Fund manager performance: reaching for the Holy Grail

The past 12 months have proven challenging for most fund managers, with above-index returns eluding most of the sector. Ashleigh McIntyre reports.

It has been a bumpy few years for funds management. The global financial crisis (GFC) hit the industry hard in 2008 but in 2009 fund managers staged a dramatic recovery.

However, it seems that 2010 was an impossible year to pick and, as such, above-index returns eluded most fund managers.

Although Australia managed to escape the worst of the GFC, returns in 2010 were still plagued by concerns about the European sovereign debt crisis, the potential for a double-dip in the United States and rising interest rates on home soil.

Global equity markets provided a solid return of 10.4 per cent in local currency terms, however the rising Australian dollar severely constrained returns for local investors, with the MSCI World ex Australia Net Return index posting -2 per cent.

Australian share market returns were also disappointing overall – the S&P/ASX300 Accumulation Index delivered a return of just 1.9 per cent in 2010, compared to the 37.6 per cent return posted in the 2009 calendar year.

In an environment that could best be described as ‘tough going’, it was unsurprising that it was the first time in more than a decade that the average manager, irrespective of style, underperformed the broad market index, according to Morningstar’s 2010 Australian Equities Funds Wrap-Up.

This was a stark contrast to the massive earnings of 2009, when both value and growth managers were able to beat the index. Morningstar co-head of fund research Tim Murphy says performance last year was relatively flat across the board, with small pockets of gains here and there.

When it came to outperforming the index, he says conditions seemed to favour stock pickers in the absence of a broad share market rally.

This was especially true for industrials stocks where the sector underperformed the broader market, but specific stock selection allowed many managers to outperform.

Despite opportunities like this, researchers agree the market was not an easy one to get right for fund managers. In fact, less than one-fifth of the domestic share funds on Morningstar’s database managed to beat the index, while the average large-cap Australian share fund manager returned just 0.05 per cent.

Lonsec found a similar story in its Large Cap Australian Equity Sector Review, where the peer group delivered an average return of 0.5 per cent (after fees), down from 39.4 per cent last year.

Equities sector review

Those chasing returns in Australian equities found some relief in the resources sector, with the majority of the re-emergence occurring in the second half.

According to Leanne Milton, head of research for fund services at Standard & Poor’s (S&P), this was driven by growth in emerging economies like China where domestic consumption, population growth, industrialisation and urbanisation were all contributing factors.

Other than that, healthcare was the only sector to deliver positive returns, while financials went into negative territory (down over 44 percentage points since last year).

Morningstar’s sector report supported these figures, stating that selecting financial services companies was a hazardous exercise due to the sovereign debt woes that were continuing to have an influence on financial services companies’ ability to secure funding.

The report found that the average large-cap fund manager was underweight in financials, which proved to be an effective strategy, as those who were overweight financials tended to underperform.

Although the year proved to be relatively disappointing for Australian equities, global equities were another story – all sectors apart from utilities managed to give positive returns (albeit not as high as in 2009).

Milton says that performance in global equity markets was stronger across more sectors, with consumer discretionary giving strong returns, followed by industrials and materials.

But while global equity markets provided a solid return of 10.4 per cent in local currency terms last year, the sharp rise in the Australian dollar negatively affected returns for Australian investors, Milton says.

Small cap versus large cap

Although investment style failed to provide any insight into the performance of funds, Lonsec says one factor that gave an indication of fund performance in 2010 was the size of companies a fund was exposed to.

Once again, small caps outperformed large caps in both global and Australian equities.

According to Milton, the S&P/ASX Small Ordinaries Accumulation Index provided a return of 13 per cent, while the S&P/ASX Emerging Companies Index posted a very strong return of 26 per cent.

“This performance was largely driven by the resources sector, which continued to benefit from strong demand from developing economies and high commodity prices,” she says.

Global small cap stocks also produced a solid 11 per cent return in Australian dollar terms, which in US dollar terms is a return of over 24 per cent. Milton says the reason for this is that small cap stocks tend to benefit in the early stages of an economic recovery as they quickly adjust to what is happening, as was the case in the last year.

Winners and losers

Researchers agree that there was a large divergence across fund manager returns, with those that performed exceptionally well in the Australian equities space tending to be exposed to small and micro-cap stocks.

Some of the better-performing funds were the Macquarie Australian Microcap fund with a return of 28 per cent in the 12 months to 31 December, along with the Novaport Wholesale Microcap fund with a return of 27 per cent. Both funds are ‘style neutral’, Milton says.

While a small-cap bias helped some funds outperform, large-cap Australian equity funds also managed to give a decent return, with some of the better performers including Bennelong ex-20 Australian Equities fund and the Patersons Wholesale 80:20 Equity fund.

The opposite was also true, with the worst performers generally those with industrial-biased portfolios that had no exposure to resources. Large-cap managers with little exposure to resources or small-caps, as well as those with a value bias tended to underperform, Milton says.

In terms of global equities, the better performing funds were those that were fully hedged and biased to small-cap stocks, Milton says. These included the Fidelity Hedged Global Equities Fund at 20.9 per cent and the Schroder Global Active Value Hedged Fund at 17.6 per cent.

The poorer performers on the global equities front tended to be unhedged large-cap value managers that were not able to take advantage of the small-cap rally or to capitalise on emerging markets performance, many of which went backwards, Milton says.

Other asset class returns

Compared to the strong returns last year, especially in the emerging markets, Asia ex Japan and China asset classes, this year was rather stagnant, Murphy says.

“It was pretty flat across the board. REITS [real estate investment trusts] were slightly negative but essentially they were flat, while large-cap Australian equities were slightly up but also close enough to flat,” Murphy says.

He adds the exceptions were global fixed interest, which eked out a decent absolute return, while global property was the standout of the year at 26 per cent.

“Global property was up fairly strongly and that was largely driven out of the US, where investors are doing anything to chase yield and the cash rates are at 0 per cent.

“They are returning a couple of per cent and we’ve seen a lot of flow into those areas chasing that phenomena, which has created an interesting outlook of REITS becoming very overvalued in the US.

“Almost every active manager is underweight in the US and that therefore meant that almost all active managers underperformed last year in global property. You don’t often see an index manager like Vanguard at the top of the pile on any given year,” he says.

Global fixed interest also performed fairly strongly due to the continued contraction of credit spreads, Murphy says.

“Certainly for the first three-quarters of the year there were falling yields on US and European debt, which is good for bond prices, so that contributed to the slightly higher return there.”

In Australia, the situation for fixed interest was not quite as good, with increasing interest rates affecting returns, Murphy says.

Active versus passive

The constant debate of active over passive funds also continued throughout the year, with researchers commenting that despite a poor year in 2010, active managers performed comparatively well over the three-year period.

Milton says over both the one and three-year period, passive funds produced returns slightly better than the average manager for large-cap Australian equities, while in unhedged global equities they performed slightly worse.

“While there is a place for passive managers in a portfolio, this shows that there has clearly been scope for active managers to add value in recent years,” she says.

According to Lonsec’s sector wrap, active managers have been relatively more successful in delivering returns in excess of the benchmark and often with lower levels of volatility in the past three years.

“The trend towards low-cost, passive alternatives in Australian equities continued in 2010, with retail fund inflows towards active strategies being relatively flat,” Lonsec’s report states.

“The increasing popularity of [exchange-traded funds] and availability of [separately managed accounts] has created increased competition for the traditional managed fund or unitised investment product.

“Despite this trend in the retail market, there has been increased activity in the institutional space with a number of active managers signalling the successful award of new mandates and or future commitments,” the report states.

Trading places

The loyalty instilled in funds management employees by the GFC seems to have well and truly worn off, with a number of key investment professionals taking the opportunity to move on from their current employers.

Milton says that 40 key funds management staff left firms managing products in S&P’s ratings space.

“Most of the movement happened in the first half of the year after bonuses were paid, and also as a result of the Blackrock and Barclays Global Investors merger,” she says.

The majority of departures (90 per cent) came from mainstream fund managers, while the remainder were from boutiques, according to Milton. She says she also noticed the trend that a number of investment professionals left to join boutiques, or establish their own.

“Experienced investment personnel have been attracted to being in charge of their own destiny and achieving financial rewards through equity ownership,” she says.

Some of the changes in the funds management space have been the loss of ING Investment Management’s senior portfolio manager Ron Mehmet to BT Financial Group’s Advance Asset Management, the appointment of a new chief investment officer for MLC in Nicky Richards, and senior portfolio manager Randal Jenneke’s switch from Schroders to T. Rowe Price.

AMP Capital Investors also announced a major restructure of its investment divisions in December 2010, with several new appointments made to its multi-asset group and multi-manager teams in early 2011.

Looking ahead

“Furthermore, consumer and corporate balance sheets are in terrific shape. This is fuelling increasing business confidence which is translating into growing capital investment,” he says.

Paul Cuddy, chief executive of Bennelong Australian Equity Partners and one of the top managers in 2010, expects the Australian market to deliver 10 to 15 per cent over the coming year, with equities benefiting from the strong terms of trade underpinning employment and wages growth.

But the news is not all good for the Australian market, Cuddy says.

“We are definitely seeing evidence of a two-speed economy. The economy is facing increasing pressures when you look beyond resources and resource related service industries,” he says.

Cuddy says that the economy is moving from surplus to deficit at the same time that consumers and businesses are facing higher prices for energy, utilities and interest rates.

“With an economy operating at essentially full capacity, this is likely to test inflation. Companies that can absorb cost pressures and maintain or even grow margins will do well. Conversely, companies that cannot pass on the cost of inflation will do it tougher.”

While there are conflicting opinions about what the year ahead will hold for fund managers, most can agree that global issues still hold much sway over Australian markets.

Paul Taylor is a portfolio manager and head of Fidelity’s Australian Equities fund, which managed to outperform the index over 2010 – despite the fact that most managers fell well below.

He believes that these macro concerns will continue well into 2011: “There are still obviously quite a few macro issues that are hanging over the market like a storm cloud, and those issues continue to be sovereign debt levels and the concern that China might start tightening due to worries about inflation,” he says.

The many possible outcomes from these macro issues are creating much uncertainty around what will happen to the Australian equities market, according to Morningstar’s Tim Murphy.

“The Australian economy is obviously doing pretty well, but it is still a fairly focused, cyclical economy that is reliant on what goes on in China to a large degree,” Murphy says.

“If some of the measures being taken in China do put a curb on demand for our resources it will affect our market and our currency.

“The dispersion of possible outcomes in the Australian market is therefore quite wide and we think it pays to have some degree of insurance against that should the bad scenario play out,” he says.

Murphy says that his asset allocation team is favouring international assets, in particular unhedged equities as insurance against an uncertain Australian economy.

Looking at global markets, Aberdeen Asset Management was one of the better performers over the 12 months to February 28, returning 20.3 per cent.

Aberdeen’s senior investment specialist Stuart James said he believes the global economy will remain relatively positive in the short term due to increasing sentiment.

“[Market sentiment] is clearly more optimistic than it was last year, in particular towards developed markets rather than emerging markets ... I can see that continuing for at least the next three to four months,” he says.

However, James says he remains worried that the optimism may mask the underlying problems of sovereign debt in Europe, debt problems in the United States and inflation in China.

“While not in the headlines, [these issues] are still very real and there is still a danger of [poor] execution by the governments around the world,” he says.

For those managers who want to outperform, James says managers need to focus on the underlying businesses.

“Try and turn down the macro noise, ignore the benchmark and look for the opportunities on a company level because it is the companies that drive the portfolio. That’s what we’re trying to do.”