Fund manager performance: market uncertainty makes for testing times

Although they haven’t exactly broken out the champagne, life has become a lot easier for fund managers over the past 12 months. Janine Mace examines the implications for the future.

After several really difficult years, investment markets have revived and turned in strong performances.

However, the market rallies have contained traps, with some managers failing to read the trends correctly and finding their performance numbers suffering accordingly. 

This has particularly been the case for the managers who failed to predict the market suddenly turning its back on its former resources darlings and continuing its embrace of all things yield. 

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According to Chris Douglas, Morningstar’s co-head of fund research Australasia, the past 12 months have seen very strong market conditions and manager performance, especially since the middle of last year. 

“Most managers have done very, very well, with A-REITs up over 30 per cent, G-REITs up 22 per cent and Australian equities up 20 per cent. We have seen a tremendous tail wind for managers over the past year,” he says. 

Lonsec Research CEO Amanda Gillespie agrees the environment has been much better for investment managers. 

“There have been across-the-board positive performances and in many cases double-digit returns. The results are also very strong for the average diversified growth manager, with a 12.8 per cent performance.” 

Within the positive story, however, there are a number of sub-plots. 

“It’s been a tale of two halves. The six months to September saw low equity returns and better bond returns, but in the past six months, equities and property managers performed well,” Gillespie notes. 

“Within that, the benchmark struggled in the first six months as investors were risk averse, which saw them gravitate to large cap stocks.” 

Much of the turnaround can be credited to events in Europe. 

“This time last year there was a tremendous amount of negative news, but a line in the sand came with [European Central Bank president] Draghi’s comments and markets have risen strongly since then,” Douglas notes. 

He believes it has been a period when selective investors have been rewarded. “It is also a period where diversification really paid off and this is becoming essential for investors. If investors are too wedded to the market, they can lose out.” 

Uncertainty makes for testing times  

Although managers may have had a good year, their performance has been hampered by the continuing global political and financial uncertainty. 

As Douglas notes: “A number of areas have had a big influence on manager performance, such as the Australian dollar being stubbornly high. 

The US quantitative easing (QE) program and almost zero interest rates have also had an influence, as have the conditions in the global economy. The ongoing currency wars are also increasingly influential.” 

James Tsinidis, research manager alternatives at Zenith Investment Partners, agrees the investment environment has had an impact. 

“We have seen a real performance divergence by some managers due to them getting their macro calls very wrong, as the market has been strongly affected by macro influences. Markets have turned on a dime due to things like the European Central Bank announcement and Japanese money printing,” he explains. 

“This has seen liquidity shifting to brand names and established companies both globally and in Australia, usually at the expense of resources stocks.” 

Douglas believes the impact of international events is unlikely to change any time soon. 

“If you think about the Australian sharemarket with its weighting to financials and resources, these are very heavily influenced by offshore events, so they still have a big influence on the direction and performance of local markets.” 

 Yield remains king 

For Gillespie, one of the key determinants of manager performance over the past year has been the demand for yield. 

“Continuing European uncertainty and uncertainty about the unprecedented government activity and low interest rates have meant investors continue to be risk averse and seeking yield in a low growth environment.” 

She believes the current global hunt for yield will continue for some time. 

“The yield curve and ageing demographic of investors both point to a continuing search for yield. However, it doesn’t mean yield can’t get overvalued.” 

Matthew Olsen, deputy CEO and head of manager research at van Eyk Research, agrees the demand for yield is an important influence. 

“We expect there to continue to be a sub-par growth environment, so any stocks offering yield will continue to be bid up.” 

Despite the testing conditions, he believes most investment managers did a reasonable job, with many of the firm’s higher-rated managers doing a very good job. “Our more highly rated managers delivered excess return of 5 per cent after fees.” 

Success this year required active management and conviction about overweight and underweight portfolio positions, he says. 

“In range-bound markets, managers find it tough due to the lack of momentum, but in a rising market they have done a good job in picking performers.” 

According to Olsen, some of the longer-term bets made by managers in 2012 (such as going overweight cyclical stocks), started to pay off late in the year and early in 2013. 

“This is largely due to the global stimulus policies and repair of corporate balance sheets, meaning the level of debt has been significantly reduced by the increasingly conservative position taken by boards,” he explains. 

“In that environment, fund managers are more comfortable in exposing themselves to cyclical stocks due to companies’ more lowly geared positions.” 

The tricky environment saw some strategies prove more successful than others. 

“The best results came from income-style managers, as the hunt for yield was a big theme this year,” Gillespie says. “Geared equity-style managers also did well.” 

Australian equity managers with concentrated portfolios and a style-neutral approach found it harder to outperform the benchmark, “especially if they were benchmark-aware due to the outperformance of the banks, Telstra and healthcare stocks”, she notes. 

Many of the previously successful strategies suffered in the changing conditions. 

“Australian long/short managers also had a tough 10 months as a group, but some lagged as they were defensively positioned,” Tsinidis says. 

Australian equities shine 

Although the local equity market had a good year, with the S&P/ASX 300 Accumulation Index recording a 19.2 per cent rise, manager performance was mixed, with the emphasis on yield making life particularly difficult. 

“We are seeing quite divergent performances and for any area which is seen as having problems, the market has been quite brutal. Some areas have done well and some have been sold off harshly,” Douglas notes.

By way of example, he cites small cap industrials, which were up 14 per cent, while small cap resources were down (37.6 per cent). 

The Australian equity market told many different stories in the past year, according to Zenith Investment Partners head of research, Bronwen Moncrieff. 

“We saw differences in performance between large cap Australian equities and micro and small cap Australian equities, although the average manager outperformed the index,” she said. 

 However, this outperformance was not significant. 

“In Australian equities, our mainstream managers achieved just under 20 per cent and outperformed the benchmark, but not by a huge amount, so the active versus passive debate will continue,” Gillespie notes. 

Tsinidis believes managers have found market conditions tough. 

“This has been an unusual bull market as the rally has been led by defensives and this has led some managers to really getting crushed and their numbers have been weak,” he says. 

Correctly reading the trends has been more important than ever. 

“It has rendered bottom-up research useless, with the manager’s top-down positioning fairly crucial over the past 12 months,” he says. 

“If managers picked the macro trend correctly and were heavily weighted banks, property and infrastructure, and consumer discretionary, they have done well.” 

Often when managers expect a recovery, they go overweight resources and small caps, “but this time it didn’t work”, Tsinidis comments. 

The emphasis on yield outweighed most other factors, Douglas explains. 

“The general theme has been that high dividend paying and defensive equity sectors have done quite well. Within Australian equities, banks and Telstra have done very well as they are high dividend payers,” he says. 

This has made traditional valuation methodologies less useful. 

“The role of valuations is less in this market as some stocks have been bid up quite strongly and we are seeing a huge divergence between income-paying stocks and the rest of the market,” Tsinidis says. 

“Traditional valuation metrics are not as relevant if what is getting valued is yield.” 

For those managers who picked the trends correctly, the results were good, particularly in the small cap area, where the benchmark was down -5.8 per cent, but Lonsec’s manager universe achieved 11.4 per cent. 

International equities rally 

Although not as impressive as the Australian market’s rally, international shares did well in the year to 31 March. 

“There have been a lot of negative stories, but international equities were still up 10 per cent plus in the past 12 months - despite Cyprus and the Italian government problems,” Douglas notes. 

“There were pockets of the market that did quite well. For example, financials in the US was the best-performing sector in 2012, largely due to the Fed’s QE [quantitative easing] program and low interest rates.” 

When it comes to manager performance, international equity managers were broadly in line with the market, Gillespie says.  

“They were good in absolute terms, but most found it hard to outperform. Those with a bias in their portfolio to large caps found that helped and those with a yield tilt also did well,” Gillespie says. 

The most difficult area for international equity managers has been emerging markets. Although Morningstar’s top-rated emerging market fund recorded over 21 per cent, many of the sector managers turned in low single-digit returns and a number recorded negative results. 

“Emerging markets have been the worst-performing part of the market. Over three years, emerging markets are the only one to have had a negative performance,” Douglas says. 

“The fundamentals in emerging markets are still there, but they have got a number of headwinds, with unemployment rising and exchange rate issues from the currency situation.” 

Property and fixed interest 

When it comes to absolute return, one of the big winners was listed property managers, both in Australia and globally.

The Australian index (S&P/ASX 300 A-REIT) turned in a very impressive 30.5 per cent, while the international index (UBS Global Investors NR Hedged A$) hit 23.1 per cent.  

“REITs saw a very strong performance in Australia and globally due to the focus on yield and income-type investments,” Gillespie notes. 

Manager outperformance against the benchmark was less impressive, with the Lonsec’s manager universe adding 0.6 per cent to return 31.1 per cent.  

“Australian property manager performance was in line with the benchmark, but it is a very narrow market and there is not as much opportunity to outperform,” Tsinidis explains. 

“Although global property was up 23 per cent, the managers lagged and have not done as well as Australian property managers.” 

Gillespie agrees performance from the global REIT managers was less impressive, with performance “more in line with the benchmark as global factors overwhelmed them in some cases”. 

Fixed interest once again proved its worth, with the Australian index returning 7.0 per cent and the Barclays Capital Global Aggregate (Australian dollar hedged) index recording 8.6 per cent.  

Investment managers added alpha in both classes, with Lonsec’s Australian manager universe returning 7.5 per cent, while the international managers achieved 10.3 per cent. 

“Fixed interest managers performed well over the year. Those segments that outperformed were credit, emerging markets debt and fixed interest,” Gillespie notes. 

“However, these markets were challenged by the increasing political risk globally, which now needs to be factored into forecasts and included in valuation models.” 

Flat result for alternatives 

In contrast to the performance by property managers, the past year has been subdued for managers pursuing alternative strategies. 

“In the alternatives space, the overall universe was pretty much flat compared to the double-digit returns in Australian equities and property,” Gillespie notes. 

“From our point of view, alternatives have a strong role to play in a portfolio, but absolute returns this year have been disappointing.” 

However, she is unsurprised by the results, as alternatives tend to lag when traditional markets run hard due to their lower level of beta.  

“Some strategies such as CTA [commodity trading advisor] and managed futures underperformed due to the range-bound market, as these strategies perform better in strong directional markets,” Gillespie says. 

“Fund of hedge funds delivered poor returns due to the fact many of them needed to change the mix in their portfolio to offer increased liquidity to investors. Any funds with commodity strategies have tended to suffer as well.” 

Outlook for the year 

When it comes to the next 12 months, Gillespie says she is “cautiously optimistic” due to the pro-growth policies being pursued by most governments, although she believes volatility will persist. 

“Corporate balance sheets are in good shape and a low yield curve environment bodes well for equities in contrast to bonds. We expect global equity interest by investors will increase and we have already seen increases in institutional mandates, especially given the strength of the Australian dollar,” she notes. 

“Fixed interest managers on the other hand, are not expecting as good a year, or as much capital gain. They are expecting more a year dominated by carry and single digit returns. However, it appears the thirst for income looks set to continue for some time.” 

In Olsen’s view, the two big global themes of European austerity and stimulatory policies in the US and Japan will be key. 

“This has enabled fund managers to pick their exposure and identify companies which will benefit from those conditions. However, we expect to see a continuation of sub-par growth and still feel there is a lot of risk in global economies,” Olsen says. 

Equities are cheap relative to bonds in his opinion. “Particularly given the more responsible behaviour by companies, we believe equities offer better earnings potential than fixed interest.” 

The emphasis on buying yield stocks in the local market could end in tears, Tsinidis says. “Some managers are getting concerned about how far prices have run in the quality names and are worried about valuations, but the question is where to put the money instead.” 

Managers feel the heat 

Although advisers are the ones feeling the most heat from regulatory change and structural shifts in the investment industry, fund managers are not immune. The continuing reluctance of investors to embrace risk assets is putting pressure on their profit margins. 

“Funds flow is an issue, as if you are not getting it, it makes things difficult. Funds management is still a profitable business, but in terms of business growth, expectations may not be being met,” Moncrieff says. 

Douglas agrees flows are a problem for managers. 

“Funds under management have fallen by 30 per cent to 40 per cent, but the cost base of managers has remained static. This has led to a lot of competition for investor’s assets. We are also seeing consolidation among industry and other super funds and this is having an impact,” Douglas says. 

Sluggish inflows are largely due to the lack of investor confidence and wariness about risk. “Managers are introducing lower volatility strategies in an attempt to coax investors back into the market,” Gillespie explains. 

“They need to be innovative to bring new products to market and nimble enough to meet investors’ demands.” 

As a result, she expects to see more objectives-based product offerings, such as multi-asset strategies. 

“Managers need to compete with the continuing flows into direct investments such as shares and ETFs [exchange-traded funds].” 

According to Douglas, some managers are seeing inflows due to good performance or tied distribution arrangements. 

“Some boutiques are doing it tough, but some are doing very well. In 2008, we saw a handful close, but many survived as they have a fairly flexible cost base. There is talk again about a lot of pressure on boutiques, but we don’t expect to see closures.” 

While Olsen agrees the odd boutique manager may close, “the ones we evaluate have done quite well. We believe in active management and there are some skilful managers out there.” 

Moncrieff wonders where the pressure on the bottom line will lead. 

“If you look at the Australian equities manager universe, there are around 100 managers and there are a lot of options, so you have to wonder at the viability of that into the future.” 

Tsinidis agrees the current pressure will reshape the funds management industry. 

“It will lead to more ‘haves’ and ‘have nots’, with the bigger managers getting bigger and the smaller ones getting more boutique-like,” he says. 

“Key relationships are even more important in this type of market. If you are on the radar of the big groups you get the inflows and interest.” 

Fees under the microscope 

While inflows may be slow, pressure on fees right along the value chain is getting tougher as well. 

“We are increasingly seeing questions over active management costs and the Future of Financial Advice (FOFA) reforms. The introduction of no payment of commissions is having a major impact as well,” Douglas notes. 

Moncrieff believes the issue of fees is one of the biggest challenges facing managers, partly due to the regulatory and superannuation changes. 

“For financial planners, costs are being pushed down and this is having an impact on investment managers. However, we still see a big difference between institutional and retail fees. It’s not up to retail investors to fund the reduction in fees from the institutional space,” Moncrieff says. 

Pressure on management fees is unlikely to dissipate any time soon, Douglas says. 

“There is much more scrutiny of what managers are doing and the costs.” 

Gillespie agrees: “The fees versus alpha challenge continues, especially in the large cap equities space. There is a very high focus on cost versus performance at the moment.” 

In very efficient sectors such as Australian large caps, questions about fees are being fuelled by the low prices being charged by index managers.  

The idea of using performance fees is even gaining some traction in the retail space, with Solaris Investment Management offering clients investment management services with no management fee and only a performance fee. 

“This is an innovative option and shows a willingness to look at other approaches,” Moncrieff notes. 

Olsen believes the continuing environment of heightened global risk means managers need to consider new ways to attract investors out of cash. 

“One way to deal with it is through performance fees, as fund managers will do well if performance is good. You need to ask if the manager adequately is incentivised to outperform,” Olsen says. 

When fees are under fire, questions about performance take on a new importance - particularly for equities managers. 

“There is quite a lot of change in the market and with performance having been difficult for three to four years, fund managers have found it hard,” Douglas admits. 

Even traditional sources of easy returns have been hard to find.  

“A challenge for equity managers has been the lack of IPOs [initial public offerings] in the past 12 months. There has been an extremely low level of IPOs in the year to March, so there has been less of an opportunity set for managers,” Gillespie points out. 

She believes it will be fixed interest managers’ turn next to face up to some tricky investment problems. 

“The challenge for fixed interest managers is the perception of return-free risk. How this will play out as investors move back up the return spectrum in fixed interest will be interesting.” 

Competition for the talent 

An interesting trend in the investment management space is occurring at the institutional end of the investor market which may make life a little harder for managers. 

“The institutional space – particularly the large super funds – has seen a trend to internalising of fund management capabilities and this is one to watch for the future,” Gillespie says. 

“We may see some competition for talent as pension funds build out their teams.” 

Douglas is more relaxed. 

“We see waves of portfolio manager turnover occasionally – especially in the pre-2008 period – but it has quietened down now. We have seen a few high-profile departures to the industry fund space, but not a huge amount,” he says. 

Olsen believes staff retention is always an important issue to which investors need to pay attention. 

“Fund managers need to retain key people and keep them motivated.”