One manager’s noise is another manager’s music

After three successive negative years in global equities, many investors are feeling the pain. Global equities have increasingly become a larger proportion of an investor’s portfolio with balanced and growth funds now allocating up to around 25 per cent in global equities.

For Australian investors, the pain has been compounded more recently by the increase in the value of the Australian dollar against many of its counterparts, particularly the US dollar.

Twelve months ago the Australian dollar was trading at approximately 20 per cent lower than where it is today, at around $0.615 to the US dollar.

This impacts many global investors as they are not protected from the change in currency fluctuations unless they protect themselves from currency moves, or the fund in which they invest actively manages currency changes.

However, the bear market isn’t necessarily a bad event for everyone.

One’s misfortune may be another’s opportunity. Certain global equity managers have proven an ability to generate positive returns from falling stocks, writedowns, mismanagement and disappointing earnings. It’s the ability to look outside the box and take advantage of a number of strategies available in the market place to generate returns.

One strategy includes holding large cash balances in the absence of opportunities or clear ‘buys’. Alternatively, short selling can be much more effective — the process of selling a stock today in anticipation of buying it back at a later date, cheaper.

In this challenging environment, managers ought to adopt a more agile investment approach than traditional money managers typically do. They must be flexible and shouldn’t invest for the sake of being fully invested. Nor should they have to own index constituents for the purposes of benchmarking — own a stock because you like it on a valuation basis.

For managers with a more nimble approach, companies releasing bad news or experiencing downgrades or write-offs can be a rewarding experience. Funds can take advantage of this type of information by using short selling strategies.

Managers who can short sell still undertake the same fundamental analysis on a company as traditional managers — the key difference is that if a traditional manager doesn’t like a company/stock for certain reasons, they typically don’t buy the stock or will be underweight, whereas the managers with the flexibility to short sell can profit from selling the stock for exactly those reasons.

Why own a company trading on a high growth price/earnings (PE) ratio when there’s no growth, or growth is contracting? A different approach is to sell the stock until it becomes more fairly valued.

Traditional managers are restricted to investing long, and tend to do one of two things on companies releasing bad news — first, hope they don’t own the stock, and second, they sell the stock — often at a loss.

To recover the losses from three successive negative years the S&P 500 Index needs to achieve a return of more than 50 per cent this year to reach pre-2000 levels.

There’s a lot to be said about the benefits of compounding. The ability to consistently generate a positive return year after year is very powerful.

Investors chasing returns often buy the high and sell the low, and this introduces the element of timing the market. It’s a simple principle, but often overlooked — when an investor invests say $100, if they lose 10 per cent in the first year, they need to make more than 10 per cent in the next year to get back to level.

In an environment where household names like Intel, McDonald’s, IBM, AT&T, Microsoft and Disney experienced double digit falls last year, and seven out of the top 10 performing stocks on the Dow Jones Industrial Index made a loss, it’s very hard for long-only managers to make good returns. Long/short managers, on the other hand, have the flexibility to make money in this environment.

This is confirmed by the fact that the leading global equity funds in 2002 had the ability to short sell, while most international funds and indices were negative. This result is largely attributable to a flexible investment approach that includes short selling. The prevailing market noise bodes well for this strategy.

Investors have learnt that it’s no longer good enough for a manager to say we beat the index when the index is down, say, 10 per cent and the manager is down 6 per cent.

Glenn Poswell is senior portfolio manager with DeutscheBank Absolute Return Strategies team.