Archive for category: News & Insights

August was a weak month for equity markets with continued concerns over trade tensions between the US and China. While equities sold off bonds, ‘bond proxy’ assets such as property generated positive returns. For the year to the end of August Australian bonds, as represented by the Bloomberg AusBond Composite 0+ Yr Index, returned an impressive 11.2%, outperforming Australian equities. Despite bond yields being at low levels and valuations generally indicating that bonds are overpriced, bonds have continued to provide diversification to equities in downmarket periods.

We continue to believe that bonds play an important diversification role within managed portfolios, despite valuations remaining high. From a portfolio perspective, the primary role of fixed income assets is to provide diversification, with the secondary role being to generate income. Lonsec’s portfolio construction process employs a fixed income allocation within the portfolios to provide a diversified exposure to duration, credit and absolute return bond strategies. We caution against ‘chasing yield’ in the defensive part of the portfolio as most high yielding bond assets tend to be correlated to equities, which work well when equity markets are performing well, but on the reverse will move directionally with equities in an equity market pull-back. In our most recent Asset Allocation Investment Committee, we did not change our allocation to bonds but we increased our exposure to ‘bond proxy’ assets such as global REITs providing some more defensiveness to the portfolios.

Active management has fallen out of favour among investors, reflecting changing investor preferences and the scars of the Global Financial Crisis, which have led investors to shun stock pickers and more elaborate strategies in favour of lower-cost, vanilla products. Investors today are focused far less on alpha generation, with its goal of outperforming benchmarks, and are now far more content in generating the majority of their returns from index funds or similar passive strategies.

The growth in passive management has been astonishing. In the last five calendar years, investors moved US$1.5 trillion into funds managed by Vanguard, one of the world’s largest managers of passive strategies. Blackrock, the second largest passive manager, took in US$685 billion over the same period. Vanguard now manages close to US$4.0 trillion globally in passive strategies and on average owns around 7% of every listed US company, according to Bloomberg data. As passive managers continue to suck up funds, active managers are struggling to get a positive message through.

Passive managers don’t apply any security selection, meaning the money simply flows into passive or index strategies that replicate benchmarks like the S&P/ASX 300 Index in Australia or the S&P 500 Index in the United States, with Exchange Traded Funds making it easier than ever before for investors to gain relatively cheap passive exposure.

At its core, passive investing is a momentum strategy. It buys more of those stocks that go up in price and sells more of those that fall in price. Passive strategies tend to work best when financial markets experience strong upward moves in share prices. Passive management is used mostly in the portfolio management of equities (Australian, Global and Emerging Markets) and fixed income (Australian and Global) and have given rise to the major ETF providers that currently dominate the market (see chart below).

FUM share of Australia’s major ETF providers (August 2019)

Source: ASX, Lonsec

The beta rally has put active managers in the shade

The post-GFC period has been characterised by strong equity market returns, but given the length of the bull market to date, investors are questioning how long this situation can last.

Given the inevitable cyclicality of financial markets, the one thing that’s certain is that strong markets will not last forever. In a low return environment, market beta may end up providing disappointing returns, making alpha a valuable contributor to portfolios.

The aim of active management is to be an additional incremental return source, above market returns. Alpha doesn’t scale well with beta, meaning it becomes a smaller percentage of returns when beta is very high. This is the environment we find ourselves in, so we would expect beta to do well and for seekers of alpha to struggle. But even taking a broader view, the case for active management does not appear great.

The hard truth is that most active fund managers underperform benchmarks constructed by index committees. One of the world’s most widely used benchmarks for assessing US equity fund performance is the S&P 500 index. The committee looks at only a handful of criteria when looking to add new stocks to the index, including: liquidity, financial viability (four consecutive quarters of positive earnings), market capitalisation (must be greater than US$6.1 billion), and sector representation (the committee tries to keep the weight of each sector in balance with sector weightings of the S&P Total Market Index of eligible companies). Changes to the index are made when needed.

The S&P committee does no macroeconomic forecasting, invests over a long-term horizon with low portfolio turnover, and is unconstrained by sector or industry limitations, position weightings, investment style, or performance pressures. Yet this straightforward strategy has generally outperformed active fund managers.

Some active managers can consistently outperform

If alpha were easy to find, it wouldn’t exist. There are three general sources to generate excess return for investment portfolios: strategic asset allocation, tactical tilts within asset classes (including opportunistic investing), and superior fund manager selection. While opportunistic investments tend to be episodic alpha generators in portfolios, the biggest long-term drivers of alpha are asset allocation and manager selection.

Even as managers have struggled to generate alpha, a significant number of managers are still generating returns in excess of market indices. The key is having the right resources and the right approach to find them. Average active fund managers tend to underperform industry benchmarks, but the best fund managers outperform over longer time frames.

There’s a deep body of research that looks at how investors can gain an edge by identifying active fund managers that are able to tap sustainable sources of alpha. Research indicates that to meaningfully outperform, it is often helpful to find active fund managers with a portfolio that looks significantly different to the benchmark they are attempting to beat (i.e. they have a high degree of ‘activeness’).

In the financial literature, there are numerous studies showing that the average active fund manager underperforms the benchmark index after fees. However, research presented in 2006 by Martijn Cremers and Antti Petajisto of the Yale School of Management introduced an idea called Active Share. This is a new method of measuring the extent of active management employed by fund managers and is a useful tool for finding those that can consistently outperform. By analysing 2,650 US equity funds from 1980 to 2003, Cremers and Petajisto found that the top-ranking active funds—those with an active share of 80% or higher—beat their benchmark indices by 2.0–2.7% p.a. before fees and by 1.5–1.6% p.a. after fees.

Active share aims to measure the proportion of a manager’s holdings that are different to the benchmark. It is calculated by taking the sum of the absolute value of the differences of the weight of each holding in the manager’s portfolio versus the weight of each holding in the benchmark index and dividing by two. For a long-only equity fund, the active share is between 0% and 100%. The active share for fully passive strategies that replicate an index is 0%, and more than 90% for strategies that are very different to the benchmark index.

As you might expect, the portfolios of active, high-conviction fund managers will diverge significantly from the benchmark, and will frequently incur volatility relative to benchmark returns. However, this differentiation provides investors with the opportunity to add value over the long term.

What to look for when assessing active managers

Skilled managers with high active share have shown a higher tendency to outperform the market. Investors that tilt towards active managers with high active share have a greater chance of outperforming. They tend to be smaller fund management organizations, often where the founder is an investor first and invests his or her wealth alongside external clients, bringing their investing acumen to a portfolio of funds.

Active managers with high active share tend to maintain this high level consistently over time. This proves useful when conducting analysis to help identify managers that are likely to outperform in the future as well. While some of these managers may not have beaten the index in recent periods, when there are dislocations in markets, these managers will be well positioned to generate long-term returns above the fees they charge.

Active share by itself does not indicate whether a fund will outperform an unmanaged benchmark. There are other important aspects to consider when conducting manager due diligence. Here are a few things you should consider:

• Find out as much as you can about the fund’s culture and process. Outperformers see investing as a profession and not a business. Examine the fund’s investment philosophy to see if it is consistent and lived out through the fund’s investment decisions. Does the manager exercise patience and discipline?
• Successful active fund managers have low portfolio turnover with long holding periods of at least four years versus roughly one year for average performing funds. This is a useful metric to look at when assessing a fund’s buy/sell discipline. Another strong indicator is for active managers to add to stock holdings when market pricing improves, rather than giving in to agency behaviour of selling into a falling market.
• Alpha generators are high conviction stock pickers. This means their portfolios are concentrated in their best ideas, leading to a higher level of ‘activeness’ and differentiation from the benchmark.

While there are active managers that are persistently generating alpha, finding them is not a simple task. For investors that are committed to generating long-term outperformance, it’s critical to have the right resources in place to identify these managers. A world class research effort is required to be able to identify and evaluate those managers that can generate consistent outperformance from the thousands of managers out there.

Historically, high valuations in a range of asset classes including equities, sovereign bonds, credit and unlisted assets mean future beta returns are expected to be lower. This will make it a challenging environment for investors to meet their investment objectives. For those with the knowledge and capacity, finding alpha can help bridge the gap.

With an increasing focus in the market on how we are all building our client portfolios, it is incredibly important to have a strong and defendable investment framework in place. This investment framework consists of, but is not limited to, how we structure our investment committee, what our APL looks like, and where we get our research from. However, the foundation for this framework must lie with a clearly defined and articulated investment philosophy underpinning all our investment decisions.

At its essence an investment philosophy reflects a broad set of investment beliefs. It underpins our investment strategy and process and ultimately is our ‘source of truth’ as it gives a frame of reference around all investment decisions.

Your investment philosophy should provide transparency and ensure consistency in your decision making and help mitigate behavioral biases such as chasing last year’s winners. Typically, an investment philosophy will be underpinned by some sort of empirical evidence supporting the philosophy. An example of this may be a belief in active management or an investment approach based on a valuation discipline.

There are a number of different approaches that can be taken when articulating your investment philosophy, but for many with a diverse client base, keeping it simple is the best solution. Think broadly about what you are trying to achieve across your client base, irrespective of whether they are wealth accumulators, retirees or high net worth clients.

• Do you believe in diversification?
• Do you believe that market beta is the primary driver of returns?
• How do you define risk?
• Do you believe markets are inefficient/efficient?

Answering questions such as this will help build the framework for what will become your investment philosophy. For anyone that has a more focused client base (for example; predominately retirees), you can start to ask questions around liquidity, income and timeframes.

Importantly, once you have established a set of principles that you believe in, ensure that you match this belief through your investment portfolios. For example, a philosophy based on protecting portfolios from downside risk and volatility, cannot be implemented via an index based solution.

It is always important to ensure that your investment philosophy does not remain a pretty plaque on the wall of your boardroom, but instead forms the basis for every conversation you have with your clients, as it should be clearly reflected in your recommended solutions. This is especially important in difficult market environments as a clearly articulated investment philosophy will be the reference point for your client education process.

Prolonged QE lulled markets into a false sense of stability

The recovery from the Global Financial Crisis (GFC) has been largely assisted by ultra-loose monetary policy and unprecedented levels of Quantitative Easing (QE), which has been highly supportive of global equity markets. QE provides additional liquidity within the financial system via a central bank purchasing securities in efforts to increase the money supply and encourage lending and investment. Following the GFC, a number of central banks adopted this unconventional monetary policy in attempts to spur economic growth, despite the long-term efficacy of this experiment remaining unclear. However, prolonged bouts of QE depress interest rates to an abnormally low level, and as such capital is shifted into higher-yielding financial assets. This change in investor behavior consequently distorts capital markets by artificially inflating the value of financial assets while decreasing volatility.

As the Chart 1 below shows, central bank balance sheets were relatively static until ‘QE1’ was initiated. The years that followed involved significant central bank market intervention which has resulted in periods of unusually depressed volatility. This is outlined in Chart 2, which illustrates the uncharacteristically subdued dispersion of returns during the GFC recovery, which is attributable to the excessively accommodative monetary policy adopted during this period. Conversely, in the pre-GFC period, it is believed that market euphoria contributed to atypically low dispersion of returns.

Chart 1: Global central bank balance sheets, 2006-18

Source: AQR, Bloomberg

Under normal market conditions, the appeal of Alternative strategies within a well-diversified portfolio relates to their ability to dampen volatility and enhance risk-adjusted returns when blended with other asset classes. Unfortunately for investors in this asset class, prolonged quantitative easing has largely stifled volatility and asset class dispersion of returns which hedge funds have attributed to their ongoing underperformance. As such, protracted periods of loose monetary policy across the last decade has heightened correlation and lowered the dispersion of returns amongst asset classes and the underlying securities which has seen Alternative strategies become a less attractive value proposition to investors.

Chart 2: Historical dispersion of returns

Source: AQR, Bloomberg

However, in 2018 inflation finally reached the 2% p.a. target after years of chronically undershooting the US Fed’s target band of 2–3%. The combination of robust economic growth and an uptick in inflation emboldened the Fed’s hawkish stance and led to four interest rate hikes last year. Consequently, the process for central banks to unwind their inflated balance sheets and normalize monetary policy to counter runaway inflation is Quantitative Tightening (QT). Similar to QE, QT remains largely untested as it involves draining liquidity from the financial system, which is broadly negative for financial assets. The market volatility observed throughout 2018 was largely attributable to the regime change from QE to QT, which saw an increase in risk premia manifest into deteriorating P/E multiples and equities derating significantly. Similarly, the initiation of QT resulted in poor returns for fixed income securities due to bond yields spiking and credit spreads widening. Overall, the elevated levels of volatility throughout 2018 culminated in disappointing returns across traditional assets class.

Geopolitical factors are creating a powder keg environment

The abrupt market dislocation which followed the brief tightening phase in 2018 has resulted in global central banks abandoning any prospect of a return to normalized monetary policy. Most notably was the dovish ‘Powell-Put’ which sidelined the Fed governor’s previously hawkish rhetoric, replacing it with a more accommodative monetary policy stance which has been replicated by central banks globally. This about-face from Powell in conjunction with additional easing and fiscal stimulus in China led to a significant reversal and market rally for the remainder of the 2019 financial year.

Trump’s adversarial negotiating techniques continue to weigh on markets with pressure mounting for a permanent truce as the 2020 election looms, the Chinese economy reports the slowest economic growth in decades, and the German economy teeters on the brink of recession. Trump’s modus operandi has typically been to threaten international trading partners with economic penalties for not kowtowing to his demands, and this approach has been mostly successful, with the exception of China. However, there is a limit to the resilience of the US economy as the sugar hit from Trump’s hallmark tax cuts fade. Consequently, the US Fed was forced to cut interest rates by 0.25% in July for the first time in 11-years, citing the trade wars and a global economic slowdown. Meanwhile, markets continue to grapple with the increasingly hostile US-Iran relationship, the perilous Italian sovereign debt challenge, and the North Korean nuclear program.

The US-China trade war re-escalation in early August quickly dispelled any hopes of a prolonged market recovery in 2019, with Trump abruptly announcing further tariffs on virtually all remaining Chinese imports. The US Treasury department subsequently labelled China as a ‘currency manipulator’ after the country allowed the Yuan to breach the psychologically critical level of US$1/¥7, resulting in additional tit-for-tat countermeasures by both sides. As such, August was a tumultuous month for markets with severe selloffs followed by relief-rallies, new tariffs precipitating reversals and bravado foreshadowing olive branches. Trump’s public rhetoric continues to be equally volatile, oscillating from heaping praise on the ‘strongman Xi Jinping’ to declaring him as America’s greatest enemy, with the unpredictability of such events (i.e. Tweets) whipsawing markets.

Trump’s public optimism has never faltered, despite his economic credibility starting to weaken in the face of a synchronized global slowdown and fears of an imminent recession. This was highlighted when the yields on the 10-year and 2-year Treasury notes inverted in August for the first time since the GFC, which historically has been a precursor to every recession in the last 50 years (albeit the timing is notoriously unreliable). However, critics will argue that protracted periods of QE have distorted the yield curve such that its predictive qualities are now weak or non-existent. Despite this, it does clearly indicate that investors are preparing for a global slowdown, which again sparked a savage wave of panic selling and a thirst for safe-haven assets.

The global economic outlook continues to deteriorate with Brexit uncertainties similarly contributing to the powerful recessionary forces that are gathering pace. The UK prime minister Boris Johnson has steadfastly committed to leaving the European Union on 31 October. Johnson’s unwavering commitment to Brexit highlights the increased probability of a ‘no deal’ Brexit, which has further exacerbated the pessimistic outlook held by markets. The potential for a disorderly Brexit has thrust the pound into a downward trajectory while simultaneously crimping corporate sector activity, leaving the economy hinging on a recession. As Chart 3 shows, this heightened uncertainty and volatility has led to significant underperformance of the FTSE 100 Index versus the MSCI AC World Index since the Brexit referendum was held.

Chart 3: MSCI AC World Index vs FTSE 100 Index

Source: Lonsec

How Alternatives can help mitigate the effects of volatility

The ongoing trade dispute, diverging monetary policy, populism, Brexit uncertainties and concerns over the longest economic expansion on record running out of steam have all culminated into the elevated levels of volatility observed throughout 2018-19. However, this potentially paves the way for Alternative strategies to deliver alpha to patient investors. Increased volatility and dispersion of returns amongst asset classes may support Alternative assets, as risks within global financial markets remain tilted to the downside amid a synchronised global slowdown. That said, Alternative strategies failed to protect and generate alpha during the 2018 correction where the environment was more conducive to performance.

This historical relationship is best illustrated through contrasting the below two charts. Chart 4 highlights the historically positive correlation between volatility and Alternative assets. This is captured via a composite of the excess returns (bank bill rate plus 3%) generated among Lonsec’s Alternative asset peer group against the VIX, which is a measure of implied volatility. The results generally illustrate a stronger correlation during periods of heightened volatility, and therefore, greater excess returns for Alternative strategies when markets are distressed. Conversely, Chart 5 elucidates the typically negative correlation between volatility and broader equity market returns.

Chart 4: Post-GFC volatility positively correlated with Alternative assets excess returns

Source: Lonsec

In an increasingly volatile and late-cycle environment, Lonsec remains overweight Alternative assets in efforts to leverage the more prominent market dislocations occurring. Despite their generally tepid returns in a strong bull market, Lonsec emphasises the importance of Alternative investment strategies in client portfolios, as skewed valuations create an attractive opportunity set for contrarian investors. Alternative strategies may provide a degree of insulation from market turbulence through their broad-based diversification via uncorrelated and unconventional investment strategies.

Chart 5: Volatility and S&P 500 Returns Offer a Negative Correlation

Source: Lonsec

While the current economic expansion may continue beyond the consensus expectations, Lonsec highlights the importance of including uncorrelated and diversified return drivers into balanced portfolios. In this respect, Alternative strategies continue to offer a compelling late-cycle solution in the face of a sustained bull-market, a gradual economic softening, or a severe equity market deterioration.

One of the continual challenges in running an investment committee is ensuring that it operates effectively and facilitates sound decision making. There are several ingredients that can assist in this process, but the most fundamental are the governance structures you have in place. At a minimum your investment committee should be governed by a charter outlining things such as the role of the committee, its membership, record-keeping, quorum requirements, and the voting structure for determining investment decisions.

But governance is just the foundation of an effective investment committee. One critical element is of course to ensure that you have the right people on your committee (we’ve discussed this in more detail). Another is to establish among your members an appropriate structure for your discussions so that they stay relevant and focused on the issues at hand. Many of us have sat on investment committees where the conversation moves off track or thought processes shoot off on tangents. This can be unavoidable at times given the breadth of the subject matter, and it’s important not to end a discussion prematurely because the person speaking is presenting a different view. Getting the most out of your investment committee means balancing the diversity of voices with the need to have a structured discussion and agenda that facilities disciplined and controlled decision making.

To help achieve this, we believe having a clear model as a starting point to facilitate discussion is important. For example, if you’re operating an investment committee focused on asset allocation, then it’s important to clearly identify the time horizon that the investment decision is based on, as well as the relevant metrics that contribute to asset allocation decisions, whether they include asset valuations, business cycle and economic inputs, or sentiment indicators. Ideally, there will be a reference model capturing the various inputs your committee considers to be relevant.

Having a starting reference point such as a model ensures that any discussion can be framed against what the committee is trying to achieve and the information it considers important in making decisions. This ensures that discussions are focused and not skewed by the latest headlines or anecdotes, and that members can reach a clear resolution before moving on to the next agenda item. As part of such a process, all committee members should understand how their model works, what it says (and doesn’t say), and what its key inputs and sensitivities are.

Lonsec continually reviews its own internal investment committee process to ensure that it operates efficiently, captures all relevant information, and reflects our core beliefs about managing money. We also work with clients to assist them in structuring their investment committee as well as being an external member on their investment committees, bringing not only our research knowledge and portfolio expertise, but understanding of the intricacies of investment committees.