Steering through the downturn

The hard data has caught up with the anecdotal evidence where fund manager performance is concerned, and in 2008-09 it is not a question of which fund manager did best but which did least badly.

Broadly speaking, the majority of fund managers lost more than 30 per cent in 2008, and in early March this year, share prices of some leading fund managers plummeted by up to 15 per cent, by no measurement positive results and indicative of the spiralling market sentiment impacting the financial sector.

“On an absolute return basis 2008 was a very disappointing year for investors, with the Lonsec peer group average return of -36.9 per cent reflective of the broad-based sell off in Australian equities over the year,” Lonsec reported in its Large Cap Australian Equity Sector Review last month.

Not a bad performance?

Relative returns or not, in the last year the average active Australian equity manager outperformed the broader market. According to research house Morningstar, performance results to the end of February showed that approximately 60 per cent of actively-managed large-cap Australian share funds (332 out of 553 funds) with one-year returns to the end of February this year were able to outperform or “do less badly” than the index after fees.

“This is an early indicator that many fund managers are cushioning their investors from the full extent of the market downturn,” said Phillip Gray, editorial and communications manager at Morningstar.

“The funds with the worst returns can be attributed to either internal gearing or unsuccessful stock-picking.”

“The median Australian equity large cap manager has outperformed the S&P/ASX Index by 2.5 per cent over the 12 months to December 31, 2008,” noted Justine Gorman, co-head of equities at ratings and research agency Standard and Poor’s (S&P), which bases its research primarily on qualitative analysis.

“As a group, the median boutique Aussie large-cap manager has outperformed by 5 per cent over the same period.” This is because, according to Gorman, “boutiques are generally set up by skilled fund managers, the investment mandates are less constrained than the mandates run by their larger house peers, and these smaller boutique investment teams tend to get ideas into the portfolio faster”.

“Most managers have been able to exclude the worst index performers from their portfolio,” she added.

“Those funds that tended to perform better than the benchmark were the ones that avoided investing in companies with uncertain debt funding arrangements, relatively weak balance sheets and poor earnings visibility,” said Andrew Scifo, investment analyst at Lonsec Managed Funds Research, whose research is also qualitatively skewed. He said examples of companies which fall into this category include Allco Finance Group, Babcock and Brown and Centro Properties.

Measuring actual performance

Morningstar is the one of the few research houses to analyse the quantitative performance of fund managers in the Australian equities space. Table 1 (Active large cap) and Table 2 (Index large cap) offer the top performers in the retail and wholesale Australian large-cap share unit trusts, ranked by one-year returns to February 28, 2009.

Table 3 (Retail and wholesale Australian small-cap) ranks retail and wholesale domestic small cap funds also by one-year return to the end of February. Of 134 funds, 118 (listed in the table) outperformed the S&P/ASX Small Ordinaries Index.

Gray included the return from the S&P/ASX 200 Accumulation Index for the same period when he compiled the large-cap tables to enable an initial analysis of how many and which fund managers are “outperforming/performing less badly” than the market, and to what extent.

“This is the issue of downside risk, which can only be tested during a market downturn,” said Gray.

Only actively-managed funds were included in the analysis, he said, as “it’s not meaningful to expect index funds to be able to outperform”. (Some of these index funds are listed in Table 2.)

“The reason many of these are appearing as underperforming the index is because of their fees, as the returns we publish are after ongoing fees,” noted Gray.

“Active managers are able to avoid the ‘biggest losers’ in a market index, and therefore tend to generally do better than the broader market (as measured by the index),” said Gorman.

“Obviously, mandates that allow the manager to take big positions in their ‘best stock ideas’ mean the manager does not have to hold a portfolio full of small positions that they do not have a strong view on, just for the sake of diversification.”

In a fine position

In its February report, Lonsec noted key themes in addition to the broad-based market declines affecting fund managers, including the implementation of more concentrated portfolios by a number of managers.

“The uncertainty and volatility in the equities market resulted in a number of managers preferring to take larger positions in companies that had a higher conviction and were well understood, as opposed to having a longer tail of smaller, lower conviction positions,” Lonsec reported.

“Some managers were running more concentrated portfolios than in 2007, but they didn’t necessarily do better,” said Scifo.

Lonsec also noted increased risk aversion and the improved relative performance of ‘value’ versus ‘growth’ style managers as key themes in the sector.

“A flight to perceived quality and companies with relatively strong balance sheets, low debt and earnings certainty were company characteristics sought by fund managers in 2008,” Lonsec said in its review.

S&P noted in its recent Sector Report: Australian Equities — Large-Cap, published late last year, that investors’ pain was lessened by strong returns in the energy and materials sectors.

“Managers that are overweight to the energy, materials, consumer staples, healthcare and telecommunication sectors have benefitted from these stronger sectors,” S&P reported, a point Lonsec also noted.

“The traditionally more defensive sectors, such as healthcare and telecommunications, were the beneficiaries of investor risk aversion, and these two sectors were relatively better performing during the year,” Lonsec said.

However, S&P also said the “strength of the Australian dollar is making Australian non-resource-related exports less competitive on the world market, which will affect these companies’ ability to achieve earnings growth”.

S&P further remarked that large caps were “a safer bet” than small caps, proving more resilient in tough economic times despite small caps outperforming their large-cap counterparts over the long term.

“For the past five years small-cap stocks have outperformed the large-cap names,” S&P said in its sector review.

However, the S&P report noted: “Due to the recent slowdown in global growth and the overall decline in market sentiment since August 2007, large-cap stocks have demonstrated their resilience in tougher times.”

A system of assessment

It is a decidedly grim outlook when looking solely at performance. But a qualitative assessment of fund managers offers some valuable perspective for the long term.

“Our ratings are not primarily based on performance,” said Scifo. “It’s more to do with our qualitative assessment of the fund manager and their investment process.”

Lonsec places great emphasis on who is running the portfolio being rated, taking into account their qualifications, the stability of the team and the process being employed: is it logical, consistently applied, true to label, and doing what the manager says it does?

There are other factors, added Scifo, including the kinds of risk management tools in place and, of course, performance.

S&P takes a similar route in applying its star ratings to fund managers, assessing fund managers primarily on a qualitative basis. Its guide to qualitative fund ratings explains that there are a wide range of factors S&P considers in the process, including “portfolio management discipline”, and, like Lonsec, fund management experience and performance consistency.

“Qualitative assessment of managers is extremely important, and not just in bear markets,” said Gorman. “It aims to assess a manager’s ability to meet its investment objectives by understanding the factors that will influence this outcome.

“Quantitative assessment alone is fraught with danger because it only tells the researcher how a manager has performed in the past. S&P will use past performance as a tool to understand a manager’s previous investment decisions, and it is very useful for prompting fund manager questions.”

In particular, Gorman noted the importance of assessing factors such as remuneration, the investment team’s skill and experience, other “team stabilising factors”, the manager’s passion for investing, the manager’s understanding of the factors affecting the industries and companies they are exposed to, and risk considerations at the stock and aggregate portfolio level.

“There are also business sustainability concerns that need to be assessed,” said Gorman.

S&P commended the quality of the Australian equities offerings in its sector report, noting the high number of four-star rated managers in its review.

“S&P considers the best managers to be those that take the time to look at the quality of company earnings. The quality, rather than quantity, could provide investors with good returns over the medium to long term,” the S&P report said.

It’s all subjective

A comparison of Lonsec and S&P’s ratings reveal how subjective a qualitative form of assessment can be, with only a handful of managers receiving the same top rankings from the research houses. Lonsec’s analysis covered 35 funds within the large cap Australian equities ‘mainstream’ sector, with nine emerging with a ‘highly recommended’ status.

S&P’s review provided a list of 238 funds (52 fund managers), upgrading 12 strategies, placing seven strategies from two Australian equity managers ‘on hold’ and downgrading 16 at the time of reporting last year.

Among those with both Lonsec ‘highly recommended’ and S&P five-star rankings are Ausbil’s Australian Active Equity Fund, BT Wholesale — Core Australian Share Fund and the BT Imputation Fund, the one fund manager receiving upgrades to the highest spot in the past year from both.

The BT Imputation Fund was upgraded to ‘highly recommended’ by Lonsec last year, while S&P awarded the fund its five-star rating, up from its previous four-star mark.

“The BT Australian equities team is one of the largest and most experienced in the Australian market,” Lonsec said in its Large Cap Australian Equity Sector Review, in December last year. “The team has a strong internal research focus, permitting deep coverage of Australian stocks. The fund was upgraded to ‘highly recommended’ based on Lonsec’s increased conviction in the quality of portfolio manager Jack Chemello. Chemello was promoted to his management position of the fund in March 2007.

S&P said its five-star rating reflected its “very high conviction that the manager will consistently generate risk-adjusted returns in excess of both its relevant investment objective and its peers”.

“This fund aims to provide investors with exposure to Australian companies with a yield and franking focus, which results in the fund having a higher yield than the market, and a high level of franking,” S&P said in its Rated Fund Report which also cited the “well-resourced analytical team” led by Chemello.

True to label

Among the various considerations ratings houses take into account are investment styles — value, core, style neutral, growth and so on.

The S&P large cap review in Australian equities examined 99 investment strategies offered to investors, grouping strategies with similar investment styles and approaches.

The core/style-neutral and concentrated peer groups experienced larger growth relative to other peer groups.

A key issue in style is that of whether managers are staying true to label in the face of depreciating market returns and a financial landscape that is likely to remain uncertain for quite some time.

Lonsec’s Scifo was reluctant to comment on whether managers are generally staying true to label, pointing out “analysis of investment style or being true to label should really be made over a period of time, rather than at a set point in time, and also considered on a case-by-case scenario”.

“Generally speaking, however, we have not observed any major style deviations in 2008,” Scifo said.

S&P indicated in its sector report that it viewed staying true to label favourably when undertaking its assessment of the investment strategy and manager.

“Some style-based fund managers can feel pressured to abandon their investment strategies and adopt whichever style has been performing well recently (this is known as style drift),” S&P noted in its report, adding this tended to occur most frequently during bull markets.

“Australian equity managers maybe holding a higher amount of cash in their portfolios at this point in time,” said S&P’s Gorman. “A lack of liquidity is not the issue, equities, especially within the larger-cap segment, have not suffered as badly as other asset classes, such as property, mortgages and credit.”

Gorman said growth managers may be experiencing difficulty in finding securities that “present any real promise for recovery” and, as a result, the cash levels in their portfolios will be inclined to rise to the upper limits allowable.

“Redemption requests may also be on the increase. Value managers with a longer investment horizon may be finding some good value in the Australian market at the moment,” added Gorman.

“Changes to earnings expectations will be the issue most managers are keen to quantify.”

- Amal Awad