A lack of Global Small Cap investing???

International equity small-cap stocks widely outperformed large-cap stocks over the year to September 2010, returning 24.4 per cent and 12.7 per cent, respectively in US dollar terms.

I took the above from today’s InvestorDaily email and whilst the fact that global small cap outperformed large cap is not surprising, as it is bound to happen from time to time, what is surprising is the complete lack of selection of global small cap fund that advisers and investors have. I noticed at my place of work we have very few on our approved product list so I looked up Lonsec to see what other funds they may have at least “Recommended” and there were only three!…BlackRock, Zurich, and Schroder.

The Fama and French three factor model has been around for almost twenty years, many of us have read Jeremy Siegel’s book, “Stocks for the Long Run”, and there are many local and international papers which have similar messages…that is…over time small cap stocks outperform large cap stocks on a risk-adjusted basis. Of course, the past doesn’t equal the future, but we are creatures of habit most of the time and our market has shown little appetite for small cap…bizarre.

One of the recent posts I put up referred to S&P’s SPIVA report which also showed that active managers have recently been more successful in small cap stock selection than large cap and this makes intuitive sense. There are fewer analysts covering small cap space so there are more opportunities for mis-pricings so we can make a simplistic conclusion that the small cap part of the market is less efficient than large cap. OK…so small caps are the go…but there’s usually a but…small cap stocks are much more volatile and I must admit it is this volatility that is often the turn off (perhaps the additional illiquidity is too)…so there is a reasonable fear factor associated with them and I can understand that.

What I don’t understand is this insistence on regional biases…particularly Asia. Personally I don’t understand why you would constrain your investment universe (and opportunity) simply based on region. Why not place your funds with a global small cap or global unconstrained manager (with proven skill and aligned bias) and let them make the bet as to whether Asia is worthy of an overweight. By investing in an Asian managed fund we are really choosing a Global Small Cap fund anyway, so my simple message is go global and don’t reduce your investment opportunity.

Please note…despite these comments I have no views as to whether global small cap investments are likely to outperform or perform well moving forward.

The Best Australian Share Funds don’t achieve their Alpha Targets

Source: van Eyk, Morningstar

The above chart contains some performance statistics of a list of Australian share funds with at least a 5 year track record and were awarded an A-Rating by van Eyk this month. The A-rating is the second highest possible rating van Eyk award with the highest being AA…no Australian share fund achieved an AA rating in this latest review so this table is effectively the highest rated Australian share funds. I must point out that Integrity, Solaris, and Sigma have funds that were also A-Rated but they do not make the table due to a short performance history.

Before I provide any analysis I’ll provide some background to this simple table. The performance was measured over 5 years using monthly figures. So if a fund only had a 5 year track record, then the “total number of 5 year periods” is 1. If a fund has a 6 year track record, then the “total number of 5 year periods” is 13 because we have 13 separate rolling 5 year numbers due to monthly data. The table shows the number of 5 year periods where the fund outperforms the ASX200 as well as its stated alpha target.

Unfortunately, of these 9 highly rated funds, only 2 funds, Fidelity and Ausbil Dexia, have exceeded their alpha target more than 50% of the time. Fidelity’s Australian share fund has exceeded their alpha target (2.5%) every single rolling five year period since their inception which is absolutely outstanding and an absolute credit to this team. Fidelity started around the start of the new bull phase in 2003 and have obviously had to endure the GFC as well as its choppy recovery.

Ausbil, whose performance figures started around mid-1997 also have outstanding results. Whilst 60% of the time they have exceeded their alpha target they have exceeded the ASX200 index 100% of the time when looking at their 5 year rolling average.

Whilst Alphinity (formerly Challenger) has shown near decent numbers (49%) in terms of achieving their alpha target, I don’t group Alphinity in the same league as Fidelity and Ausbil because most of their strong performance occurred during the 1990s when they were possibly the best Australian share manager around and their performance since 2003 has been nothing short of abysmal…unfortunately this is a fund whose performance track record has effectively died in recent years.

As for the rest, it looks like considering their alpha target in terms of performance expectation is a complete waste of time. Most are nowhere near achieving this target and several managers haven’t achieved one single rolling period in excess of their target. I wonder how the fund managers feel continually failing to achieve their target…must be depressing. 

Anyway, at least all nine managers have outperformed their index, over 5 year periods, more than half of the time…well, at least before platforms fees, retail fees, adviser fees, etc!

SPIVA Report – Active Managers Bad Year

My favourite investmnent returns report was released yesterday by Standard and Poors, their SPIVA Report. Its my favourite because unlike other investment return analysis/reports, this report takes into consideration investment fund survivorship. As many of us know, when an investment fund continues to underperform it typically closes never to be seen again and the reports we see on investmnet manager performance end up being a biased report of winners (e.g. Morningstar and Mercers) as these closed funds are ignored.

Anyway, the whole SPIVA report can be found here but the main results are really just the following table…

As the table shows, with the exception of A-REITs, most active managers failed to beat the main broad-based indices over the 2010 calendar year. For the 5 years to the end of 2010, only small cap Australian equity managers appear to be worth spending the additional fees on with 71% of them outperforming the Small Ordinaries index. With the massive focus on the large-cap end of the market, it makes intuitive sense that an active manager has its best chance of outperforming a small cap index in this less efficient part of the market.

With such a high proportion of global and local managers failing to beat the benchmark for both equities and bonds, active management remains a tough sell. Whilst A-REIT managers had a good year last year, when you consider that 70% of that market is made up of just 7 companies (Westfield Group, Stockland, Westfield Retail, GPT, CFS Retail, and Mirvac) and yet there are dozens of analysts looking at these companies, it is very difficult to justify active management for this overly concentrated asset class irrespective of last year’s results.

Active managers will always have a place, as passive managers can’t exist without them, but their job is really cut out for them as they struggle to justify their fees for weak performance in this increasingly difficult investing environment.

Fee for service responsible for increased passive investment???

A change in adviser remuneration structure is causing a structural shift in asset allocation away from active products towards more passive products such as exchange traded funds (ETFs) and passive funds, according to Fidelity Investment Managers.

The above paragraph, taken from Money Management’s daily,  isn’t quite true. Whilst I believe adviser remuneration restructure has some impact on the move towards passive products, the big move to passive management really accelerated after investors and advisers saw that many active managers (including hedge funds) didn’t quite deliver their marketing hype during the negative return periods of the GFC. These large negative market returns frightened investors who demanded increased transparency, simplicity, and definitely at a reasonable cost…passively managed strategies tick all of these boxes and whilst some Morningstar and Mercer performance tables show a comeback of the active manager the damage was done and the psychology has changed from chasing return to reducing risk. 

I have a belief that, in general, investors and advisers felt their payments for alpha (active) risk would somehow reduce a portfolio’s beta (market) risk…alpha and beta risks are independent or uncorrelated so if the market goes down a lot then every long only fund goes down a lot…the impact of active management for the long only portfolio has a relatively small impact in big market downturns. So advisers and investors have simply decided to de-risk their portfolio by removing their portfolio’s only reducible risk…the alpha risk….and they just happen to save fees at the same time which is always an easier sell for an adviser. In fact, the reality is that the retail investor not only reduced their exposure to alpha risk but also beta risk as the proportion of cash or term deposits held by investors has possibly never been higher.

The GFC has changed the way everyone looks at risk and we are all a little more conservative and wary today.

My Least Favourite Hedge Funds

I’m always being approached by fund managers pitching their latest or greatest fund and many of them appear quite good with impressive people, performance, and/or process. Every now and then I see a fund that to me makes little sense and the latest to annoy me is the generic Asian Fund of Hedge Fund…I haven’t named the actual manager as there is quite a few managers doing them.

My reason behind my dislike goes like this…these funds are selling two attributes…1) they are focused on Asia and it’s expected strong economic growth which is expected to generate strong returns, and 2) the absolute return focus of the underlying funds and therefore their combination. I view the combination of these attributes as a little contradictory.

If I want an absolute return focused fund of hedge fund, I do not want to restrict my selection to one region. If there is a skillful manager based or investing in Ireland or Greece or US with a successful absolute return focus why should my fund ignore that potential?

Having a geographic focus is a beta (market) play whilst hedge funds are an alpha (skill) play…they shouldn’t be used to confuse or for marketing purposes just because naive investors will fall for it. If you are a fund of hedge fund keep it local for tax reasons or go global to increase your opportunity set. If you want to invest in a region, you are typically wanting to do so because you believe markets are going to go up… so do yourself a favour and buy a cheap index fund or long only managed fund that is region focused and save yourself some fees and increased risk.

Combining the two actually increases your risks of not achieving your desired outcome which can be achieved more efficiently with a global fund of hedge fund and a long only Asian fund combined to provide an acceptable level of risk.

Active versus Passive net cash flow

I found the above chart in an article at marketwatch.com and it shows the net cash flows of both active and passive managed funds in the US over the last 10 years. As can be seen, whilst passive funds (or index funds) have had positive flows every single year, actively managed funds have had massive outflows the last four years and net outflows six out of the last ten. Now these numbers are distorted a little, in so far that actively managed funds manage many more assets than passive managers so proportionately the differences wouldn’t be as exaggerated.

Either way, this trend of moving from active to passive has occurred in Australia also. Particularly in recent years with the extreme volatility of equity markets. Retail investors and their advisers are abandoning actively managed funds in favour of passiveyl managed funds for three simple reasons…

1. Simplicity…you know what you are going to get…the index minus some costs
2. Transparent…there will be no hidden surprises thanks to bets gone wrong (think Challenger AUstralian equities and their bets on ABC Childcare and Babcock and Brown)…you know exactly where you are invested and in the case of the Australian equities you see the performance on the news every night
3. Low cost…whilst I and many others believe it is possible to generate alpha, unfortunately managers find it very difficult to achieve alpha after their fees are taken out…this is particularly the case with bond funds

From an advisers perspective, using passive fund managers simply means the only concern is asset allocation and no action required should the key people leave the fund 452-style or the fund blows up performance-wise…increasingly advisers are realising this and they are focusing on their business and clients as opposed to wasting their time positioning themselves as investment experts.

With the expansion of exchange traded funds (ETFs) in Australia, and they are just index funds at this stage, and the MySuper recommendations from Jeremy Cooper, I can really only see massive growth for passively managed funds in Australia and significant funds outflow for the actively managed. This risk to massive flow to index managers is that prices can be inflated without consideration to value (tech boom to provide an exaggerated example and therefore providing opportunity for the active manager which is not a bad thing) but the chances of a bubble in equities in these risk averse times  appears a long way off.

The often forgotten risk of active funds management

On Wednesday of this week (18 August), the portfolio management team of 452 Capital announced to Colonial that they are calling it quits (at an undisclosed date) and will no longer be managing their Australian Equity Funds. So of course, the Research Houses downgrade their ratings to Sell, Redeem, Hold etc (we moved to Sell) and the flood of redemptions begins. Apparently Colonial are installing the high quality team at Integrity, but at the end of the day Integrity is not 452 whether it be better or worse so investors will no longer getting what they pay to get and the natural outcome of redemptions continue.

The irony in Integrity taking over is that the founder of Integrity, Paul Fiani, left UBS a few years ago and this resulted in billions leaving UBS resulting in a disastrous tax outcome for investors.

Anyway…I believe the outflow from 452 just one day after the announcement was equivalent to around 2 month’s of their usual redemptions. As this continues the poor investors who truly want to stay, whether they like it or not, will ultimately be lumped with a very large distribution and return of capital that will be subject to tax. Not a good result at all.

The thing with active fund managers is that when you invest with one you are taking a bet on the success of the key investment decision makers and when they leave so too does the performance (whether that performance be judged by style or other)…for the passively managed fund whereby investment decisions are not any where near as reliant upon key individuals, this risk does not really exist and these difficult situations, for investors and advisers, are avoided.

I’m sure many advisers will receive some negative outcomes from some of their clients and this is quite unfortunate. From what I can tell, 452 started in 2003 and in the 7 years to the end of July 2010 they produced performance of 9.50%pa…unfortunately for their investors it underperformed the ASX200 Accumulation Index which returned 9.94%pa. 452 Capital had outstanding pedigree (Founded by former Perpetual guru, Peter Morgan) and received very high ratings from most of the major Research Houses (Lonsec, van Eyk, etc)…unfortunately none of that has helped the long term 452 investor and its time to look for a new home for the funds that are heading their way.