Hitting the mark: consistent global performers

There’s no lack of motivation to invest in an international equity fund currently, but decidedly less information about which funds to invest in.

Local research on international equity funds is far thinner on the ground than, for example, research on Australian equity funds — understandably so, given that very few managers run international equity funds from Australia, so the research effort is usually materially greater for an international equity fund.

The result is that advisers are “more vulnerable building the international equity component of a portfolio, than in domestic equities,” according to Deirdre Keown, analyst with PortfolioConstruction Forum.

“For an adviser to get it right in picking an Australian equity fund, or investing directly into Aussie equities, isn’t anything like the same challenge as putting together the international equity component of a portfolio.”

Keown put together this year’s PortfolioConstruction Forum Managed Funds Outperformance Report for Money Management, focusing on international equity funds — the 148 Australian-domiciled international equity funds in the Mercer IS survey — and, as with prior Outperformance Reports commissioned by Money Management, it aims to uncover those funds that have outperformed their peers and industry benchmarks consistently over time.

This year’s analysis again focuses on rolling average “after-tax-and-fee” returns.

Rolling returns

Rolling average returns are used because “they are more representative of a fund’s return history than returns over any single period,” explains Keown.

“It’s not unknown for fund managers to cherry-pick the best returns to a recent month end, when promoting a fund. Rolling average returns smooth out aberrations in a fund’s return history, and reveal what’s been typical for the fund. If you do this over various time periods, for example, looking at the rolling monthly, quarterly and annual returns of a fund over the last year, three years, and five years, you can also see the trends — is the manager coming on or off the boil?”

Once all the funds’ one month, quarterly, and annual returns are calculated over the various periods, they are decile ranked.

“Decile rankings are similar to quartile rankings — they help to show the extent to which a fund has outperformed or underperformed its peers and the industry benchmarks — but decile rankings give a finer grading,” Keown says.

“As well, academic research has shown that decile rankings are consistent over time at the very top and very bottom deciles. That is, there’s some ‘stickiness’ to them. A fund that’s in the top few deciles now is likely to be in the top few deciles in 12 to 18 months time. The same applies at the bottom deciles.”

At a sector level, the report found that, on average, international equity funds performed well over the three years to 31 December, 2005, but struggled over five years.

The average rolling average one-year return across all funds was a competitive 9.93 per cent per annum for the three-year period, with some funds having an average one-year return in the 15 to 20 per cent range.

By contrast, even the best performing funds over the five-year period achieved a rolling average one-year return of just 5.61 per cent.

“Either the fund managers that have been around during the past three years are more skilled — that is, some of the duds have shut up shop — or the last three years has been a more benign market environment — or both,” Keown says.

Not unexpectedly, style played a big part in specific fund outperformance, with value-biased funds doing better in the last three years.

“Growth funds feature over the five-year period, but not in the three years,” Keown says.

“However, that’s not to say the value managers didn’t shine over the five years as well. A few did.”

Consistent performers

Acadian Asset Management’s Global Equity fund emerged as the most consistent performer over both the three-year and five-year periods.

“It stands out as having achieved consistent top decile rolling average one-month, quarterly and one-year returns over the past three and five years,” Keown said.

The quantitatively-run, value-biased fund achieved the highest rolling average one-year return of 19.58 per cent over the three-year period, giving it a first decile ranking over the period.

“In a three-year period, you have actually got 25 one-year return periods, which makes 19.58 per cent pretty stunning as a rolling average return,” Keown says.

The Boston and Singapore-based firm, which manages $33 billion in assets, $791 million of which are managed for Australian clients, posted a rolling average one-year return over five years of 4.62 per cent, another top decile ranking.

Fellow value funds, Dimensional Global Value and Bernstein Global Value also emerged as consistent outperformers over both the three and five year periods.

Dimensional posted a rolling average one-year return of 16.72 per cent over three years for a second decile ranking, and 2.52 per cent over five years for a first decile ranking.

The Morgan Stanley Global Franchise fund looks good over the five years, posting an annual rolling return average of 5.61 per cent, the highest in the review over the period.

However, the fund appears to have come off the boil somewhat in more recent times, posting a fourth decile rolling average one-year return over three years.

“It appears to have found the more recent three years a great deal more challenging than the two years prior that, which also make up the total five-year period,” Keown says.

Nicholas Applegate’s Global Select fund and Marathon Asset Management fund were other consistent outperformers in the five-year period. Both have come off the boil, with their three-year rankings falling into the second and third deciles.

The secrets to success

Acadian Asset Management’s managing director Rick Barry attributes the Global Equity fund’s “excess returns” over both periods largely to stock selection, even while acknowledging that “as a value manager we’ve had the wind at our back at times”.

Singapore-based Barry told Money Management the fund has maintained a tilt towards value over both the five and three-year periods, although the value tilt has varied in degree.

“Continuing to vary the portfolio’s value exposure in this way should enable us to continue to add value through stock selection going forward.”

He says the portfolio was “not managed in an absolute return sense but rather as benchmark relative. This means when the markets don’t perform well, as in the earlier years of the five-year review period, we are still able to add value in an absolute sense.”

He added that the fund has “consistently outperformed the benchmark over both periods, which clearly shows our strategy enables us to add value to clients in both positive and negative markets”.

Focusing on value

Morgan Stanley Investment Management’s “discipline in sticking to our absolute-value strategy in the late 1990s” played a key role in its Global Franchise fund’s (five-year) performance, according to vice-president Damien Green.

“We did not participate in the tech or telecommunications asset bubble of the period, and the rising valuations in media stocks caused us to trim our positions significantly. As a consequence, when the tech bubble popped we were not exposed to compromised companies or the inflated prices that the market had been paying for them,” he says.

“Instead, we held solid, high free-cash-flow generating companies, predominantly consumer staples companies, with strong dominant intangibles in the form of brands. The ability of these companies to compound shareholder returns and generate free-cash-flow at relatively low capital intensity has not changed over this time.”

Green says the manager’s investment strategy remains one of not holding companies with high capital intensity (capital expenditures as percentage of revenues) that usually translates into significant tangible assets on the balance sheet. In fact, most of the stocks in the portfolio in January 2000 were still in the portfolio at the end of 2005.

He says that during the “tangible asset-driven market characteristic of the second half of the five-year survey period, we continued to hold our resolve by maintaining no exposure to the bullish sectors of the market. Although the fund had an extraordinary year in 2005, typically, you can expect the portfolio to underperform in markets that are driven by sectors that we do not own.”

A contrarian approach

The foundations of the Bernstein Global Value fund’s outperformance were also laid during the Internet bubble, according to a Bernstein spokesman.

“Given our price-disciplined approach, we invested in the companies that most other investors were avoiding, and our contrarian approach was validated. After the bubble burst, technology, media and telecom (TMT) stocks plunged while the valuations of the rest of market recovered or fell by less, generating strong relative and absolute returns for our clients.”

Since then, the spokesperson says, sector valuations have narrowed, and they have become much more compressed at the industry and stock level too.

“In this environment, however, we’ve still been able to outperform by using our in-house research to carefully select stocks whose valuations belie their long-term earnings power. We’ve also added value to clients’ portfolios through active currency management where permitted.”

The spokesperson acknowledged that “with more than five years of solid outperformance, the value style of investing has had a good run.

“However, it’s hard to predict which style, growth or value, will outperform over the next three years, and we do know that in the long-run the value index outperforms the broad market.”

He expects the fund to “continue delivering a premium to the benchmark, though perhaps on a more modest scale than in recent years, using the same toolset as in the past.

“Currently, our bottom-up research suggests many financial companies are undervalued. We are also maintaining overweight positions in many energy, industrial commodities and capital equipment stocks.”

Nicholas Applegate’s senior vice-president global equities portfolio, Pedro Marcal, anticipates that “growth companies will outperform value-oriented investment strategies over the next three years. These things go in cycles and recent developments are suggesting that companies are growing again.”

US-based Marcal told Money Management the Global Select portfolio “produced very high alpha during several periods in the early years of the (five-year) review, when growth investing dramatically outperformed value investing”.

“As the survey points out, however, the more recent three-year environment has favoured value investors, although during this period we have outperformed the ACWI Growth index a total of 23 months out of a total 36 months.”

The growth manager’s investment style is to invest in companies that are “adapting to and managing change and are poised to exceed analysts’ earnings expectations”, Marcal says.

“I am confident this change-based investment philosophy and process will lead us to outstanding investment opportunities before the market recognises them.”

Marcal says the growth manager is currently “overweight the emerging markets, particularly in Asia, specifically in Japan, and underweight the United States”.