Given the sudden volatility in global markets at the end of 2018, we felt it was important to meet with fund managers we currently invest in and seek out potential new opportunities. So we commenced 2019 with an extensive research program meeting 42 investment managers over 4 weeks in Melbourne, Sydney, Hong Kong and New York.
We want to invest with active managers that can outperform over time, so we continually assess the managers' ongoing ability to make timely decisions with conviction. We also ensure that their portfolio construction is a true reflection of their views. Manager selection is a key part of generating better client outcomes and by understanding what we are invested in, we can judge whether the managers are performing as expected in any given market environment.
Here are the key themes for each asset class from the 42 meetings.
Australian Equities: Under the cloud of housing and regulatory risk
We met with managers of all styles, large cap, small cap, long-short equities and it was a challenging year for all. A consistent theme was the increasing regulatory risk facing Australian companies and the difficulty in forecasting earnings under such change.
Companies in the Finance, Utilities, Telcos and Health Care sectors have all come under varying degrees of regulatory change over recent years and the outlook remains uncertain with a potential change of Federal government this year. This has a greater impact on the larger end of town and so managers with a focus on smaller companies seemed less concerned.
The other consistent theme was the impact from the falling housing market. Long short equity managers have been focused on how it may negatively impact sectors such as discretionary retailers.
Consistent with these views, we have been progressively reducing our large-cap Australian exposure in favour of small-cap or long short strategies over the past year.
International Equities: Our largest allocation
At almost 40%, this is currently our largest allocation within the portfolio after taking advantage of cheap valuations to add to our equity position late in the fourth quarter.
We met with managers of varying styles and mandate types. One consistent theme was that many managers were holding record levels of cash at year end and were not chasing the current market rally.
They believe there will be better buying opportunities ahead as global growth slows. This reflects the negative sentiment we wrote about previously and could be considered a contrarian indicator. We wonder when they will increase exposure if the macro conditions improve, putting further upward pressure on markets.
In contrast to the Australian managers, most believed there was long term value in the stocks they held and there was a large and diverse opportunity set for them to explore.
China was of interest and a source of conjecture. Chinese equities fell 25% last year and the economy is showing signs of weakness. For some managers, the value on offer was too compelling and they were increasing exposure whilst for others the dark clouds of the debt bubble and slowing growth posed a longer-term concern.
Government Bonds: Standout performer of 2018
Government Bonds returned to their traditional role as a defensive anchor in portfolios, performing strongly during the December quarter. Our largest single fund exposure in 2018 was to Australian bonds, which was the standout performer for the year, increasing 5.1%. It was no surprise to see funds experiencing strong inflows and demand for their products.
Despite positive performance for the year most managers still underperformed the benchmark due to hedging some of their duration or interest rate risk. The outlook for Australian bonds remains positive with the RBA changing its outlook for interest rates from a potential rate rise to a cut as the Australian economy faces property related headwinds.
The outlook for global bonds was mixed. With a yield of 2.6%, the US 10yr bond yield is at least above inflation however if the US economy maintains solid growth, the Federal Reserve may need to resume raising interest rates putting upward pressure on yields (prices down).
Whilst in Europe and Japan, interest rates are well below 1% providing no real return and the risk of capital loss should yields rise. Most global bond managers were therefore taking some US interest rate risk but hedging their Japanese or European exposures.
Corporate Debt: Very limited exposure
We have written about the potential risks in credit markets previously and in December these risks were exposed as global credit markets declined sharply. Valuations are now only back to historical averages and as the economic cycle continues to mature, most managers were trying to improve the credit quality in their portfolio.
As both domestic and global banks tighten credit, opportunities for non-financial lenders are opening-up as they target borrowers who have been denied credit from the banks. We were told of the high returns on offer for private asset lending by several managers. This is a specialist asset class where managers with long term credit / banking experience are required to ensure adequate investor protection. The best opportunities also seem to be in the illiquid private markets which are not suitable for all investors.
The meetings confirmed our view of the cycle and we continue to have a very limited exposure to credit.
Global Alpha: Struggling in a volatile environment
As a reminder, these are strategies which are uncorrelated to the major asset classes which means they do not rely on markets to go up to generate returns.
In general, many strategies struggled with the rapidly changing environment and markets driven by sentiment from geopolitics and central bank policy as opposed to fundamentals.
We have seen recent improvements in the performance of some strategies as volatility became more extreme. This highlights the potential benefits of these strategies at the later stage of the cycle.
Infrastructure: Sit back and monitor until they get cheaper
Whilst we currently have no specific allocation to the sector, we met with specialist managers to explore the opportunity set in more detail. The sector has been a large beneficiary of the global decline in interest rates due to the long-term nature of the cash flows and the often-high degree of financial leverage employed. This makes the sector sensitive to rising rates and has also resulted in arguably high valuations versus historical averages. These factors lead us to hold back from the sector currently.
The manager insights were interesting and somewhat polarising. One fund told us that the sector was overvalued and not to invest, refreshing to hear an objective view rather than a sales pitch. Another group when pressed told us that they had lowered the hurdle rate for investment in order to justify the current high valuations.
At this later stage of the economic cycle, the appeal of many of these assets such as power and water utilities is the defensive nature of their earnings. However, until the valuation justifies an investment we will continue to sit back and monitor.
Using our research framework which focuses on people, process, business model, performance, and alignment, we sought to review the managers during what was a tough year for all asset classes and investment styles. We believe it is always in periods of market stress that you can glean the most insights about a manager rather than when it is easy to generate returns. It was interesting to see how varied the approaches to this environment were.
This was particularly the case within equities. Some managers held their conviction albeit with high cash, and some tried to protect their capital bases by increasing their cash levels further. Yet no one used their discretion to embrace the value on offer to significantly increase their equity exposure ahead of what has now been a very strong start to 2019. Additionally, we feel the growth vs value debate will continue to rage given there was no clear outperformance driven by either style of manager.
Almost all bond managers we spoke to had positioned their portfolios in anticipation of increasing bond yields last year. For most of 2018, bond yields were rising on the back of higher inflation and growth expectations. Managers were generally positioned for this trend to continue, however in the last 2 months of the year bond yields collapsed (bond prices increasing) as growth and inflation expectations were reset lower. Most managers failed to capture the full extent of the move.
A positive insight was that despite the negativity in markets, most teams were adding new recruits across all levels of experience. Funds were generally seeing stable or increasing inflows into their businesses despite the volatility and generally, most managers were encouraged by an improved opportunity set and the ability to show skill as active managers.
Overall, it was a very timely and informative research program for our team to undertake. It has provided our team with further qualitative and quantitative information to assist with improving the return profile of our portfolios today. We hope you have enjoyed the summary of our insights. Comments welcome below.
Some Australian managers are finding the conditions highly prospective, unlike what you mention for the average Australian equity manager. For example, event driven market neutral manager Harvest Lane does not depend on the vagaries of central bankers 180 degree policy turns. They had a fantastic year in 2018 when all others wilted (they made double digit returns - including making money through the devastating October to December quarter) and are highly enthused by their future prospects. Furthermore, Harvest Lane don't earn any fees for themselves unless they make clients absolute returns > cash. Given the environment, having a genuinely aligned manager makes a lot of sense and I for one believe is worth supporting.
Hi Jerome. We couldn't meet with every manager from all asset classes in such a short period so thanks for highlighting this manager.