Consistency is the heart of Commonwealth’s success

Commonwealth Financial Services’ more cautious investment style appears to be working. Zilla Efrat takes a look at its philosophy and approach to investment decisions.

Two years ago, Commonwealth Financial Services switched from a more aggressive investment style to one which focused on consistency. Its decision certainly seems to have paid off.

Commonwealth secured third place in Money Management's Fund Manager of the Year award for 1998 and won the global unit trust category.

Market share figures from research house ASSIRT reveal that Commonwealth has also beaten its rivals in terms of fund inflows over the past three quarters, and that it attracted more than $2.6 billion in 1998. The bank now has $25.6 billion under management, making it the fourth largest fund manager in Australia.

Commonwealth chief investment officer Martin Littler says: "Two years ago, we recognised that we were a large fund manager with a conservative client base.

We took the view that the extra return that came with taking higher risks did not actually justify taking the risk.

"While we do believe that active management can add value, we do not try to extract value for every dollar under management. Instead, we try to add value through small pockets or sectors."

Newly appointed head of Commonwealth Asset Management Nick Basile says consistency - or avoiding any nasty surprises - is now the bank's key objective, even if this leads to lower returns at times.

"We believe that if we can achieve consistency over the long term, we will drift to the top of the league tables in the longer term," he says.

While Commonwealth's processes will no doubt evolve over time, he says some basic principles are carved in stone. These include strong risk control, a focus on longer-term time horizons, diversification at all levels and maintaining a disciplined and structured approach.

Commonwealth has developed what it calls a "core plus active satellite" strategy to manage its $5.9 billion in Australian shares and its $1.2 billion in international equities.

At the "core" are the more passive index-linked investments and, wrapped around these, are its actively managed investments.

Clients can go for one style or a mix of both, enabling the bank to offer a range of funds across the risk spectrum.

Basile says passive investments - or index tracking - is an easy way to achieve market performance, but at a low cost.

In contrast, he says investors can squeeze out extra returns from active investments, but they could also be disappointed.

Commonwealth, however, does not fully replicate an index and opts for an optimised approach instead.

Taking the fully replicated route adds to the costs as there is a premium to be paid when buying some of the smaller or more illiquid stocks, Littler says.

Despite stiff competition from active managers, Commonwealth wonMoney Management'sfund manager of the year global unit trust category in 1998 because of this index strategy and because it was fully weighted in the US market.

Already one of the biggest index fund managers in Australia, Commonwealth views this as a strong area for future growth. This is because it performs more consistently and that, according to Basile, should lead to better returns in the long term.

"In Australia, only 5-7 per cent of equity management is index linked. The figure is closer to 20 per cent in the UK and 30 per cent in the US," Basile says.

"We see our market rising to something akin to that overseas. If we are correct, there will be about $40 billion up for grabs over the next five years. And, we want to be the leading participant in this market as it grows."

On the active equity side of the business, Commonwealth is a top down manager.

"You can describe us as a business cycle manager," Littler adds, noting that the bank thinks in terms of industries and business sectors, and their position in terms of business cycles.

It uses fundamental stock analysis to screen shares in each of the sectors it likes. There are also certain areas that it always likes: opportunities in government privatisation and companies that can extract monopoly rents.

Commonwealth's eight active equity portfolio managers spend a lot of time talking to companies, "kicking their tyres" and trying to identify opportunities.

Its offices are open plan with an emphasis is on communication. "All our portfolio managers sit close together and can overhear each other," Littler says.

The bank believes in a devil's advocate approach and often gets someone to take the opposing view in order to get a more rigorous debate over a buy or sell decision.

As a result of its style, Commonwealth was overweight in industrials and financial services and underweight in resources throughout 1998.

Investments that paid off include Telstra, Hills Motorway, Transurban, Commonwealth Bank, Macquarie Bank, Westfield Holdings, Tabcorp and Harvey Norman.

"Because we run both active and passive portfolios, we can cross lots of

trades, limiting the impact on the market and saving on brokerage fees," Basile says.

Last year, a significant portion of Commonwealth's Australian equity deals were done internally, but always at an arms length to avoid any conflicts of interest.

Another competitive edge is its access to the wider banking group's research, particularly its economic research.

"The Australian Stock Exchange does not replicate what the economy looks like and a large part of Australian business is not listed," Littler says.

"The bank's research is often out of the listed sector and we get access to non-listed information which may give a different slant to what the listed companies are saying."

Being part of the larger banking group has also given Commonwealth a natural edge when making fixed interest investments.

In addition to research, there are real opportunities, such as the high yield corporate deals in which other sections of the bank are involved.

"Whether we participate or not, is a different matter, but Commonwealth Bank would hear about every big deal in Australia," Littler says.

"Our net tends to go deeper into the ocean and to pick up a few more of the dredges."

An example was the bank's involvement in the Brisbane Airport privatisation which enabled it to access some of the project's debt for its customers.

Commonwealth has $8.8 billion in cash and $6.3 billion in fixed interest investments, together making up almost two thirds of all its funds under management.

Its team of four active fixed interest portfolio managers are strongly focused on fundamental research, as well as on adding value in terms of duration, yield curve and stock selection.

"We are a fairly vanilla fixed interest manager. We split up the yield curve and parts are then managed by particular portfolio managers," Littler says.

Unlike many of the smaller funds managers, Commonwealth, with $3.2 billion of property under its management, is also able to invest in both direct property and listed securities. It is one of the largest managers of direct property in Australia, a factor which gives it a strong diversification element.

"I don't think that we are doing anything different to anyone else in direct property," Littler says.

"We look for geographic diversification and diversification across sub-sectors like retail, industrial, commercial and rural property."

Nonetheless, a first for the group will be its listing of the Commonwealth Property Office Fund on the stock exchange on April 29. It holds seven prime Australian office properties, worth about $619.5 million.

Looking ahead, Littler says: "Protection of the franchise and brand name remains our paramount concern. We are focused on true to label performance and ensuring that there are no nasty surprises for our clients."