Big financial institutions do not usually stray too far from their own doorsteps when making equity investments. They like the comfort and familiarity of their home markets. But such attitudes are set to change dramatically with the arrival of Europe's single currency, the euro. Instead of using a country-based approach, big European investors will orient their portfolios more towards industrial sectors. Their approach will become less domestic and more international.
European monetary union (EMU) starts in just over a year, and some institutions are already changing their portfolio strategies, especially in continental Europe. But the real signal will not come until next May, when euro member-countries will be chosen and their bilateral exchange rates fixed.
"In an environment of fixed exchange rates in Europe, investors should be indifferent to which market they invest in," says Mr Gary Dugan, European equity market strategist at JP Morgan. "They are likely to seek out the best opportunities in whichever sector they wish to invest."
Investment is likely to flow to the most attractive companies in any sector across the euro zone, not to a single market. Because they will be measuring their portfolios against a future European stock index rather than national ones, they will need to increase their weightings in some sectors, decreasing them in others.
Energy stocks, for example, have a 10 per cent weighting in the markets likely to be part of EMU. But no pure energy stocks are represented in Germany's Dax blue chip index, Mr Dugan says. In Spain, banks and utilities dominate.
The UK is overweight in consumer stocks, where the German market is deficient. Germany's strength lies in the capital goods sector. EMU will enable fund managers to iron out these sector biases without incurring exchange rate risk. At Deutsche Morgan Grenfell, Mr Hans-Dieter Klein, head of German equity research, believes the usual "top-down" method of investing among various European countries will become obsolete. Since EMU members will have the same currency, common interest rates, converging inflation rates and similar fiscal policies, "it will no longer be necessary to make national allocations on the basis of macro-economic factors".
Instead, the equity allocation process within EMU will concentrate on stocks and sectors and thus be "bottom-up", he writes in a DMG study called `EquityPhoria - Entering New Territory'. This will pose new challenges for investing institutions, which will need to obtain in-depth local knowledge of the companies they are investing in and evaluate this in a European context.
Moving from a pre-EMU to an Emu investment environment will entail much volatility as institutions change their portfolio mix. Fund managers will look for stocks with the greatest liquidity and may be prepared to pay a premium for them, Mr Dugan says.
Mr Dugan expects greater focus on equities in some portfolios previously dominated by bonds, since recent years have seen a narrowing of the risk gap between the two. Unless they have been severely discouraged by the latest turbulence on world markets, retail investors, too, should become more share-oriented and internationally minded, he adds.
If the UK joins Emu, some portfolio moves by institutions could be dramatic. A typical UK pension fund has 52 per cent of assets in domestic equities and only 9 per cent in continental European shares. "Take away the currency risk," Mr Dugan says, "and the reasoning behind this heavy bias towards domestic equities becomes less easy to argue". In the event of UK membership of EMU, British portfolio managers would have to sell half their UK equity portfolio to invest in continental shares if they wanted to match a pan-European benchmark. This would affect the UK market, although continental investors would take up some of the slack as they moved into equities across Europe.
In Germany, institutions own only 19 per cent of their domestic market; the UK figure is 62 per cent. Companies hold 42 per cent of the German equity market. But because their shareholdings are strategic, they are likely to keep them. Thus the pace and pattern of diversification will vary between types of investor and countries.
Irish institutions, on the other hand, have one of the highest percentages of investments overseas with some 40 per cent or about £22 billion in other countries' equity markets. According to Mr John Conroy of NCB this is because the Irish institutions started the process earlier, immediately after the abolition of exchange controls.
The impact of EMU will go deeper than merely persuading institutions of the need to adopt a pan-European strategy. With greater market transparency brought by the single currency, companies will be under more intense pressure to compete. This will speed the restructuring process and encourage greater economic deregulation by governments.
Eventually, a single European stock exchange will develop in the euro zone, expected to be the world's third biggest equity trading area after the US and Japan. "If investors had their way, it would happen tomorrow," says Mr Dugan.
