Should you sack your fund manager?

Australian Financial Review, July 2008

We should all have been in Canada. Stock markets from Hong Kong to the USA, Germany to our very own ASX 200 all plummeted in the 2007-8 financial year. But not plucky Canada: the resource-rich land of the maple leaf returned 6.7%.

Assuming that you didn’t have the foresight to put all of your money into the Toronto Stock Exchange, you are probably nursing some most unwelcome losses from your share market investments over the last 12 months, whether domestically or globally invested. But it’s often argued that the difficult markets are the ones where fund managers really prove their worth: where there isn’t a rising tide to lift all boats, and managers must really fend for themselves. So as we look at the full-year numbers from fund managers in Australia, what can we learn about fund manager performance?

The good news is that, although they had a difficult year, fund managers in Australia did on average earn their fees in 2007-8. David Carruthers of Mercer, which provides regular data on the performance of managed funds, says that after four years of 20% returns, the Australian market dropped by almost 14%. “The average active manager did better than this, outperforming the market during the year by a healthy 1.4%, more than covering the costs of their fees.” In fact, the median manager in the Mercer Australian shares survey delivered a 12.3% loss.

At times like this, it can seem a rather hollow boast to have ‘only’ lost 12.3%. Surely a shrewder move would have been to put the whole lot into cash? But most managed funds would never have been allowed to do that even if they had wanted to: generally they have a set maximum that can be allocated to cash and are expected to be putting most of the money to work in the stock markets.

Just one domestic fund in the whole Mercer survey turned a positive result in 2007-8 – and then some. Extraordinarily, the SGH 20 fund returned 12%, fully 12.6% ahead of the next in line (the SGH Absolute Return Trust, from the same manager, SG Hiscock & Co, distributed through Melbourne’s Equity Trustees).

So what was it doing right? This fund, run by a man called Robert Hook, takes a concentrated approach to portfolios: it holds between 15 and 25 stocks at any one time, has no constraints at all in which ones it picks or how much it puts in them, and has no obligation to hold the big hitters like BHP or Commonwealth Bank. Stephen Hiscock, founder of SG Hiscock, puts it like this: “In a nutshell, it’s an experienced guy, running concentrated portfolios, trying to choose the 20 best stocks in the market.”

In practice, this has meant some big holdings in stocks that rarely appear in the top 10 lists of some bigger funds. Examples over the last 12 months have included CSL, Incitec Pivot, Worley Parsons, Aquila Resources and Newcrest Mining. At the same time it has been underweight property trusts and financials, among other things.

The unusual list of star performers does appear to support the theory that smart managers really earn their money in dicey markets, when one really has to look for the unlikely winners and have an investment style that allows you to back them.

In theory, this has been a perfect environment for long/short funds, which can take positions to benefit from falling markets. And it’s true that several of the names near the top of the Mercer survey are long/short funds: the Macquarie Australia Long Short Equitised fund ranks third, the Tribeca Australia Equity Long Short Trust is sixth, the GMO Australia Long Short Equity Trust 10^th, and long/short or absolute return products from AMP and Portfolio Partners also make the top 15. None of them turned a positive number, but their returns do suggest that being able to short insulated them from losses even if it didn’t cut them out completely.

The highest ranked long-short fund is another SG Hiscock product, the SGH Absolute Return Trust, which ranks second overall on the Mercer list. This can go up to 25% short and can also go up to 50% in cash (although in aggregate it must never be less than 50% net invested in the equity market). Good positions here have included positive views on resources and negative on property trusts; the fund does not disclose its short positions (managers very rarely do) but it is believed to have got on the right side of Allco’s share price collapse.

The presence of two SG Hiscock funds at the top of the tree appears to show the strength of going with the right manager – though Hiscock, one of whose property trust funds has halved in unit price value, knows well that the same market can hit different styles of funds in very different ways. Still, choice of manager clearly has made a big difference in this environment. According to Mercer, a top quartile manager would have produced a return of -9% or better, whereas a lower quartile manager would have lost at least 14.7%. (Bottom of the pile, incidentally, was the Challenger Select Australian Share fund, which logged a 29.5% loss; another Challenger fund, the Socially Responsive Share fund, was fourth worst at a 26.5% loss.)

For international funds, the outperformance has been less pronounced. In a horrible year for international shares – overseas shares, unhedged, returned a 21.3% loss – the median manager barely limped above that number, with the median manager in the Mercer survey outperforming by just 0.4%, probably not enough to cover fees. “The median manager’s outperformance of the index is behind expectation, especially after allowance for fees,” says Carruthers.

In international shares, style of investment made quite a difference, according to Mercer. The median growth fund outperformed the index by 0.8%, while the median value manager underperformed by 0.7%. Four of the worst five performers in the survey were value styled, including the bottom three, all of which came from the same manager, Bernstein.

The difference between the good and the bad managers was significant here too: Mercer says a top quartile manager would have lost 17.3% or less (some boast, but remember movements in the currency would have taken out about 8% of that) while a lower quartile manager would have lost 22.7% or worse.

Once again, only one manager in the whole survey managed a positive return in 2007-8: the RCM Global Equity Unconstrained Fund, which was up 0.3%.

As the name suggests, this fund doesn’t have any restrictions on its investment approach such as having to mirror a benchmark. Also, it’s allowed to put large amounts into cash, and at the moment about one third of the fund is invested this way. “It’s very flexible,” says Paul Schofield, the portfolio manager, in London. “I can have a large cash balance, I can be opportunistic and thematic in the portfolio, and we are not fixated on a benchmark. For me, it’s a question of: is this idea better than cash? I don’t care if it’s better than the MSCI World.”

Even this fund is down in the calendar year to date, so Schofield is reluctant to boast about performance, but he has beaten the herd by some key bets: one, by getting as far away from banks and other financial stocks as possible for the last 12 months; and two, by emphasising commodities and energy stocks. Examples have included Devon Energy in the US and Canadian Natural Resources, as well as some Australian stocks, Santos and Origin Energy, and some little-known solar energy stocks, JA Solar and LDK Solar.

Sooner or later, markets are going to turn around; working out the timing and nature of that bounce is what is really going to separate the good managers from the bad. Take bank stocks. “In the last 12 months if you didn’t have any exposure to banks then you were laughing,” says Schofield. “The interesting question now is when does that decision have to change.” Those who get it right will be the ones at the top of the pile when we write this feature this time next year.