Losses lead to portfolio revamp

Performance research highlights ongoing challenges in the lean times post-GFC, writes John Collett.
By · 25 Aug 2012
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25 Aug 2012
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Performance research highlights ongoing challenges in the lean times post-GFC, writes John Collett.

Fund managers are no longer the masters of the universe. Poor performance that fails to beat sharemarket benchmarks and investor outflows has led to funds management businesses shrinking or closing, job opportunities drying up and bonuses being denied.

When investment markets were running hot, no one questioned their performance. Investors received double-digit annual returns and there was plenty left over after fees.

Traditionally, funds owned by the big banks and insurers have been constructed to closely match or mirror the composition of the sharemarket. This approach means the funds move in lock step with the indexes and so eliminate underperforming the market.

It has worked in the past because big-brand marketing and large networks of financial planners have grown funds under management, but not in the lean times since the GFC. They are now adding funds that rely more on stock picking and are less dependent on the sharemarket index.

Even so, fund managers are still finding it difficult to consistently outperform the market after fees.

The latest fund performance survey by researcher Mercer shows that over the five years to July 31 this year, the median-performing Australian share fund produced an average annual return of minus 2.1 per cent, compared with minus 3 per cent for the S&P/ASX 300 Index. Fund managers have beaten the index by 0.9 percentage points before management fees.

However, when the typical fee of about 1 per cent is deducted, the median-performing fund in the Mercer survey is almost exactly line-ball with the index.

Stock pickers

Not only have about half the funds underperformed the market, after fees, but other research shows a distinct lack of consistency.

The head of asset consulting at researcher van Eyk, Jonathan Ramsay, says investors who chase the best-performing fund managers are destined to be disappointed. Fund outperformance of the market rarely lasts more than a few years.

Ramsay's recent analysis of Australian shares managers found only 10 funds that beat the Australian sharemarket by at least 5 percentage points, before fees, over the past 20 years. The performance of these funds showed that even though their outperformance could go on for a number of years, they all either went on to have long periods of underperformance or, at best, performed in line with the market.

Ramsay says the notable achievement of the best and most enduring funds management organisations was avoiding underperformance when markets were subdued while being able to catch the next market wave when it came along.

The research manager at investment researcher Morningstar, Tom Whitelaw, says fund managers that are likely to be successful can be identified. Successful managers tend to be those that "grind out a small level of outperformance" almost every day, so outperformance is achieved over the long term and through market cycles.

They construct portfolios that cushion the losses when markets are weak, Whitelaw says.

That means when markets rise the funds will not perform as well as the market or some other funds. However, the result over the long term is a better one for investors, Whitelaw says. "Everyone has slip-ups and it is about getting more right than wrong over the long term," he says. Australian large-cap funds with Morningstar's highest gold rating, which include Greencape Capital's two funds, the Schroder Wholesale Australian Equity Fund and the Fidelity Australian Equities Fund, manage money in this way, Whitelaw says.

Market tracking

Investors have an alternative to "active" managers and their high fees. Index investing is where the fund invests in a way that mirrors or tracks an investment market. Most of the returns for investors using a fund manager come from the market, with a much smaller portion from the skill of the fund manager.

Index funds provide a cheap way of buying in the market.

Of course, with an index fund, investors will never outperform the market but neither will they underperform it. But there are limitations to index investing. The Australian sharemarket is particularly top-heavy. Fewer than a dozen companies account for half of the Australian sharemarket's capitalisation.

An index fund that tracks Australian shares is investing mostly in the market's giants that generally do not grow their businesses as quickly as smaller companies. One of the key attractions of an index-managed fund is low fees. An Australian share index fund from Vanguard, for example, has management costs of 0.75 per cent for amounts up to $50,000, and less on subsequent amounts. "Low costs matter in both bear and bull markets," says the head of product management and development at Vanguard, Robyn Laidlaw. "Investors can't control the market, just as investment managers can't guarantee investment returns, but costs are one thing that can be controlled."

As well as managed funds that track indices, such as Australian shares or international shares, there are exchange-traded funds (ETFs) available that also track sharemarkets and sharemarket sectors, such as "financials", and other types of markets, such as commodity markets. ETFs are listed on the Australian sharemarket and can be bought and sold like any other share, with investment management fees that are usually less than 0.5 per cent a year. But the investor will incur brokerage each time ETFs are bought and sold. Managed funds have an advantage over most ETFs in that distributions from a managed fund can be automatically reinvested in the fund.

Many financial planners prefer the "core plus satellite" approach. The idea is to buy the market with low-cost index funds, the core, and then to spice up the returns with some active share fund managers, which are also known as "concentrated" funds (see box).

Concentrated investing

Fund managers have been launching so-called "concentrated" Australian share funds. These are more focused, or "best ideas" Australian share funds, according to Morningstar's Tom Whitelaw.

Typically, the funds will have 15 to 30 shares and be invested differently to the market than the mainstay "core" funds that can have anything between 30 and 80 shares in their portfolios. Investors need to be careful, though investing in a fund that is concentrated and actively managed is like a sports car. The journey will be quicker but, in the wrong hands, there is a greater risk of running off the road.

Big fund managers have launched concentrated funds while others are offered by boutique fund managers. Managing a concentrated portfolio is a skill in its own right, Whitelaw says. "Investors looking to add some spice to a portfolio would be better served by a more dedicated high-conviction fund manager," he says.

He says concentrated funds are often better used as "supporting players" to core offerings, as concentrated funds are higher risk. Morningstar defines a concentrated fund as one that holds, on average over a 12-months period, 30 or fewer stocks. No concentrated fund has yet received Morningstar's highest gold rating.

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