The average outperformance for the past 10 years in the reporting months of August and September were 3.2 per cent and 4.9 per cent, respectively. The reporting months of February and March saw outperformance averages of 0.2 per cent and 2.5 per cent, respectively.

Jacob Smart, senior investment analyst at Zenith Investment Partners says markets can be unpredictable and highly volatile in-between reporting seasons and the external market and economic noise surrounding listed companies doesn’t help.

“Earnings season gives companies the chance to cut through that noise and tell investors about the actual progress of their businesses.”

“This is why active fund managers in Australia have beaten the benchmark over the past 10 years, by sticking to analysing the fundamentals of listed companies through earnings.”

For the most recent earnings season of February/March 2021, the report found that the  active managers under Zenith’s research coverage generated a return of 5.1 per cent after fees, compared to a 3.9 per cent return of the S&P/ASX 300 Accumulation Index benchmark.

“Historically, fund managers have outpaced the market during report periods, particularly in the months of August and September.” Mr Smart says.

“Given the greater market inefficiencies caused by increasing retail investor participation since COVID-19, we believe there is no reason why this historical trend can’t continue.”

“Fund managers will once again look to showcase their ability to add value for investors in the upcoming reporting period.”

Zenith’s sector report also revealed that  the median active fund managers under-performed the local benchmark by 0.4 per cent outside of earning season.

The report analysed 189 Australian share funds in the large companies sector. Each fund had an average number of 53 portfolio holdings.

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Jacob Smart

Market participants, especially equity investors, can be forgiven if the words déjà vu spring to mind during this COVID-19 period. Although there are definite similarities between the Australian equity market drawdowns and subsequent recoveries of COVID-19 and the Global Financial Crisis (GFC), COVID-19 has proven to be the GFC in fast-forward. That is, during this period, we have seen the fastest bear market in Australian equity history.

As experienced during the GFC, the deterioration of the economy resulted in companies raising capital to shore up balance sheets. In its latest sector report, Australian Shares – Large Companies, Zenith Investment Partners found that this time around, companies with growth ambitions also took the opportunity to tap the market for additional capital.

As a result, April 2020 was a record-breaking month, with 37 placements raising a total of $A 13 billion.

According to Jacob Smart, Senior Investment Analyst at Zenith, to see a similar spike in the number and size of capital raisings from placements within a single month, you would need to go back to October 2009, where the number of placements topped 20 and in November 2008 total funds raised hit a month high of $A 7 billion.

“On 1 April 2020, the Australian Stock Exchange eased capital raising rules making it easier for companies to raise additional capital due to COVID-19,” said Smart. “With this temporary rule change, we saw companies such as Flight Centre and NAB, shore up balance sheets at a rate reminiscent of the GFC.”

But it was not just companies in trouble that issued placements during this period.

“Some company behaviour we saw was somewhat opportunistic, with companies that were unaffected or less impacted by COVID-19 also raising capital,” said Smart.

“Rather than fortifying their balance sheets, companies such as NextDC and Breville raised capital for growth initiatives such as acquisitions and investment.”

Given the attractive terms of the placements, participation resulted in high levels of excess returns for Zenith’s rated funds. Of the 57 placements between 21 February 2020 and 31 May 2020, Zenith’s rated managers participated in 43 which produced an average return of 33%.

Performance of investment styles

Smart notes that there are similarities regarding the performance of investment styles and market dynamics during the two crises.

During the GFC, the growth investment style exhibited a stronger degree of capital protection in the drawdown, whilst the value investment style significantly outperformed in the subsequent recovery.

Although the full effects of COVID-19 are not yet known, it appears as if history is repeating itself.

Unsurprisingly, value managers were prominent in the placements of more distressed companies such as Metcash, Kathmandu and Flight Centre. Whilst companies without balance sheet issues such as Ramsay Health Care, IDP Education and Cochlear were popular amongst the growth managers

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Jacob Smart, Zenith Investment Analyst

The last 20 years have seen global fund managers who favour growth style investing outperform their value counterparts. A key driver of this outperformance has been the falling interest rate environment as growth stocks are more sensitive to interest rate movements. This has seen them benefit more from the recent decline in global interest rates.

However, in its latest sector report – International Shares – Long/Short, Zenith Investment Partners found evidence of value outperforming growth in a low interest rate world and believes a value allocation can be highly beneficial for an investor’s overall portfolio.

“Our research found that where interest rates and bond yields hover near zero, value can outperform growth,” said Jacob Smart, Senior Investment Analyst at Zenith Investment Partners.

“We used Japan as a case study as they have experienced a sustained period of low interest rates with long-term bond yields having remained persistently low – below 2% – over the past two decades.

“The lack of growth and inflation has prompted market participants to revise the prospects of the economy downwards. Despite comprehensive monetary stimulus from the Bank of Japan, economic activity stagnated.

“These financial conditions have seen value outperform growth by 2.9% p.a. over the past two decades, almost the opposite of what has played out in other global markets over the same period,” said Smart.

“While the current market environment has been supportive of growth as an investment style, the Japanese case study shows that value investing can work in a low interest rate environment, an environment that appears on the horizon for global markets.

“As such, Zenith believes that it is crucial for investors to blend value and growth investment styles to gain a balanced portfolio outcome.”

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Jacob Smart

Investors focused on short-term performance will no doubt be disappointed with the underperformance of the Australian Shares long/short sector. However, research by Zenith Investment Partners shows that it is very difficult to produce superior investment outcomes without periods of short-term relative underperformance.

Take Marty McFly, every movie buff’s favourite time traveller. Even if he travelled back in time to 31 March 2014 and invested $130 ‘long’ in the top 10 performing stocks and $30 ‘short’ in the bottom 10 performing stocks, based on their share price performance over the five-year period to 31 March 2019, he would have generated a return of 51.6% p.a. over the five-year period compared to 7.4% p.a. for the S&P/ASX 200 Accumulation Index.

Despite having a time-travelling DeLorean, McFly’s portfolio still experienced a maximum drawdown of 13%, with several periods of underperformance that were more severe than the Index.

Jacob Smart, Investment Analyst at Zenith Investment Partners, believes there are some similarities between the performance of Zenith rated funds and that of McFly’s portfolio.

“While we expect that our rated funds will produce highly attractive returns over the long term, there will be short periods where they will underperform. As such, we emphasise our belief that investors must take a long-term view when investing in actively managed funds.”

Investing for the long-term

The Zenith 2019 Australian Shares Long/Sort Sector Report found that for the 12 months to 31 March 2019, Zenith rated funds returned an average of 5.2% compared to 11.7% for the S&P/ASX 300 Accumulation Index, representing significant underperformance of 6.5%.

Smart attributes the underperformance experienced by this sector to the large dislocation of company valuations within the Australian share market.

“In 2018, the spread between the cheapest and most expensive stocks reached record highs and, even after the fourth quarter correction last year, remained at elevated levels,” said Smart.

“The cheaper segment of the market continued to become even cheaper throughout 2018, while at the other end of the market, the sharp rise in early-to-mid 2018 forced several managers to reduce or exit meaningful short exposures. As such, losses were absorbed and the funds were not in a position to fully benefit from the subsequent valuation contraction experienced in late 2018.”

By Jacob Smart, Investment Analyst

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Jacob Smart

A prolonged bull run in equity markets and increased concerns about a possible market correction have underpinned a sharp rise in the use of long/short strategies in investor portfolios, according to Zenith.

Over the year to March 2018, the amount invested in Zenith’s rated Australian shares long/short strategies increased 43% to $8.7 billion. Over the past four years, this segment has grown 78% (up from $4.9 billion).

Long/short equity funds invest in shares like long-only equity funds, however, they are also equipped with the ability to “short sell” stocks. Short selling allows investors to profit when stocks or markets decline – hence their appeal to investors in times of market uncertainty.

Long/short outperforms, with lower risk

The surge in inflow has coincided with a good performance period for Australian shares long/short funds. In the five years to March 2018, Zenith’s rated fund managers returned 11.7% p.a., compared to the S&P/ASX 300 Accumulation Index return of 7.6% p.a. Risk volatility was also lower for long/short funds, with annualised standard deviation of 8.9% versus 11.2% for the Index.

Long/short delivering on their protection pledge

The basic premise of long/short investing is that in order to provide better protection on the downside, investors trade away some of the potential upside. Expressed differently, if share markets fall, the funds should fall by a lesser amount, and when markets rise, the funds should also rise – but to a lesser amount.

In its Research Report, Zenith assessed whether Australian shares long/short funds have delivered on this promise, comparing the results to traditional long-only funds.

In the five years to March 2018, long/short funds captured an impressive 92% of the market’s upside return, which is within close range of the 98% upside capture for long-only funds.

When markets fell, long/short funds provided a much higher degree of downside protection, suffering only 57% of the market’s decline, compared to 86% for long-only funds.

Jacob Smart, Zenith Investment Analyst summarised, “The results of our analysis provide clear evidence of the beneficial role that long/short strategies can potentially play in an investor’s portfolio. It is also important to recognise that short selling is a specialised skill set that we assess carefully when rating funds. The ability to short sell effectively is a key determinant of success in the overall strategy.”

Size is much more limiting in the long/short space

Zenith believes that short selling effectiveness is sensitive to strategy size, mainly because short selling requires stock borrow, which has limited supply. This supply shortage is reflected in the low volume of short sold stocks, with only 2% of the Australian equity market held sold short as at 31 March 2018.

Zenith believes the overall capacity of long/short strategies – which is limited by a fund manager’s short selling capacity – currently sits at approximately $1 billion. Smart concluded, “Our hypothetical capacity target provides a line of sight to guide optimal short selling effectiveness. Pleasingly, all our rated managers have leverage-adjusted short exposures that are below this figure, providing our financial adviser clients with confidence that capacity among our rated funds is prudently managed.”

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Jacob Smart

Global long/short funds have passed a litmus test on whether higher fee investments can be compensated with higher investors returns, according to Zenith’s most recent Sector Review.

Zenith’s 2017 Global Shares – Long/Short Sector Review compared the fees, performance and volatility of both long-only and long/short funds in the global equity asset class. While both groups invest in the same universe of stocks, only long/short funds can short-sell as a way to potentially deliver positive returns even if stock prices fall (albeit short selling comes with additional risks).

The Review found that the average global long/short fund charges a significant fee premium relative to long-only peers (with Indirect Cost Ratios of 2.17% and 1.02% respectively).

Zenith found that although investors can pay significantly more to invest in global long/short funds, the associated absolute and risk-adjusted returns are typically superior to their global long-only counterparts. On average for the three years to 30 June 2017, global long/short funds achieved higher returns than their global long-only counterparts (14.1% p.a. versus 12.9% p.a.), even after fees are taken into account.

The Review also considered whether investors were compensated for the higher return in terms of risk, as measured by standard deviation. Both groups recorded similar levels of risk (10.9% p.a. versus 10.6% p.a.), suggesting that investors have typically been sufficiently rewarded for both the higher return and the premium fees paid for global long/short funds.

Jacob Smart, Zenith Investment Analyst said “investors need to consider the higher fees of global long/short funds in the context of the specialised skill sets required, additional liquidity constraints on short selling and the leverage employed by these strategies requires them to manage a higher level of market exposure.  Overall, we believe this premium is justified and the performance differential in this review period validates that proposition.”

The Sector Review also revealed that the changes in fee disclosure under RG97 is likely to have no impact on the net returns of existing investments. Zenith notes that investors have always been paying these newly disclosed fees, however previously they were not required to be disclosed in a formal manner. Smart said “we believe the increased fee disclosures under RG97 are positive as investors are afforded improved transparency around the underlying costs associated with their investment.”

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