Fureyous

Perhaps haven’t been reading enough but I’ve just read my first article of the year with a fund manager suggesting huge returns for the Australian sharemarket…click here. Apparently the Platypus CIO believes the ASX200 ‘looks set to finish 2012 over the 5000 mark”.

At last check the ASX today was 4267 so ifit grows to 5000 by the end of the year that’s a capital gain for the remaining months of a little over 17%. Throw in a conservative dividend yield of 4% and that’s a 21% return!!! I love to hear the big calls

Sure, if the European and US economies look to be sorted and China’s issues are fine then 5000 is very do-able…I hope he’s right…but it is a big if and there’s a long way to go before we should be remotely confident of a 21% return this year so be very careful of what fund managers say…perhaps there may be conflicting reasons?

   Send article as PDF   

Source: RBA

Its been a few weeks since I provided an update on the local government yield curve and consistent with the slight improvement in the sharemarket the Australian Government Bond Yield Curve has indicated a better outlook for the local economy. As the chart shows, since 6 January the yield curve has increased around 20bps across all maturities which isn’t a bad increase but yields still aren’t as high as they were last November.

Current figures still suggest the Reserve Bank will decrease its cash rate next meeting and the shape of the curve is consistent with weaker economic outlook suggested by the IMF and World Bank reports. It also suggests that inflation continues to be a non-threat and the ABS inflation figures showed that the market was pretty much correct by dismissing inflation over recent months.

Since October the S&P500 has rallied around 20% in the face of some pretty ugly political behaviour in both the US and Europe regarding their respective economies and that’s quite a surprise. This is also supported by the downtrend in the VIX…see below chart…given the current downside risks I tend to think this trend will reverse and volatlility will increase.

Source: Bloomberg

I don’t know what direction equity markets will go but my thoughts are to stay conservative…there’s a lot of water to pass under the economic bridge before catastrophic risks (global/European banking meltdown) is off the table. Whilst the market’s suggesting the risk is reducing its still there.

   Send article as PDF   

Lonsec have a reasonable investment strategy paper released today (subscription required) suggesting one of the best ways of managing equity market risk is to use variable beta managers. A variable beta manager is a manager who has the ability to significantly change their exposure to the market depending on their view. So if a variable beta fund believes shares are undervalued they will fully invest into the sharemarket and if they believe overvalued they may increase their cash holdings or maybe increase their shorts (i.e. selling stocks in the hope they will falll in price before they buy them back).

To support their point, Lonsec say that they have added K2 Australian Absolute Return Fund to their model portfolio because, “K2 have a specific focus on downside risk in their portfolio by varying their market exposure within the fund. During a strong bull run, strategies such as K2 will keep their fund fully invested…then sell out of equities when they believe the risks are too great…”. Sounds great and K2′s overall track record is certainly one that many Australian fund managers would envy.

I’m skeptical of every fund so I conducted some in-depth performance analysis to understand K2′s performance drivers and most of the results certainly supported that they are a manager of skill. For example, since the end of 1999, K2 have outperformed the Australian sharemarket indices and achieved alpha of almost 5%pa whilst their market beta was a relatively low 0.66 (i.e. less risk than the market). It did have a small cap bias but my model showed that the market and small cap effect only explained around half of their performance with rest explained by other effects such as market timing…either way, great results for K2 since 1999.

Their relative performance since the end of the bull market (Oct 2007)  is excellent and this was totally explained by having low exposure to the market…beta less than 1 again plus very high alpha around 4%pa.

Where K2′s performance fell down was during the bull market from March 2003 to October 2007. Overall, they significantly underperformed the MSCI Australian Index by around 4,5%pa, but I guess it is difficult to complain when you receive 20%pa instead of the market’s 25%pa. My performance analysis showed that during this bull market K2 did not have the market exposure Lonsec claimed they would have (i.e. a beta close to 1) with a relatively low market beta of ~0.55 plus a reasonable exposure to small cap stocks. This low beta explains why they underperformed the market because during this time, K2 still were able to display skill with a strong alpha of 1% (after taking into small cap effects).

Anyway, in theory a variable beta fund could be a worthy addition to an investment portfolio if you are looking to outsource management of market exposure. I agree with Lonsec that K2 is an excellent fund for doing this job. The warning derived from my analysis is that, whilst variable beta funds (or a research houses) may tell you they will be fully exposed to sharemarkets during a bull market run, there’s always a chance they won’t hence they could significantly underperform the market during these times.

   Send article as PDF   

I read the following comment this morning in the Money Management daily enews…Market Neutral Funds Underrated: Zenith…

There is demonstrable portfolio improvement to be had from allocating to market neutral strategies as part of the equity allocation…

That says to me that if you want to improve your equities part of the portfolio then replace part of it with something that is not equities; or, if you want to improve your equities portfolio then diversify away from equities; or even more cynically, because equities have performed badly you should not have invested in equities and had some market neutral investments.

You see, if an investment is market neutral then its net exposure to the market, by definition is basically zero…or a market beta of zero. For example, if I invest $100,000 in my best stock ideas from the ASX200 and then short the ASX200 index by $100,000, my net exposure to the market is zero and therefore market neutral. I then take my $100,000 and invest it in something conservative like a portfolio of cash-like investments and the return I receive is a cash-like return plus the outperformance (or underperformance) of my best stock ideas.

So, as you can see, my return is not at all equity-like because my return equals cash plus alpha minus fees…which, given the fees are typically very high and over the long run alpha does not often outperform fees, means my long run return will probably be less than cash…but this is still a better return than shares over the last 4 years!!!

OK, believe it or not I don’t mean to suggest that market neutral strategies should never be part of an investment portfolio. Just that they carry is a very different type of risk than equities. So the decision to include market neutral strategies in a portfolio means there must firstly be a non-traditional approach to the asset allocation decision (i.e. the inclusion of “alternatives”) and therefore there must be a decision made as to which traditional beta risks must be exchanged for this market neutral strategy…I’m sure it will often be equities but it could equally likely be credit risk, property, or even other so-called alternatives such as commodities or private equity etc.

In the article there were a few funds mentioned that Zenith reviewed and some of them with quite good recent performance. Blackrock’s Market Neutral fund returned 28% over the last 12 months so there’s every chance both longs and shorts did reasonably well…as opposed to my example, Blackrock short stocks as opposed to the index as a whole. Despite that great performance it was quite muted in 2010, and underperformed shares in 2009. Market Neutral funds do have the ability to provide good returns but always keep in mind those returns are purely reliant upon manager skill.

My final comment relates to Zenith’s view on fees…

The idea that overall returns will be improved by reducing input costs relates more to industries such as manufacturing but doesn’t apply to something like funds management where there is intellectual property involved – so it doesn’t make sense to look at the MER rather than the net returns.

…and its something I strongly disagree with. With the failure of so many active managers to outperform their benchmark and not deliver on their promises, the easiest way to increase your return is with low fees. Hedge funds were found out over 2007 and 2008 and 2 and 20 has largely disappeared. Successful Funds management is very difficult and if you are good you will be rewarded with strong inflows and strong inflows can still fill the pockets of the greedy fund manager with more money than they’ll ever need…Ill save my rant on performance fees for another day.

   Send article as PDF   

Page 31 of the Australian Financial Review (AFR) today has an article suggesting “that the traditional buy-hold approach to owning shares is dead”…full text, with subscription can be found here. The article’s stated reason for buy-hold is that “in the long run, markets always go up and will provide investors with a good return on their investment as well as tax benefits, despite any volatility”.

Unfortunately, financial planners are placed in a dim light as usual, with ignorant comments like, “The buy-hold strategy is often sold by financial planners because it requires less management work – helpful for those with a large client base – as stocks selected are held for many years”.

Whilst there is a little bit if truth in each of the above statements, unfortunately the main reason behind the buy-hold strategy is ignored altogether. That is, that timing markets is very very hard and after transaction costs and potentially other costs are taken into account, there is more evidence to suggest that buy-hold is a far more successful method of achieving sharemarket returns than active management. This belief has the foundation in numerous academic articles, most notably Brinson, Beebower and Hood’s “Determinant of Portfolio Performance”, and the consistent failure of active managers to outperform benchmarks (see recent SPIVA results).

Unfortunately the AFR article suggests that in order to be successful at beating the buy-hold approach,  signals such as momentum, timing markets (good luck!) and the ability to pick ‘high-quality’ companies using certain factors is all you have to do. If only it was that easy.

For the individual investor, picking stocks is largely a mug’s game…sure you might beat the market but I can pretty much garantee it will typically be more through good luck than any demonstration of skill and any outperformance will probably come from taking on more roisk (even unknowingly).

Personally, I like the idea of being dynamic with regards to investment portfolio. My approach is a little different and is based around designing portfolios to accept or not accept various macro risks…the likelihood of underperformane must be accepted and outperformance will never be guaranteed like some of these fund managers market but rarely live up to.

Bottom line…there is no silver bullet but the most efficient way to receive sharemarket returns will be via a very cheap index fund…and that is a buy-hold strategy and a very popular strategy of financial planners and for good reason.

   Send article as PDF   

Source: RBA

Just when you think the yield curve can’t get any lower, the last 8 days have taken another 10 to 15bps off. Sharemarkets have obviously dropped on the Euro-debacle and this yield curve demonstrates not only significant interest rate reductions in the months to come but a significantly slowing Australian eonomy thanks to the global pressures.

Futures markets are banking on 25bps drop in the RBA next month and another 50bps in February 2012. This doesn’t mean the yield curve will drop but either way, I am still happy to lock in my home loan for the next few years at a rate that is significantly below variable rates, but that’s enough about me.

Investment strategy-wise, loads of uncertainty is the norm and term deposits continue to pay a massive spread over government bonds. Our sharemarket carries a bit of risk amongst banks and resources so I’m sure if there’s any value its bound to be in other sectors.

   Send article as PDF   

The last month has shown a bit of a bounce-back in the sharemarkets but as the above yield curve indicates, so far its more of a dead cat bounce and there’s a long way to go. The yield curve is still negatively sloping to beyond two years indicating the market is expecting a few rate rise drops by the Reserve Bank in the months/years to come.  I tend to think the Reserve Bank will stay on hold once again on Tuesday simply because I think they’d rather wait and see how this latest Euro rescue package pans out. The early signs are positive but there are still a few concerns, notably the yields on Italian bonds are still very high (see below) and if they stay high then that spells trouble for Europe as Italy is the biggest debt holder in Europe and the third biggest in the world (behind Japan and USA) and they can’t be bailed out.

Italian 10 Year Bonds – 28 Oct 2011

Source: Bloomberg

Anyway, there’s a long long way to go before Europe is aywhere near out of trouble and the details of their latest plan aren’t even finalised so I imagine the Australian bond market will be tentative for some time yet and equity markets will continue their high volatility.

   Send article as PDF   

I don’t really have too much to say on this as nothing has really changed too significantly…the market is expecting interest rate cuts with an economy influenced by overseas events. The uncertainty in markets remains huge and its difficult to feel bullish on sharemarkets or the global economy and the downside risks clearly remain as nothing is resolved. Whilst we’ve had a couple of very big up days in the sharemarket there’s little strong evidence at this point in time to support its continuation (valuation doesn’t quite cut it) so I’m sure there’ll be some sharp down days soon. Volatility to continue and look out for bad Chinese data.

   Send article as PDF   

Source: Bloomberg, RBA

The above chart uses price from this morning for the 28 September data and as it shows there has only been a slight improvement in the yield curve over the last couple of weeks so really  no significant impact on troubled beliefs at this point in time. Overnight the equity markets were very strong, particularly in Europe, but there is no strong evidence of any Euro-debt resolutions and the market rally is currently one based on ‘hope’. Volatility will continue.

   Send article as PDF   

Earlier in the week I was at a meeting whereby one of the attendees suggested that in a balanced portfolio (~70% equities) the equities proportion adds around 90% of the risk, and then in yesterday’s Australian Financial Review I see a headline quote from Stephen Nash (FIIG Securities) that said, “If investors replaced half their equity portfolio with long bonds, they could cut their risk by half and cut the return by about 1 per cent” .

Over the last 100 years or so, equities have outperformed bonds and bills by around 4%pa around the world so whilst I’m unsure a loss of 1% in return potential is a reasonable assumption these comments certainly got me thinking about what has actually happened with regards to equities versus bonds in terms of risk.

Source: Index data originally sourced from Morningstar via van Eyk

The above tables shows some analysis I did for both local and global equities and bonds over the last 21 years or so. I also combined the returns to produce a 50% allocation each to bonds and equities as per Stephen Nash’s suggestion.

These results who that, certainly over the last 20 years, declining interest rates around the world certainly resulted in much better returns versus equities on a risk adjusted basis (sharpe ratio) than equities and therefore resulted in a significant risk reduction of the 50/50 portfolio. Maximum drawdowns for the 50/50 portfolios more than halved over the last 10 and 20 years and this significant risk reduction was also evident when looking at theoretical Value at Risk (calculated using historic return and risk figures) or the actual 5th percentile of returns.

The time period where Stephen Nash’s comment didn’t quite ring true was in the 1990s when Global shares were the strong performer and the “Risk” reduction of the 50/50 portfolio didn’t quite make it to half. However the risk reduction was still significantly reduced (and more than halved) when looking at Sharpe ratio, theoretical value at risk, or the actual 5th percentile of returns.

This overly simplistic analysis does suggest that replacing half an equities portfolio with bonds may significantly reduce risk in terms of volatility or in terms of downside risk. However, what we face today are bonds that are yielding around no more than 4%pa across all maturities (and I am talking government bonds, not credit). So unlike the last 20 years where yields have decreased (5 years government bonds decrease from more than 10% in 1995 to around 3.6% today…RBA data I looked at only went back to 1995), the risk to bonds in the long term is  increasing yields which means downside risk is far greater than we have seen for some time.

What is in favour of bonds is the enormous volatility equity markets so I tend to agree with Stephen Nash that bonds will half the short term risk of the equities portfolio but I do have fears for the long term risk of such a strategy.

   Send article as PDF