In our last wire, Dominant themes in 5 key asset classes, we highlighted the conservative stance most managers had taken following the extreme volatility during the December quarter. We believed the generally cautious tone would result in the rally extending as managers re-assessed the improving outlook based on what appeared to be progress towards a trade war resolution and central banks resuming an easing bias.
This thesis largely played out as many managers progressively increased exposure into the rally that took US equities to a record high and Australian equities to a post-GFC high.
The recent months have provided a great opportunity to assess managers ability to adhere to their process, maintain conviction and manage risk.
The team conducted 68 fund manager meetings between March and May 2019, as per the table below, and we summarise their outlooks in the following wire.
Australian Equities: Questioning WAAAX valuations
We met with a variety of Australian managers of varying styles, noting an improvement in sentiment on the back of strong gains for the market this year. The recent Liberal re-election, APRA credit standard easing, and the reduction in the RBA cash rate have driven most to remove the potential for a severe Australian economic downturn. As a result, many managers were increasing their exposure to domestic-focused names such as the major banks.
We questioned positioning in the Australian technology sector following exceptional performance. The domestic market has a limited universe of investible technology companies which has pushed valuations far in excess of offshore peers. The so called WAAAX stocks, WiseTech, Altium, Appen, Afterpay and Xero, have combined market values approaching $29bn but forecast profit of just $270m, a multiple of >100x earnings versus the broader market at ~16x. Many managers had a stock they preferred from a business model perspective, but most could not justify the current prices.
There has been some significant dispersion in performance by managers with yield focused funds outperforming and high conviction / cyclical focused funds underperforming. In our database, over 12 months there are only 13 out of 86 (15%) managers that have beaten the index and we continue to favour passive strategies when allocating to large cap managers.
Mid and small cap Australian equities are a sector where active managers continue to generate good outperformance and we met with several different managers in this space. We have added one new manager with an absolute return approach that replaces a long only small-cap manager following an award-winning period of performance.
Government Bonds: Portfolio ballast
Government bonds continued their traditional role as a defensive anchor in portfolios as yields continued to fall (bond values higher) on expectations of lower growth, low inflation, and central bank easing.
This environment has produced strong total returns for bond managers, yet most still underperformed their relevant benchmarks. For example, in our database of Australian bond funds over the past 12 months only 4 out of 26 (15%) active managers have beaten the index. Pleasingly the only 2 active bond managers we invest with are in the 4 that beat the index.
While the managers can clearly identify numerous economic risks (supportive of bond prices), they accept that much of this negativity has already been priced into bonds. There is an astonishing US$ 11 trillion (not a typo) of global government bonds trading at negative yields, that is investors are paying interest to hold them. Most of these bonds are European and Japanese and so global bond managers are challenged by an opportunity set which may struggle to produce income for investors.
We continue to favour US and Australian focused managers given relatively attractive yields despite the RBA cutting interest rates to a record low this month and US bonds also now pricing in multiple cuts.
Amid current geopolitical risks and slowing global growth, government bonds remain a portfolio ballast.
Corporate Debt: Next 12-18 months remain a challenge
We continue to monitor the search for yield that is pushing investors and managers into riskier parts of the corporate structure with little risk compensation. Global corporate debt managers shared different views depending on sector.
Concerns around the extended leverage and valuations in the US high yield and leveraged loan market were apparent although managers were comforted by the peak in US interest rates and still healthy economic growth.
The next 12 to 18 months will remain a challenge for the sector as large maturities of debt issued at lower interest rates needs to be repriced in the US. This could put pressure on spreads causing weakness in corporate debt prices.
Domestic managers were more upbeat, especially when compared to the end of last year, seeing attractive opportunities within the domestic corporate debt market. We have added one manager that is nimble enough to take advantage of these when they arise.
International Equities: US-China trade war makes for tough terrain
Global equity managers have faced a difficult environment and the US-China trade war was the key point of uncertainty. We questioned managers on how they were incorporating newly imposed tariffs into their earnings estimates however the constant change in stance has meant most have not made changes at this time.
Some of the more interesting insights came from the feedback managers got in their company meetings. The trade war uncertainty is impacting inventory management with some companies and consumers temporarily changing their purchasing decisions to avert short-term impacts from the tariffs. This has clouded the recent earnings picture, in tandem with economic data, making it difficult to assess the real impact to company profits.
Managers with large exposures to the US and growth stocks continued to outperform whilst those with a value bias or large exposure to Asia have underperformed. Managers which turned or stayed cautious following last year’s weakness have also lagged the strong recovery in 2019. Compared to other sectors the active managers have fared better in aggregate but with a wider dispersion. A total of 34 out of 85 (40%) managers have beaten the index over the year.
The difficult environment has impacted some teams and we removed a manager due to personnel changes which was reflected in a lack of conviction within the strategy. Other changes we made were to reduce managers with significantly concentrated exposures in either US technology or Asia, opting for more diversified and quality focused managers.
Infrastructure: Defensive nature is attractive
Listed infrastructure managers continue to see a limited opportunity set of compelling opportunities within their global investment universe. Whilst not overly keen to temper investor enthusiasm for their own product, areas of concern remain rising valuations supported by low discount rates and investors placing high probabilities of earnings upgrades to support current valuations.
Despite the valuation concern, in a slowing growth environment, the defensive nature of these assets could see infrastructure assets trade at a premium for some time.
Real Estate: 3 key themes to follow
Real estate managers we met with demonstrated clear outperformance of the index and conviction in their ability to continue to do so. Whilst they acknowledge the strong performance of the sector has been aided by lower interest rates, they highlighted a growing opportunity set driven by the changing shape of the global economy.
There are several key themes creating both risk and opportunity.
- E-Commerce has put pressure on many older style retail malls whilst significantly increasing the demand for industrial property in the form of distribution centres.
- Global IT demand has created a new asset class in data centres whilst the ageing population provides strong tailwinds to those exposed to aged care facilities and housing.
- Another interesting trend is the rise of shared office facilities such as WeWork which are becoming major tenants in prime office centres around the world.
Private Equity: $2 trillion cash waiting to be deployed
We are seeing an increasing number of private equity opportunities crossing our paths. Investors continue to seek growth assets uncorrelated to equity markets and we note the growing number of retail investment vehicles being created to address the mismatch between illiquid private equity investments and retail investor time horizons.
We continue to monitor the space closely given high valuations and significant capital waiting to be deployed (estimated in excess of $2tn).
We see more interesting opportunities in higher growth mid-cap private equity and venture capital investments both of which are unsuitable for our liquid portfolios but may be of interest to long term private investors.
Global alpha managers have not kept up with traditional bonds and equities over the last year. The lack of clear trends across markets has made it difficult for most macro and systematic funds without causing returns to be negative in general. We have added a high-quality established US manager with a significant track record.
Local market neutral strategies have had a distinctly difficult time which has occurred within both strongly falling and rising markets.
The range of fund styles and reasons for the poor period of performance amongst the market neutral strategies varies, but include:
- Struggling due to size of assets under management,
- Stock specific risks unfolding in multiple well-held companies at the same time
- Strong performance of highly valued growth stocks over value stocks.
Markets dynamics are continually changing which means managers with an absolute return objective need to be flexible enough to adapt, without changing their stripes. We have removed one market neutral manager on this basis and maintain only a small allocation to two managers with conservative positioning, nimble fund sizes and long-term records of strong risk-adjusted performance.
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We hope you enjoyed our latest manager review. With many events on the horizon including the G20 meeting in Japan we are sure the next few months of meetings will remain interesting and insightful. We look forward to updating you again next quarter. Click 'follow', below to be the first to receive my next wire.