10 June 2020

The complacent ‘There is no alternative’ (TINA) mentality that prevailed for many in the investment community in the latter stages of 2019 and early 2020 meant most investment assets, irrespective of relative quality, rose in value.

As interest rates and bond yields fell to new lows, there was an almost consensus view that investors had no choice but to take on more investment risk to achieve a return above that being offered by lower risk assets like bank deposits and Government bonds where yields were expected to continue to decline towards zero.

This environment generally seemed to make it harder for active managers, especially those with a value or quality investment philosophy, to beat index or passive strategies. However, the insights of investment luminaries like William Sharpe[1] would seem to indicate an indexing approach would normally beat the average active fund manager strategy, in part due to the latter’s usually higher fees, plus the added costs associated with higher portfolio turnover.

But overpriced sharemarkets can leave index investors doubly vulnerable to the unanticipated. As the 2020 ‘black swan’ event shut down swathes of the global economy, not only have sharemarkets from mid-February to mid-March fallen dramatically, but index investors have borne the full extent of that downslide – the reverse effect of capturing the full upside in the prior bull market.

The sudden turn to a bear market combined with the differing prospects for industries and companies could set the perfect stage for active fund managers to get one back on their indexing competitors, who saw an increasing percentage of investor inflows during the 2010 bull market decade. But in Q1 2020, have active fund managers delivered superior performance after fees, but pre-tax, versus asset class benchmarks which represent index strategies?

Here are some observations from the data I’ve analysed, noting I have confined this analysis to a limited number of single asset class fund groups, as defined by Morningstar, who have provided the data for this study. The asset class groups reviewed spanned NZ equity trusts, NZ bond funds, NZ based global bond and equity funds. A total of 100 single asset class funds.

• The range of Q1 returns for NZ bond funds varied from -1.99 percent to 3.36 percent with an average of 0.76 percent versus the benchmark of 2.69 percent. It appears many funds had ongoing risk levels above that of the benchmark. Overall: a ‘fail’ for active managers.

• Q1 returns for NZ equity funds ranged from -2.26 percent to -21.75 percent with an average of -13.5 percent versus a benchmark of -15.5 percent. Thematically, funds with a large cap bias performed better in the quarter. Interesting to also note the best performers in Q1 2020 were underperformers on a longer-term timeframe, even while the fund sector average kept up with the benchmark. Overall: a ‘pass’ in this asset class for active managers.

• With global bonds the return also widely varied in Q1 ranging between -11 percent to 4.6 percent versus the asset class of 1.4 percent. The NZ based funds for this asset class have on average consistently struggled to keep up with the benchmark over shorter and longer-term timeframes.

• In global equities the range of returns was unsurprisingly high from -19 percent to -1 percent versus an index that was -10 percent. The sector average fund return was -10 percent. Longer term performance for funds in this sector is also very similar to the benchmark. I’m somewhat disappointed that only 50 percent of active global equity funds beat the benchmark in an environment highly suitable for active management.

So, what can we take from this? Due to the very short-term period it’s impossible to reach any significant conclusions. But I can tell you being good at managing the downside doesn’t necessarily make an active manager the right one to use in a more positive investment world.

Additionally, you should consider some of the common ways an active manager can add value in a down market and stay within the investment parameters available for the fund. This might include strategies such as having part of the fund in cash or other relatively capital stable assets like bonds; investing more in lower risk bonds or companies by the nature of their industry, larger size, level of financial or operational gearing; putting in place derivative strategies that realise profits as the market or individual share prices fall; or taking a currency position different from your benchmark for global funds.

Take lifting the cash or bonds allocation in an equity fund. Typically, a retail equity fund may hold up to five percent of the fund in cash on any one day for liquidity reasons. If the market index falls 20 percent, such a fund will beat the benchmark by one percent by virtue of operational reasons. A number of managers have commented they held above normal cash levels in some funds due to concerns about pending withdrawals at a time of reduced security liquidity and widening bid/offer spreads.

I haven’t heard any investment manager yet claim to have fully predicted this crisis, worked out the market and security impacts and then optimally positioned their portfolio for this. However, as the impact of COVID-19 on China increased in January to February, a number of fund managers indicated they reduced their exposure to those industries most likely to be negatively affected by a slowing in Chinese demand, especially travel and tourism stocks. Others reduced general fund risk by limiting or reducing exposure to weaker credit rated companies, small caps or those more likely to need to raise capital in a weaker economy.

On an industry basis healthcare, food manufacturing and distribution, and IT software looked like they would be beneficiaries with increased or stable demand. Airlines, retail and anything tourism related has seen a massive contraction which may take several years to recover from.

If your active manager had a portfolio over or underweighted towards the former versus the latter industries before the crisis was apparent for non COVID-19 reasons, then they were set to outperform or underperform in this crisis. Because getting your portfolio reset in a dysfunctional market is nigh on impossible.

My take-aways for investment advisers are:

• On the whole, you shouldn’t have been particularly surprised by relative under or outperformance of the active funds you select for your clients in Q1 2020 because you should have already known how their funds were positioned from a risk perspective prior to the ‘COVID-19 crash’ as:

- The fund manager and the fund research services you utilise provided a high level of transparency and understanding.

- You were already highly engaged in understanding their portfolio risks versus their benchmarks.

• You may wish to revisit the appropriateness of some of the funds your clients have utilised as it is now clearer if they are riskier or less true to label than was previously evident.

• Be conscious the outperformers in a down market may be the underperformers in a recovery period.

My messages for investors include:

• If any of the returns from the funds you invest in have surprised you, then it is best to seek professional investment advice simply based on, ‘if you don’t understand it, you shouldn’t be in it’.

• Ask your current investment adviser to explain the performance drivers of the funds they invest in for you. If they can’t do this to your satisfaction, then consider looking at alternative professional advice options.

It’s been very interesting analysing how active managers as a group cope in a crisis. The data, while short term, hasn’t changed my thinking that finding active managers who can outperform requires intensive and diligent ongoing research by investment advisers. As a group, the data series would appear to show they are more than likely on average, and with some wide dispersions, to underperform their market index in most asset classes.

Join us for our upcoming webinar - Keeping on top of your KiwiSaver in stressful times

On Wednesday 17 June 2020 at 12.00pm - 1.00pm, Craig Smith and I will discuss:

• COVID-19’s effect on financial markets

• KiwiSaver in a longer term context

• KiwiSaver success strategies

Register here

[1] https://web.stanford.edu/~wfsharpe/art/talks/indexed_investing.htm

This article was originally published in New Zealand Asset Magazine.

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June 2020.