Investment Road Test: Lonsec Model Equity Portfolio

PORTFOLIO POINT: Lonsec’s buy-and-hold approach offers investors a chance to beat the index without paying hefty active management fees.

APRA set a cat among the pigeons last week with its fund manager performance study. It confirmed that many fund managers don’t add sufficient value to justify their fees.

The data is unsurprising: asset consultants such as Mercer, StateStreet and Intech have been reporting on the phenomenon of fund manager under-performance for many years. But the APRA report linked the results to the fee structure of the fund manager and argued that it was still possible to add investment value by a low-cost approach to stock picking.

And that is exactly what one of Australia’s leading independent research houses has been doing, successfully, since April 2000. The Lonsec Model Equity Portfolio has generated a total return of 299.2% since inception and has outperformed the ASX 100 Accumulation Index by a whopping 200.3% in that period.

Retail investors can access the Lonsec model portfolio stock selections through a wide range of SMA (separately managed account) and IMA (individually managed account) providers. Many financial planners also use Lonsec model equity portfolios. Lonsec adopts a simple but powerful approach:

• The methodology is based on the idea that stocks are long-term vehicles for wealth creation – and rather than high turnover or active trading, stocks are bought and held to access the growing earnings that good companies generate.
• Lonsec starts with a well reasoned, “top-down” approach: identifying sectors where above average GDP contributions are being experienced.
• Sector rotation is used but sparingly.
• Once a favourable sector is identified, Lonsec then uses the “bottom-up” approach to identify the most efficient stocks in that sector. This involves an assessment of a range of qualitative and quantitative factors, including relative price/earnings multiples and return on equity.
• There is very low turnover in the Lonsec model equity portfolios, normally only when a sector is moving out of favour or where there is a fundamental shift in the relative value of a stock.
• By working with a small, “concentrated” portfolio of less than 12 stocks, the Lonsec model portfolio shows a clear “tracking error” (less than 100% correlation) with the returns of the overall index.

As with any stock picker, there is a depth of proprietary IP involved in the process, and one of the value adds is that the outcome of the process is a blended portfolio rather than just a list of stocks that are a 'Buy’, 'Hold’ or 'Sell’, unlike the usual output from most broker research. Lonsec takes the “top down” part of the process seriously and this can be seen in that it vacated the A-REIT sector well before the problems of high gearing manifested themselves.

The usual reaction to perceptions of fund manager under-performance is to utilise lower-cost index funds or to move to a DIY approach. Index funds are very effective but demonstrable evidence of outperformance from stock pickers like Lonsec highlights that markets are inefficient and can be beaten.

This is recognised in the APRA report, which makes the cryptic comment: “'¦ on average, value adding from active management appears statistically to be unable to overcome higher costs associated with attempts to exploit market inefficiencies'¦”

The only drawback of the Lonsec approach is that performance is measured for investors who started with the portfolio at its inception. Investors wary of buying stocks at later times at different prices may prefer to time their purchases or use an IMA which tailors portfolios to specific circumstances.

Nevertheless, lower-cost, low-turnover direct share portfolios like those promoted by Lonsec can add significant value to the retirement savings of every Australian investor.

The score: 4.5 points
0.5 Ease of understanding/transparency
1 Fees
1 Performance/durability/volatility/relevance of underlying asset
1 Regulatory profile/risks
1 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online, a provider of investment training to financial services professionals. He is a customer of Lonsec research services, but has no pecuniary interest in the product researched.