Managing Market Risk using Variable Beta Funds
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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“Market Neutral Strategies as part of the Equity Allocation”…huh???
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.
Bond ETFs on the ASX…now the game begins
With the ASX last week announcing that it is allowing bond ETFs to trade on the market, financial planners have the last basic building block in place to recommend portfolios that are completely listed covering all major asset classes. Previously listed portfolios were limited to equities (local and global of varying strategies) and commodities. With the inclusion of bond ETFs on the ASX that may result in many financial advisers abandoning master trust and wrap platforms, whereby they used managed funds for their fixed interest exposure, to the more transparent and lower cost listed portfolios.
With the movement to fee-for-service by the financial planning industry, thanks to the Future of Financial Advice (FOFA) reforms that kick off in July, ETFs are bound to be a very popular investment vehicle by financial planners so we will undoubtedly see further cost cutting by the platforms and further consolidation as the smaller platforms struggle to stay profitable.
This change of rules by the ASX is way overdue and whilst this initial move into bond ETFs is a small step…underlying bonds must come from only two Australian bond indices (UBS Composite or S&P Australian Fixed Interest)…its bound to start a significant change in behaviour in the financial planning and investment platform industries.
Keep art and collectables out of superannuation
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.
Promoting the wrong Financial Planners
Sorry about this article but i have to express my disgust at an article I’ve just read on a former Storm Financial adviser in today’s Sydney Morning Herald…I reluctantly place the link here but I don’t want to give any more publicity to this adviser. Overall the article, by Stuart Washington, is quite fair and appropriately cynical in parts but nevertheless I’d rather it wasn’t written at all.
As the article demonstrates, the one-trick pony that Storm Financial influenced their clients with was a double gearing strategy whereby clients, would borrow against their home and then use these funds to further gear with a margin loan into sharemarket investments. Storm apparently charged fees that would typically amount to around 7% of the invested amount…i.e. appallingly very high. This strategy made millions of dollars for Storm and lost $3billion of investor funds over 2008/09. On this system the financial adviser is of the opinion (in her book) that, “Academically, it was the perfect wealth system – use someone else’s money to make money, buy low and sell high”
On this, I just have a few comments to make…
- This adviser clearly has no idea what academics think of this ticking time bomb strategy…there’s nothing academically rigorous about it
- Clearly, this adviser has no understanding of the volatility and return history of sharemarkets
- It was only the perfect wealth system for the financial advisers who collected disgustingly high fees for this massively risky strategy
- Avoid any adviser who flippantly uses the term, “buy low, sell high
I’m disappointed that somehow this ignorance hasn’t stopped this financial adviser gaining publicity by appearing on various television shows including, Sunrise (Kochie should know better), The Circle, and The Project (usually the best current affairs show and run by comedians…go figure).
Finally, I cannot believe that her current passion is Financial Literacy and “lifting the sorry state of financial education in this country”…given the earlier quoted statement on the Storm system, this financial adviser should start educating herself and do this industry a favour and consider an exit…Yep, I am Fureyous that many of the best financial planners are not given the publicity that this person has undeservedly received.
Buy-hold strategy may have had its day…I don’t think so
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.
Australian Goverment Bond Yield Curve…noisy improvement
Source: RBA
The above chart shows the latest Australian Government Bond Yield curve which is around 5 to 2obps higher than it was a little over three weeks ago. On the scale of yield curve movement over the last few months its largely market noise and is therefore relatively meaningless…the market is still pricing in further RBA rate decreases and the outlook for the Australian economy is still relatively weak…its currently difficult to find any strong economic growth driver that doesn’t carry significant risk of not fulfilling its potential and that includes China.
The change in outlook for the 2011 Australian Economy in one picture
Source: RBA
The above chart shows pretty much what happened to the outlook for the Austrlaian economy and why bonds were the best investment for the year.
It shows the longer terms yields (3 years and above) dropping by up to 200bps thus providing very large capital gains for bond investors who had the courage of buying long term bonds at the start of the year. This yield curve movement also indicated the declining outlook for the Australian economy thanks largely to the Euro crisis and its potential impact on the banking system across the world.
For the short term bond holders (terms of 1 to 3 years), yields dropped by up to 150bps still providing strong capital growth. Whilst the yield to maturity dropped enormously across all maturies for Australian Government bonds, the Reserve Bank took a while to start the decrease and then only decreased by 50bps by the end of December. This curve still suggests the RBA has a few rate decreases to come and the Euro crisis will probably be the main determinant of that. That is despite the weak retail sales and weak residential property sales that provide increasing evidence of our weaker than you know economy. The Reserve Bank are also forecasting lower commodity prices which doesn help our resources sector so the outlook for growth across our economy may be moving closer to a one speed economy than we think.
Anyway, the year 2011 was certainly a year where the conservative bond investor was a winner and whilst I haven’t seen the final numbers yet, it looks like the gross returns should be a comfortably in double digits.
Investment Thoughts for 2012
Firstly I think its appropriate to suggest that I intend to make no return predictions for this year as I do believe its pretty much impossible with litte upside for me. However, what I would like to do is simply point out a few facts, rules, and current issues that need to be considered when building or reviewing the investment portfolio.
- The big issue this year will once again be the Euro-sovereign crisis. This shold result in significant volatility for equity markets from time to time and daily movements exceeding 2% up or down will be relatively frequent. This type of volatility is the current norm for markets but whether those markets move up or down through to the end of 2012 is anyone’s guess.
- Now whilst equity markets appear historically cheap on a PE basis, this is not necessarily a buy signal as PE ratios should be low in the face of high risk and lower than usual earnings growth, so be very very careful. Despite this warning, cash and bonds are hardly attractive on their own simple value metric, yield to maturity.
- If you think you can pick stocks better than the professionals, I’m afraid you cannot. Even the professionals, backed by massive amounts of resources and always very very intelligent people, frequently fail to beat the market so if you are looking to accept any equity-like risk make sure you are very well diversified and use an index manager or an active manager who is not taking on too many risky bets (remember, noone really knows at this point in time how this European situation will ultimately impact markets)…just because your only stock Telstra outperformed the market this year does not mean you are a good investor…it actually suggests the opposite
- The only free lunch in investing is diversification…this means don’t just invest in Australian equities (or Telstra), spread your investments across other investments such as Global equities, local and foreign fixed interest, local and global property, commodoties and if possible other alternative investments…but make sure the risk you accept is within your comfort zone
- The sharemarket performance of specific countries has very little to do with those countries economic growth. Two of the worst sharemarket performers this year were China, yes China, and India!!! Sharemarkets go up if information is more positive than expected and vice versa…this has nothing to do with economic growth…its expectations so if you can predict the future you’re looking good if you can’t, you’re possibly in trouble (unless you diversify)
- If you are retired and want your money to last for the rest of your life…you can do this by either buying an annuity (lifetime or term certain which very long) or invest in a diversified portfolio of share, property, bonds, cash and don’t draw out too much each year (for example 5% or more linked to inflation). The financial services industry has talked many retirees into investing a very high proportion of their investment portfolio into shares (e.g. greater than 50%) and sold the concept of “over time the sharemarket outperforms”…whilst this is often the case in savings mode, it unfortunately doesn’t apply in drawdown (or pension) phase…you’ run a very big chance of running out of money before you know it!!!
- You cannot get 10%pa return on your money without taking on a lot of investment risk. Cash and Bond interest rates paid by the Australian government are at most 4.25% (and that’s the cash rate)…so if you need to earn more than 4.25% you must take on more investment risk than the Australian government…so that will mean shares if you need to earn a lot more than 4.25% or may mean bank term deposits of you only need a little more than 4.25%.
- Australian houses have dropped in price over the past 12 months…this is not an argument to suggest they are cheap. Interest rates may be reasonable but compared to our average household income we still have the most expensive housing in the world ( and don’t listen to what the banks say…they’re behind on their home loan budgets and need new business)
- The best investment for anyone’s money will always be to pay off your non-tax deductible debt…so that includes your home loan, personal loan, and perhaps that loan that was taken out to contribute to superannuation (I know quite a few people did this in 2007 and they need to pay out those loans asap…but I’m sure they know that already). Non-deductible debt is a risk-free high return that compares to no other investment…if you don’t have non-deductible debt, fantastic and half your luck … and I’m happy for you to pay off my home loan!
I’m sure there’s many other little tidbits but I’m sure that’s more than enough to read for now and if I think of anything I’ll obviously let you know!