Investment Road Test: Magellan still finds navigation difficult

An impressive LIC from Magellan Financial Group has been hit hard by a decision to remain unhedged, but there could be an upside over the longer term.

PORTFOLIO POINT: The decision to remain unhedged may be weighing on its share price, but Magellan Flagship Fund could suit investors with a long-term view.

For Australian investors seeking access to the sharemarket returns of successful global companies – irrespective of where they are headquartered – the Magellan Flagship Fund (ASX code: MFF) may be of interest:

Conventional international share funds invest based on the location of the country within which the target company is headquartered. Linked to this old school notion, the typical international fund manager tracks very closely to the composition and performance of major global sharemarket indices, like the MSCI World Index. These indices are weighted in direct proportion to the share which each country represents within the total world sharemarket: for example, if the US sharemarket represents around 1/3 of the total value of all global sharemarkets, then it will hold a 1/3 weighting within the index. That means that index-aware investment managers are forced to allocate the same 1/3 weighting of all their funds, into the US stockmarket. Specifically, that means that the 1/3 allocation must be directed to companies listed on US stock exchanges, irrespective of their relative merit on the global scale.

However, the Magellan Flagship Fund is an investment manager using a “benchmark unaware” approach to find and invest in the best companies around the world, unfazed by the strictures of traditional index investing. Magellan was founded prior to the GFC by two heavyweights from the investment banking/corporate advisory world; Chris Mackay and Hamish Douglass held senior posts at UBS and Deutsche Bank before changing roles to become fund managers. Neither had funds management experience prior to establishing the group in 2006.

The MFF targets global brand name companies with excellent market positions and profitability. Its worth looking at what the management of MFF have to say about the prospect of doing so in the chaos of the post-GFC world:

“These companies combine high ROE, cash generative home market leadership with growth options (both domestic and international), favourable technological trends such as urbanisation and mobile internet, and global reach. Every day, our companies benefit from the rise in opportunities and freedom from increased market based specialisation, trade and easier transfers of people and capital manifested in the collapse of Communism and the Berlin Wall and the re-entry of China into world trade and investment. Despite the current prevalence of fear and despair, our companies continue with many positive initiatives.” (MFF Annual Report, p. 3).

MFF invests in successful big name companies and lists its top holdings in its annual report:

American Express
Yum! Brands
Procter & Gamble
US Bancorp
Bank of America
China Mobile
Wells Fargo

The Annual Report states that these companies generated strong profit during the last 12 months, citing the examples of Coca Cola (34.3%), American Express (30.2%), Yum! Brands (41.5%) and eBay (64.6%). Why then does the MFF share price trade at a sizable discount to its net tangible asset backing?

MFF is issued in the form of a listed investment company. Because of its “closed end” format, MFF investors can only exit their holdings by selling to incoming investors on the ASX. Unlike the “create and redeem” mechanism used by unlisted (“open ended”) funds, liquidity for MFF investors is limited to the demand from other investors on the ASX. This is normally a benefit in that it supports the use of benchmark unaware investment style – since the closed ended fund can be managed without the need to maximize liquidity, necessary when an open ended fund is exposed to the prospect of a rush of investors looking to sell down. But the closed ended format also means that LICs can trade at a discount or premium to their NTA, depending on the prevailing investor sentiment.

It seems that the problem for MFF investors is that the management has decided not to hedge the currency risk created by its global portfolio. This means that stocks which are denominated in weak currencies – e.g. the USD and euro – have had their fundamental performance held back by currency losses between the strengthening AUD and the weaker USD and euro. For the financial year of 2011, the annual report states that the effect of these currency losses completely wiped out the underlying share gains, turning an 18.4% pre tax/after costs gain into a slight after tax loss, after currency translations. This problem echoes Doug Turek’s recent Eureka article (Hedging's little extra) where he highlights the problems for unhedged international share investors.

Looking at the medium to long-term trend for currencies, it is plausible to assume that the AUD will remain high against the USD and euro, for at least until the current commodity supercycle ends. Most commentators see this supercycle as having a few more years yet to run – UK independent economist Chris Watling told an audience of investment professionals this month that based on previous cycles, there was somewhere between 2 and 12 years left to run. So the strong AUD is likely to be with us for some time yet.

This begs the question as to why the managers of MFF continue not to hedge their currency exposure. There is an eloquent defence of the decision not to hedge set out in the CIO report in the company’s annual report. Whatever the rationale, the decision not to hedge is hurting the MFF share price, which is trading around 0.8 price to NTA. This discount has led to the deployment of an on-market share buyback program over the last year, with shares being bought back at prices around $0.63 (below last week’s MFF price of $0.70). The management fees are 1.25% pa with an additional 10% outperformance fee paid if the MFF AUD return exceeds that of the MSCI. These fees are about normal for this type of LIC.

For investors with a long-term view, MFF may be an interesting addition to the portfolio, especially where the investor expects the AUD to fall in value and where MFF shares can be bought at a discount to their fair value. The problem with the decision not to hedge the currency risk is one which likely comes from the textbooks used by traditional investment managers, but is out of synch with the overall absolute return style which the promoters of MFF have set for themselves.

The score: 2.5 stars
0.5 Ease of understanding/transparency
0.5 Fees
0.0 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile/risks
0.5 Innovation

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services with Alpha Invest but does not receive any benefit in relation to the product reviewed.

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