Hedge Clippings | Friday 25 October, 2019

Equity Returns - are investors expecting too much?

An article published in the business section of the ABC News website on Thursday provided an insight and research into investor's expectations of annual returns from the share market.  Australian investors at 10.7% came in around the global average of 10.9%, while American investors at 12.4% were more optimistic, and Europeans were more cautious at 9% (understandably, in Hedge Clippings' opinion).

The article quoted Sally, an investor who, having been invested in the local market via ETF's for the last 18 months, is happy with her return of 9% but would like a little more - in line with the survey results. With interest rates and returns on cash at close to zero, or term deposits at 2% if you're lucky, we understand the attraction of equities at around 10% plus the potential for some franking credits.

Our concern is that Sally (and others) haven't factored in equity risk, and the potential loss of her capital. Has she been lulled into a false sense of security by a market buoyed by low interest rates, and marketing of ETFs and passive investing at low fees?

Taking a look at the ASX200 Accumulation Index, she's on track over 5 years, and the same over the longer term, 25 years. However, her risk is hidden in the 1 to 5 year returns:

The sting, of course, is in the tail, or in this case the GFC, which some might consider a one-off event. However, the market fell around the same amount in 1987, and while the trigger might have been different, the pain was the same.

Those in favour of index investing and ETF's can and will say you can exit when you want to, but will Sally know when to do so, particularly when everyone else, including mutual funds, are doing the same?

So, how have actively managed equity funds performed over the same period? Taken as an average, as follows:

Whilst the may have underperformed over the shorter time frames, the key is the reduction in risk, as shown by the maximum drawdown of -23% in the GFC.

That's the average of all equity-based funds in AFM's database, but using the old "head in the freezer, toes in the oven = average" analogy, what about the top tier funds:

Of course, selecting the top funds - which can vary over time - is not easy. However, careful research, and appropriate diversification across manager, strategy, market sector and geographic region could provide Sally with attractive returns without the same level of risk.

Hedge Clippings | Friday 18 October, 2019
 

Hedge Clippings | Friday 11 October, 2019
 

Diversification - the key to good performance and reducing risk.

Given the overall sideways nature of the market (albeit with some day to day volatility) and the dominance of the top 20 or 50 stocks, outperformance is likely to come from stock picking at the smaller end of the market.

While it's early days for September fund performance, with just under 20% of funds having reported to date, at first glance those funds focusing on the small cap end of the market provided their investors with some stellar returns last month. While the ASX200 accumulation index returned 1.84% for the month, a number of funds returned over 4%, with the top 3 to date, Bennelong's Emerging Companies Fund, Cyan's CG3, and Celeste's Australian Small Company's Fund reporting 9.92%, 8.62% and 5.40% respectively.

Obviously one month's performance is not an end unto itself, and a longer-term analysis is required, but with the ASX200 up around 12% over 12 months - assisted by falling interest rates - 15% of the funds in AFM's database are outperforming, and within that group some returning over twice that amount.

Regular followers of Hedge Clippings would know that our preferred approach is to invest in funds by creating a diversified portfolio of funds, thereby reducing risk without necessarily reducing performance. In fact, by selecting funds with a low correlation to each other, performance can actually increase whilst volatility, and risk of capital loss, decreases.

Going forward we will be discussing this - with examples - in more detail. Watch this space.

Hedge Clippings | Friday 04 October, 2019
 

A predictable week that was.

If Hedge Clippings ever placed a bet on the week's news, this would have been the one to make a motza from the bookies. After all, everything that occurred over the past week was pretty predictable.

Firstly, the RBA cut rates by 25bps as expected. OK, that was pretty easy, and we only came across one person (no names, but they'll know) who thought they wouldn't. Not only had the RBA's governor hinted strongly that they would, but all the economic indicators, both here and overseas, were pointing in that direction.

Next, the big four banks elected not to pass on the full 25bps to borrowers. Then both the Treasurer and the PM got stuck into them for not doing so, while the opposition jumped on the bandwagon to criticise the government. Three out of three, we could have taken out that trifecta with our eyes (and ears) closed.

However, spare a thought for the banks for a moment (we know, that's not always easy, and not predictable). Not passing the full cut on when rates are 1% was never going to happen simply because only a portion of their funding is tied to the RBA's cash rate. According to the AFR, 60 - 70% comes from deposits, including some on which the term is fixed. And for that portion which is in non-interest-bearing transaction accounts, their margins are being squeezed further.

Offshore was just as predictable. China put on a show of military goose-stepping force not seen for 75 years to celebrate the 70th anniversary of their "glorious" revolution, while the protesters in Hong Kong carried on protesting regardless.  

Trump continued to tweet against the injustices of the Democrats and others, claiming he should be impeached or worse, while Boris continued to defy Europe, Jeremy Corbyn, and a fair section of his own party (plus the Speaker) - all of whom he couldn't give a toss about.

Finally, to the sporting field. Richmond flogged the Giants to such an extent that spectators should have asked for a refund on the price of their tickets. We might be biased, but that was mighty predictable as well.

The Wallabies made life difficult for themselves (something they've become experts at over the past few years) by selecting a goal kicker with a success rate this season of just 56% and losing a winnable match against Wales. While not totally predictable, sadly very familiar!

But then, against all the odds, we would have blown all our winnings backing Ireland against lowly Japan, who were inspirational, producing some of the most entertaining rugby seen for a while. Just as well we hadn't placed our bets - or collected our winnings - from the other un-losable wagers.

Hedge Clippings | Friday 27 September, 2019
 

Political intrigue and change seem to be occurring so frequently, and so rapidly, that it's difficult for Hedge Clippings to keep pace.

It was less than two weeks ago that the drone strike on Saudi Arabia's oil facilities knocked out 50% of production overnight, causing a near 20% spike in the price of crude as a result. That had the world on edge and wondering about the potential for renewed conflict in the Middle East, and the potential for Iran's war of words with the US to escalate to military conflict.

That would certainly damage world oil supplies. However the US has a vast oil inventory to last 700 days - plus over 8,000 new shale oil wells that had been drilled, but not yet completed - in other words, additional supply which could come online rapidly if required or when/if prices made it economical to do so.

Not so Australia, which has a minuscule stockpile by comparison. In spite of the International Energy Agency (IEA) mandating that countries stockpile 90 days' worth of crude oil, based on current consumption trends we have just 32 days of total petroleum stocks, 28 days of petrol, 30 days of aviation fuel, and 22 days of diesel.

Of course, there is nothing to say that military action won't occur, but one would hope that all parties involved recognise the risks of that happening.

Key to that must be Donald Trump, never far away from political change or intrigue, who seems to be busy fighting battles over his tax returns, plus his more recent phone records with the Ukrainian government. One hopes he'll be sufficiently occupied with those minor issues and not looking for a distraction on the global stage.

And while on the subject of political change or intrigue, this week's antics of Boris and the UK parliament really must take first prize. It seems somewhat fitting that England is the home of the pantomime. No doubt the musical Boris will be opening in the West End shortly, or maybe they'll just relocate an orchestra to Westminster.

And through all this our own ScoMo seemed to be having a dream run on the world stage. Having enjoyed a State dinner as the guest of the President at the White House, and patching up Malcolm's unfortunate phone call, he even managed to defuse or sidestep the criticism of a Scandinavian teenager.

Having had the turmoil of successive prime ministers from both sides of politics, no doubt it was Australia's turn for some political stability.

Hedge Clippings | Friday 20 September, 2019
 

Aside from anticipation surrounding the start of the RWC which kicks off this evening with Japan* taking on Russia, prior to the Wallabies taking on Fiji tomorrow, there hasn't been much of note this week...

Not much? Boris and Her Majesty the Queen (fresh from being embarrassed by former PM David Cameron's latest gaffe of actually opening up on their private conversations) might disagree, as might the Saudi's oil industry. Then again, the US Fed did drop interest rates by 25 basis points - as expected - and Australian unemployment crept up to 5.3% in August from 5.2% the month before, and 4.9% in February, increasing expectations of a further rate cut when the RBA meets in a couple of weeks. Overseas it was announced that globally negative yielding debt has now reached a peak of US$17 trillion, up from $10 trillion at the start of May.

As we have discussed before, whilst erring on the side of caution, given the current outlook for the bond market it is unlikely that the current equity bull run is likely to end. Interest rates are falling and unlikely to rise any time soon, and there's no sign of wages lead inflation or, if it comes to that, any other kind. Although kindling a fire under inflation that any increase in oil prices might create, it is much more likely to add to the potential of an economic slowdown - which would merely trigger calls for further easings in monetary policy, and fiscal stimulus.

Once again we quote and defer to commentary from Longview Economics and their excellent weekly research, who also agree that in the absence of any macro shocks, this bull market looks set to continue, despite some near term challenges for earnings growth. Added to which, they add, Trump's recent comments about a 'halfway house' type trade deal with China, plus his sacking of his most hawkish adviser, and his suggestion of a middle class tax cut, all point to a president who is increasingly focussing on re-election (and, given how he regards it as his key barometer for success, focussing on getting the stock market up).

*For those interested in tonight's team selections, here's the Japanese line up:

Hedge Clippings | Friday 13 September, 2019
 

Hedge Clippings attended two very different but equally interesting presentations during the week, one being Livewire's "Live 2019" event, which brought together a range of "best in breed" active fund managers presenting their views on the current market, and sharing some of their wisdom and best ideas.

The event kicked off with a debate between opposing teams who were either in the "risk-on" or "risk-off" camp, a highly topical subject given that irrespective of their view on the length or strength of the current bull run, even the "risk-on" advocates were quick to point out that there are significant risks in the current market.

Managers including Totus Capital's Ben McGarry, Perpetual's Anthony Aboud, and Philip King from Regal Funds Management were of the view that whilst the current market may continue for some time, and where "value" investing is out of favour, specific sections of the "growth" stocks were shaping up as one of the great shorting opportunities.

Overall, the consensus was that interest rates are going to remain at these levels (or lower) for some considerable time. In fact, it was difficult to find anyone who was prepared to predict not only when interest rates may rise, but what factor may be responsible for their doing so. As such it was difficult not to argue that equity markets as a whole would benefit as a result. However, there was some concern (shared by Hedge Clippings) around ETF's and index investing: Firstly, that the rising tide effect lifts all ships, or all stocks if they're part of the index, irrespective of their quality, and secondly that any significant exit from ETF's in the future would lead to a snowball effect.

Of particular interest were two specific sessions, one an interview with Scott Nuttall, Co-COO of US-based global private equity giant KKR, and the other a Q&A session with Magellan's Hamish Douglass, and Platinum's Andrew Clifford.

The second presentation we attended was from Winton Capital Management, the UK-based systematic manager founded in 1997 by CEO and co-CIO, David Harding, following 10 years running AHL using similar statistical and mathematical systems to provide diversified returns trading futures markets.

Winton employs significantly complex trading strategies, backed by large numbers of significantly intelligent "quants", no doubt with buckets of PhD's amongst them. What was interesting in David's presentation was that issues such as risk on vs risk off, growth vs value, or the overall macro view of the world which were debated at length at the Livewire event, didn't really come into their processes at all. Instead, Winton's approach (borrowed from their presentation material) is that their "investment decisions are driven by the empirical analysis of data rather than opinions based on economic and financial theory."

Over 30 years since founding AHL, and subsequently Winton, David's success is undoubted - not only in building a significant global business, but also being financially successful enough, as a result, to have generously, with his wife Claudia, joined the Giving Pledge, a commitment to give away more than half their wealth during their lifetimes. 

We are not espousing quant versus discretionary managers or vice versa (although we are not great fans of index investing for the reasons stated above) because each have their place subject to performance. In fact, without the discretionary managers, and other discretionary investors, the market probably wouldn't have the deficiencies such that quants such as Winton would be able to implement their super smart algorithms.

Hedge Clippings | Friday 06 September, 2019
 

"Good start, Boris!" 

Not our quote (unfortunately), but a heckle from across the floor this week as Great Britain's latest Prime Minister lost not just one, but two crucial votes, plunging the country - and potentially Europe with it - into further confusion. What happens now is anyone's guess, although Boris, while understandably angry, didn't seem to take a backward step. Neither did he seem to flinch when his brother resigned from parliament. One gets the impression that Boris isn't phased by much, but he can't even organise the election he wants, unless he possibly moves a vote of no confidence in his own government.

Watching Boris and the debate on the nightly news, or YouTube, would be entertaining if it weren't so sad. What is really interesting is watching the UK speaker, who is possibly more entertaining than Boris himself. To think that it was only a few years ago that our British friends were suggesting that Australian politics were a little tumultuous! It has almost forced Donald off the front pages, although we doubt that will last for long.

But back to reality - if such a state really exists. The debate between proponents of growth vs. value investing continues, even as value seems to be an old fashioned and out of favour concept. In August the ASX200 total return ended a volatile month in negative territory, as did the S&P500, while both still recording a YTD return of over 20% and 18% respectively, with 20% of the funds on AFM's database outperforming the local index both YTD and over 12 months. In the current environment, more than ever, manager research and fund selection becomes vital, as does portfolio diversification.

With the potential for a slowdown to become a recession, investors are understandably thinking of cash as an alternative in spite of concerns over ever lowering cash rates possibly turning negative. In this environment finding a high yielding but risk averse investment becomes even more difficult, but crucial. Our suggestion is that investors ensure they fully understand the underlying investment, and risks, before being lured by advertising headlines of seemingly attractive regular income.

Hedge Clippings | Friday 30 August, 2019
 

Regular readers of Hedge Clippings would no doubt have noticed that we have been erring on the cautious side for some time, particularly when it comes to prevailing interest rates (which seem set to stay low, for longer, or go lower) and the impact of geo-political issues - or at least of powerful political personalities.

Many investors large and small are lamenting the effect that "unrealistically" low interest rates are having on equity valuations, but should be recognising that low to negative interest rates are the new normal and probably here to stay for the foreseeable future. Equally, given the antics of Xi, Trump and now Boris, it is fair to assume that the political risks which currently abound aren't going to dissipate any time soon.

In this environment the ability for central banks to cushion any market shock - or even do anything but keep reducing rates to try to avoid a recession - seems limited, and therein lies the danger. There's no firepower left to adjust to what might lie ahead. And as pointed out by no lesser hedge fund legend than Ray Dalio of Bridgewater Associates, with central banks considering issuing 50 and 100 year bonds, and with $US16 trillion in negative yielding bonds already on issue, the opportunities are limited.

No one, neither central bankers nor legendary fund managers, and certainly not yours truly, have witnessed this before, and there are no certain models or precedents on which to base the potential outcome.

Hence caution. Cash may well be a safe haven. Even at a negative yield.

Hedge Clippings | Friday 23 August, 2019
 

Hedge Clippings, like many others, avidly reads and then dissects every nuance within the minutes of the RBA's monthly board meetings as we try to interpret or discern their views, and thus the future direction of monetary policy. This week was no different, although having read the August minutes we took a slightly different approach. Using the principal of "a picture paints a thousand words" we downloaded and printed the minutes and then set about highlighting in orange words or phrases that were cautious or negative, and in green those that were positive.

Hey presto, a colour coded picture of the RBA's mood and thoughts on the future. There's an element of discretion or subjectivity in the use of the various colours, which we viewed as having significantly more "orange" risk to the downside, than "green" to the upside, so readers might paint the picture differently.  If you want to try it yourself, here's a link to the RBA's original "blank canvas".

While staying on the visual theme, although significantly more data driven, the chart below (courtesy of Craig Racine's Gyrostat Capital) shows falls of 20% or more in the S&P500 since the crash of 1929, which precedes even Hedge Clippings' experience, however we grew up regularly being reminded of how tough it was back then (although we're sure it was).

The chart not only shows the full % drawdown of each event, indicated by the red section of each bar below the line, but also the time taken (in months) for the fall to take place, indicated by the pink section in the middle, and finally the time taken in months for the market to recover to its pre fall high, represented by the top, or yellow section. 

What it shows is that market events (in this case falls of 20% or more) are not as rare as one might think, having occurred 13 times including the big daddy of them all in 1929. Also, as shown by the date series, they occur frequently.

Next, the time taken for the fall to occur doesn't last long! This is the "down by elevator" effect, while the top section of the bar shows recovery is not even "up by the escalator" by comparison. It's more of a long uphill foot slog. Remember, when an asset or market falls by 50% it needs to rise by 100% to reach its pre fall value.

Taking this forward to the current environment, at a time when many are questioning the equity market's stability in the face of inverted bond yields, and stretched valuations, one other point is worth noting: We're approaching 12 years since the last event, namely the GFC, with the longest previous interval being 13 years from August 1987 to 2000.

"This time it's different" is a claim sometimes heard, and given concerted efforts by central banks around the globe, this time it may well be. That shouldn't stop investors taking some form of downside protection, however, particularly if they're at that stage of life where the time to recovery from the next market event when (not if) it happens, may well exceed their own time to no recovery - if you get the drift.

There have been huge inflows into US and local equity markets, particularly into low fee index funds chasing yield, while in Australia there are significant levels of retiree's cash sitting on the sidelines, earning little, or in some cases no return. There's a risk that investors desperately seeking yield move too much of their safe haven cash to risky equities and ETF's, or private equity look-alikes, without carefully considering the full risks and consequences.