Mark knight

We are surrounded by research, data and commentary that seldom looks beyond an investment horizon of between one to three years. The benchmark or index, of course, does not take active decisions, it is simply a ‘weighing device’, typically based on market-cap criteria and the net sum of investor behaviour at any given point in time.

By contrast, with an eye to producing superior, risk adjusted long-term returns, the thoughtful active manager will use judgment to avoid such short-term traps and invest in the inevitability of economic and market growth, and mean reversion over time. It makes sense that there will be periods of underperformance because, after all, this risk recycles as a source of future long-term excess return.

Assessing performance efficiency

In this way, whether referencing an index or an active return, any given short-term result offers a poor guide for the future prospects for investment performance. In fact, it isn’t telling us much at all. We can only assess the efficiency of a market index, or the effective judgment of an active manager, over the very long term.

Given this and the complementary point that the common person’s investment span is genuinely multi-decade, it remains a mystery as to why so many pundits develop a prognosis based on data and records that extend for only a few years. Surely it makes sense to draw inference from market and manager results that have endured the rigour of varying cycles, peaks and troughs over an extended timeframe.

The value of long term returns

The Mercer Australian Large Cap Share Performance Survey for the 20 years to end December 2022 shows that the S&P/ASX 300 (All Ords before 1/4/2000) returned 8.8% pa on a compound basis. Of the 30 active strategies in the survey, all beat the market with a median result of 10.3% pa, compounding at a very respectable 1.5% pa above the market. The upper quartile compounded at 11.2% pa, beating the market by 2.4% pa. Even the lower quartile mark of 9.5% pa outperformed the broader market. These results do not include the effect of franking and are shown on a before fees basis.

Over a 20-year timeframe, investing $10,000 at a median return of 10.3% pa produces a balance of $71.041. If, rather, one invested in an index fund or market ETF and received a before fees return of 8.9% pa, the final balance would amount to a far lower $55,297.

The pitfalls of reducing share exposure

Reducing share exposure either after the commencement of a correction or during the period of recovery, will interfere with compound growth and be detrimental to capital accumulation. However, after the worst corrections, history shows that share values may take several years to return to their starting value.

During the famous stock market crash of 1987, the S&P 500 collapsed by 28.5% and took 398 trading days to recover. The global financial crisis that extended across the second half of 2007 and 2008 caused the S&P 500 to depreciate by 56.8% and recovery took 1,022 trading days.

Small caps versus large caps

Compared to the large-cap segment of the market, the small-cap sector of the market is arguably less efficient (lower levels of information), with less broker coverage and therefore affords relatively greater opportunity for alpha generation over the long run.

The data bears this out in a stark fashion. The Mercer Australian Small Cap (ex 100) Share Performance Survey for the 20 years to end December 2022 shows that the S&P/ASX Small Ords returned 6.6% pa on a compound basis. Of the 14 strategies in the survey, all of them beat the market with a median result of 12.3% pa, compounding at a very respectable 5.7% pa above the market. The upper quartile compounded at 14.2% pa, beating the market by 7.6% pa. Even the lower quartile mark of 11.2% pa outperformed the broader market by 4.6% pa. During the last 10 years in particular, there has been a proliferation of micro-cap strategies that utilise the S&P/ASX Emerging Companies index as their benchmark. For the 10 years ending December 2022, the Mercer Survey indicated a peer group median compound return of 9.5% pa versus 6.5% pa for the benchmark.

The importance of research, and ESG

Fundamental, proprietary research of course provides the insights that allow active managers to create a capital return beyond the return of the market sector in which they invest. This research is both qualitative and quantitative and, traditionally, has focused on the financial aspects of corporate performance.

It is now increasingly common for the same managers to also investigate the target companies approach to the environment, society and corporate governance (ESG), alongside its financial aspects, for a fuller view of the earnings risks and opportunities. The fuller the view, the greater the likelihood of excess returns on a risk-adjusted basis over time. Proper ESG integration will also insist on extensive engagement and advocacy with the interaction between fund manager and company manager encouraging corporate behaviour that is both responsible and sustainable. Issues such as climate change and modern slavery are topical. An index or index tracker is unable to do this work. As is the case with valuations, the index is ‘blind’, without any ability to use thoughtfulness and intellect to produce superior outcomes over time, or to actively reduce risks obvious or not.

Keep an eye on fees

Given the vast array of available investment strategies and vehicles it is difficult to generalise about the average level of investment management fees and what level is and isn’t reasonable. Investors though should remain considered in this area because the compounding effect of fees can genuinely interfere with long-term growth objectives. It is also important to distinguish between investment, administration and advice fees. Only investment management fees should be attributed to investment portfolios and included in net fee calculations. To enjoy the benefits of an active approach, investors should ensure that excess returns are expected to well exceed fees on a rolling long term basis.

By Mark Knight, CEO of Ausbil Investment Management

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