Active managers smash passive managers in 2009

Yesterday Morningstar released their investment performance league tables for each of the major asset classes for the Australian market. For almost every asset class in 2009, a higher proportion of active manager outperformed the index funds, like Vanguard, than underperformed.

Vanguard's 1 year performance rankings for each asset class are...

• Australian Shares - 55th out of 99
• International Shares (Unhedged) - 55th out of 77
• International Shares (Hedged) - 10th out of 16
• Australian Fixed Interest - 27th out of 30
• International Fixed Interest (Hedged) - 18th out of 20
• Australian Property - 21st out of 34
• International Property - 10th (Hedged) and 24th (Unhedged) out of 27

Now these performance rankings by Vanguard are pretty bad as they are expected to perform around the middle of rankings, but a couple of things need to be kept in mind. Firstly, risk was rewarded in 2009 with significant growth in small cap equities and credit securities...the index funds are biased away from these and more conservative in nature and the performance tables are not adjusted for these risks. Secondly, these league tables always have a survivorship bias towards the winning funds...funds all around the world as well as in Australia disappeared during 2008 and 2009.

After the disaster of 2008 there was an enormous shift towards passive managers after numerous active managers fell over. Given the outperformance by active managers in the Morningstar league tables, will we see a shift out of passive and back into active in 2010?

Relating the Risks of Bonds to Recent Times

If you are interested in an educational article on the main risks a bond investor faces and how those risks have played out over the past year or two, please visit this link.

Bond Fund Correlations

The above chart shows the 6 month daily correlation between Hedged Global Shares and four Australian bond funds...

• Tyndall Australian Bond
• UBS International Bond
• Macquarie Diversified Fixed Interest
• Principal Global Strategic Income Fund

Each fund is different. Tyndall is invested in high grade Australian bonds, UBS International in high grade global bonds, Macquarie is 60% Australian bonds, 40% global and also takes on some investment grade credit risks, and Principal's fund invests in high yielding securities including hybrids, asset backed securities, junk bonds, as well as some conservative bonds. All global exposures are hedged to Australian dollars.

What this chart demonstrates is the increasing correlation between Principal and hedged international shares from mid 2007, the start of the credit crunch. Basically, diversification benefits did not really exist for the high yielding investment.

However for the other funds, which had conservative bonds as a high proportion, their low correlation with hedge international shares shows their diverisifcation benefits in tact.

So a simple conclusion is...whilst high yielding investment may giove you the opportunity for higher returns, don't think they will provide diversification benefits if sharemarkets tank. With a weak outlook for shares, so too is the outlook for companies to pay their debt so the price of low-grade credit can fall significantly also. A final point, which is often overlooked...bonds have limited upside...at maturity the most you will ever receive is the face value...that's it.

World Government Bonds perform best over last 5 years

The above table shows the returns for various subclasses of fixed interest from the perspective of the Australian investor (i.e. in Austrlaian dollars) through to the end of June 2009. As can be seen, the World Government Bond index hedged to Australian dollars has been the winner over the last 3 and 5 years. High Yield, as expected given the widening of credit spreads over the last 2 years, comes in last.

Disappointingly, the Morningstar index of bond fund managers fall quite short versus their respecitve indices. For example, Morningstar Australian Bond managers perform significanlty worse than the UBS Composite index and the Morningstar Global Bond managers perform well below the BarCap Global Aggregate index.

Another blow for active managers

Following the APRA report from a few weeks ago, late last week Standard and Poors published a paper that wasn't too flattering of the active side of the Australian funds management industry. The paper can be found here.

Their analysis had the following conclusions:

• Over 5 years, the benchmarks outperformed the majority of active managers
• ASX/S&P200 index outperformed two-thirds of active Australian general equity funds
• UBS Composite 0+ Bond index outperformed more than 97% of actively managed bond funds over the last 5 years
• Between 10% to 30% of all funds have disappeared over the last 5 years

A fascinating, but unsurprising result of which most in fund research or academia have known for a long time. The most surprising result is that it has come from Standard and Poors who are potentially damaging their own business (albeit in a very small way) by suggesting that active management, on average, fails.

I guess Standard and Poors will be suggesting that it requires their skill to pick the best managers!!!

Benchmarks

One of the things that annoys me when I'm analyising managed fund performance is their chosen bechmarks. I'm of the belief that a managed fund benchmark should have the following attributes...

• Investable
  

• Realistic


• Replicable


• a reflection of the fund's investable universe

Unfortunately there are numerous funds out there that have benchmarks that fail these key attributes and have benchmarks based on marketing or investor needs. For example, many hedge funds have had an annual positive return benchmark even though they are largely exposed to equity or credit markets.

This week I have seen global listed infrastructure funds that benchmark to CPI plus x% and this is also the case for numerous multi-manager investment funds and the benchmark of asset allocations set by the numerous asset consultants and research agencies.

What a ludicrous benchmark CPI plus or annual positive return benchmarks are for funds that are exposed to equity markets. High inflation is not good for equities and neither is deflation so the relationship is weak. If I want to beat CPI I can just invest in an inflation linked bonds.

Equity markets are so volatile that at any stage the equity markets will be outperforming a stated positive return so a positive return benchmark is surely just a way of increasing fees for the manager on the back of the belief in the equity premium.

Overall, if a fund's benchmark does not reflect their investible universe and it cannot be replicated for investment then the fund will be dismissed by me. The role of an active manager is to outperform its benchmark after adjusting for risk (and fees). When a benchmark doesn't reflect a fund's actual risk then iits time to dismiss the fund as an investment consideration.

Style Biased Index Funds - the Future of Managed Funds

Index funds were born out of modern portfolio theory which suggested that the highest risk-adjusted return should come from purchasing the market portfolio. As it is impossible to purchase market as a whole, the index fund effectively replicates the market by purchasing a large proportion of the market with each stock’s weighting proportional to its market capitalisation. Around the world, this method has been replicated across all asset classes. In Australia, the available index funds are mostly limited to the major asset classes. Some geographic index funds, like BRIC, China, S&P500, etc are also available as well as specific sub asset classes like Global Credit index funds. There is little doubt index funds provide a low-cost way of providing investors exposure to specific markets without the active management risk of the 'bad bet'.

The current bear market has resulted in many investors looking for simplicity, transparency, and low costs and index funds satisfy all criteria. Whilst many wealth and funds management companies have suffered during the Global Financial Crisis, index funds have thrived. Barclay’s have released a wide array of listed international index funds, Vanguard also released some exchange traded funds and only yesterday announced they are moving into larger premises and hiring an additional 8 sales professionals. And now, in Australia the index fund has another variety with the introduction of Research Associates' Fundamental Index (RAFI) and various investment products linked to this index approach.

In recent weeks I have received more queries regarding this new index method than anything else (except the ubiquitous structured product). It is marketed as an alternative to traditional index funds and its difference is that it doesn’t use a company’s market capitalisation as the weighting determinant but uses measures such as sales, profits, dividends, amongst others. The founders of RAFI believe traditional indices overweight overpriced stocks and underweight underpriced stocks and they believe this new method overcomes this flaw. Despite the strong support the fundamental index has received locally and overseas, there have been many critics.

The main criticisms of the Fundamental index method are that it resembles an ‘active value strategy in disguise’ requiring numerous subjective decisions around stock selection. As a result of this, many believe the fundamental index is not efficient when compared to multi-factor quantitative strategies. Even if these arguments are true, at this point in time they are fruitless arguments in Australia because accessing passive strategies that are different but priced similarly to traditional index funds are few and far between (the one exception is DFA which is not necessarily easy to access as an adviser). At least the fundamental index investments are around 40bps cheaper than active equity managers and this is a significant cost saving over the long term. With this cost saving if its stated return premium is due to a value bias then as long as this bias/risk is understood there is nothing wrong with that. With the exception of the DFA funds, to achieve a value bias typically costs a lot more than the RAFI funds.

Back to the critics opinions…belief in the so-called efficiency of multi-factor quantitative strategies creates an opportunity in the Australian funds management industry. Globally, it is widely acknowledged that over the ‘long term’, equity portfolios biased towards...

• low price to book,
• small companies, and more recently,
• companies exhibiting performance momentum (i.e. performed well over the last 3 to 12 months)

...outperform traditional indices on a risk-adjusted basis. Accessing these style biases in low cost ways cannot easily be achieved in Australia for the retail investor. Perhaps this is the future of equity index investment in Australia.

For the active manager style biased index funds will be a significant threat. The active manager will have new truly investible benchmarks and they will have to prove their skill against low cost funds with similar style biases. This in turn could reduce costs due to increased competition and only the strong will remain. The active manager often hides behind their style bias when underperformance occurs, however, with style biased index funds in direct competition this will not be an excuse.

The introduction of the fundamental index products are an excellent addition to the Australian managed fund scene and moving forward I look forward to seeing more low cost, style biased index funds to provide more efficiency and choice for the retail investment portfolio.

Another financial product rant

As I sit down to write another article, Great Southern has just collapsed and I have been asked to speak to some Financial Planners about structured products. If the Global Financial Crisis has taught us anything or confirmed what we already know, it’s that we must avoid investing in anything we don’t understand and avoid high commission or high fee charging investment products. Unlike other industries, in ours the higher the cost very rarely means you are receiving higher quality as the Agribusiness, Hedge Fund and Structured Products have shown. Each of these sub-asset classes are also not the easiest investments to understand.

Both Timbercorp and Great Southern’s collapse have created enormous anxiety for the investor as there is still significant uncertainty as to what they are likely to receive from their initial investment or where they stand in terms of ongoing commitments. The complexity of these companies’ promises and structures will soon come to light but it appears the administrators are still coming to grips with them also.

Whilst there have been a few hedge fund collapses and closures, the current bear market has exposed them as funds that still have exposure to market risks, whether credit, equities, bonds, etc. and that their promise of positive returns in any market was simply a marketing line as the average global hedge fund or main hedge fund indices returned around -20% for the 2008 year. When you add their lack of liquidity and, for some, their recent suspension, compared to the more traditional managed funds their performance is even more disappointing.

Finally we have the structured products that promise capital protection or limited losses whilst still providing the investors exposure to the performance potential of various sharemarkets. In terms of complexity and hidden fees, structured products may well take the prize.

There is one particularly product I have reviewed in recent weeks that I find astonishing. I’m even more astonished that it received the second highest rating from one of Australia’s leading research houses. In its most conservative form (in terms of maximum loss), at first read, for an investment of around $6,000 the investor will receive $50,000 exposure to the Australian sharemarket (ASX200) and after 2 years receives a maximum return of $9,250 (or ~18.5% of the $50000 exposure) and at worst, nothing (if the ASX200 has a zero or negative performance over the 2 years).

For many prospective investors this type of investment may sound quite appealing, particularly if bullish on the ASX200 index, as only an 18.5% return over 2 years is required to be what appears to be a return of more than 150% on the initial investment. Unfortunately, in this case, looks are very deceiving.

Firstly, the $6,000 investment is in fact a payment for an options position (as opposed to an initial investment) and can only be recovered if the ASX200 returns 12% over the 2 years (i.e. 12% of $50,000 equals $6,000). The options position being purchased is the purchase of one call option with a strike price of $50,000 and selling another call option with a strike price of $59,250 that matures in 2 years.

Secondly, because the exposure is the ASX200 index and not the ASX200 Accumulation index, the investor receives no exposure to dividends, let alone franked dividends. Given the current dividend yield of the Australian sharemarket is around 7%, if we assume a conservative forward dividend yield of 5%, then just to get your initial investment back, the ASX200 (including dividends) needs to return 11% (that is, 6% capital growth plus the 5% dividend).

Over the last 25 years, the ASX200 Accumulation Index has returned just over 9% and over 25 years, 10.93%. If we look at the index in question, the ASX200 Share Price Index, its 20 year performance is approximately 4.6% and over 25 years is 6.45%. So what initially may have appeared an attractive structured product in fact requires above average returns just to get your money back.

I have never seen more demand for structured products than now. Unfortunately, many of these are simply fee grabs by the investment banks who issue them as they take advantage of the risk aversion many investors now have after suffering significant sharemarket losses. I urge all adviser take significant care when looking at structured products. For most investors they would probably be better off investing in a simple well-diversified fund with a 50/50 split between growth and defensive assets...don’t forget this structure also has limited downside whilst providing sharemarket exposure.

Hedge Funds...struggling

Back on January 20 in this blog I predicted that one of the trends of 2009 will be the demise of the hedge fund...

http://www.bloomberg.com/apps/news?pid=email_en&refer=home&sid=a8uLPVL9X8yY

...I might be right. The hedge fund used to thrive in tough times...not this time.

Mortgage Funds - still $1???

I've had enquiries from numerous advisers wanting to invest their client's money into mortgage funds. Thanks to the Rudd Government's deposit guarantee many mortgage fund investors decided to redeem their funds and shift to the more secure bank deposits. Unfortunately for the funds and their remaining investors the level of redemptions were so great, the funds had to suspend all redemptions. Now we are left with the funds drip feeding redemptions to investors and one of the last redemption reports I heard was that investors only received 30% of their requested redemption and will have to wait for the remaining funds when the next window opens.

With the global credit crisis and resulting decline in interest rates, mortgage fund's income return now looks quite attractive as many funds have a large book of fixed rate mortgages. Whilst they look good, credit spreads are still enormous and whilst these funds aren't taking on any new borrowers (the redemptions took care of that) they are still rolling their good borrowers at fixed interest rates of at least 9%! Very nice in this environment if you can get it.

What I would like to know is...how can a mortgage fund still price itself at a fixed $1 per unit? The clear lack of liquidity of these unerlying investmetns combined with the massive movement in credit spreads over the last 18 months does not suggest that mortgages price is static. Certainly mortgage backed securities on the over-the-counter market have had a shocking run since the credit crunch began in mid-2007 so to still suggest a $1 price is ludicous.

Clearly the funds do not know how to price these securities with any accuracy, but given the lack of demand for these securities and credit blow-out, if you want to invest at $1 per unit then I suggest you are paying way too much. The interest rate is not anywhere as attractive as it needs to be given the increased liquidity risks and current economic environment.

Target Date Managed Funds - the next big managed fund in Australia?

There’s a big trend in the USA for target date retirement funds. These are managed funds whose goal is to provide funds for a specific date and the investment strategy is such that it invests in equities in the early part and progressively switches to bonds through to maturity whereby the majority of funds will be invested in bonds (or at least a large proportion). The logic appears sound whereby take all the risk when there’s lots of time before expiry and reduce the equity market risk as the target date approaches. Given the dissatisfaction of the ‘set and forget’ asset allocation approach, will Target Date Funds become the next big thing in Australia?

 

Either way, they are loaded with efficiency problems and although Vanguard appear to supportive of them there’s 2 academics in Queensland currently doing some interesting papers on these funds, Professor Michael Drew and Dr Anup Basu, and exposing some of their problems. Look out for their upcoming paper in the Journal of Portfolio Management.

Active Management Struggles in 2008

The Morningstar rankings for all major asset classes were released this week and once again, the results do not look particularly promising for active managers in the fixed interest and property securities asset classes.

Some of the more interesting outcomes for investment returns at the end of 2008 include:

Fixed Interest Results...

• Vanguard and Barclay's Australian Fixed Interest index funds were the 4th and 5th best performers amongst 35 local bond managers in 2008 (and 5th and 6th best out of 27 managers over the last 7 years)
• Vanguard's International Fixed Interest index fund ranked 3rd amongst 22 international bond managers in 2008 (and 1st out of 14 managers over the last 7 years)
• Vanguard's International Credit Securities Index fund ranked 3rd out of 16 diversified credit managers in 2008 (and 1st out of 12 managers over the last 7 years)

Property Results...

• Barclays, State Street, and Vanguard's Property Securities Index funds ranked 13th, 12th, and 16th out of 36 local property securities managers for 2008 ( and 9th, 8th, and 13th out of 28 managers over the last 7 years)
• Vanguard International Property Securities ranked 1st out of 26 global property security managers (and 4th out of 18 managers over the lst 3 years...which is the effective life of this asset class in Australia)

These results are help form quite a compelling argument in favour of using index funds for investing in the fixed interest and property securities asset classes. In fact, the index managers beat most of the active managers amongst the international equities asset class whether hedged or unhedged.

The only asset class where most active managers beat the index managers in 2008 was Australian Shares. This category was led by Advance Imputation fund which held a very high proportion of cash in its portfolio which clearly aided it return amongst its peers.

Credit Suisse International Fixed Interest or Credit Suisse Global Income

Just to sort out the differences which by their name alone doesn’t appear to be much...

·         Credit Suisse International Fixed Interest is a global bond fund and has been sold to Aberdeen…its quite a conservative fund that invests in very high rated fixed interest investments...on the other hand...

·         Credit Suisse Global Income is a global credit fund that is regarded as “Alternative Income” with significant allocations to lower rated bonds and has not been sold to Aberdeen, is retained by Credit Suisse.

Massive difference in performance too…International Fixed Interest returned an excellent +12.17% for 2008 whilst Global Income returned an awful –33.31%!!! Strangely, the poor performer is higher rated by research agency Lonsec whilst the other is not…but, personally, I expect their returns for 2009 to reverse so am comfortable with their ratings (which is driven by the Aberdeen purchase).

 

Tactical Asset Allocation in the Defensive part of the portfolio

I received a call from an adviser earlier in the week who wanted my opinion in terms of increasing a client’s allocation to Colonial’s cash account and reducing the allocation to Colonial’s Diversified Fixed Interest fund. For 2008 these 2 funds returned around 6.5% and 0.1% and the adviser’s thoughts were that these returns suggested perhaps the switch was appropriate. Now, whilst we know the past doesn’t equal the future, I believe this tactical switch is not appropriate for other tactical reasons as follows…

·         An earlier post in this blog shows the direction of interest rates and that is clearly down…so increasing allocations to cash should not yield spectacular returns by any stretch of the imagination

·         The reason Colonial’s Diversified Fixed Interest only returned 0.11% wasn’t because of conservative bonds (which had wonderful 2008 returns) but because of credit exposure.

·         Given credit spreads are still quite high whilst conservative interest rates locally and globally are at record lows suggests to me that the return potential in 2009 does not rest with cash or bonds but in credit related securities like corporate bonds…therefore, reducing the allocation to Colonial’s Diversified Fixed Income is reducing the return potential and increasing the allocation to cash is virtually guaranteeing another low return

Volatility 'and Fear' Creeping up

Source: Bloomberg

The above chart is everyone’s latest favourite, the VIX index (otherwise known as the Fear Index). Today it closed at 57, up from 50 at the start of the day, and as can be seen it is creeping back up towards those October and November levels. Given the S&P500 closed down today by more than 5%, its no wonder the VIX is up but the big question is…does this mean there is more pain to come?

So what is the VIX index?...its a mathematical calculation of the implied volatility taken from S&P500 option contracts that are sold on the Chicago Board Options Exchange (CBOE). It is an expectation of the S&P500 market volatility of the next 30 days.

Short Selling Ban

This morning, The Sydney Morning Herald suggested that when the short selling ban is lifted AMP, NAB, QBE and Wesfarmers are stocks that are “most likely to come under pressure”. If this is true, what on earth do hedge funds or short sellers know that the rest of the “long only” funds management industry, stock analysts, and shareholders do not? I’m sure the answer is nothing. These stocks are some of the most researched and widely held stocks by fund managers in this country and if they were seriously overvalued and warranted short selling then existing shareholders would be selling anyway.

Whilst equity markets may not be perfectly efficient, they are mostly efficient most of the time and adjust to news quickly. The biggest price drop amongst Australian stocks in many years occurred whilst the short selling ban was in place. The reality of hedge funds is that on average they are no more skilled than any “long only” fund manager so the likelihood of these stocks being short sold to significantly low prices is ludicrous. Equity prices will only be driven lower by worse than expected news on the company, sector, industry, and/or economy…not short selling alone!

Fund Suspensions -Who, Why, When, How, and What's next?

Who has suspended?

Please note the following list includes funds that may or may not be on the Guardian FP/ Cameron Walshe/ Standard Pacific Approved Product Lists.

· Alternative Income…numerous funds with exposure to CDOs and lower grade credit

o Challenger High Yield

o AMP Enhanced Yield

· Hybrid Property…effectively all funds that contain both direct property and listed property securities have suspended. Some of those funds include…

o APN Diversified Property Fund

o AXA Australian Property Fund

o BlackRock Combined Property Income Fund

o Challenger Hybrid Property Fund

o Charter Hall Umbrella Fund

o Multiplex Diversified Property Fund

o Orchard Hybrid Property Fund

o Perpetual Property for Income Fund

o Tankstream Property Income Fund

· Direct Property…

o Centro Direct Property Fund

o Centro Direct International Fund

· Fund of Hedge Funds…

o HFA Diversified

o BT Global Returns Fund

o DWS Strategic Value Fund

o GSJBWere Multi-Strategy Fund

o Select Gottex Market Neutral Fund

o UBS Global Alpha Strategies Fund

· Mortgage Securities…

o Australian Unity Mortgage Income Trust

o Australian Unity High Yield Mortgage Trust

o AXA Australian Monthly Income Fund

o Challenger Howard Mortgage Fund

o ING Mortgage Trust No 2

o Mariner Mortgage Trust

o Mirvac Aqua Income Fund

o Mirvac Aqua High Income Fund

o Mirvac Aqua Enhanced income Fund

o Perpetual Monthly Income Fund

Source: Lonsec

Why have funds suspended?

Most of the specific reasons are linked to the global credit crisis in one way or another with…

· Credit Spreads widening …resulting in significant price drops in credit markets, and geared funds like Basis Capital suffered margin calls they couldn’t meet…

· Credit crunch…securitisation markets have been virtually closed, lower than government risk fixed interest investments have found it difficult to raise capital (for example Centro)…this lack of liquidity resulted in credit related funds like AMP Enhanced Yield and Challenger High Yield showed very weak performance results and the credit crunch impacted…

· Highly geared assets such as the listed property sector which sold down rapidly…this resulted in asset allocation and liquidity issues for the hybrid property sector…

· The bank deposit guarantee resulted in a massive shift to bank issued cash and term deposits which were offering higher than government returns at effectively the same AAA-rated risk…the conservative mortgage fund sector along with enhanced yield funds suffered most with this

· Declining credit and equity returns during 2008 resulted in hedge funds delivering their worst returns in years and failing to deliver on their “absolute return in any market” promise…redemptions have been large globally in hedge funds

· Foreign-based fund of Hedge Fund managers split their assets into liquid and illiquid trusts whereby redemptions are funded only from the liquid trust. For the Australian hedge fund manager, like HFA(Lighthouse) or BT (Grosvenor), the outcome is that Australian investors are increasingly be exposed to the illiquid trust and according to the Corporations Act some of these funds fail to satisfy its definition of a liquid fund...and…

· Only Deutsche Strategic Value Fund has suspended due to a change in the portfolio management team.

When are suspensions being lifted?

The length of time each of the funds will be suspended varies from fund to fund.

· Some funds, like some mortgage funds, suggested a 3 month suspension with redemptions available early this quarter

· Deutsche Strategic Value may change from suspension as early as February 1 as long as their portfolio management team are settled

· Others have suspended from 6 months to 12 months and some indefinitely.

How are redemptions being treated?

· It appears there are 3 ways that redemptions are being treated…

1. Redemption requests are not being accepted. This includes HFA

2. Redemption requests are considered on a first-in first served basis. Obviously some requests may be rejected.

3. All redemptions requests are being treated equally. This may result in a scaleback, meaning that only a proportion of the redemption request is received.

Given so many are suspended please check the websites of the respective fund manager for further information in terms of when suspensions are and how they are being treated.

What is research thinking?

Whilst the suspension is in the best interest of the investor, the suspension has effectively changed the perceived risk profile of the fund. Most investors and advisers did not realise the extent of the liquidity risk they were taking on and there is every expectation that many funds will be flooded with redemptions as soon as their redemption window opens.

As a result, irrespective of their return potential, it is expected these funds and the sub-sectors to which they belong will be out of favour for a long time to come….maybe years for some.