US Earnings Growth

My last blog post focused on the US stockmarket and equity valuations. You will recall that opinion is strongly divided between the bulls and the bears. The latter have argued there is a disconnect between the high stock valuations and the lack of underlying earnings growth from US companies.* It was with interest therefore that I read a recent technical report from JP Morgan Asset Management. In summary they reported another record breaking quarter for earnings for S&P 500 stockmarket index companies, the fifth quarter out of six since the beginning of 2013. Year on year to the end of the second quarter to 2014 earnings per share (EPS) for the constituents of the S&P 500 stockmarket index grew by 11.4%. To explain, EPS are profits, after costs and taxes, that are attributable to each share.

In simple terms the EPS growth was principally due to two factors – sales growth and increased margins although share buy-backs also made a small contribution. In relation to sales growth JP Morgan observed in the second quarter of 2014 there was strong revenue or sales per share growth; this had been lacking in the previous few years and its re-appearance is positive for company profits. Margin is the profit from each sale item. For example if a company that sells widgets for £1 each made 20p profit last year, but this year the same £1 sale results in 25p profit, for example due to efficiency savings or lower labour costs, the margin has risen.

Another interesting point in the article was that in the second quarter companies levered to the domestic economy surprised analysts’ expectations on the upside. However it should be noted that earnings growth varied across the sectors, with telecoms, materials and healthcare performing well, utilities weakly whilst  EPS for financials contracted.

In conclusion JP Morgan suggested the record high profitability for US companies is set to continue, domestic economic activity will drive revenue growth and the potential for taking on debt onto balance sheets will help counter headwinds such as higher labour costs and wage demands. They conclude although above average equity valuations will reduce expectations of future returns, the current analysis adds up to a constructive and benign environment for equity investment in the US. Time will tell.

* This refers to the oft quoted valuation measure called the P/E ratio, the argument from the bears goes in the US, earnings per share (E) have not kept pace with share prices (P).

This blog is intended as  general investment commentary on the US and is not an invitation to invest or not invest in the areas mentioned. You should seek individual advice before making investment decisions.

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When the US Sneezes

We all know the rest of this adage – “the world catches a cold.” With the US representing around 30% of the global economy what happens on the other side of the pond has an impact on us all, be that a US consumer recession, a banking collapse or tapering of QE. It is therefore with interest I recently read two fund managers expressing polarised opinions on the US stockmarket.

Bearish on the US is Alastair Mundy who runs the Investec Cautious Managed fund. Mundy is a well-known and respected contrarian investor. He has a particularly cautious view of the market and is concerned about the way investors have piled into equities and are buying high. He observed the S&P 500, a key US stockmarket index rose 30% in dollar terms in 2013. Although so far in 2014 returns have been more muted he cites the Bank of International Settlements (BIS)* who considers that “euphoric” financial markets have become detached from reality. Debt remains high in the West and monetary policy is loose. Mundy concluded that valuations of equities, especially in the US are high, he noted corporate earnings have disappointed and warned of more volatile uncertain markets. To date his short position on the US market has impacted negatively on his fund’s performance.

In contrast Felix Wintle, manager of the Neptune US Opportunities fund is aware of the concerns but is positive about the US. He believes the equity rally has further to go despite those who argue that the market has gone up too far and we have not had a 10% market correction recently. Wintle queries what is so special about a 10% fall and observes we had 4% to 5% corrections since 22/5/13 on five occasions. Despite their regularity they have been shallow and investors have bought the weakness, a classic behaviour in a bull market.

Another concern he address is the low yield on 10 year US Treasuries. Ordinarily low government bond yields signifies the market is expecting weak economic growth and hence muted inflation. This makes fixed interest attractive, pushing up prices and lowering yields. However Wintle says technical factors have pulled Treasury yields lower. One of these is the huge reduction in stock being issued by the US government. It is apparently 60% lower than a year ago. This is due to the reduction in the US federal deficit, down a staggering $1 trillion since 2010. It now sits at around $537 billion. This deficit reduction has been an unspoken bull story.

Wintle also consider that valuations are not stretched although CAPE**, a measure of equity valuation is at an elevated level. However he discounts this on the basis CAPE is a historical 10 year moving average during which there was significant stockmarket volatility. Finally Wintle observes an increase in M&A*** activity, a sign of that company managers are more confident in business conditions. He does however consider higher oil prices would be a concern and run-away inflation would hit consumption.

So what do I conclude? Am I am a Wintle or a Mundy, a bull or a bear? I think I am more leaning to Wintle’s view, perhaps though with a dash of caution thrown in. I expect volatility to pick up in the next 12 months and a large correction of 10% or more would not surprise me. This could be triggered by geo-political events or investors talking themselves into a crash – the wall of worry theory. However I sense the US bull market is set to continue supported domestically and by recovery in China and other global emerging markets. This would benefit global exporters and mega-cap US companies with strong overseas earnings.

Of particular interest for me however are US smaller companies. These have underperformed other sectors in the last year. Data from FE Trust (12 months to 15/8/14) show the following average returns of funds in the following IMA**** sectors:

UK Smaller Companies – 11.7%

North America – 8.8%

North American Smaller Companies – 4.0%

If the US domestic economy improves and consumers feel more confident it should be positive for US smaller companies. As you will recall these are much more domestically focused than larger companies. Another positive feature is they are less covered by analyst research than larger companies and mispriced gems are more likely to be exist for good stockpicking fund managers to unearth. Finally smaller companies are likely beneficiaries of M&A activity.

*The BIS is an financial organisation which seeks to assist central banks in their pursuit of monetary and financial stability. It acts as a bank to central banks.

**CAPE is the cyclically adjusted price earnings ratio. The PE ratio is a standard valuation measure for a stock or a market and is the price of a share divided by the earnings per share. The higher the PE the higher the market values the stock or market. A PE may be a forward or historic measure.

***M&A is mergers and acquisitions

****The IMA is the Investment Management Association who place funds, OEICs and unit trusts, with similar investment mandates into sectors.

This blog is intended as  general investment commentary on the US and is not an invitation to invest or not invest in the areas mentioned. You should seek individual advice before making investment decisions.

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China Debt, A Systemic Risk?

Chinese debt is often cited as a potential systemic threat to the global economy. Other culprits are deflation and Japanisation of Europe (the latter incidentally was dismissed by Rob Burnett, Head of European Equities at Neptune Investment Management in a recent webinar I listened to – but this is another story), tapering of QE and predicted interest rate rises. Although I think a stockmarket correction is more likely to come from profit taking or investors talking them themselves into a crash, the wall of worry theory, I want to cover the issue of Chinese debt. To this end it was interesting to read a recent report on this subject from ETF Securities a leading providing of exchange traded commodities. They produce high quality research and reports but clearly have a vested interest in China’s economy given the commodities market is highly correlated with it.

In the report ETF Securities compared debt levels to GDP across the world in the form of a bar chart. To remind you GDP or Gross Domestic Product is the sum of all the goods and services a country produces; effectively the output of its economy.  A debt to GDP ratio is a more important measure than total debt in monetary amounts, as a very productive economy can service a high level of debt. Top of the pile with highest debt to GDP, (debt is private sector including the consumer and government borrowing) was Ireland, bottom was Saudi Arabia. Countries with high debt to GDP ratios included Japan (2nd), Luxembourg (3rd) and Belgium (5th). Countries at the other end of the scale were Russia, Mexico, India, Indonesia and Argentina. As an aside this accords with the observation of generally low debt levels in emerging markets, one reason I favour this sector.

Back to China. Chinese debt to GDP was half way along the scale. It is not a highly indebted economy compared to Japan, the US or the UK, although debt may be under reported. However a unique feature was that Chinese debt was divided into government, local government and consumer debt. For all other economies the bar chart showed only government and private sector debt and this suggests Chinese local government borrowing is a particular feature of their economy. (As another aside, apart from Japan, in every other country government debt was lower than that of the private sector). Further local government debt in China exceeds central government debt. Most of the local authority debt is to fund off budget spending. This arose from fiscal reform in 1994 which shifted revenue away from local to central government. At the same time local authorities had to fund the same level of expenditure including infrastructure spending from the same tax revenue. Local government funding structures are complex and opaque as technically local governments are prohibited from borrowing directly. This led to them setting up companies called Local Government Funding Vehicles (LGFVs) to raise finance.  ETF Securities note:

The central government has recognised that local governments have debt financing needs and the charade of off-budget financing is untenable in the long-term…. Eventually we expect the government to bring in the necessary reform to allow local governments to raise bond finance more directly through something akin to the municipal bond market in the US.

The article also stated central government has already raised bond finance on behalf of some local governments and suggested further liberalisation and oversight of local authority debt but that local debt levels are likely to rise to meet annual growth targets. Rising leverage has risks but ETF Securities consider Chinese government debt is quite moderate and well below the levels considered excessive in other economies.

I conclude there are concerns about Chinese debt (including the shadow banking system*). The biggest issue for me is the lack of transparency, raising the question do we really know how bad and intertwined debt in China is? The role of complex, opaque and ultimately toxic CDOs (collaterized debt obligations) in the 2008 global banking crisis suggests caution.  However with high economic growth rates, large foreign reserves and central bank fire-power I somehow think the Chinese will remain in control of the problem. Time will tell.

*The shadow banking system in China is in contrast to state owned and highly regulated banks, who previously accounted for virtually all lending in China. Shadow banks are alternative providers of credit and include trusts, leasing companies and money market funds. They have raised significant concerns. An interesting article in the Economist you may wish to read is:

http://www.economist.com/news/finance-and-economics/21601872-every-time-regulators-curb-one-form-non-bank-lending-another-begins

The opinions expressed in this blog post are those of ETF Securities and my own. You should not make investment decisions based on them but should seek individual independent advice.

 

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Half Time Team Talk

In football parlance, for investors we have just come out for the second half. So what is the half time assessment of stockmarkets in 2014? My brief comments are based on my own observations and those of Neptune Investment Management, M&G and Neil Woodford, formerly of Invesco Perpetual and manager of the newly launched Woodford Equity Income fund.

Equity Market Overview

According to Neptune developed equity markets have been in stop start mode in 2014 with returns flat up to April but then a return to the bull market in the second quarter. Weather related factors in the USA were a temporary headwind to economic growth in the first quarter as were deflation fears in the EuroZone. The ECB* have taken action in loosening monetary policy with potential money printing or QE to follow. The second quarter rally has driven US and German stockmarkets to new highs.

Unexpected Bond Rally

M&G observed a surprising feature of the first half of the year was the rally in fixed interest, notably government debt. Prices have risen and yields have fallen even in Spanish and Italian bonds. This was unexpected given tapering of QE in the USA and the likelihood of higher interest rates notably in the UK. The predicted great rotation from fixed interest (or bonds) to equities is still to happen on a significant scale although it should be noted that institutions such as pension funds that need to match financial obligations at different dates will continue to be long term holders of bonds as will income investors.

Other Assets

Commercial property is a sector which is highly economically sensitive and returns are gathering pace although unlike residential property they are predominantly from rental yields rather than capital values. Gold has continued to tread water at just over $1,300 an ounce, although a recent theme is that central banks are net buyers of gold rather than sellers.

UK

In the UK Neptune noted there was a shift in the equity market with investors moving away from the winners in 2013 to the laggards. For example there was a sell off in mid-caps in the Spring with undervalued UK large companies and mega-caps back in favour. At a sector level there was pressure on house-builders, building merchants and retailers with a move into energy and materials. Incidentally this accords with improved investor sentiment to miners and commodity companies globally which have fared badly in recent years.

US

In the US the economy contracted by 2.9% in the first quarter, much of this was weather related. Despite this the S&P 500 index has continued to rise illustrating that economic growth and stockmarket performance may be negatively correlated. M&A activity has picked up and this may be a factor here.

Japan

In Japan the stock market rally has lost steam. One factor was the increase in VAT from 5% to 8% in April which is expected to dampen consumer spending although wage growth was positive, land prices are rising and corporate earnings have strengthened.

Europe

The spectre of deflation has been a concern although as Neptune observe, “the ECB’s thorough stress test of banks is a landmark moment for the Euro area. Following the results, strong banks will be able to lend freely into the economy.”

To close I was interested to hear Neil Woodford’s view on the market as it strongly backed the assessment from Apollo Multi-Asset Management which I covered in a blog dated 8/3/14, “Beta Jockey’s to Fall at the First Hurdle,” see

http://www.montgomuse.co.uk/beta-jockeys-to-fall-at-the-first-hurdle/ .

In Woodford’s article he argues stock-picking is back in favour. He observes in the last five years with extraordinary monetary policy it has been difficult to beat the market. This is because QE has raised asset prices indiscriminately, like a rising tide lifting all boats. Evidence comes from data of global stock market correlations since 1990 which have been significantly higher than average especially between 2009 and 2012. In recent months correlations have fallen and Woodford believes that stock price movements will return to being determined by fundamentals, such as cashflows, balance sheet strength and good management. In this scenario good stock-pickers will do well.

Conclusion

Time and space does not permit full coverage of the global economy and stockmarkets. Moreover there have been country specific factors, for example the Russian market sold off with the Ukraine crisis whilst sentiment to India has improved with a new reformist government.

My assessment is systemic risk to the global economy and financial system does not feel as bad as in 2008 with the banking collapse or in 2011 with the EuroZone crisis. Although high equity valuations in some markets invariably will result in profit taking and corrections, the global economy is in recovery mode, albeit a patchy one. Overall it looks good for equities which remain my favoured asset class although investors will need to be selective, considering undervalued sectors and markets for example large UK companies and emerging markets. In the bond market I favour flexible strategic bond funds that can invest across the range of fixed interest assets and inflation linked bonds.

*The ECB is the European Central Bank

This blog reflects my own views not necessarily those of Neptune Investment Management, M&G Investments, Apollo Multi-Asset Management or Woodford Investment Management. It is intended as general investment commentary and is not an invitation to invest or not invest in the areas mentioned. You should seek individual advice before making investment decisions.

Posted in Asset Allocation, EuroZone, Japan, Market Commentary, Review of the Year, Stockmarkets, UK Equities, UK Mid-Caps, US | Comments Off

Nice One George

July 1st marked a significant change to the investment landscape with the launch of the NISA, the New Individual Savings Account, also referred to a super ISA.

George Osborne*, the Chancellor of the Exchequer surprised us all in the recent budget with liberalisation on how pension benefits can be taken and the new rules on ISAs. At last a Chancellor had the common sense to round up the NISA allowance to a memorable figure rather than the odd amounts such as £11,880 that previously applied.

Aside from the boost of the annual ISA allowance to £15,000 per person in the 2014/15 tax year there were several other key changes:

*All of the annual NISA allowance can be invested in a cash NISA, previously the maximum was 50%.

*Transfers are now permitted between a stocks and shares NISA and a cash NISA. Previously a transfer could only occur in the other direction. The change permits de-risking of equity portfolios using a cash shelter with a decent interest rate.

*Cash held within a stocks and shares NISA, such as Fidelity FundsNetwork NISA Cash Park will now be tax free. Previously the anomaly existed that interest from cash held in a stocks and shares ISA was taxable. It was intended as a disincentive to remain in cash; stocks and shares ISAs after all are intended to boost equity investment. Mind you with Fidelity FundsNetwork paying a paltry 0.1% p.a. interest and other providers paying nought the issue of tax was negligible.

You are still only permitted to contribute to one cash NISA and one stocks and shares NISA each tax year, however transfers of previous tax year ISAs can be to an alternative provider.

I suspect the changes will boost competition especially amongst cash NISA providers. Not only has the cash allowance risen from £5,940 prior to 1/7/14 to £15,000 now, banks and building societies will be eyeing up investors with large amounts of money in stocks and shares NISAs looking to switch to the safety of cash. This competition plus likely interest rate rises in the next year or two is likely to drive up cash rates.

What will be interesting is to see whether stocks and shares NISA providers will develop competitive cash NISAs that sit alongside the former permitting ease and speed of transfers between the two versions. If they can under HMRC rules and offer this facility they are less likely to leak funds to banks and building societies. Incidentally they do not have a great record when it comes to cash ISA transfers and unless they up their game on speed and efficiency I see problems down the line.

*George may not be nice in the future as past performance of Chancellors is not necessarily a guide to the future.

 

This blog post reflects my own opinions and is a general commentary on changes to ISAs not a recommendation to invest in a NISA.

You should seek individual advice before making investment decisions.

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Climbing a Wall of Worry

Imagine being a rock climber. The higher you get up the rock face or cliff the scarier it gets, particularly if you dare to look down. So it is for investors as stock market indices in the US and the UK scale new heights. A widely expressed fear is we are heading for a crash and investors are getting nervous. So should you be banking profits or switching to the safe haven of cash? Let’s examine some facts that will hopefully provide some guidance.

The current bull market in equities has been going for more than five years and this is significantly longer than average. Data from the US since 1932 suggests this is just over three years and a correction is arguably due. That said the current equity rally started from a very low base after the worst financial crisis since the 1930’s depression. This bull market therefore incorporates a strong element of recovery in very beat up asset prices. It may be dangerous to suggest this but this bull market may be different. Moreover equity performance has been variable in different global markets. The US followed by the UK have led the way being the fastest economies out of recession. The EuroZone in general has lagged whilst global emerging markets have delivered poor returns in recent years with slowing economic growth in China which is seeking to reform its economy, a flight of capital with “risk off” investor sentiment and tapering of QE. Japan had a strong equity rally that lasted for a year but this has since stalled with the third arrow of Abenomics*, structural reform being difficult to fire.

In support of the bears, who might be happy to climb a tree but not a rock, it is true in some markets valuations are stretched with prices rising faster than earnings. For this reason earlier this year asset allocators began rotating from US to UK equities and downbeat sectors such as miners and emerging markets have started to attract investor interest. Moreover a few months ago there was a sharp sell-off in UK mid-caps after a very strong rally in recent years. The best explanation appears to have been this was profit taking by nervous investors. Interestingly undervalued mega-caps are now back in favour after years of dull relative returns.

So what do I think? I am not unduly worried by a correction. The global economy is still in the early stages of recovery and whilst there are systemic risks from a property bubble and bad debt in China and deflation in Europe, my sense is these are relatively small compared to the global banking crisis of 2008 and the EuroZone fallout in 2010 and 2011. I suspect the biggest risk is fear itself. Investors like lemmings have a habit of throwing themselves off the top of the cliff. A sell off will be caused by investor panic rather than fundamentals. In support of this view it was telling to read fund managers suggest in a bull market you buy on the dips and add to your best ideas. A correction itself triggers buying but is healthy in removing the froth in valuations. It may cause the bull market to pause for breath but it may not alter the upward trend. As an example consider the famous stockmarket crash in October 1987 when equities fell 22% in two days. You may recall the chart of the UK equity market I cited in my last blog:

http://www.telegraph.co.uk/finance/markets/9196093/Graphic-50-years-of-the-FTSE-All-Share-index.html

In the context of the equity rally of the 1980s and 1990s the 1987 crash appears as a relatively small blip and the FTSE 100 finished higher at the end of 1987 than at the start of it.

My guidance would be to adopt a long term buy and hold strategy and ride the volatility but it is your money and I can’t take your place on the rock face. You may prefer to be cautious and undertake selective profit taking and risk reduction or rotate to undervalued equity sectors and markets. It is a perfectly reasonable strategy to invest tactically, bank what you have and for caution to take precedent over gaining more. The risk of risk reduction is the correction may not happen, an investor holds cash earning diddly squat and they pay more to buy back into equities later on. This is precisely what happened in late 2011. At that time I was convinced a EuroZone inspired crash was imminent. I was wrong. Guessing the market is notoriously difficult.

*Abenomics is the name given to Japanese Prime Minister Shinzo Abe’s policies to revive the Japanese economy.

This blog reflects my own understanding, views and interpretations of global stockmarkets . It is intended as general investment commentary and is not an invitation to invest or not invest in the areas mentioned. You should seek individual advice before making investment decisions.

 

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Is Active Fund Management Worth Paying For?

Fidelity Investments have recently cut charges on their range of very low cost index tracker funds undercutting their rivals and raising again the old chestnut, is it worth paying extra management charges for a fund manager to actively select stocks compared to buying a low cost index tracker? To remind you index trackers and Exchange Traded Funds (ETFs) are passive investments that seek to replicate the performance of a stockmarket index for example the FTSE All Share or S&P 500 indices.

Advisers and professional investors are very much divided with strong advocates on both sides. Historically I have favoured active fund management, inherently it makes sense to select stocks and I think fund managers do have skills (those that advocate passives suggest outperformance is random or not consistent), however I am open minded and with Fidelity’s ultra-low management fees and recent study of high quality research on passive versus active fund management from Vanguard, a leading provider of index trackers and rPlan, an investment platform, I am happy for my convictions (some may say prejudices) to be challenged.

Charges

In the words of Donald Rumsfeld, former US Secretary of Defence “there are known knowns and known unknowns.” When it comes to fund management there is a known known at outset, management charges and index trackers are indisputably cheaper than actively managed funds. As an example the newly launched Fidelity Index UK fund which tracks the FTSE All Share Index has an ongoing charges figure (OCF)* of 0.07% p.a. if bought through Fidelity. On other platforms the charge is 0.09% p.a.

An OCF is the annual management charge plus fund expenses such as custodian and auditor fees. Fidelity’s and other index tracker providers’ charges are dirt cheap and compare very favourably with a typical 0.75% p.a. to 1% p.a. OCF for actively managed funds. Although Fidelity’s other trackers carry OCFs ranging from 0.08% p.a. to 0.23% p.a. the latter for their emerging markets fund, actively managed funds clearly start the race with an impediment, and if performance is identical passive funds will outperform. Moreover the long term compounding effect of lower charges is very significant. Finally when equity returns are low or falling fixed fees have a more significant impact than in bull markets; its basic maths. In conclusion If you follow the investment maxim to make decisions based on what you know rather than what you do not know then index trackers are the best choice.

Performance

Here we are in the realms of known unknowns as unlike charges performance cannot be predicted in advance, assuming past performance is discounted. What I find interesting however, even with hindsight financial experts disagree whether the evidence shows active or passive fund management has done best! You can wheel out selected statistics to argue both ways. As my wife reminds me, her experience from disputes at work is, “one person says one thing, someone else says another thing, then there is the truth.” Now I do not wish to be arrogant and claim …here comes the truth but I offer the following points in no particular order for and against index tracking.

Index Momentum

The claim that passive index trackers outperform is not new. It arises from the 1990s when Virgin Money who launched a FTSE All Share tracker in 1995 observed correctly that most active funds underperformed passives and their higher management fees were often not justifiable. The 1980s and 1990s were a golden period for stockmarkets, with falling global inflation and what was referred to as a Goldilocks economy in the US, not too hot not too cold, stockmarkets rose strongly and steadily. The following graphic of 50 years of the FTSE All Share Index to April 2012 from the Daily Telegraph demonstrates this point nicely:

http://www.telegraph.co.uk/finance/markets/9196093/Graphic-50-years-of-the-FTSE-All-Share-index.html

Markets rose strongly through the 1980s and 1990s until the technology bubble burst in 2000. The index has significantly moved sideways since with V shaped peaks and troughs. What is interesting here is that the value of FTSE All Share index in 2012 was no higher than it was in 2000 and the same is true of the FTSE 100 index even today. This means an investor buying an UK tracker at the peak of the market at end of 1999 and drawing dividends would have lost capital.

It is my view that index tracking funds do well in steadily rising markets, especially when there is a low disparity of stock returns -  a recent example is in the last five years, when general market exposure was more important than stock selection (see my blog post of 8/3/14 http://www.montgomuse.co.uk/beta-jockeys-to-fall-at-the-first-hurdle/ ). In periods of volatility, especially when markets move sideways or are falling, disparity of stock returns is higher and active fund management is may outperform. One reason is active fund managers can move to cash, select defensive stocks and avoid the basket cases. In conclusion index momentum is a key factor in whether actives or passives outperform. The last 13 to 14 years suggests index momentum favours actively managed funds.

Passives are Structurally Expected to Underperform the Market

Index trackers although outwardly simple are complex and differ in their methods of replication of the index. A variety of factors contribute to what is known as their tracking difference, the performance gap between the tracker and the index. Index trackers seek to keep this to a minimum. A key element of tracking difference are the charges. In the vast majority of cases index trackers are destined to underperform the index because they carry management fees; the index itself has no such drag. Actively managed funds in contrast have no such inherent structural encumbrance and have the potential to significantly beat the market and vice versa. An adventurous risk investor (like me) is willing to pay higher management costs for the potential for significantly greater investment returns whilst a cautious risk investor may not.

Market Efficiency Favours Passive Trackers

It is widely accepted that highly efficient markets favour index trackers. This is because analyst coverage is so extensive that stock prices accurately reflect companies’ true worth. The potential of good stockpickers to find under-valued gems is very limited when all the news in priced in. The best example of this is the observation that very few active US fund managers beat the market for example the S&P 500 index. In contrast active fund management works best in under researched markets and a good example are smaller companies where there are often significant pricing anomalies. The logical application here is to use passives in sectors where market efficiency is high and actives where it is not.

Passives and Actives are Favoured in Different Sectors

The rPlan research was based on five year returns to 30/10/13. This  significantly covers the post financial crash period. Equities rose sharply during the period notably from March 2009 in a classic recovery bull market, which should have favoured passives.

rPlan showed the probability of active fund outperformance of the average index tracker was 100% for China, 99% for Europe, 73% for Japan and 66% for UK. I am not unclear what definitions are being used here but interestingly unlike other research their study included investment trusts which are actively managed and ETFs which are passively managed. In rPlan’s study only the US and property had probabilities of active fund outperformance at less than 50%, i.e. 39% and 31% respectively.

What was also interesting about rPlan’s research was they showed outperformance of passives over actives over the 5 years to 30/10/13 was just 1.5% to 4.5% for three sectors, US, property and gilts. However for the other sectors, bonds, UK, Japan, Europe and China the outperformance of actives in equity sectors ranged from 15% to 35%.

Active Funds are Inconsistent, Passives Remove Fund Manager Risk

Research from Vanguard show that in many cases that actively managed funds that outperform over a five year period fail to repeat that in the following period. In other words performance is inconsistent and you cannot guarantee a star fund manager will not lose his sparkle or the investment style of the fund will not fall out of favour. This comes back to the caveat of past performance not being a guide to future returns.

A key argument in favour of passive trackers is they remove fund manager risk out of the equation. By using trackers the focus can be solely on getting the asset allocation right; it is widely accepted asset allocation is the single biggest contributor to performance, much more important than fund manager skills. The worst performing fund in the best performing investment sector invariably will outperform the best performing fund in the worst performing sector.

Unlike passives actives require the need to review both the asset allocation and fund manager performance. I frequently review portfolios and recommend the replacement of a specific fund with an alternative in the same sector because the fund manager has made mistakes and has underperformed. This increases portfolio turnover and advice costs for clients. In contrast passive funds would only normally be replaced if the asset allocation needs to be adjusted.

Performance Differences are Greater than Charge Differences

In all my years as an IFA it has been my observation that differences in performance are greater than differences in charges. As an example take the IMA UK All Companies sector which UK equity funds are placed in. Data from Trustnet (9/6/14) shows there are 258 funds. Over the last year the average return was 14.3% but the disparity of returns ranged from 3.3%  to 34.1%. However the difference between the lowest and highest charging funds would unlikely to have exceeded 1.5% p.a. Whilst I do not think charges are unimportant I principally focus on the performance potential when researching investments. If I find two funds that are equally good then charge considerations will be a deciding factor.

Passives Favoured in Difficult to Access Markets

In certain emerging markets where liquidity is poor, corporate governance is weak and the costs of buying stocks high, an index tracker offers clear benefits, you buy the index rather than stocks themselves. This will require the use of synthetic ETFs which instead of replicating an index by holding the constituent stocks buys the return of the relevant stockmarket index through a third party. This does however require counterparty risk. Moreover ETFs themselves are securities traded on stockmarkets and are not covered by the Financial Services Compensation Scheme in the event of insolvency. Index tracker funds are as they are regulated collective investments.

Conclusion

It is not the case that only index trackers or only active fund managers should be bought by investors. There is a case for holding both in portfolios. An investor may achieve the selected asset allocation through index trackers as a core and then add satellite active funds, where fund manager skills can exploit inefficient markets and add value. Index trackers can also be used for highly efficient or difficult to access markets or for clients who are particularly cost conscious and doubt the value of fund manager skills.

I have to hold my hands up, I have underused index tracking strategies in the past. In future I will use them more for selected investments e.g. large cap, US equities and difficult to access markets. However the research I have studied has not led me to alter my view that active fund management is a logical and beneficial strategy for many clients especially those where potential returns are more important than charges.

* It should be noted that the OCF  excludes portfolio turnover costs and may exclude stamp duty reserve tax.

This blog reflects my own understanding, views and interpretations not those of Vanguard or rPlan. It is intended as a general investment commentary and is not an invitation to invest in the areas mentioned. You should seek individual advice before making investment decisions.

 

Posted in Active Fund Management, Fund Management, Index Tracking | Comments Off

The Impact of Investment Styles on Fund Performance

It is fairly well known that many fund managers adopt specific investment styles in running their portfolios. These are the underlying investment principles and strategies a fund manager favours and this in turn determines their asset and sector allocations and the type of stocks they buy. Whilst the main styles are often described as “value” or “growth,” there are variants, for example a style that is a blend of value and growth, contrarian investing, deep value, bottom up (stock-picking focused), top down (based on macro-economic assessment) and style agnostic. The terminology can be confusing, the boundaries between terms are sometimes blurred and some style terms can be combined for example a fund manager may be described as a bottom up value investor.

So what is the relevance of these styles for investors? First a few definitions.

Value & Growth Investment Styles

https://www.fidelity.com/learning-center/investment-products/mutual-funds/growth-vs-value-investing

This article from Fidelity’s US website describes these as follows:

Growth funds focus on companies that managers believe will experience faster than average growth as measured by revenues, earnings, or cash flow. Growth fund managers also look carefully at the way a company manages its business. For instance, many growth-oriented companies are more likely to reinvest profits in expansion projects or acquisitions, rather than use them to pay out dividends to shareholders.

The goal of value funds is to find proverbial diamonds in the rough; that is, companies whose stock prices don’t necessarily reflect their fundamental worth. The reasons for these stocks being undervalued by the market can vary. Sometimes a company or industry has fallen on hard times. Other times a poor quarterly earnings report or some external event can temporarily depress a company’s stock price and create a longer-term buying opportunity. In searching for these companies, managers look for what many experts call a “margin of safety.” This means that the market has discounted a security more than it should have and that its market value, the price at which it is trading, is less than its intrinsic value, the present value of its future cash flows.

Relevance of Styles

The relevance of investment styles relates to the business cycle. At various times in the cycle certain investment styles, strategies, sectors or stocks are favoured. If a fund manager can call these cycles correctly there is money to be made. To give some historical context before some current examples. The global financial crisis of 2007 and 2008 and the subsequent recession and EuroZone crisis resulted in risk averse sentiment amongst investors. Cyclical sectors like miners tanked and emerging markets were avoided. Instead investors sought the safety of defensive stocks, principally in developed economies, i.e. companies with stable earnings and sustainable dividends as well as safe haven government bonds and strong currencies.

Defensive stocks traditionally include tobacco companies, food retailers, utilities and pharmaceuticals and tend to do relatively well in recessions on the principle people still smoke, eat, use gas and take medicines in a downturn, though hopefully not all at the same time.

Subsequently as the global financial and EuroZone crises abated appetite for risk increased and the sectors and assets that were most oversold rallied. This particularly benefitted economically sensitive cyclical companies, smaller companies, European stocks and bonds, and high yield debt.

The changes in the global economy, investor sentiment and favoured styles have a key bearing of the performance of actively managed funds. Some funds and fund managers have set styles that they do not shift from or shift too slowly from, whilst others are tactically nimble, clever or contrarian, adapt their strategies and call the market well.

Examples

Here are some examples I have come across recently:

M&G Recovery – this has a distinct value or deep value investment style, buying and holding out of favour UK companies the fund manager considers the market has not fully appreciated. This style was previously very successful but has led to the M&G Recovery fund underperforming its peer funds in the last five years as defensive growth or cyclical growth stocks have outperformed at different stages. It has also performed poorly as M&A activity (mergers and acquisitions) which benefit recovery stocks has been very muted in recent years especially amongst larger companies. Corporates have been hoarding record levels of cash because of  economic uncertainty rather than splashing out on capital expenditure. Now M&A activity is picking up the M&G Recovery fund fortunes may improve.

Schroder UK Absolute Target – this fund seeks to make money in all market conditions by taking long and short positions in UK equities. To remind you a long position is an active investment in a stock or index with an expectation its price will rise. A short position is a bet a stock or index will fall. This fund suffered a 4% loss in March and April  due to a sudden sell-off in mid-cap stocks the fund had long positions in. These performed extremely well in 2013. It seems investors decided to take profits and sold out of the mid-cap winners and bought into mega caps. It was a rotation from cyclical stocks to large cap value. Unfortunately Schroder were underweight here and were short on AstraZeneca, which rallied on the initial bid by Pfizer. Other fund managers in contrast pared back mid-cap holdings prior to the correction on the back of valuation concerns.

Standard Life UK Equity Income Unconstrained – this has an excellent track record compared to its peers over one, three and five years. It adopts a contrarian investment strategy by looking for dividends across the market capitalisation spectrum, including smaller and medium sized companies. In contrast traditional equity income funds focus on solid dividend payers within the large and mega cap space. The focus down the scale has resulted in excellent returns for the Standard Life fund.

Old Mutual UK Alpha – Since 2006 banks have gone from aggressive growth stocks and solid dividend payers, to basket cases, some requiring life support and now to recovery stocks. Their balance sheet complexity put off professional investors given fears of hidden toxic debt and the wise principle of not investing in anything you do not understand. However some investors saw the recovery potential and value in selected over-sold stocks and invested early. Veteran fund manager of the Old Mutual UK Alpha, Richard Buxton was one who has benefitted from this contrarian stance. Interestingly the M&G Recovery has recently been underweight in financials which also hurt performance. This sector by the way is broader than banks and includes for example insurance companies and asset managers.

Conclusion

Market conditions and economic cycles play a key role in investment returns. It is not just asset allocating correctly to equities, fixed interest, cash or property, nor stock selection, although these are important. The best fund managers are likely to have a flexible and nimble investment style to take advantage of changing cycles and opportunities.

This blog is intended as general stock market commentary only, not advice to invest in the sectors or funds highlighted. You should seek individual advice before making investment decisions.

 

Posted in Contrarian Investment, Investment Strategies, Investment Styles | Comments Off

Who Would be an Investment Adviser?

No sooner had I made the case for UK mid-caps (blog post of 8/4/14) there was a sharp sell-off in this sector. So was this a bad call? You could easily conclude this. However you could adopt a more practical opportunistic approach. Listen to your IFA’s recommendations and then short them by doing the very opposite or wait a few weeks for the recommended investments to crash in value and then buy into the story!

Fund managers are somewhat baffled by the sell off and the best explanation appears to be that this is no more than profit taking with last year’s winners being dumped. A change in sentiment to investment styles may also be a factor. More on this in a blog post to follow. Interestingly some mid-cap fund managers have used the opportunity by adding to their best stock convictions at lower prices.

Bull markets are characterised by occasional sell-offs, euphemistically referred to as corrections. They do not necessarily signal an end to the rally; it may just be pausing for breath to eliminate valuation froth. For the long term buy and hold investor the sell-off may end up in 10 years’ time looking like a mere blip. I am not convinced the fundamentals have changed.

This blog is intended as general stock market commentary only. You should seek individual advice before making investment decisions.

 

Posted in UK Equities, UK Mid-Caps | Comments Off

“We’ve got top men working on it right now!”

This was the evasive answer Indiana Jones, a leading archaeologist played by Harrison Ford and his companion Dr. Brody received at the end of the blockbuster film “Raiders of the Lost Ark,” when they inquired about the Ark of the Covenant.

“Who?” Jones asked, not satisfied with the reply.

“Top men.” The slow emphatic reply from an unyielding US government official.

The film then cuts to a scene where the Ark is being nailed into a wooden crate and then wheeled through an enormous secret US government hanger to be hid away. Of course there were no top men.

There is a certain analogy with the controversial issue of bank bonuses. The argument goes if we want to turn around a failing bank like RBS, owned by the UK government then we need the best bankers and if don’t pay them large bonuses they’ll go elsewhere. An analogy is sometimes made with the Premier League, if you want success in football you have pay top dollar for the best players. I don’t buy this argument when it comes to the banks. After all wasn’t it the top bankers who caused the financial crash in 2007 and 2008 that required government bail outs and led to the worst global recession since the 1930s?

The bank bonus culture has been with us for many years, banks have been tripping over themselves to attract the best talent and pay their top people well so they did not leave for the competition. All well and good if it translates to bottom line profits, profits growth and shareholder value – attractive dividends and share price appreciation. Too often shareholders in banks have had a rotten deal with miserable returns; and what we observed with RBS this week typifies the cock eyed thinking. The bank made a loss of more £8 billion in 2013 and yet wanted to pay £588 million in bonuses. The top people have not delivered, so why should they be given bonuses? I also think it odd that bonuses are paid out of the balance sheet not profits and do not believe there is no young up and coming talent within a bank to replace the so called top bankers running off to the opposition.

Similarly it was reported in February that Barclays Bank, which has not needed taxpayer support, announced a £2.38 billion bonus pot for 2013 up 10% from 2012. Dividends by comparison were just £859 million. The context for this was that profits fell from £7.6 billion in 2012 to £5.17 billion in 2013 (Source FT http://www.ft.com/cms/s/0/373c4d50-92ea-11e3-b07c-00144feab7de.html#slide0 ). According to the FT dividends were flat at 6.5 p per share.

I appreciate the issue of bankers’ bonuses is more complex than my analysis with one off profit and loss contributors, deferred pay-outs, bonuses paid in shares rather than cash but shareholders do wish to see their interests more aligned with banker remuneration. However what is interesting is to see how the fund management industry does it in comparison to investment banking. And I hear some of you saying, doesn’t my IFA, Mike Grant keep banging on about top fund managers and how talented they are to justify his investment recommendations? Whilst I am not party to the remuneration arrangements of star fund managers I am sure they are paid very well. However there is a much clearer link between management company remuneration and investor returns. This is due to the percentage management charge, typically 0.75% to 1% p.a. of the fund value. If a fund manager delivers a market beating return and grows the unit price from £1 to £1.20, investors gain 20% and the management fee will increase by 20% as well. The individual fund manager’s individual bonus from hitting or exceeding a target will invariably come from the annual management fee. It is worth pointing out that very few OEICs (open ended investment companies) or unit trusts have a performance bonus on top of the annual management charge paid by investors.

In conclusion I am supportive of top people in the investment fund industry if not the banking industry. They gain when investors do and lose money when markets fall. It seems a fair meritocracy to me.

This blog is intended as general stock market commentary only. You should seek individual advice before making investment decisions.

Posted in Banks, Fees & Bonuses, Fund Management, Fund Managers | Comments Off