Our team conducted 105 fund manager meetings between June and November 2019. Market volatility, valuations and heightened geopolitical uncertainty dominated conversations. We met with managers from all asset classes who were confronted with slowing global growth and inflation, negative bond yields and record low interest rates.
The difficult macro environment has divided the investment community. An interesting observation is that the equity managers have become more defensively positioned whilst the bond and credit managers were taking on more risk. Despite the uncertainty global equity markets have continued to make new highs; credit spreads are relatively low, and earnings have held up relatively well.
Through these meetings and further research, we have made the following changes to our portfolios. We have added an Australian equity manager, a global government bond manager and an infrastructure manager. We have removed a domestic government bond manager.
Manager Research Overview
Using our research framework which focuses on people, processes, business model, performance, and alignment, we reviewed managers during what remains an interesting time for active managers.
In our June review we highlighted the lack of strong conviction in most managers outlook of the economy and this trend has largely continued. It was evident that there was a rotation into high conviction quality stocks across our equity managers and an increasing allocation to riskier segments in a search for yield across our defensive government bond and corporate debt managers. Whilst most managers were positive on the economic outlook, they acknowledged the market backdrop has changed and were mindful of how they reflected their expectations in fund positioning.
The recent months have provided a great opportunity to assess managers ability to adhere to their process, maintain conviction and manage risk. We are pleased to invest with several active managers that have navigated these conditions successfully, with 75% of the active managers we invest in outperforming their benchmark over the last 6 months, compared to 55% of the active managers we monitor closely.
Asset Class Investment Review
As you can see, the average annual return from 1979 to 2018 has been 11% p.a. However, someone beginning their investment journey in 2007 on the premise of the long term 11% p.a. return but then only achieving 3% p.a. over the next 10 years, may indeed wish they had opted for a different asset mix given the coming volatility in equities. The severely negative returns through the financial crisis in 2008 get completely swallowed by average returns over long periods. While this supports the argument to stick with it in fear of making the wrong decision at the wrong time, it doesn’t make the person in question feel any better about their actual experience.
Of course, we cannot predict the future of markets any better than the next person and we don’t try to. We do however know that recommending to our clients a static asset mix based on long term average returns simply doesn’t reflect what their actual experience will be like. Instead of being put in a static box of defensive, balanced or growth for example, most clients we speak to want to take risk when it’s going up, and take chips off the table when it’s not. It’s common sense.
Over the last 6 months central banks have eased monetary policy to arrest flagging economic growth. This policy accommodation has pushed developed market bond yields lower (bond values higher), which saw the sector experience the fastest rate of inflows since the financial crisis.
Active duration management, a measure of bonds sensitivity to changes in interest rates, was key to government bond managers performance relative to the benchmark over the past 6 months. Many managers struggled to keep pace as they were not positioned to benefit from a sharp decline in bond yields. We met with several active government bond managers to try to understand how they were positioned in this challenging environment and if they had made any significant changes. We did notice some managers trying to enhance their return potential through increasing allocations to emerging market government bonds where real yields are still positive.
Domestic bond managers fared better than our global bond managers with most still struggling to beat their benchmarks. In our database of Australian Bond managers 16 out of 26 (62%) active managers beat the index compared to 4 out of 20 (20%) of the international managers.
Over the quarter we exited a domestic manager after double digit returns and added a global manager offering higher yields.
There was a similar search for yield rhetoric from our corporate debt managers who were also faced with yield compression as base rates have fallen and credit spreads continue to compress.
There have been some specific defaults in segments of the market exposed to the slowdown in global manufacturing but not an overall deterioration in borrower quality. The managers we met with remain wary of risk in pockets of global credit markets, particularly the lower grade, less liquid segments of the market but so far overall serviceability and liquidity remain strong.
Our international corporate debt managers are also becoming increasingly opportunistic, allocating to ‘non-traditional’ opportunities within emerging markets, as their portfolios are reflective of expectations of global growth resilience. Our domestic managers continue to hold a higher level of portfolio risk but are focusing on balance sheet health, cash flows and corporate profitability.
The Australian equity market reached 12-year highs over the last 6 months, supported by record low cash rates, high iron ore prices and federal income tax cuts, providing stimulus to Australian businesses and households.
Many of our Australian equity managers have sighted that low bond yields have driven up valuations with every sector in positive territory over the year. The reasoning was that despite weak growth, the cost of capital is low and the relative value of equities over cash is elevated and could support higher valuations.
Only 17 out of 90 (19%) of the active Australian equity managers on our database have beaten the index over the last year. Due to this underperformance, we continue to favour passive large cap strategies and active managers for small and mid-cap Australian equities. However, we have added a large cap active manager due to a favourable fee structure charged only for outperformance.
Investing in a period characterised by significant uncertainties, global value chain disruptions (through rising tariffs), and dampening global growth has arguably made security selection increasingly important for international equity managers. Whilst managers have had several things to worry about over the past 6 months, the reality is global equity markets continue to hit all-time highs
International equity managers who have been exposed to growth stocks have continued to outperform value focused managers, despite the sharp rotation experienced in September Variable beta managers (adjustable exposure to the market) who lacked conviction on the outlook 6 months ago, have started to increase their exposure after lagging in performance of their long only peers. A total of 42 out of 85 (49%) managers have beaten the index over the last 6 months, with a large percentage of the variable beta mangers underperforming.
Despite discussions around the relative value in some regions, namely Europe and emerging markets, we haven’t noticed any discernible geographic changes within the managers we monitor. We did however notice that the growth managers who have experienced solid returns have broadly capitalised on the performance of some of their stocks and rotated into more defensive names.
We continue to prefer the international managers who hold a concentrated selection of high-quality businesses.
Listed infrastructure has rallied significantly this year, as the sector continues to be a beneficiary of low bond yields and investor demand. This was one sector where active management outperformed over the year with 9 out of 12 (75%), of the active managers we monitor outperforming the benchmark.
Of the managers we met with in the listed space some sighted unique opportunities in quality infrastructure assets that have depressed valuations due to geopolitical issues. One topical issue has been Brexit with UK labour party talks of nationalisation of assets which has led to a sell-off in UK listed infrastructure.
We are cautious of the valuations within infrastructure but see merit in the benefits they provide a portfolio through diversification, low correlations to other asset classes and lower volatility. We tilt towards favouring unlisted infrastructure where volatility is low, and investors get access to large stable assets that provide essential services.
Real estate managers have seen some of the largest returns over the last six months. Tailwinds from falling interest rates and strong tenant demand in residential real estate have overshadowed the headwinds faced by retail store tenant demand and social unrest in Hong Kong.
Whilst most managers have had solid returns there have been some growing concerns for parts of the industry The aggressive expansion of co-working office space provider WeWork, induced volatility to global office markets when they pulled their IPO over concerns around their business model.
On the whole, the managers we met stated that operating fundamentals for global real estate remain sound.
This year has seen the closure of several absolute return equity strategies and unconstrained global macro managers as they failed to navigate the current environment, with large divergences in returns across trend following or momentum-based strategies. We continue to hold an allocation to two managers, who have been more adept in this difficult environment.