Fund managers face another tough year

It's been a tough 12 months for fund managers with investor sentiment persistently negative and Australian shares among the worst-performing. Unfortunately, things might not get any easier in the immediate future, writes Janine Mace.

If you’re a fund manager, life certainly hasn’t been all wine and bonuses in recent times.

The past year has proved to be yet another tough one, with investment markets continuing to ebb and flow between renewed optimism and waves of intense market volatility.

A continuous tide of negative news has highlighted that the uncertain conditions ushered in by the global financial crisis (GFC) are far from gone.

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Managers have had to contend with volatility generated by the tsunami in Japan, political unrest in the Middle East, the US having its credit rating downgraded and ongoing concern about European debt.

As Plan For Life's December 2011 Analysis of Retail Managed Funds noted: “Nervous, choppy and more often than not negative investment markets saw virtually all companies report decreases in business.”

In these conditions fund manager performance suffered, with results being all over the park. David Wright, director of Zenith Investment Partners, best sums up manager performance with the comment: “It varied widely and wildly by asset class.”

The volatile conditions made investing extremely challenging. “We kept seeing short bursts of good results – especially in the second half of the past calendar year – followed by down trends,” Wright explains.

Leanne Milton, head of research fund services at S&P Capital IQ, agrees conditions have been tricky. “Fund managers are pretty cautious and it is a very risk-averse environment,” she says.

“It has been a bit of a choppy year due to the overhang of the GFC and the European situation. This led to a lot of volatility and the fear factor in the markets.”

Milton believes global events have been key drivers. “Macro themes have dominated performance – especially China and Europe. It has been hard for bottom-up managers and it has led to a less conducive environment to generate alpha,” she notes.

Asset class performance

The volatility has had an impact at the asset class level, according to Lonsec general manager research Amanda Gillespie.

“In absolute terms, the more defensive-style assets such as fixed interest and income-style products have done better than growth.”

On Milton’s reckoning, the best-performing sectors to the end of the March quarter 2012 were Australian fixed interest, global property and global fixed interest. The worst performers included Australian shares, Asia ex Japan and emerging markets.

However, the 12-month returns mask the volatility within the period. “For vanilla Australian fixed interest and global fixed interest, there was a lot of underperformance in 2011, but this changed in late 2011 and in the first quarter 2012,” Milton notes.

Among the various asset classes, the Australian share market had a rough time of it over the past year. The S&P/ASX200 Index finished the year to 31 March 2012 down 10.4 per cent, with smaller stocks faring even worse.

“Since 2008 it has been choppy and the market for Australian equities has seen two years of negative performance and underperformance,” Milton notes.

Gillespie agrees many fund managers concentrating on the local share market have found the going very tough. “Those managers with a bias towards quality businesses and those with more robust business models did better than those managers with a greater emphasis on valuation metrics.”

According to Milton, investment-style performance in the local market was different to the global experience. In Australia, growth stocks returned -14 per cent, while value shares were only slightly negative, which was the reverse of global equities.

“Growth outperformed value in international equities – especially energy, IT and consumer staples – but in Australian equities, value outperformed growth,” she notes.

At the sector level, performance was mixed. “Telcos and utilities held up, consumer staples were reasonable, while resources, IT, consumer discretionary sand financials pulled back.

"The fund managers’ allocation to these sectors pretty much determined their performance. Those with exposure to defensive stocks have been under significant pressure last year, which has led to performance issues,” Milton explains.

Small cap managers also found life much more difficult over the past year than in 2010, when smaller local resource companies were keenly sought by investors.

The S&P/ASX Small Ordinaries Index posted a return of -11.3 per cent in the year to 31 March 2012, reducing its three-year return to 14.7 per cent.

The top five Australian large cap equity managers rated by S&P were Pengana Capital, Bennelong, Investors Mutual, Sandhurst and Clime. Its best performing small cap managers were again Investors Mutual and Sandhurst, but Aberdeen also performed well.

Balanced and international equity funds

The weak equity markets also made life difficult for balanced managers.

“In the broad universe of managers, balanced managers have been pretty disappointing, with a 1 per cent absolute return to 30 March, 2012. These managers still rely on equity markets, and the Australian equity market was down and global equities were flat, so it held returns back,” Gillespie explains.

When it comes to international equity funds, both macro uncertainties and the high Australian dollar influenced fund managers’ results.

The impact of the rising local currency on manager performance was particularly noticeable, with unhedged international equities returning 0.4 per cent and hedged equities posting a gain of 2.2 per cent.

According to Wright, the big difference in performance on a hedged and unhedged basis highlights the significance of the hedging decision.

“Unhedged has lagged due to the high Australian dollar. There is a strong case for exposure to both hedged and unhedged international equities as currency movements are so difficult to predict.”

Size mattered when it came to global shares. “Large caps outperformed small caps in international equities,” Milton notes.

Among global shares, growth stocks proved to be the best performers, returning almost 4 per cent, while value shares returned -1.0 per cent. This contrasts with the result for Australian equities, where the reverse applied.

According to Gillespie, while the returns from international equities were fairly flat, funds with a defensive skew such as GARP managers did well.

Investors in emerging markets equities were also hit by the volatile conditions, with outflows occurring in most markets. This was due to an anticipated slowdown in growth, weaker export demand and heightened investor anxiety.

“Emerging markets were hit hard and international equity managers with a skew to them were hurt,” Gillespie explains.

Fixed interest

While equities funds have been largely disappointing, fixed interest funds have continued to turn in reasonable results.

This is despite the uncertainty characterising the second half of 2011, which was sparked by the US credit rating downgrade and European sovereign debt concerns.

These events resulted in a significant ‘flight to quality’ in government bonds and a subsequent negative movement in spread-related sectors.

Despite this, Gillespie points to some good results. “Equities were pretty weak, but fixed interest still performed last year. Diversified fixed interest did 8 per cent,” she says.

“In an absolute sense they did very well, generally in the order of 8 per cent to10 per cent, and this is on the back of strong returns for several years.”

Wright agrees: “Some of the performances by bond funds have been the best among the asset classes.”

However, several factors made it a “challenging year” for fixed interest managers, particularly the ongoing concerns about sovereign debt issues, he says.

Gillespie agrees there were market dynamics holding back some managers. “In a relative sense, active managers found it harder to deliver alpha due to the really stretched valuations. This led them to be positioned with a short duration focus, but yields have continued to grind lower and this surprised many people.”

Property and alternatives

Property funds have also had a hard time of it.

“REITs have been the forgotten asset class since the GFC, both internationally and in Australia,” Wright notes.

“They have not been included in portfolios since the GFC, but global REITs are a pretty attractive asset class as they combine rapidly emerging REIT markets with the Australian and US markets.”

In performance terms, many have also done well. “Global REITs in an absolute sense have had better returns than term deposits,” he notes.

Gillespie agrees with this assessment. “Global property did very well and the index was up 4.5 per cent on the year to March 2012. It was the best performing market in the growth sector. In a relative sense, property has done better than equities.”

She believes changes in the local REIT market also had an impact.

“The managers that have done well are quite benchmark-unaware and were underweight the retail sector, which is not surprising given the well-known problems in retailing,” Gillespie notes.

When it comes to alternatives funds, manager performance has been as variable as in other asset classes.

“It is such a diverse universe, performance is very difficult to compare. In the Lonsec universe the equities market had a significant impact,” explains Gillespie.

“Funds that suffered most were the commodities-based funds and they were down double digits. The worst performing were the commodities and event-driven funds, and the best were the managed futures funds as they are very diversified across a huge number of positions.”

The top five performers rated by S&P in the alternatives space were Aspect, Platinum, Wingate, Regal and Acadian.

Key challenges for fund managers

Investment market conditions aside, the biggest issue for fund managers has been, and continues to be, fund flows. As Milton notes: “Retail flows are the number one issue, especially given the cash rates.”

The sustained high rates and perceived security offered by bank deposits have made life very difficult for fund managers.

“Investors are really risk averse and they have got good relative performance from cash and term deposits, so there have been very little flows into fund managers – especially equity products,” Milton says.

The Plan For Life report found total funds under management in retail managed funds fell 5.1 per cent to $487 billion in 2011, down from $513 billion in December 2010. Gross inflows for the year totalled $166 billion, which was down slightly year-on-year (-2.1 per cent).

According to Plan For Life, the managers with the best flow results – or lowest percentage falls – were BT (-0.2 per cent) Mercer (-2.1 per cent) and AMP (-3.9 per cent), while Perpetual (-11.8 per cent), Macquarie (-7.9 per cent), OnePath (-7.7 per cent), IOOF (-7.4 per cent) and National Australia Bank/MLC (-7.2 per cent) reported steeper declines.

Wright believes these figures highlight the significant problem facing the local industry. “There is a major challenge in the lack of new investment flows, even for managers that are doing well,” he says.

“Inflows are mostly coming from winning business from other managers, but we are not seeing new inflows of money. This is the biggest issue at the moment.”

He believes investor uncertainty about re-entering investment markets is likely to continue for some time. “A lot of investors are sitting on their hands waiting for it to get better, but if they are waiting for a bull equities market, that is a very optimistic view,” Wright says.

Gillespie is another who views the situation with concern. “Managers are finding it really tough to increase funds under management, and this is symptomatic of the investment environment generally and also a reaction to the volatility and magnitude of negative returns in 2007-08.”

Inflows are also needed to ensure open funds grow and do not stagnate or shrink.

“A lot of good funds – even those where performance is good – have long vintages, and some people always need to get their money back due to deceased estate payments or other personal circumstances. So funds need inflows to match those payments,” Wright notes.

Business issues build

The continuing lack of inflows is creating real business issues for many fund management houses.

“With managers struggling to get inflows, it places pressure on performance fees, and businesses based on that are finding things difficult,” Gillespie notes.

“We are keeping an eye on managers with a focus on those with a less diversified business model – for example those with a focus on a single asset class – as this may represent a higher business risk.”

The pressure is particularly acute for boutiques.

“Some boutiques are under pressure and we are starting to see some mergers and acquisition activity. Boutiques have proliferated over the past five to seven years – especially in Australian equities – and if they have a lack of working capital, this will lead to some consolidation,” Wright explains.

Milton agrees the current environment is less friendly for boutique managers. “It is leading to difficulties for boutiques and especially Australian equity small cap managers, which is traditionally a very competitive space.”

However, they are not the only ones suffering. “With fixed interest funds, no-one is getting inflows either,” she says.

Gillespie believes managers are being tested due to a range of factors. “The trend to direct is having an impact and also the popularity of ETFs,” she notes.

“Regulatory change is having an impact and this is seeing some firms reconsider their business model, and costs are becoming more of a focus.”

Staff turnover also remains an issue, particularly in the small cap universe. However, most experts feel the lack of inflows is more of a headache at the moment.

“Personnel changes have traditionally proved to be a persistent feature of the smaller cap universe, as talent looks to move if not sufficiently tied-in to overall business profitability or appropriately compensated,” says Lonsec senior investment analyst Sam Morris.

He notes Lonsec recognises key person risk as a prevalent risk factor for many of the quality small cap funds, as successful performance in this asset class “is highly dependent upon the investment skill and experience of key individuals”.

New investment approaches

The problem of reluctant investors and stagnant fund flows is starting to see questions being asked about where the industry goes from here.

“Managers need to think about whether they evolve their processes or stick with the traditional model,” Gillespie notes.

“They need to make their processes robust, but they also need to think about how the market is evolving and what investors want.”

She cites the emergence of real return or objective-based multi-asset funds as evidence firms are recognising they may need to change if they are to lure investors back into managed funds.

“We have seen a shift to a preference for managers with flexible mandates, an emphasis on absolute return and a focus on capital preservation. The trend towards more objective-based style funds represents an important shift in the market,” Gillespie argues.

Managers who launched new multi-asset real return funds did well last year, she says. “They did better as they had more scope to spread risk due to their more flexible mandate.”

Although some managers with a dynamic asset allocation model also did well, those with a “more traditional strategic asset allocation focus tended to suffer due to the equity market’s performance”, Gillespie notes.

Milton agrees current conditions are giving rise to fresh approaches. “We are seeing new Australian equity large cap strategies with a higher tracking error appear.”

She believes the focus on capital preservation and absolute return represents a significant shift.

“It is all about what kinds of investment will beat cash and we are seeing greater interest in alternatives, such as global macro, CTA and other alternative strategies. Multi-sector is also making a comeback.”

Active versus passive

One investment debate that never seems to be resolved is the issue of active versus passive.

Despite claims volatility creates a stock picker’s paradise, passive managers have done well in recent times. As Milton notes: “We have seen a lot of inflows into passive managers as it has been difficult to pick managers that will outperform. Investors have been doing that because they are tired of trying to pick active managers.”

Wright agrees: “There has been a massive switch from active to passive since the GFC. It happens after every major market event, but this time it is exacerbated by the regulatory reviews and people looking for lower fee options.”

He believes it is a temporary phenomenon.

“The quality active managers have come to the fore since the GFC, as index managers usually perform better in a bull market. Pre-GFC it was hard for managers to differentiate, but in the environment since then, quality active managers have been able to differentiate and there has been greater transparency of skills,” Wright says.

One aspect of the debate that has been highlighted by recent conditions is just how ‘active’ many active managers are in their investment processes. Research released by Morningstar last year found Australian large cap share funds were “among the least active globally relative to other single-country and international share funds”.

Wright points to Platinum as an example of a manager who has gone through a difficult patch due to its active trading strategy, but says this shows it is “truly an active manager, which is what you pay for”.

What’s ahead?

Although the going has been tough for managers over the past few years, conditions do not look set to get any easier.

Wright believes it will continue to be a challenging environment for some time and Milton agrees. “We expect a heightening level of volatility and uncertainty in the next 12 months,” she says.

The March 2012 Financial Services Council Chief Investment Officer (CIO) Investment Index noted a similarly cautious view by CIOs in major management houses such as Blackrock, BT, Perpetual and Schroders.

Overall manager confidence had slipped from the December 2011 result, although the positive view towards Australian equities had firmed. However, sentiment towards international and Australian fixed income worsened sufficiently to drag down overall sentiment.

When it came to the outlook for the various asset classes, the FSC report found CIOs expect Australian and international equities to outperform other asset classes in the next 12 months, while views on domestic and international property were mixed.

Wright believes this caution reflects the genuine concerns that remain. “Europe has not played itself out fully as yet, and once the outcome is clearer people may begin to focus on the US debt problem, so the situation will continue for a while.”

Milton believes local equities are facing headwinds.

“The Australian economy will grow at a weak pace due to the high dollar and slowing economy and house prices. Equity managers remain cautious despite equities looking cheap on most measures, with a slowdown in Chinese commodity demand a key risk looking forward.”

She says in this environment equity managers will look for companies “with sustainable and quality cash flows when looking to invest”.

The outlook for international equities is mixed. “The global developed markets look cheap on long-term measures, but emerging markets not so much on the long-term figures,” Milton says.

Wright agrees, but believes there will be investment opportunities. “We are not too pessimistic as there are a lot of positives coming out of emerging markets. In China, Brazil, India and Eastern Europe there are pockets of good growth, and Australia is highly leveraged to that through resources.”

He believes this means investors will need to use active managers to avoid the potential problems. “We are not going to be experiencing a strong double-digit growth environment for a long time, but we expect to see single-digit growth in most asset classes,” Wright says.

“However, this presents an opportunity to use alternative and new strategies which have performed well, such as CTA and global macro strategies. A low-return environment means people will seek out alternative sources of return, and we see that as a good thing. It means people are not relying on bull equity markets for returns.”

Gillespie agrees the changed conditions will see new investment approaches flourish. “The volatility will continue, but this brings with it opportunity, and managers with more flexible mandates may be able to take advantage of that,” she says.

“We also expect to see a continued challenging of traditional portfolio construction styles and an ongoing debate about the suitability of active versus passive.”