Why fund managers are getting things wrong
Nobody who watches the way the big professional fund managers select their stocks was at all surprised to discover that the major equity fund managers couldn’t beat the index to June 30, 2016.
Many of these highly paid operators have very little idea of what is required for their customers -- small superannuation savers are the sufferers. But before I explain where analysts are going wrong, let’s look at the figures.
The Dow Jones has issued a report card on the major fund managers in significant sectors of the share market. In large cap funds measured over five years, 69.2 per cent underperformed the benchmark index. And in 2015-16, 59.7 per cent underperformed the benchmark index — they are not getting any better.
In mid and small caps, the performance is not much better, and in international equities it is decidedly worse. Clearly something is terribly wrong with the way too many of our big fund managers and analysts operate. You may have your own views as to why this is happening but let me set out mine. And it may help you in your own strategic thinking.
Certainly in large cap funds the base portfolio is usually the index and the managers/analysts pitch their holdings either below or above that index level, depending on their research. But that should not cause such widespread under-performance.
Cat and mouse games
To discover why they are always getting it wrong, you only need to go to analysts’ briefings. These briefings have degenerated into a game between the analysts and the chief executives, plus the chief financial officer. The analysts want to work out what the profit is going to be for that year plus the year after, and ask a lot of detailed questions to help them make their forecast.
The CEO and finance directors go very close to giving out inside information, but unfortunately that is the way the game is played. The analysts celebrate if they get the profit right. It is a short-term nonsense game.
What the analysts should be doing is remembering that a large amount of their client base are long-term investors, and analysts should be examining the future strategies of the company and evaluating their likely success. What happens to the profit in the next six to nine months is of far less importance, and if you concentrate on forecasting that figure then you are likely to make silly long-term strategic mistakes.
And that is what is showing up in the figures. What makes it worse for those unfortunates whose money is lost in the process is that the managers and analysts charge enormous fees. In a period where the total share market is not rising strongly, these fees really hit performance and represent another reason why the index funds are doing so well. One day the trustees who manage this money will start to think about the interests of the members they are supposed to represent.
Meanwhile, thank goodness for self-managed funds where members can manage their own money or carefully select who will manage their funds. I might add that in the small cap field you often find very good people who do the work correctly. If those managers perform well, then I have no problem with large fees. But the fees must be related to performance — usually a percentage of the gain adjusted for an index. Once fees are levied on the basis of a percentage of total assets there is a very different dynamic. But remember, managers that have their fees based on gains often take big risks, so great care needs to be taken in selection.
An illustration of how far away institutions are moving from reality is illustrated with the CSL director fees. Where a company performs badly and still pays its top executives high fees, then shareholders should exercise all the powers they have. But CSL is a global company that has performed extremely well.
The current CEO, Paul Perreault, is a global executive who would be snapped up by other international pharmaceutical companies if he was available. A whole series of institutions have applied a formula to the CSL policy and have declared that he is paid too much – it’s no wonder these people underperform.
Banks in a bind
And talking of corporate performance – we are starting to see the going get much tougher for global and local banks. It’s taken a long while but around the world regulators have coordinated to impose greater capital requirements on banks and much more regulation. At the same time, there are greater restrictions on what banks can do. And these changes have come at a time when interest rates have been substantially reduced and made negative in places like Europe and Japan.
In a low interest rate environment, and especially a negative interest rate environment, banks struggle to get a return. The regulators and central banks are only now starting to wake up that when the banking sector is nervous their customers became even more cautious. Very low interest rates reduce rather than stimulate growth, because they weaken the banking sector.
So globally we are seeing a massive rerating of bank shares. Bank of America and Citicorp traded at about double their book value before the crisis, but have since traded below, as have banks in France, Germany, Japan and Italy. Deutsche Bank, which is facing a potential multibillion-dollar US penalty over crisis-era mortgage activity has $US135 billion tied up in cash and central-bank deposits. Meanwhile, its investment banking revenue has been sapped by regulations and docile markets.
Part of the banking problem is that there are fears that the weakness in Deutsche Bank and the Italian banks could infect the whole banking community, particularly given Deutsche Bank’s role in derivatives. The tougher banking environment makes it harder for troubled banks to trade their way out of difficulty.
And, at the same time, specialist disruptors are using new technology to slice part of the market away from the banks with low-cost products, which further compounds the share market nervousness. In the US, Wells Fargo decided to try to break out of this straightjacket by introducing a wide range of new products, particularly in the credit card area. But it didn’t work, and the CEO John Stumpf has lost his job. This will make all banks that little bit more nervous about breaking out of the straightjacket, because once they do the CEO’s job is on the line.
A double-edged disruption sword
Here is Australia, more and more disruptors are getting into the business market and offering better products than the banks. For example, if somebody invests in a plant or a building that has a long life they want long-term money. All too often, the banks limit their lending to three to five years at best. Non-banks are lending for much longer periods, so although the interest rates might be higher the actual cash available in the business increases.
And, in the retail area, Coles is now starting to make a major challenge to the banks in credit cards. It has 500,000 card holders and it is now offering 15 months’ interest-free cards to increase its market share over Christmas. I must emphasise that new card owners are not exempt from making principal payments during the 15 months’ interest-free period.
Most people are locked into bank shares because of their high dividends given the need for income, but the tougher bank environment means there is not going to be a lot of profit growth.
And during the week I discovered an apartment developer who was told a year ago by his bank that if he sold 75 per cent of the apartment development to Australians, and limited overseas buyers to 25 per cent, they would fund the development. There was no binding agreement, but that is what he did. Then, a year later, he went proudly to the bank with a fully sold development, 75 per cent Australian and 25 per cent foreign, apartment project. The bank executive shook his head. The developer was told that times are tougher and said that developments now can’t have more than 10 per cent foreign.
The development is a good one and he will have no trouble finding non-bank financiers, although interest rates will be between 10 and 15 per cent. The banks, of course, are blaming the regulations imposed by APRA. But, as I heard this story, I couldn’t help feeling that at least that particular bank must have a large exposure to the apartment market and doesn’t want to increase it.
Particularly in Melbourne, there are feverish efforts to refinance Chinese apartment purchasers who can’t complete the contract. If either an Australian or a Chinese bank panics and pulls the plug on a major developer, there will be great carnage. At this stage they haven’t done it, and hopefully won’t, but my example above shows the nervousness of the market.
But banks are not the only ones facing big challenges. All the supermarkets are now involved in an industry where there is very little volume growth, yet all of them have major investment projects trying to increase market share in a stagnant market—that’s not good for profits. In addition, there is a risk of higher penalty rates and shift allowances. That is why Coles has tried to grab credit card deals. My fear is that Woolworths, whose morale has been damaged by the Masters affair and whose stores have been run down through the Masters period, are the most vulnerable.
Readings & Viewings
It’s been another busy week. Presidential debates, oil, resignations and phone blow-ups. Here are some interesting items we came across during week.
First to oil, where prices spiked after Vladimir Putin said he would cap production in line with OPEC. But Goldman Sachs isn’t convinced.
Then, after weeks of pressure, Wells Fargo boss John Stumpf has pulled up stumps after it was revealed his employees had opened as many as two million unauthorised deposit and credit card accounts to meet sales targets.
It’s no wonder some young people think corporate crime is acceptable. A study just completed in Tanzania has found that 60 per cent of youth believe bribery and corruption are acceptable.
Now, to property. Amid ongoing commentary that Australia’s housing market is in a bubble -- but backed by little statistical evidence -- the Canadian Government is taking steps to rein in its property sector.
French economist Thomas Piketty, who was in Australia this week, believes it’s time to tax wealthy property owners.
Few investors would agree, of course, including those just across the Channel. The UK property market is experiencing a rise in demand from house buyers.
But it seems some UK borrowers are lying to their lenders to get their foot in the property door.
The latest winners on the Nobel Prize for Economics are all about “contract theory”. What is it? Well, it’s all about relationships.
Talking about relationships, Tesco and Unilever are having a tiff in the UK. Is it really Brexit of Marmite?
There’s also few renovations going on in the US with Newell Brands -- a $US25 billion diversified manufacturer, measuring up a deal to sell its tools business to Stanley Black & Decker for $1.95 billion in cash.
Is Michelle Obama trying to tell Hillary Clinton something? The First Lady is making it harder for the next President to rip out her vegie garden.
Donald Trump told voters to “follow the money” as part of his election campaign. The US Government has taken his advice, and sent a letter to the Donald J. Trump Foundation asking it to “please explain”.
But Donald and Hillary seem to have what it takes, judging by their performance at this week’s live Q&A debate.
It’s been another very rough week for Samsung, with the Korean electronics products maker pulling its Galaxy Note 7 phone out of production. It’s a public relations nightmare, and costly too -- the group has forecast a $US2.3 billion drop in third quarter profit.
As you would imagine, Apple is loving the drama. Analysts predict Samsung’s woes will result in millions of extra iPhone sales.
Shane Oliver, AMP Capital
Investment markets and key developments over the past week
- Most share markets (with the exception of Chinese shares) fell over the last week on the back of a some soft US earnings reports, nervousness ahead of a likely Fed rate hike in December as the $US broke decisively higher and as investors fret about a Democrat clean sweep in the coming US election. Bond yields were flat to up slightly, oil prices rose but metal prices fell, the $US rose further but the $A was little changed.
- Seven reasons why a Fed rate hike in December and the $US breaking higher are unlikely to cause a re-run of the market scare we saw late last year/early this year. The US money market is now pricing in a 66 per cent probability of a December Fed rate hike and this is putting renewed upwards pressure on the value of the $US and on bond yields with the latter weighing on defensive high yield share market sectors like REITs and listed infrastructure. While this could contribute to a corrective pull back in shares in the short term, a return to the turmoil seen through the second half of last year and into early this year is unlikely.
- First, the global growth outlook is a bit more positive now.
- Second, there is now a greater level of understanding and confidence that the Chinese Renminbi is not going to crash as the Chinese are targeting a relatively stable trade weighted level for the Renminbi and capital outflows from China have not accelerated.
- Third, last year poor supply/demand dynamics and a rising $US were causing a double whammy for commodity prices, which in turn was weighing on commodity producers whereas now commodity prices appear to have bottomed. This in turn is adding to confidence that the profit recession in both the US and Australia has likely ended.
- Fourth, worries about a $US funding crisis in the emerging world have receded as commodity prices have stabilised and emerging market growth is looking a bit healthier.
- Fifth, the back-up in bond yields is likely to remain gradual as global growth remains subdued, the Fed will likely remain gradual in hiking rates and any handover from monetary to fiscal policy in will also be gradual.
- Sixth, the Fed has made it clear that it is aware of the impact of US rate hikes globally and that a stronger $US does part of its job for its so there should now be greater confidence that it won't just blindly hike interest rates to the point that it threatens US/global growth.
- Seventh, while defensive yield share market sectors may see more downside, cyclical share market sectors are likely to strengthen with this rotation already evident.
- From worries about a Trump presidency to worries about a Clinton/Democrat clean sweep. With the Trump campaign falling into disarray again as his fitness for presidency is once again called into question their support there is now an increasing risk that a backlash against Republicans could see them lose not just their Senate majority but also control of the House of Representatives. Such a scenario would worry investors to the extent that it would make it easier for less business friendly tax and regulation policies to be put in place that might weigh on health, energy and financial companies. The polls are clearly moving in Clinton's favour again, but it’s doubtful that it’s enough to generate a wave of support strong enough to see the Democrats take both houses of Congress. While there is a good chance the Democrats will gain a majority in the Senate (but not necessarily the 60 seat control) it’s hard to see them winning the 30 seats necessary to control the House. Current polling suggests they will pick up only around 10 seats. Sure Obama's victory in 2008 saw a Democrat clean sweep, but back then the Democrats already had small minorities in both houses of Congress which they built on whereas this time around they are starting well behind and don't have the GFC to help them. So while the probability of Clinton becoming president has gone up (from around 55 per cent a few weeks ago to now around 70 per cent), a Democrat clean sweep is possible but I would only raise the probability of it occurring from 5 per cent to 10 per cent. History shows that the best combination for shares is a Democrat president and a Republican House.
- Finally, there is more good news on the commodity price front for Australia with the more than doubling in average coal prices flowing through to coal contract negotiations with Japan. While coal prices may not ultimately settle at current high levels they do look to have bottomed and the rise in coal prices is another sign that the terms of trade and national income have seen the worst. Higher bulk commodity prices if sustained will also see a big improvement in the Federal budget deficit and could eliminate the trade deficit. Given this along with reasonable economic growth and the rising prospect of a December Fed rate hike taking upwards pressure off the $A, the probability of a November RBA rate cut is rapidly collapsing.
Major global economic events and implication
- The minutes from the Fed's last meeting reinforced the impression that the Fed is on track to hike rates in December. But by the same token the minutes were not really hawkish with ongoing reference to "few signs of emerging inflation pressures" leaving the impression that the Fed expects to remain gradual in raising rates. US data releases were inconsequential with a slight fall in small business optimism and a fall in job openings but continuing high levels for hiring and people quitting for new jobs and jobless claims running around their lowest since 1973. Its early days in the September quarter earnings reporting season with only 30 S&P 500 companies reporting so far, but while Alcoa kicked off with disappointment 77 per cent of companies have so far surprised on the upside.
- Chinese export and import data for September were weaker than expected, after several months of improvement. Its a bit too early to tell whether this is a concern. In other activity data power consumption slowed to 6.9 per cent year on year in September but auto sales rose 26 per cent yoy. Meanwhile consumer price inflation picked up to 1.9 per cent yoy mainly due to higher food prices and producer prices rose 0.1 per cent yoy, their first rise in over four years. The improvement in producer price inflation is suggestive of stronger nominal economic growth in China.
Australian economic events and implications
- Both consumer and business confidence are now above long term average levels which is consistent with ongoing reasonable economic growth. Meanwhile housing finance was soft in August which appears to contrast with strong auction clearance rates, but its noteworthy that while auction clearances are high it is on declining volumes so maybe they a not as strong as they appear.
- The RBA’s Financial Stability Review indicated some lessening in concern regarding household debt as lending standards have strengthened and credit growth has slowed but it does appear to be increasingly (& understandably) concerned around the risks flowing from large increases in the supply of apartments. Overall though I see Australian banks as remaining resilient to shocks.
Shane Oliver is head of investment strategy and chief economist at AMP Capital.
- If it wasn’t for the employment data, the economic diary in Australia would be relatively empty. But the importance of the employment data cannot be overstated in the context of the upcoming November Reserve Bank Board meeting. On the global front the focus is very much on the Chinese economic growth figures due on Wednesday. In the US, housing and inflation data will take centre stage.
- The week kicks off in Australia on Tuesday when the Reserve Bank releases minutes of the Board meeting held a fortnight earlier. The Reserve Bank Board may have left interest rates unchanged for the second consecutive month, but there were more changes made to the accompanying statement. So investors are probably hoping that the new Reserve Bank Governor is more forthcoming in providing additional detail on policy discussions.
- Also on Tuesday the Australian Bureau of Statistics (ABS) will recast the industry vehicle sales data, providing seasonally adjusted and trend estimates, while Roy Morgan and ANZ will release the weekly consumer sentiment survey. Households remain relatively upbeat and healthy confidence levels should bode well for the retailers.
- In addition on Tuesday, the Reserve Bank Governor Philip Lowe will deliver a speech at Citi's 8th Annual Australian & New Zealand Investment Conference, in Sydney (8:10am AEDT). Given it will be only the second public address as Governor it will be closely dissected by investors, traders and financial analysts.
- On Thursday, the ABS releases the September employment data. In recent months unemployment has been ticking modestly lower. In fact the jobless rate hit a 3-year low of 5.63 per cent in August. We tip job growth of around 15,000 in the month and the jobless rate to lift modestly to 5.7 per cent. A soft employment result and a super-low inflation outcome at the end of October could open the door for a November rate cut. However the anecdotal evidence suggests spending is lifting across the economy, and coupled with the lift in job vacancies, should result in a lift in hiring in coming months.
Overseas: Chinese economic growth to dominate attention
- There are healthy helpings of ‘top shelf’ economic data in both China and the US in the coming week with a number of speeches by US Federal Reserve Presidents thrown in for good measure throughout the week.
- In the US the week kicks off on Monday, with the release of New York Manufacturing index, US industrial production and capacity utilisation.
- On Tuesday, the US consumer price index (CPI) is issued alongside the NAHB housing market index. The “core” reading of consumer prices (excludes food and energy) may have risen just 0.2 per cent in September to stand 2.2 per cent higher over the year. And while the Federal Reserve focuses on the core personal spending deflator (excludes food and energy), a modest lift in inflation will continue to keep the discussion open on a December rate hike. The weekly data on chain store sales is also released on Tuesday.
- On Wednesday, there are three ‘top shelf’ indicators – US housing starts, building permits and the Federal Reserve Beige book. An encouraging 2.5 per cent lift in housing starts is tipped, while building permits may have edged higher by 1.1 per cent in September after falling by 0.4 per cent in August.
- Also on Wednesday, Chinese economic growth data is issued with the usual monthly readings on retail sales, production and investment. The Chinese economy expanded at a 6.7 per cent annual pace in the June quarter. Predictably growth will ease further in coming years to reflect maturation of the economy’s development. In terms of the other activity indicators retail sales should have continued its run of double-digit annual growth.
- On Thursday, existing home sales, the leading index, the Philadelphia Federal Reserve Business Outlook survey and the usual weekly data on new claims for unemployment insurance (jobless claims) are all slated for release. Overall flat to softer results are expected.
Sharemarket, interest rates, currencies & commodities
- The US earnings season has begun – that is, the time when US listed companies release their latest revenue and profit figures. And yet again analysts are telling investors to brace for weakness. According to the S&P Global Market Intelligence unit, analyst forecasts suggest a 1 per cent annual decline in S&P 500 third quarter earnings – marking the fifth straight quarter of sliding earnings.
- Once again the energy sector is expected to lead the declines, with losses also forecast for real estate and industrial stocks. On the flip-side, materials and financials are expected to see more upbeat results.
- Amongst those companies reporting on Monday is Bank of America, IBM, Netflix, and Hasbro. While on Tuesday, Johnson & Johnson, Goldman Sachs, Yahoo!, Blackrock, Domino’s Pizza and Intel all issue profit results.
- On Wednesday, no less than 100 companies are expected to release earnings including, Morgan Stanley, EBay, American Express, Halliburton and Las Vegas Sands.
- On Thursday, Verizon, Microsoft, and PayPal are slated to report their earnings results. And on Friday, General Electric, McDonalds and Honeywell are amongst those to report.
Craig James is Chief Economist at CommSec.