A year of outperformance

It is a cruel irony that last year’s outperformance of the Australian equities sector should give few clues to fund manager performance during the 12 months ahead.

When the top performing fund in 2004 delivered returns in excess of 40 per cent, it seemed quite natural for planners to want to be influenced by this outperformance.

But researchers, asset managers and even fund managers themselves are warning that last year’s soaring markets have flattered some modest manager performances.

With even the weakest performing managers posting double digit returns, they warn that adding value above the benchmark (alpha) was not as easy as the figures suggest.

It is estimated, for example, that only half of the active managers that outperformed last year’s benchmark indices would have returned enough alpha to justify the fees and taxes they charge.

Altogether, 40 out of the 57 funds appearing in the Intech Research Australian equity funds survey beat the S&P ASX 200 benchmark of 28 per cent last year.

Yet the median middle manager outperformed the index by only 1 per cent, with the upper quartile median manager returning 2.5 per cent over benchmark.

The top surveyed manager beat the benchmark by 15.8 per cent, but, according to former Intech senior portfolio manager Chris Thompson, it was “out there all on its own in the table”.

Thompson says the spread between upper and lower quartile managers last year was the lowest in years, suggesting manager selection wouldn’t have made much difference for the year.

“Everyone did well in absolute returns on our survey, with the worst performing managers still returning in excess of 20 per cent.”

Measuring managers on one-year returns puts them in a ‘Catch 22’ position, as a lot of them invest over at least a four-year time horizon, he cautions. In fact, he measures a manager’s performance on “everything else” but its performance over a single year.

“Invariably what you’ll find is that a manager at the top of a performance table in one year will be at the bottom the next.”

Mercer Investment Consulting’s head of Australian shares research, Andrew Francis, also advises against a short-term measurement of managers.

Most managers, including boutiques and the institutional funds, aim at delivering outperformance across a three to five-year cycle, he says.

In so doing, he says, different managers have “different processes and focuses, which can affect returns over shorter time periods. Some may tend to do better in up markets, others in relatively stable market conditions, and yet others in more difficult market conditions.”

Francis says he was “not surprised” at the low returns spread between managers, given the price earnings (PE) compression and low cross-sectional volatility (CSV) in Australian stocks in recent years.

However, he says, PE spreads and CSV — which measures the dispersion between the most and least volatile market securities — would “not stay low forever”.

Russell Investment Group chief investment officer Peter Gunning says a falling CSV in a surging market makes “active management harder by making it more difficult to identify mispriced securities”.

“Active managers have to be more aggressive in their investment strategies in times of falling CSV to generate the same level of alpha as they have done historically.”

He says the Russell group has “responded to the reality of falling CSV by turning up the basic risk within our own fund portfolios. Philosophically, we are very strong proponents of stock selection as being the primary source of value added returns”.

The alternative strategy would be to “go with the flow”, Gunning says, allowing the level of active risk in the portfolio to fall in line with cross-sectional volatility.

“Of course, that implies you are going to generate less alpha as a manager in the current environment because you are taking less risk.”

Gunning says it isn’t intrinsically difficult to choose a manager based on past performance, as almost everybody manages to a greater and lesser degree to the benchmark.

“You simply strip out the benchmark in a given year and look at a manager’s performance relative to that benchmark.”

The challenge lies in interpreting past performance within the context of current investing conditions as an indicator of future performance, he says.

Van Eyk analyst Dennis Motheneos says there was “less reward for strong manager selection and even active management in 2004, compared to previous years”.

Motheneos says the decline was brought on by historically low market volatility levels and a compression in valuation differences between companies deemed either growth or value.

He says managers’ performance differences declined last year, as evidenced by a “fall in the tracking errors of most managers and the performance of the median manager relative to the benchmark index”.

When the market is doing well, he says, volatility levels are usually low and managers will find it difficult to maintain high tracking errors, as they may have done so when volatility levels were higher.

“Lower volatility also provides less opportunity for managers to take risk relative to the benchmark index, and manager performance will tend to more closely resemble the index benchmark.”

Motheneos says it may become more important to select the right manager for outperformance in 2005 if, as expected, returns decrease and volatility levels increase.

“This will give more leeway in increasing their risk relative to the benchmark index, and may result in a widening in the gap between weak and strong performing managers.”

Motheneos says there may also be a widening in the difference between value and growth stocks, and consequently style selection may become a more important consideration than it was in 2004.

“Choosing the right manager was not so dependent on choosing the right investment style in 2004, when both value and growth managers outperformed the benchmark index.”

The main factor contributing to manager outperformance last year was security and, to a lesser extent, industry sector selection, he says.

“The key to outperformance last year was not only selecting a manager with strong security and industry selection capabilities but also a manager with a long-only strategy.”

He says market conditions in 2004 did not really suit alternative Australian equities specialists last year, defined as fund managers pursuing differentiated Australian equities strategies.

Falling CSV in a surging market was “not very conducive to these short selling specialists outperforming their long-only counterparts last year”, he says.

“However, if the market pulls back this year, as we are predicting, we expect these specialists’ strategies to come into their own.

“Those managers that conduct some short selling or hold high levels of cash should perform better than their long-only low cash level counterparts that generally performed so well in 2004.”