2015 was a pretty tough market for Australian equities and the benchmark hugging managers that track the various indexes, however, some managers had stellar years, significantly outperforming the market (and with less risk). This was especially so in the absolute return space (long short), but even there, the return dispersion between the various managers was large, and as a segment, there is enormous variance in the strategies and product structures available making it difficult to develop a standardised peer group.
And 2016 hasn’t started any better (the rain in Sydney has been nice though – not), as fears mount about China, energy gluts, geopolitical worries everywhere and the US bull market drawing to a close – but everywhere I go, there is a growing trend for IFAs, using managed accounts, to use 100% ETFs to manage their client portfolios – this strategy, thus, relies 100% on the ICs of these groups to make correct asset allocation calls, as this is the only source of value available to them – how many great asset allocators are there, and do these models just rely on SAA with the occasional tilts or are they truly dynamic? And if everyone is using the same forecasting models, or the same inputs from external providers, then most of these portfolios will be crowded in the same trades, which may result in poor outcomes in times of market stress (like now).
So is it time to reconsider the role of true to label active equity managers in a client’s portfolio, and if so, how might they be used to complement the ETF approach?
My not so academic definition of active management
But before we get there, first a definition of what active management is not.
I do not consider (and this is a non-academic argument), a fund manager who has low tracking error, that hold all the banks, BHP,/RIO and TLS etc, as active. It is not like they can’t see where the risks are in these stocks but they chose to adjust their portfolios only slightly in response; that’s not being active – this is simply an open ended fund’s way of remaining open to new flows, as BDMs seek to gather as many assets possible (rewards are linked to these activities), irrespective of the return impact on end investors – career risk plays a major role here for the fund managers of such funds. And unfortunately, most of the surveys that prove that active managers do not add value, include these type of funds – how can they add true alpha over time in this environment?
The rise of the absolute return managers is cause for celebration given my whinge about so called active managers
Over the past five to six years, a new group have emerged that have some important features (see below) – many are wholesale only but more and more are being offered to retail clients and are available on platforms. Names such as LHC, Totus, Bennelong, Auscap, Wavestone and Winston manager, Monash Investors, are not afraid to deviate significantly from equity benchmarks, holding none of the standard names (potentially shorting them when it makes sense to do so), whilst also having an ability to vary the market beta to manage downside risk or be completely market neutral when it suits. That is, these funds are managed by bright people, generally in two to three person teams, who have the ability truly express their views, using all of the tools that are now available to fund managers – they are not concerned about benchmark returns but in generating absolute returns. Equals, Active.
Features of these absolute return managers/strategies include,
- PMs with high IQs making more right calls than wrong over time,
- PM’s that simply cannot work in large institutions, although many have,
- Focusing on absolute returns and capital preservation and not on relative returns,
- Having mandate flexibility so that they can truly express their views,
- Capping the growth of the funds that they manage to focus on returns and not asset gathering (this feature generally comes with performance fees however),
- Having smaller teams with nimble decision making abilities,
- Not being locked into one rigid investment style, and
- Having the ability to hold cash, futures or by being both long and short to manage risk.
Examples of post fee 12 month returns to the end of November 2015 for some of these managers,
- LHC – 36.2%
- Bennelong Long Short – 32.8%
- Monash Investors – 16.6%
- Totus – 43.4%
- Auscap – 30.6%
- Wavestone – 14.1%
(Source: Australian Fund Monitors)
What these numbers don’t tell you is the above managers’ gross/net exposures, the concentration of their portfolios and other such risks taken to get these results – this article is not for that. It simply highlights that these absolute return strategies have produced very strong after fee returns in what was has been both a very flat and volatile market – all of the above had Sharpe ratios over 1.6 as a matter of interest over the past three years. I also recognise that the above is a ridiculously, and arguably meaningless time period in which to judge a manager/strategy, but I use it to highlight what can be generated when the market returns are so weak. BTW, the three year numbers for the listed managers are also very compelling.
And by highlighting the post fees text in bold, I simply highlight that these funds are more expensive than the benchmark huggers, but investors have been well and truly compensated for the higher fee load. Active management, can justify higher fees.
The non academic but intuitive active test for dummys (that would be me)…
To ascertain whether these new products are truly active though, it makes sense to review the top ten positions versus a standard index before worrying too much about the other features one would expect to see in this space. It is a very rough guide but it is intuitive. To me, if you see the same name as your ETF provider and with similar weights, it might be best that you move on. Often, the large wealth managers launch new products to capture investor demand but their absolute return portfolios can look remarkably similar to their mainstream products – this is not a philosophy but a way to generate sales. Avoid. The absolute return segment is currently dominated by true to label boutiques.
What role might these new funds play?
I have written extensively on the rise of ETFs over the past couple of years – I am a major supporter, notwithstanding the comments made above about asset allocation being the only source of value for those groups using them to manage their clients wealth, but if the so called active managers continue to hug their benchmarks, then they deserve to lose sales to the ETFs (hello disruption). Therefore, the new age funds, could be used to complement ETFs providing ICs with two sources of value (asset allocation (beta) and true alpha) – stock level cross ownership should be low between most of these absolute return funds and the ETFs being used, and they may act as a great risk management tool when shorting is used or when the fund is completely market neutral.
For planners wanting to give their clients exposure to growth assets but with less risk (counterintuitive given how much more flexible the mandates are), the absolute return equity funds might be a place to explore – they are active, and based on the above, are worth the fees. Further, given that most clients have their own direct stocks (my Daddy gave me these BHP shares, and his Daddy gave them to him (said in a Southern US accent for effect) and/or to complement ETFs, these new funds will give them exposures to companies that might be flying under the radar, and/or they may be shorting some of the well known direct stocks, which together, may act as a decent diversifying tool.
2016 – the year to review and change?
If planners are worried about equity market volatility, especially so for pre-retiree and retiree clients but still want exposure to growth assets but with generally less risk, then having some exposure to absolute return managers to complement ETFs and other direct holdings might add a lot of value in time. The research houses have taken on the challenge of covering these new managers/strategies, either as part of their Alts reviews, or as a subset of the equities review – this will assist planners make the right choices, as these strategies can be more complex to explain.
My wish from here, is that as the domestic offerings continue to grow in time, and as planners gain a greater acceptance of these strategies, that we can get similar products for global equities.
Andrew Fairweather, Founding Partner
(Obvious disclaimer – Winston represents two absolute return managers in CFM (Alternative Beta) and Monash Investors (Absolute Return Australian Shares) – hopefully my inclusion of competitors in the above article will ease anyone’s need to vent their fury in my general direction, but feel free if it makes you feel warm and fuzzy).