Fureyous

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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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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I’m quite late in reporting the recent performance of fund managers from my favourite performance report, Standard and Poor’s SPIVA. For those that don’t know the reason why this is my favourite report on fund manager performance is that it considers survivorship. It does this by examining all fund managers at the start of the reporting period, as opposed to the Mercer, Morningstar, and other performance surveys who look at performance of the fund managers who are still around at the end of the reporting period, which excludes managers who have blown up, experienced high levels of redemptions, or failed to attract sufficient funds and closed.

Anyway, the table above shows the proportion of fund managers who have failed to outperform standard benchmarks of their respective asset class.

Over the 12 months to 30 June 2011, once again only small cap Australian equity managers have more than 50% of managers outperforming their index.

The most interesting result is that more than 50% of both Australian Equity General and A-REIT managers have outperformed over the last 3 years. Unfortunately for them the 5 year results are quite dismal with more than 70% and 60% respectively underperforming their respective index.

As expected, Australian bond managers have the most trouble outperforming the UBS Composite index and despite the yield curve changing shape numerous time  the past 5 years and the same with credit spreads, active managers have consistently struggled.

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Its been a little while since I wrote anything on managed fnds. Yesterday I attended a series of presentations at Griffith University whereby undergrad students presented results of their previous few months working in financial services. Some of the results were very interesting including how many global fund managers demonstrated a different investment style than they claimed. So with this inspiration this afternoon I quickly whipped up a bit of Fama French 3 factor analysis of some of the more popular funds in Australia and my results are in the table below.

The data used in this analysis is monthly data from June 2003 to September 2011, so 99 months in total. Only Tyndall and Dimensional’s Large Cap fund failed to generate any risk-adjusted alpha. As expected the Market Beta is high for all funds, less so for Investors Mutual (IML) with a market beta of 0.77 (might be a little more flexibiility in their mandate I suspect).

HML is a factor which is effectively buying the growth index and shorting the value index, hence if the beta is negative it reflects the manager’s value bias and if positive, growth bias. The interesting results with regards to HML are…

• Tyndall claims to be a value manager but shows an insignificant value bias
• Dimensional Aust Value is strongly value biased as you would expect from a Fama French influenced manager as is Investors’ Mutual…both true to style
• Fidelity, BT and Ausbil each have a growth bias and this is not surprising based on their stated styles
• Perpetual, however show a significant bias to growth despite claiming to be a value manager…perhaps its tought to stick to your style when your so big…not sure

The final factor, SMB, is the equivalent of buying the MSCI Small Cap index and shorting the market which is large cap biased. The results show that all managers extract some of their return from the small cap space with Dimensional, unsurprisingly, showing the strongest bias to small caps.

So, this 8 year analysis shows Tyndall and Perpetual may be a little suspect with regards to their style. From a portfolio construction perspective, with their strong levels of skill and relative opposite styles it looks like combining Fidelity Australian  and Dimensional Australian Value funds may be a combination worthy of consideration.

My disclaimer…past returns do not equal future returns so everything I just wrote could turn out to be completely wrong in the future…so don’t act on this analysis without seeking professional advice!!!

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Last night UBS lost $2billion due to another “rogue” doing unauthorised trades and as reported last night by Zero Hedge, Goldman Sachs are shutting down their famed (or perhaps infamous), Global Alpha hedge fund. The obvious question posed by Zero Hedge is whose next? and I wonder which Australian fund(s), if any, will be hit.

Since the GFC when numerous Australian funds (mortgage, credit, hedge funds, and illiquid property funds) froze to redemptions, these funds have struggled as investors have sought increased transparency and lower cost investments (index funds, term deposits, and annuities). Because Australian investors haven’t jumped backed into these potentially illiquid and high risk funds I don’t there’s too much likelihood of another round of fund problems here. There may be the occasional hedge fund blow up (in fact I heard anecdotally about a start-up options trading hedge fund that blew up last month just a matter of months after starting), but given the relatively conservative appetite in Australia I think all should be ok (although Europe and US economies are still in deep doo-doo as is the Euro-sovereign and Euro currency situation)…I’ll let you know if I change my mind!

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With the US heading towards recession and the Euro Sovereign Crisis getting ugly again where to invest one’s funds has never been tougher. Australian bonds yields are around 4%, meaning they are on PE ratio of 25 which compared to local and global shares, which are currently on forward PEs of around 10, are very expensive. Whilst shares are relatively better priced than bonds the additional volality makes them a challenging bet as downside certainly still exists.

My current thoughts around investment strategy are not so concerned with bonds versus shares but more around some style biases worth considering if you are looking to access each asset class.

Shares

• I’m more inclined to favour “value” biased funds as growth stocks are currently gettng hammered if they don’t hit their numbers and they obviously have further to fall. The value style has a bias towards low PE or low Price/Book which certainly provides some downside protection in this market. The biggest risk to this bias is that alot of banks are probaly classified as value stocks but they are the ones most likely to suffer should the Euro Sovereign crisis develop into a Lehman Brothers’ type scenario
• “Income” bias also appears a better bet. I personally like the Zurich Equity Income fund as it is typically much less volatile than the market but pays a very high income (it actually targets 10%pa in dividends). I’d certainly rather earn my returns from income than capital growth today.
• In the Australian market I see one of the other big downside risks is in the small cap sector that may also be regarded as high growth and has a riskier exposure to commodities. Sure commodities appear to be good at the moment but their price increase has been so rapid that the downside in the face of a recession in the US is probably reasonably high. So underweight small cap in my book.

Fixed Interest

• I definitely prefer Australian bonds than overseas. Whilst I’ve favoured Global Fixed interest funds in the past, with their high exposure to Italy and Spain it appears they have lost their defensive characteristics so I prefer active managers without too much exposure to the Euro sovereigns.
• As opposed to 2008, I prefer diversified corporate credit (investment grade). The spreads are still quite wide and more than compensate for their default risk. Corporates around the world have been de-risking their balance sheets over the past few years and are relatively cashed up today so credit does appear good value.
• Whilst the Australin government bond yield curve has dropped quite dramatically in the last couple of months the same can’t be said for term deposits. Whilst the term deposit interest rate has dropped it looks still quite attractive for any term up to 5 years….but be prepared to hunt around for a good deal…probably at a building society or credit union.

Its certainly a very tough investment environment today and next Saturday night I hope to do something a little more interesting than this!

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Looks like there’ll be a fair few redemptions coming up for ING’s and maybe even UBS’s managed funds because today ING have sold their Australian funds business to UBS. This is no comment on the quality of either team, but there is bound to be some unrest over the coming months as teams are merged and synergies are found.

The common belief is that when key people leave so too does performance, but even if performance doesn’t suffer, there will be some change in the style of the investmetn management…so…the investment exhibits different behaviour and the fees you pay as an investor are now paying for something most likely a little different.

I’m guessing the Research Houses will most likely be issuing HOLD ratings across many funds and this will be the catalyst for the redemptions as adviser’s recommend funds are switched to a more stable team…ditto for insto funds.

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International equity small-cap stocks widely outperformed large-cap stocks over the year to September 2010, returning 24.4 per cent and 12.7 per cent, respectively in US dollar terms.

I took the above from today’s InvestorDaily email and whilst the fact that global small cap outperformed large cap is not surprising, as it is bound to happen from time to time, what is surprising is the complete lack of selection of global small cap fund that advisers and investors have. I noticed at my place of work we have very few on our approved product list so I looked up Lonsec to see what other funds they may have at least “Recommended” and there were only three!…BlackRock, Zurich, and Schroder.

The Fama and French three factor model has been around for almost twenty years, many of us have read Jeremy Siegel’s book, “Stocks for the Long Run”, and there are many local and international papers which have similar messages…that is…over time small cap stocks outperform large cap stocks on a risk-adjusted basis. Of course, the past doesn’t equal the future, but we are creatures of habit most of the time and our market has shown little appetite for small cap…bizarre.

One of the recent posts I put up referred to S&P’s SPIVA report which also showed that active managers have recently been more successful in small cap stock selection than large cap and this makes intuitive sense. There are fewer analysts covering small cap space so there are more opportunities for mis-pricings so we can make a simplistic conclusion that the small cap part of the market is less efficient than large cap. OK…so small caps are the go…but there’s usually a but…small cap stocks are much more volatile and I must admit it is this volatility that is often the turn off (perhaps the additional illiquidity is too)…so there is a reasonable fear factor associated with them and I can understand that.

What I don’t understand is this insistence on regional biases…particularly Asia. Personally I don’t understand why you would constrain your investment universe (and opportunity) simply based on region. Why not place your funds with a global small cap or global unconstrained manager (with proven skill and aligned bias) and let them make the bet as to whether Asia is worthy of an overweight. By investing in an Asian managed fund we are really choosing a Global Small Cap fund anyway, so my simple message is go global and don’t reduce your investment opportunity.

Please note…despite these comments I have no views as to whether global small cap investments are likely to outperform or perform well moving forward.

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Source: van Eyk, Morningstar

The above chart contains some performance statistics of a list of Australian share funds with at least a 5 year track record and were awarded an A-Rating by van Eyk this month. The A-rating is the second highest possible rating van Eyk award with the highest being AA…no Australian share fund achieved an AA rating in this latest review so this table is effectively the highest rated Australian share funds. I must point out that Integrity, Solaris, and Sigma have funds that were also A-Rated but they do not make the table due to a short performance history.

Before I provide any analysis I’ll provide some background to this simple table. The performance was measured over 5 years using monthly figures. So if a fund only had a 5 year track record, then the “total number of 5 year periods” is 1. If a fund has a 6 year track record, then the “total number of 5 year periods” is 13 because we have 13 separate rolling 5 year numbers due to monthly data. The table shows the number of 5 year periods where the fund outperforms the ASX200 as well as its stated alpha target.

Unfortunately, of these 9 highly rated funds, only 2 funds, Fidelity and Ausbil Dexia, have exceeded their alpha target more than 50% of the time. Fidelity’s Australian share fund has exceeded their alpha target (2.5%) every single rolling five year period since their inception which is absolutely outstanding and an absolute credit to this team. Fidelity started around the start of the new bull phase in 2003 and have obviously had to endure the GFC as well as its choppy recovery.

Ausbil, whose performance figures started around mid-1997 also have outstanding results. Whilst 60% of the time they have exceeded their alpha target they have exceeded the ASX200 index 100% of the time when looking at their 5 year rolling average.

Whilst Alphinity (formerly Challenger) has shown near decent numbers (49%) in terms of achieving their alpha target, I don’t group Alphinity in the same league as Fidelity and Ausbil because most of their strong performance occurred during the 1990s when they were possibly the best Australian share manager around and their performance since 2003 has been nothing short of abysmal…unfortunately this is a fund whose performance track record has effectively died in recent years.

As for the rest, it looks like considering their alpha target in terms of performance expectation is a complete waste of time. Most are nowhere near achieving this target and several managers haven’t achieved one single rolling period in excess of their target. I wonder how the fund managers feel continually failing to achieve their target…must be depressing. 

Anyway, at least all nine managers have outperformed their index, over 5 year periods, more than half of the time…well, at least before platforms fees, retail fees, adviser fees, etc!

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