If you run with bulls, watch out for bears

The results posted by Australia's managed funds industry in the past two years provide a clear picture of what happens when a bull market turns bear. A year ago, investors were riding high. Share funds reported average returns of 25 per cent after fees and the best performing fund, Macquarie's Small Companies Fund, was up by 82 per cent. This year, according to figures from the research group Morningstar, the average share fund is down about 15 per cent and, thanks to an even worse performance at the smaller end of the market, that Macquarie fund has lost 33 per cent.

A year ago, investors were being rewarded for taking risks. Geared share funds took out four of the top five places for large-cap share funds, but this year those funds are languishing at the bottom of the league tables.

Colonial First State's 452 Geared Australian Share Fund, which last year topped the list with a 53 per cent return, has plummeted to the bottom with a loss of 43.42 per cent.

"Last year was the fourth year of the bull market and people who had been taking higher risks were seeing the rewards," says Anthony Serhan, the head of research with Morningstar. "This year we've seen the other side of that risk.

"It's a lesson in what happens if you go with last year's winners. Picking funds on short-term results is fraught with peril."

But while investors should brace themselves for short-term losses, there are funds that have bucked the trend. More conservative funds with less exposure to the sharemarket have largely remained in the black, though some bond funds have reported losses due to the subprime crisis, and funds holding unlisted investments also did better.

Serhan says uncertain times also tend to throw up "outlyers" - more specialised funds that are suited to specific market conditions, though they can perform equally badly when the conditions go against them.

Of the 20 best performing retail unit trusts over the past year, only eight have assets of $100 million or more. These funds are a mix of specialist resource share funds, unlisted property funds, and aggressive mortgage funds, which lend to the riskier end of the mortgage market.

The main exception is a BlackRock (formerly Merrill Lynch) global hedge fund which topped the tables with an annual return of 33.74 per cent. Its director, product specialist Vincent Lo Blanco, says this is a tactical asset allocation fund, which means the fund manager "can cherry pick the best ideas from BlackRock globally in the asset allocation world". Basically the fund uses derivatives to back its views on the merits of different investment sectors. For example, Lo Blanco says the fund is now long in put options over the German, US and British equity markets. It is also heavily invested in gold and commodities.

It can also take positions on the relative merits of investments. For example, Lo Blanco says the fund has been favouring US growth stocks over value stocks, energy stocks over the S&P500, the Australian dollar over the New Zealand and US dollars, and the Brazilian real over the euro.

Because the strategies are derivatives based, Lo Blanco says the amount of risk taken can reflect the degree of conviction the fund manager holds, and it is possible to manage risk by running stop losses to limit the downside if it is wrong.

Lo Blanco says the fund has a long-term target of earning 12per cent over the UBS Australian Bank Bill Index and probably benefited from the market turmoil last year.

"When markets and valuations are changing rapidly and medium-term trends emerge, the fund has more opportunities," he says.

In the critical Australian equities sector, the average fund struggled to beat the index return of -13.67 per cent. "When you have such a narrowly led market, with much of the growth coming from BHP, Rio, and Woodside, you don't get a lot of outperformance," says Serhan.

The top performing retail diversified Australian share fund was the Equity Trustees Core Australian Equity Fund with that loss of 1.85 per cent. Kalman says 30 per cent of this fund is invested in the wholesale SGH 20 fund which will probably be the only Australian share fund to report a positive return for the year. Managed by a boutique group, SG Hiscock, Kalman says the SGH 20 fund is a concentrated fund that holds only 15 to 25 stocks and the manager has a strong stock-picking track record. A further 50 per cent of the Core fund is invested in Equity Trustees' own Flagship Fund which focuses on income and has a low stock turnover. Kalman says it also did better than the average fund last year.

Other top performing equity funds included the Prime Value Growth Fund and the Equity Trustees Absolute Return Trust which Kalman says is able to take short positions to benefit from falling markets and to shift money between different sectors, such as moving from small to large companies.

Two of the worst-hit sectors over the past year have been smaller companies and listed property trusts, and the poor performance has flowed through to funds investing in these sectors. Serhan says the average small companies fund lost around 3per cent more than the index, which lost 20.5per cent. "A lot of active managers chose not to participate in a lot of the speculative resource plays that have driven the index," he says. "They've been quite cynical of the earnings of those companies, but it has hurt their performance."

He says funds focusing on the smaller end of the market were also hit by a liquidity freeze.

At the top of the table was the Portfolio Partners Emerging Shares fund with a loss of 5.38 per cent. This and UBS's Emerging Companies Fund were the only retail diversified small companies funds to lose less than 10 per cent, while at the bottom of the list, the Smallco Investment Fund was down 46 per cent.

Serhan says property securities funds also struggled to add value with the median manager pretty much in line with the index return of minus 37.7 per cent. Australian Unity's Property Securities Income fund managed a relatively impressive loss of 8.45 per cent, with the second-ranked fund, APN Property for Income Fund losing 28.03 per cent.

While the average diversified global share fund also tended to produce an index-type return, Serhan says there were areas where managers could add significant value. He says the index is unhedged, but a growing band of managers have been using some hedging to offset the impact of the rising Australian dollar. He says the index also has very little exposure to emerging markets, and even a small weighting to these markets would have boosted returns over the past year. The K2 Select International Absolute Return fund was the best of the large cap global share funds with a return of -7.04 per cent.

Falling sharemarkets also affected the returns of multi-sector funds where conservative funds which have lower sharemarket exposure tended to shine. The exception was BlackRock's Global Allocation Fund which has a value style of investing and can switch between shares, cash, and fixed interest. Fixed interest funds also tended to do better than those exposed to the sharemarket, though some felt the fallout from the global credit crisis (see column page 45).

Serhan says aggressive mortgage funds and unlisted property funds were among the best performers, but should be treated with caution. "A lot of funds, including the big super funds, will look good for the year because they have a large component of unlisted assets," he says. "But in all likelihood their assets will have to be marked down during this year. Valuations in unlisted assets move more slowly, but they will come through."

Serhan says loans in mortgage funds are also on the books at face value, making them look attractive against other funds where the value of debt securities was adjusted to reflect the blow-out in credit spreads. "A lot of the better performing mortgage funds are also more aggressive and fundamentally riskier propositions," he says. "You have to consider the risks attached."