Total: USD11.5 bn

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Figure 9: Stock market cap of listed companies as % GDP by country and region

171

124 123

107

84 74 72 70

63 62 52 51

44 31 27 24 19 18

63 57

119 111

85

62

-

25

50

75

100

125

150

175

Source: World Bank. Data as of Dec. 2012 *Median

First, a larger portion of economic activity is government controlled, with government spending accounting for

about half of GDP in Europe and nearly 60% of GDP in some European countries including Finland, France and

Denmark. By comparison, US government spending accounts for just over a third of GDP. Second, a larger portion

of equity values are held privately in Europe compared to in the US. Historically, Europeans have been more

reluctant to accept the downsides of going public, such as the scrutiny on compensation and a focus on short-

term quarterly targets.

While there is a substantial difference between the total capitalizations of the US equity market and the European

equity market overall, the percent allocation of market cap across industries is similar (see Figure 10) except in a

few important areas. Specifically, the US has a comparatively stronger exposure to the technology and consumer

services sector, since it is home to technology giants such as Apple, Microsoft and IBM, as well as to consumer

services household names such as Wal-Mart, Walt Disney and McDonald’s. In turn, Europe has relatively stronger

exposure to basic materials (e.g. through BASF, Rio Tinto) and consumer goods (e.g. though Nestlé, Daimler

Benz). An Asian investor may welcome these slight differences since they further increase the diversification

benefits from international investing.

Between Europe and the Eurozone, industry allocations are more congruent except for in the health care sector.

The reason is that the largest three European health care companies (Novartis, Roche, GalaxoSmithKline) are

listed in Switzerland and in the UK, neither of which is in the Eurozone.

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Figure 10: Industry allocation by market

Europe

Oil & gas9%

Basicmaterials

8%

Industrials14%

Consumer goods17%

Health care11%

Consumer services

7%

Telecomm.5%

Utilities4%

Financials22%

Technology3%

Eurozone

Oil & gas7%

Basic materials10%

Industrials16%

Consumer goods18%Health

care6%

Consumerservices

7%

Telecomm.4%

Utilities5%

Financials22%

Technology5%

US

Oil & gas10%

Basicmaterials

3%

Industrials13%

Consumer goods11%

Health care12%

Consumerservices

13%

Telecomm.2%

Utilities3%

Financials18%

Technology15%

Source: STOXX, using total market indices as of Aug. 16, 2013

When we consider the liquidity of Europe’s stock markets, we observe a linear relationship between the size and

liquidity of a stock market (see Figure 11). Europe, the world’s second largest contiguous equities market,

consequently forms the world’s second most liquid stock market.

Figure 11: Market size and liquidity

Japan

Eurozone

Europe

US

0

10

20

30

40

50

0 5 10 15 20

Annual

ized

3m

AD

TV in

US

D t

r

Free-float market cap in USD tr

Pacific*

Trendline

Source: STOXX calculation and estimates, using total market indices. Data as of Jul. 31, 2013 *Australia and New Zealand

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3.2 MARKET SIZE SEGMENTATION As we shall illustrate in this section, not all definitions of market size work for any underlying region at any point in

time. Specifically, we shall illustrate that one of the most commonly used approaches to classify size segments in

the US stock market does not work well in the European market environment, where there are fewer listed

companies, the smallest of which are smaller and less liquid than the smallest listed companies in the US market.

This means that, in our view, a smaller percentage of the total (free-float) market cap should be included in broad

and investable indices in Europe relative to in the US.

Figure 12 and Figure 13 below show company sizes and liquidities as measured in average daily trading volumes

(“ADTVs”) for different percentiles and percentile ranges of the total market of the US, Europe and the Eurozone.

We can see that companies in around the 95th

percentile of the European and Eurozone market have size and

liquidity that quite closely corresponds to the size and liquidity observed in the 98th

percentile of the US market. In

other words, the market is not as large and its liquidity is not as deep in Europe and in the Eurozone as it is in the

US.

Figure 12: Company size by percentiles of total market

0.0

0.5

1.0

1.5

2.0

2.5

3.0

98th 97th 96th 95th 94th 93rd 92nd 91st 90th

Free

-flo

at m

arke

t ca

p. i

n U

SD

bn

Percentile of company size by free-float market capitalization

US

Europe

Eurozone

Source: STOXX, Datastream. Data as of Jul. 31, 2013

Figure 13: Liquidity as function of company size by percentile range of total market

0

5

10

15

20

25

30

35

98-97% 97-96% 96-95% 95-94% 94-93% 93-92% 92-91% 91-90% 90-89%

Ave

rag

e 3

mon

th A

DTV

in U

SD

m b

y ra

ng

e

Percentile range of company size by free-float market capitalization

US

Europe

Eurozone

Source: STOXX, Datastream. Data as of Jul. 31, 2013

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As a consequence, we define our European total market indices, which aim to broadly represent a stock market, as

those largest companies (as measured by free-float) that account for 95% of total free-float, whereas in the US a

higher percentage of the market is often taken into consideration, typically around 98%. It further illustrates why

we define our European benchmark indices, the STOXX Europe 600 and the EURO STOXX, which are designed to

give a broad yet investable representation of the market, as those largest companies that account for

approximately 90% of total free-float market cap. In the US, a larger portion of total free-float can be considered

investable and thus often is included in investable indices.

Once we have thus found the beginning of the investable market segment, there are different ways of subdividing

the resulting universe of investable stocks into size buckets. The most widespread method of defining size

segments in the US today uses fixed-size ranges. Common break points currently are 10 billion US dollars (and

above) for large-caps, 2 billion US dollars (and below) for small-caps, with mid-caps falling in between. While this

method has the advantage of simplicity, it has the disadvantage that its break points need to be adjusted over

time and by underlying market, or else the percentage of stocks in each size bucket varies (see Figure 14).

Figure 14: Number of stocks in total market by region – segmented by company size

175 84 355

378 180721

493 2791'897

0%

20%

40%

60%

80%

100%

Europe Eurozone US

% o

f al

l com

pan

ies

in m

arke

t

<2 bn 2-10 bn >10 bn

~2/3~1/2

<2bn (small) 2-10bn (mid)

Source: STOXX, Datastream, using free-float market cap in USD billion. Data as of Jul. 31, 2013

Alternatively, one can define size relative to a given universe, as was done by Fama and French in their research

regarding the three-factor model. For a given universe of stocks, Fama and French defined small-caps as the

smallest 30%, large-caps as the largest 30% and mid-caps as the remaining 40% of firms. This rule is simple yet

has the advantage of defining breaking points not absolutely, but relatively to a given universe which makes it

work equally well for portfolios in different time periods and geographies.

For the STOXX indices STOXX Europe 600 and EURO STOXX, for instance, we pursue a method that strongly

resembles the second, relative approach. We use an even simpler rule with large-caps comprising the largest 33%,

mid-caps the next 33% and small-caps the smallest 33% of firms within a given investable universe.

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3.3 FUNDAMENTALS Despite the recent rally in stock prices globally, European stocks have remained attractively priced in a historical

perspective. Looking at the fundamentals in Figure 15, we can see that this statement holds true irrespective of

which specific measure of fundamental value is used. On aggregate, today’s pricing of European stocks is more

attractive than in early 2003, which is when European markets bottomed out following the burst of the dot-com

bubble.

Figure 15: Fundamentals of European benchmark indices

Price to book Dividend yield in %

0.5x

1.0x

1.5x

2.0x

2.5x

Jan. 2002 Jan. 2004 Jan. 2006 Jan. 2008 Jan. 2010 Jan. 2012

STOXX Europe 600

EURO STOXX

2

3

4

5

6

7

8


STOXX Europe 600

EURO STOXX

Equity value to 12m EBITDA Equity value to 12m sales

6.0x

7.0x

8.0x

9.0x

10.0x

11.0x

12.0x


STOXX Europe 600

EURO STOXX

0.5x

1.0x

1.5x

2.0x

2.5x


STOXX Europe 600

EURO STOXX

Source: STOXX. Monthly data from Jan. 31, 2002 to Sep. 30, 2013

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As shown in Figure 16, Europe and the Eurozone are both ranked among the world’s most attractive regions based

on net dividend yields, price to book and price to sales ratios.

Figure 16: Fundamentals of by region

Net dividend yield Rank* Price to book Rank* Price to sales Rank*

Europe 2.9% 1 1.7x 3 0.9x 2

Eurozone 2.6% 2 1.4x 1 0.7x 1

World 2.2% 4 2.0x 4 1.2x 4

US & Canada 1.8% 5 2.5x 5 1.6x 5

Asia Pacific 2.4% 3 1.4x 2 1.0x 3

Source: STOXX. STOXX developed market benchmark indices as of Jul. 31, 2013 *Least expensive = 1; most expensive = 5

3.4 PERFORMANCE Europe and the Eurozone have roughly performed in line with the US market, (see Figure 17), and thus have

historically achieved attractive returns overall.

Figure 17: Risk and return of European market segments and the US

Eurozone Large

Eurozone Mid

Eurozone Small

Europe Large

Europe Mid

Europe Small

Eurozone

Europe

US

Eurozone Blue-chipEurope Blue-chip

France

Germany

UK

6%

7%

8%

9%

10%

11%

12%

18%20%22%24%26%28%30%

Retu

rn, an

nu

alized

Volatility, annualized Source: STOXX. Daily gross returns in USD, annualized from Oct. 16, 2003 to Oct. 15, 2013, using STOXX indices

Second, with correlations to the US market of typically around 0.8 (using 10-year histories of weekly return data),

European stocks provide diversification benefits that can more than offset even an expected slight

underperformance, as shown in Figure 15, which uses return and volatility assumptions that are roughly based on

historical 10-year performance numbers from Figure 17 and computes the expected risk-return characteristics of a

hypothetical portfolio of US and European stocks.

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Figure 18: Illustration of diversification benefits

US Europe Portfolio Formula

Weight 60.0% 40.0%

Expected return 8.0% 9.0% 8.4% E +

Volatility 19.0% 23.0% 19.6%

Correlation 0.8

/ Expected return / volatility 0.39 0.42 0.43

Illustration: STOXX

3.5 PECULIARITIES OF EUROPEAN STOCK MARKETS Not all stock markets are created equal. In fact, there are fundamental differences between the functioning of

European and US trading places. The reason we discuss some of the – quite technical – distinctions between

these systems in this section is that they create the need for different and more complex operational platforms to

properly collect and evaluate data on European stocks than are necessary in the US market. In STOXX’s view, the

incremental complexities of the European system make it advisable that an Asian investor without specific

expertise in the European data and trading environment partner with a European market specialist.

Prior to 2007, traditional national exchanges enjoyed a quasi-monopoly in trading in Europe. To keep pace with

technological development and to foster competition in the provision of services to investors and between trading

venues, the EU adopted the so-called Markets in Financial Instruments Directive (“MiFID”) which came into effect

for all EU member states in November, 2007. The new rules substantially increased competition by opening the

market to new types of trading venues. For instance, the share of trading volumes of blue chips performed on the

most established exchanges decreased substantially, e.g. on the LSE from near 100% in 2007 to below 60% four

years later9)

. Also, increasing automation of exchanges contributed to the high fragmentation of the European

trading landscape. Unlike in the US, where most stocks are predominantly traded on either the New York Stock

Exchange or the NASDAQ, in Europe most issuers get substantial volume from several listings (see Figure 19).

Less than half of total liquidity – on average – comes from the respective main listings in countries such as the

UK and in France.

Figure 19: Concentration of trading volume in most liquid listing – on average by issuer and country

45% 45%

66%

50%

58%

70%

47% 47%

75%

40%

50%

60%

70%

80%

UK France Germany Netherlands Spain Italy Sweden Finland US Source: STOXX, Datastream; using three-month ADTVs as of Jun. 24, 2013

9) Trading in European Equity Markets: Fragmentation and Market Quality, Dr. Martin Wagener, Karlsruhe 2011

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Most importantly though, European regulators under MiFID defined best execution not solely on the basis of

pricing, but as a function also of a wider array of additional execution characteristics such as liquidity, order, size,

and the likelihood of execution, among others.

This has two major implications: first orders in Europe are permitted to simultaneously trade at different prices in

different venues. This means that prices are exchange-specific, and that the liquidity across trading venues

cannot simply be aggregated since there is no network featuring inter-market price priority linking the different

venues. While differences in pricing among venues are arbitraged away and thus are generally small, they are

large enough for investors with a strong focus on tracking error to typically trade on the same exchange as the

portfolio or index they track – and vice versa, since index providers need to use the prices of those exchanges that

are preferred by their clients. To date, neither ETF issuers nor their index providers have moved away from the

primary exchanges10)

and since there is a chicken-and-egg aspect to the situation, neither group is likely to in the

foreseeable future. Second, there is no single data consolidator in Europe that provides comprehensive

consolidated market information to investors.

Both points constitute major differences to the US system where RegNMS mandates exchanges to reroute orders

to other market centers if those are offering a better price (“trade-through rule”), thereby establishing a formal

network with inter-market price priority, and where the Consolidated Tape System centrally collects, processes and

disseminates trade and quote information.

Additional complexities stem from the fact, that unlike in the US, where there is one set of regulations that rules

the securities markets across state borders, legal frameworks and taxation systems vary by country within the

European marketplace. Each country has its own laws that govern the specifics of events such as mergers and

issuance rights, and each country has its own tax loopholes, which adds substantial hurdles to an efficient

processing and adjusting of pricing data.

Overall, it is fair to say that indexing concepts on European stock markets need to be backed by even more

sophisticated data collection, consolidation and management systems than are required in the US market in order

to accurately reflect market prices and liquidity, the key inputs in most indexing concepts.

4. STOXX PRODUCT OFFERING IN THE EUROPEAN STOCK MARKET

To capture different aspects of the European equities markets, investors need indices which are clearly defined,

representative, accurately measurable, and investable. STOXX offers a broad range of such index products for

Europe, (see

Figure 20). The offering is subdivided into index groups such as total market, benchmark, blue chip, size, smart

beta and so forth. These groups are discussed individually in the following paragraphs. Further information the

methodology and performance of these and other STOXX indices is available on the STOXX web page11)

.

10) A primary exchange is defined as the most important stock exchange in a given country. Examples: New York Stock

Exchange in the US, London Stock Exchange in the UK, Frankfurt Stock Exchange in Germany, etc. 11) See http://www.stoxx.com/indices/types/introduction.html

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Figure 20: Overview of STOXX European product offering

Region Europe Eurozone

Total Market STOXX Europe TMI STOXX Europe ex. [Eurozone, UK, France, Germany] TMI STOXX [country, Nordic] TMI STOXX Europe TMI [Large, Mid, Small] STOXX Europe Total Market [Strong Value, Value, Growth, Strong Growth]

EURO STOXX TMI EURO STOXX [country] TMI EURO STOXX TMI [Large, Mid, Small] EURO STOXX Total Market [Strong Value, Value, Growth, Strong Growth]

Benchmark STOXX Europe 600 STOXX UK 180 STOXX Nordic

EURO STOXX EURO STOXX ex [Banks, Financials, France, Germany] STOXX [France 90, Italy 45, Spain 30]

Blue chip STOXX Europe 50 STOXX Europe 50 ex [Banks, Financials] STOXX [France 50, Italy 20, Spain 20, UK 50, Nordic 30]

EURO STOXX 50 EURO STOXX 50 Subindex [France, Italy, Spain] EURO STOXX 50 ex [Financials, Banks] EURO STOXX 50 ex [country, e.g. France, Germany, Spain]

Size STOXX Europe [Large, Mid, Small] 200 STOXX Europe Large 200 ex [Banks, Financials] STOXX Nordic [Large, Mid, Small] STOXX Europe ex [UK, Eurozone] [Large, Mid, Small]

EURO STOXX [Large, Mid, Small] EURO STOXX Large ex [Banks, Financials]

Industry etc. STOXX Europe [Industry, Supersector, Sector, Subsector]

EURO STOXX [Industry, Supersector, Sector, Subsector]

Style STOXX Europe Strong [Value, Growth] 20 EURO STOXX Strong [Value, Growth] 20

Fundamental indicators

STOXX Europe Select Dividend 30 STOXX Europe Maximum Dividend 40 STOXX Nordic Select Dividend 20 STOXX Europe Strong Quality 30

EURO STOXX Select Dividend 30 EURO STOXX Select Dividend 30 DVP EURO STOXX 50 DVP

Smart beta STOXX Europe 600 Equal Weighted STOXX Europe 600 Minimum Variance STOXX Europe Low Risk Weighted [100, 200, 300] STOXX Europe Large 200 Risk Control [5, 10, 15, 20]%

EURO STOXX 50 Equal Weighted EURO iSTOXX 50 Equal Risk EURO STOXX 50 Low Risk Weighted [30] EURO STOXX 50 [Volatility, BuyWrite, PutWrite] EURO STOXX Minimum Variance EURO STOXX Low Risk Weighted [50, 100, 150]

Sustainability and themes

STOXX Europe Sustainability 40 STOXX Europe [Christian, Islamic, Islamic 50] STOXX Europe IPO [3, 12, 60] Months STOXX Europe Private Equity 20

EURO STOXX Sustainability 40 EURO STOXX Islamic 50

Source: STOXX, Oct. 2013

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4.1 TOTAL MARKET INDICES Each country total market index (“TMI”) aims to broadly represent a stock market, covering 95% of the free-float

market cap of a country. Regional TMIs are aggregates of country TMIs. The EURO STOXX TMI, for instance, is the

aggregate of all Eurozone TMIs. The components of TMIS are weighted by free-float market cap. There are no

caps at the component or other level. Buffer rules apply upon rebalancing to limit turnover and thus trading costs.

For further details on the rationale behind the specific target coverage of the European TMIs please see section

3.2 further up in this document.

4.2 BENCHMARK INDICES Benchmark indices (“BMI”) give a broad yet investable representation of a given universe. Each BMI is derived

from a parent TMI and covers those largest stocks in terms of free-float market cap that jointly account for about

90% of total free-float market capitalization in the given space. The universe of STOXX BMIs comprises both fixed

number and variable number component BMIs. Where a BMI has a fixed number of components, the number was

chosen such that about 90% market coverage as measured by free-float is obtained. BMI components are

weighted by their free-float market cap subject to a 20% cap at the component level. For most BMI’s, this cap is

not of any practical relevance, since a BMI’s largest component typically accounts for far less than 20% of total

index weight. Buffer rules apply upon rebalancing to limit turnover and thus trading costs.

In general, a BMI’s return, volatility and correlation properties closely resemble those same properties of the TMI

from which the BMI was derived. This is why in STOXX’s view, STOXX European benchmark indices such as the

STOXX Europe 600 or the EURO STOXX are ideal tools for investors to gain broad exposure to a given market

through an index which trades very little in representativeness against a rather steep increase in liquidity.

Two comments are noteworthy from a US perspective, which were also discussed in some detail in section 3.2:

» Compared to the US, the European market offers fewer investable stocks. The STOXX benchmark indices for Europe and for the Eurozone contain 600 and about 300 stocks, respectively. This compares to well over 1,500 investable stocks in the US market.

» To a large degree, this is so because compared to the US, a smaller portion of stocks offer enough liquidity to be considered investable from the perspective of a US investor. This is why STOXX considers only the top 90% of the total European market to be investable, which is a smaller percentage than commonly assumed in the US market.

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4.3 BLUE-CHIP INDICES The STOXX European blue-chip indices are fixed-number indices which cover the largest companies of a given

country or region as defined by the free-float market cap of the pertaining BMI. Blue-chip indices are capped at

10% at the component level.

The STOXX blue-chip offering differentiates itself from other large-cap offerings through its focus on a balanced

coverage of supersectors. This approach dates back to the creation of the EURO STOXX 50, the first blue-chip

index launched by STOXX in February, 1998. At the time, the upcoming introduction of the euro as the Eurozone

currency had created the need for a blue-chip benchmark which would track the Eurozone stock market. STOXX

introduced an algorithm that would lead to a more balanced, thus more representative and more investable index

than is typically obtained with a purely free-float based weighting scheme. Yet unlike with other multi-country

indices known to that date, the EURO STOXX 50 methodology did not seek to balance allocations by geography –

which no longer made sense in a region about to be united by a single currency - but by company business

models. Specifically, the EURO STOXX 50 methodology introduced sought to obtain a more balanced coverage

across company supersectors as defined by the Industry Classification Benchmark (“ICB”).

This proven methodology is used today for many cross-regional STOXX blue-chip indices globally. Specifically, it

works as follows: in a first step, the STOXX blue-chip algorithm partitions a given universe of stocks such that all

stocks are grouped by their supersector affiliation. Next, within each supersector group, the maximum number of

the largest stocks as measured by free-float market cap are selected, such that on aggregate the supersector

coverage is as close as possible to, but does not exceed, 60%. Lastly, the largest 5012)

supersector leaders are

picked. Jointly, they form the constituents of the blue-chip index, with constituent weights defined proportional to

free-float market capitalization subject to a 10% cap at the component level. As with most other STOXX indices,

buffer rules apply upon rebalancing to limit turnover and thus trading costs.

In STOXX’s view, STOXX European blue-chip indices such as the EURO STOXX 50, the STOXX Europe 50 or the

STOXX UK 50 provide an ideal basis for investors and asset managers with strong liquidity focus to invest into the

European large- and mega-cap segment.

4.4 SIZE INDICES Many investors demand tools that allow them to invest in and weight different market size segments individually.

STOXX offers a broad range of European size indices that meet this demand.

The STOXX Europe 200 Small/Mid/Large indices, for instance, satisfy this demand. They are obtained by

subdividing the STOXX Europe 600 into three equally sized (as measured by number of stocks) sets of stocks.

It should be noted that the STOXX size index methodology that is applied in Europe varies from what US investors

are familiar with from their home market due to structural differences between the regions. For a more detailed

discussion, please refer to section 3.2 further up in this paper.

12) Other fixed numbers are sometimes chosen, with 50 being the most typical number of constituents of a STOXX blue-chip

index

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4.5 SMART-BETA INDEX CONCEPTS In recent years, smart-beta index concepts have proven capable of systematically outperforming traditional index

concepts, which has led to a surge in investor demand.

While traditional index concepts weight companies based on their (free-float or total) market cap, STOXX offers a

broad range of products which rank, select or weight indices based on criteria other than market cap. STOXX also

offers indices based on the minimum variance portfolio and quality growth characteristics for example. In addition

STOXX offers indices focused on dividends and environmental, social and governance scores. While a detailed

discussion of smart beta indices is outside the scope of this paper, we refer the reader to the STOXX web page,

which contains more information on smart beta concepts as well as research pertinent to these concepts.

5. SUMMARY AND CONCLUSION

In this paper, we have laid out our perspective on Europe and its current investment landscape.

From a macroeconomic view, there are good reasons why Europe can be expected to successfully defend its

position as one of the world’s largest and wealthiest economic entities since the region is committed to

technological innovation, good governance, price stability, competitive tax rates and free trade.

Asian investors can quite easily tap the opportunities in Europe through equities, since Europe offers the world’s

second largest and second most liquid contiguous stock market. Having said that, not all markets are made equal.

Standard US approaches to market size segmentation, for instance, are not directly applicable in Europe which

exhibits different size and liquidity patterns. Further, the structure of the European equities market is unique and

features different national tax and regulatory environments. This creates challenges that cannot typically be

handled with systems and processes designed for US market which is less complex.

In STOXX’s view, Asian investors looking to further diversify their portfolios should consider building a strategic

equity position in Europe, which can improve both diversification and expected returns. By partnering with an

experienced specialist in the implementation of European equity strategies, Asian investors can safely navigate

the pitfalls of the European equities markets and ultimately improve the risk-return characteristics of their

portfolios.

The views and opinions expressed in this paper are solely those of the author and do not necessarily represent the views and

opinions of STOXX Ltd.

About STOXX

STOXX Ltd. is a global index provider, currently calculating a global, comprehensive index family of over 6,000 strictly rules-

based and transparent indices. Best known for the leading European equity indices EURO STOXX 50, STOXX Europe 50 and

STOXX Europe 600, STOXX Ltd. maintains and calculates the STOXX Global index family which consists of total market,

broad and blue-chip indices for the regions Americas, Europe, Asia/Pacific and sub-regions Latin America and BRIC (Brazil,

Russia, India and China) as well as global markets.

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To provide market participants with optimal transparency, STOXX indices are classified into three categories. Regular “STOXX”

indices include all standard, theme and strategy indices that are part of STOXX’s integrated index family and follow a strict

rules-based methodology. The “iSTOXX” brand typically comprises less standardized index concepts that are not integrated in

the STOXX Global index family, but are nevertheless is strictly rules based. While indices that are branded “STOXX” and

“iSTOXX” are developed by STOXX for a broad range of market participants, the “STOXX Customized” brand covers indices

that are specifically developed for clients and do not carry the STOXX brand in the index name.

STOXX indices are licensed to more than 500 companies around the world as underlyings for Exchange Traded Funds (ETFs),

futures & options, structured products and passively managed investment funds. Three of the top ETFs in Europe and 30% of

all assets under management are based on STOXX indices. STOXX Ltd. holds Europe's number one and the world's number

three position in the derivatives segment.

In addition, STOXX Ltd. is the marketing agent for the indices of Deutsche Boerse AG and SIX, amongst them the DAX and

the SMI indices. STOXX Ltd. is part of Deutsche Boerse AG and SIX. www.stoxx.com

http://www.stoxx.com/

january, 2014 2013 european equity investment … · in 1602, the world’s first formal stock...

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