“Beta 1 style funds will typically maintain a net equity exposure of close to 100%, with the proceeds from short selling reinvested in their long positions. Short selling is primarily used to enhance overall fund returns and comes with increased market risk.”

“Variable beta style funds may utilise a broad range of strategies including short selling, gearing, derivatives and cash in order to adjust their net equity position in line with the investment manager’s market outlook.”

Of the 12 funds reviewed, none attained Lonsec’s top rating, Highly Recommended.

Sector themes and observations

High quality PMs entering the sector

While the universe has not increased all that dramatically, Lonsec is of the opinion that it has evolved with the introduction of a number of competing teams with strong skill sets and experience. “Historically the retail long short sector has been dominated by successful long only managers launching active extension or long short strategies,” commented Ngin.

“Lonsec believes that the shorting element is a specialist skill set and has tried to differentiate between solid long only investors versus investors with extensive track records in shorting.”

Post the GFC, the quality of personnel within the long short space has increased, especially at the portfolio manager level.

“We have seen a number of hedge fund investment professionals gravitate to the retail space, leading to greater sophistication and greater dispersion in portfolio manager skill sets and short selling experience,” said Ngin.

Key person risk is high

Key person risk for many managers is relatively high, given the additional specialist skill set required for the effective implementation of the shorting component of a portfolio.

“While we see this as a potential risk, at Lonsec we believe that key person risk is often worth taking,” said Ngin. “That said, in the event that a key person ceased to work within an organisation, the rating of the Fund would be reviewed.”

Stop losses – stopped out

While the market only returned 3.8% for the year to May 2011, it should be noted that this was a relatively volatile period. As a result, it wasn’t unusual to see managers being ‘stopped out’ of their short positions. Managers that employed less rigid approaches to their stop losses were more likely to benefit from this volatility as they were less likely to be stopped out of positions that would later turn profitable.

“While this strategy may have worked in the favour of managers with the less rigid approaches to their stop losses over the last 12 months, Lonsec acknowledges that good risk management in long/short investing is important and that improperly managed short positions can result in significant losses,” observed Ngin.

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“A traditional small cap fund invests primarily in the S&P/ASX Small Ordinaries Index, where a mid cap fund invests predominantly in the S&P/ASX51-150 segment.”

“Lonsec reviews five microcap funds, which typically invest in small stocks outside the S&P/ASX Small Ordinaries Index. Microcap stocks are generally a relatively immature business, offer the highest level of risk and are usually quite illiquid – but potentially offer the highest level of growth opportunity.”

Of the 36 funds reviewed, five attained Lonsec’s top rating, Highly Recommended; one midcap fund, the Ausbil Australian Emerging Leaders Fund and four small cap funds – Hyperion Small Growth Companies Fund, Pengana Emerging Companies Fund, Schroders Australian Smaller Companies Fund and the UBS Emerging Companies Fund.

“Six new funds were added to Lonsec’s small cap Australian equity universe in this review, including two microcap funds, the Ausbil Microcap Fund and the Macquarie Australian Microcap Fund,” said Ngin.

Sector observations

Strong gains….if you were in the right place

“The S&P/ASX Small Ordinaries Accumulation Index gained a solid 13.1% in 2010 – a far cry from the 53.2% loss in 2008 and the 57.4% gain in 2009,” observed Ngin.

“However there is a mixed story – the S&P/ASX Small Industrials Accumulation Index returned just 2.2%, while the S&P/ASX Small Resources Accumulation Index returned a strong 30.7% return for the year.”

The Lonsec review found that the “average” small cap manager in its universe is underweight the resources sector, largely due to a “quality” bias in their investment process. “This can be incompatible with small cap resources stocks where the company may not be generating cashflow or earnings, or may be a higher risk, single mine business,” said Ngin.

Midcap stocks continued to struggle compared to small cap stocks, with the S&P/ASX Midcap 50 Index returning just 4% in 2010. In contrast, funds that were able to invest in the other end of spectrum in microcap stocks were the strongest performers, with the S&P/ASX Emerging Companies Index returning 25.7% over the same period.

Limited IPO activity in this sector

Historically, IPOs have been a major source of investment ideas for small cap managers; however 2009 was a relatively quiet year with just $7.5 billion in IPOs across large and small caps. While 2010 saw $25 billion in IPOs, most was in large caps – or small resources.

“The lack of new industrial stocks is of some concern,” commented Ngin.

“This is compounded by the departure of some industrials, such as JBHiFi, which became a midcap stock and therefore out of the investment universe for most small cap managers.”

Other IPOs – such as Rebel Sport – have been put on the backburner after the lacklustre performance of high profile industrial IPOs such as Myer, Kathmandu and QR National.

Fund flows continue to be flat

While funds under management continued to grow, this was largely due to market movement – actual inflows were relatively flat. This is consistent with the findings of Lonsec’s recent large cap review.

“Unlike the large cap sector, the small cap universe has not been subject to competition from low cost ETFs and index style products,” said Ngin.

“These products are much less likely to impact the small cap universe as the argument for passive index style products is substantially weaker in this sector.”

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Lin Ngin, Senior Investment Analyst with Lonsec commented, “The distribution of ratings in the 2010 review has a distinct positive skew, due to our focus on reviewing a selective list of high quality offerings, rather than just rating a large number of products.”

Sector themes

Fund flows

Retail fund inflows across the range of funds rated in this sector review have generally been flat. However managers researched by Lonsec have reported greater interest in hedge fund products from institutional clients.

“Although we have seen signs of life in this sector, with US13.7 billion of inflows into the global hedge fund industry in Q1 2010, this is still substantially lower than the US$100+ billion per annum in inflows from 2002 – 2007,” said Ngin.

“An interesting point regarding these inflows is the destination of the money – of the US$13.7 billion inflow, US$15 billion went to larger, established hedge funds managers – this means a number of managers experienced net outflow.”

New products

In last year’s Lonsec review, there were 10 new funds rated – this year, just one.

“Not surprisingly, the dearth of new retail offerings is intertwined with the lack of retail inflows,” observed Ngin.

“This sector is very prone to ‘flavour of the month’ products, whether they be new managed futures products in 2009 (this strategy had a very strong 2008) or commodities based funds.”

Regulation

A major fallout from the global financial crisis has been the policy and regulatory response by government authorities world-wide, particularly in relation to regulating the hedge fund industry.  Many of these regulations remain in the proposal stage and have not been enacted.

“Lonsec is generally supportive of any steps to improve transparency, although some proposed regulations such as remuneration controls, leverage limits and bans on shorting appear to be driven by hostility to the hedge fund industry as a fallout of the financial crisis.

Date: 28 July 2010

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