Fureyous

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.

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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.

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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.

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In recent times I’ve seen quite a few articles about investing in art and other collectables in your superannuation fund (I guess in response to weak sharemarket returns), and its something that has always disturbed me as this is one gutsy investment strategy for the well informed let alone your typical investor. One of my favourite econobloggers, Felix Salmon, recently had an excellent piece explaining why art is not an investment…click here. In short Salmon says…

Art doesn’t have returns, it just sits there, being expensively insured. It pays no dividends, and it can’t be marked to market, since the only way to find out the market price for an artwork is to sell it. Even the auction houses have no real idea what any given artwork is worth: look how many pieces fail to sell at auction, or sell for multiples of their estimate.

I totally agree with this assessment and his article as a whole and as  Salmon’s article suggests this also applies to wine and I’ll throw into the mix any collectable such as vintage cars, stamps, and collectible notes and coins.

In 2010, the Cooper Review recommended that art should be banned from superannuation and pretty much for the same reasons…that collectibles are not investments and are personal assets. There was a lot of opposition to this recommendation with the art community protesting by suggesting it would result in the demise of the art market. The government ultimately didn’t accept the recommendation and that was that.

Whilst it is possible these assets can increase in value, they are a poor choice for providing retirement given Salmon’s reasons…no income, impossible to value without selling,  and little to no liquidity….and they are not investments. Also, I don’t believe that diversification of collectables is going to help too much either, as I can only imagine that by reducing the cost the collectable in order to diversify will result in increasing making it more difficult to sell… that is, increasing diversification may increase risk.

Whilst I acknowledge investors frustration at sharemarkets, I do agree with the Cooper Review and Salmon that collectables are not investments and in my opinion they should not be considered as part of a superannuation investment portfolio.

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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.

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Source: RBA

Despite the above chart being a few weeks old, the above chart shows credit spreads have widened significantly over the past few months such that at the end of November, both A and BBB rated corporates have spreads in excess of 300bps. When you consider that the historic default risk is much much lower than these spreads I do believe accepting this type of risk in a well diversified portfolio (that is, with a fund) is an investment that could provide good returns over the next few years. The biggest issues with this type of portfolio relates to liquidity and the ongoing volatility.

Liquidity, or the potential lack of, is why the spreads are as wide as they are. So holding credit investment for as long as possible or through to maturity is recommended. Volatility risk is expected to be quite high as the correlation will be strong with equities. So whilst there is potential for short term falls in value for corporate credit, as long as defaults don’t hit very high and significant record levels, this type of investment should provide a decent return over the next few years. So now that I’ve written it, I guess finding a relatively passive credit fund is the next challenge.

The last thing I want to say regarding corporate credit spreads that are reflected in the above chart is the fact that there is probably a high proportion of banking and other financial services debt included in there. Because it is Australian and our financial institutions appear to be much much stronger than our international counterparts, at this stage I’m not particularly concerned…but it is the financial institutions that will create the volatility in this index thanks to the European situation and the difficulty in raising overseas capital.

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I’ve read a few too many times how Australia is well positioned because of its exporting links to China and how this should help us escape any serious economic issues flowing out of Europe. Obviously our markets haven’t quite agreed with that with bond yields dropping massively over recent months and our equity market continuing to show high volatility and dropping arond 20% since recording 2011 highs around 5000 back in April.

Overnight we have just had three articles from prominent economists indicating concerns about China …

• Will China Break? – Paul Krugman
• China: Hard landing in sight? – Patrick Chovanec
• China: Lots of News signifying nothing new – Michael Pettis

Of course, a seriously troubling Euro crisis will spill over everywhere including China. Our economy is nowhere near as secure as many commentators or fund managers indicate and I have to admit to being the most bearish on our economy for quite some time…my perceived complacency and frustration with government and opposition focusing on budget surpluses is driving me nuts.

For investors, finding good investment return potential is very difficult indeed and takes some courage. Equity markets still carry plenty of downside risk let alone the usual day to day volatility, bonds have yields in the 3%s, and with an economy looking to slow more than we hoped, property looks scary, and even commodities are bound to drop signficantly in the face of a slower China.

I’m sure the focus of investors will continue to be capital protection over capital apreciation for some time yet. So I can only imagine that cash and term deposits will continue to be the investment of choice…particularly whilst term deposits continue to pay 1.5% to 2% over government debt. Personally, I believe if you can handle the volatility and hang in there for a while I tend to think corporate debt, which on average is paying a significant premium above governemnt debt, should provide the best return potential…only record default levels should stop a decent return on corporate debt (not that its out of the realm of possibility) in the next few years so ensure the portfolio is well diversified and be prepared for a bumpy ride.

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Last Friday I attended a day long program with around 80 researchers, financial advisers, and other financial professionals as part of a 5 day portfolio construction program run by Graham Rich over a 12 month period. Friday’s program was divided into three parts…

1. Investment Fables
2. Asset Allocation using Scenario Modelling
3. Greece

Each part went for around two and a half hours each and was mostly a fairly robust discussion or debate across each topic within small groups of 6 people or the forum as a whole.

Investment Fables was a completely appropriate introduction and reminded us all how vulnerable we all can be to a good investment story. This session was hosted by Professor Jack Gray, a self confessed ‘value’ investor with an enormous amount of experience who I could spend days on end listening to…a wonderful thinker and someone everyone could learn from. We explored many investment fables (or should I say myths) across asset classes as well as economics and investing itself. A couple of examples include, “buying stocks with low PE win out”, and “stocks always outperform in the long run”.

My main take-out from this session was how fallible we all are to the investment story and of course we all know that when it comes to investing you can always find a counter-example to the investment story…. If you are a ‘value’ investor there have always been long periods when ‘value’ investing has underperformed and same goes for the belief that ‘stocks always outperform’…personally I always look to Japan as a counter-example for many stock-related myths. Pretty obvious stuff but nonetheless an excellent reminder for perspective.

Next topic was Scenario modelling and this was hosted by the Asset Allocator, Tim Farrelly and Paul Scully. Scenario Modelling is a technique that on its surface is a relatively simple and logical approach to developing an asset allocation that reflects one’s belief. The main risk I see with it is, like with any mathematical model, garbage-in means garbage-out.

I believe one of the main users of this approach is Dr Susan Gosling of MLC. The approach basically involves the design of a number of economic scenarios that the future may bring and apply ideal asset allocations to each scenario followed by the application of probabilities of each scenario occurring. For example, we may believe one scenario for the future is that the Greece debacle may explode, the Euro experiment finishes, contagion results in the default of not just Greece, but Portugal, Ireland, Italy and Spain and a collapse of the global financial system as well as a severe global depression. The ideal asset allocation one may apply to this scenario is one that primarily consists of government bonds (Australian and US???), very few equities and perhaps a reasonable amount of cash (assuming the local banks don’t collapse also). A probability associated with this scenario may be 10%. Scenario 2 is developed, it may be early recovery which entails a high equities allocation and not much in the way of bonds, and the probability assigned may be 15% etc. The final asset allocation is the sum of the probabilities by the asset allocation for each scenario.

Whilst I don’t mind this approach for the institutional investor or even personal investor, I see a difficult application in the retail financial advisory world. This approach requires constant updating as new information enters the market, and would create quite a moving feast for the asset allocation, let alone the time required for the ongoing application. Whilst I do believe scenario modelling is much more likely to yield better results than a static asset allocation, the complexity of implementation across many advisers and their clients means the risks associated with it from an AFSL perspective may outweigh the benefits. I get the impression most of the delegates were mostly concerned with implementation in a retail setting.

The final topic of the day was Greece. Graham Rich brought along two guest speakers from European Banks, Barclays and UBS, to provide the audience with their perspectives on what the future holds for the European economies and markets. Their virtual blind faith (well, a slight exaggeration) in trusting the solution with the current politicians and bureaucrats was a little too optimistic for me. Despite that, the widely agreed expectations were that equity markets will continue to be volatile, Greece will ultimately default, and that markets may get worse before they get better.

The most poignant comment of the day was early on when Graham Rich mentioned that he could not recall a time that politicians have played a bigger part in the outcome of financial markets than they do today. Lets face it, it is up to politicians, with their various agendas, to solve the European Sovereign Crisis and it is up to the politicians to implement fiscal policy to generate more jobs in the US given Monetary policy is out of ammunition. Given this situation it is very difficult for any investor to happily embrace the risk of the equity markets so for most the best decision will be to sit on the sidelines until there is light at the end of the tunnel. We all know that this means significant upside in the market will be missed but that is an opportunity cost I believe many are prepared to make.

Anyway, overall it was a worthy day with some excellent debate and comment. I will be attending their markets summit and Day 2 of the Academy in February when the debate will centre on whether Cash is still King!

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Source: RBA

In just 3 business days the yield curve has dropped down to where it was at the end of September where markets had experienced eight weeks of gloom and doom. Mind you, a lot happened in the three days to the end of yesterday…including the Greek’s putting significant doubt in the Euro rescue package, sharemarkets subsequently plummeting, and our Reserve Bank dropping their cash rates by 25bps.

According to the ASX’s Target Rate Tracker the market is placing the probability of another rate cut in December at 100%. The above yield curve certainly agress with that sentiment and with 5 month bonds trading around 4.1% the market is also saying there’ll be at least 75bps in cuts through to April.

Obviously, this all means that inflaiton is a non-issue for the Reserve Bank and the focus is on the local economy whose sentiment is being driven by the Euro Sovereign concerns. Whilst I usually go with market expectations regarding RBA activity I didn’t when incorrectly predicting last week’s RBA decision. Europe still has a long long way to go so the current theme of sharemarket volatility will undoubtedly continue. Term Deposits are the overweight position for me.

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A couple of weeks ago I did a post showing Fama French 3 Factor analysis on some of the leading Australian Equities fund managers. The analysis covered returns from June 2003 to September 2011 so it obviously covered a mixture of markets…bull bear and sideways. I just completed the same analysis but this time I divided the data into three distinct markets…

1. Bull Market from 2003 to the end of October 2007
2. Global Financial Crisis bear market from the end of October 2007 to its bottom at the end of February 2009
3. The GFC recovery since the end of February 2009 to September 2011

The updated results are…

Data Source: van Eyk, Morningstar

My factor descriptions are…

• Annualised Alpha is effectively the skill the manager brings after all factors are considered…e.g. it includes their market timing skills
• Market Beta – represents the fund’s volatility relative to the market’s. So a Market Beta of 1 means the fund’s performance moves in sync with the market’s
• HML – this factor is long MSCI Australia Growth and short MSCI Australia Value…so if the results are positive then chances are the fund is a “Growth” fund and “Value” is negative
• SMB – this factor is Long Small Caps and Short the ASX200…therefore a positive result shows a small cap bias relative to the market

I haven’t produced the statistical significance of each factor but I have highlighted the significant results for the HML factor. These results indicate some consistency of style across at least 2 of the 3 markets from DFA Australian Value and Investor’s Mutual (IML) which are both value biased; BT, Fidelity, and Ausbil which are each growth biased; and Tyndall, Perpetual, and DFA Large Cap which don’t appear to be either value or growth biased although Tyndall has a growth bias in the bull market preceding the GFC.

I’m not so sure Perpetual and Tyndall will agree with me on that given they both state they are value managers but the results are the results. Both of these managers also appear to have a greater small cap bias than all others (except DFA Aust Value) so I guess that is where their focus has been. Whilst they may claim to be “value” managers they appear to be a little more focused in small cap land than their competitors…something to keep in mind when considering their portfolio inclusion.

Unsurprisingly all managers shows high market betas, which is a typical characteristic of well diversified long only managers so when the market goes down (or up) so too do these funds.

In terms of what combinations may be best…its looking like Fidelity combined with either IML or DFA Aust Value.

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