Leading research house Lonsec has warned investors to stay alert for structural risks in Australian REITs as the sector continues to rebuild and prosper.

Lonsec’s 2014 A-REIT Sector Review, released today, showed Lonsec’s peer group of active A-REIT managers achieved returns of 12.7% over the year to 30 June 2014 and 15.4% annually over five years. Investors also enjoyed an annual distribution rate of more than 5%.

However the report also identified several ongoing risks in the sector including significant concentration risk across all 23 funds surveyed, and ongoing shrinkage in the sector due to corporate activity.

Peter Green, Senior Investment Analyst at Lonsec and principal author of the report, said the sector “continued to perform in a stellar fashion in 2013-14.”

A-REITs’ strong returns are the result of several factors. The sector has benefited from cheap funding and a fall in capitalisation rates due to the decline in government bondyields. Valuations of properties have been boosted by strong demand for institutional grade assets from both listed and unlisted entities.

In terms of ratings of the 23 A-REIT funds assessed in the report, there were five upgrades and four downgrades. Of the five that were upgraded, one – BlackRock Indexed Australian Listed Property Fund – was assigned Lonsec’s premier ‘Highly Recommended’ rating.

Flagging risks

The report found that there was significant concentration risk across all 23 funds surveyed. Because of the structure of the A-REIT sector, each of the funds typically has a substantial exposure to a small number of securities. At the end of July 2014, the ten largest stocks accounted for around 89% of the capitalisation of the S&P/ASX 200 A-REIT Accumulation Index (XPJ). The five largest names accounted for about 62%. These figures have remained broadly unchanged over the last year.

A related challenge has been the shrinkage of the sector over the last year thanks to corporate activity and the potential that Westfield Corporation (WFD) could redomicile to the United States. Lonsec believes that this will place greater emphasis on capacity management as a driver of success for fund managers in the sector. Some managers may find that their relatively large size makes it harder for them to generate alpha.

Lonsec notes that investors, and their advisers, need to remember that A-REITs are listed securities and that returns will be subject to normal equity market risks. Some stapled securities, such as Mirvac (MGR) and Goodman Group (GMG) also have large exposures to cyclical earnings streams from property development and asset management. The sector has, however, had a more defensive nature for some time, thanks to the A-REITs’ ‘back to basics’ approach following a disastrous period during the global financial crisis.

“In short, concentration risk is not the only issue that investors need to consider when investing in the A-REIT sector”, said Mr Green. “Nevertheless, the changes to capital structures that were undertaken by corporate managements following the global financial crisis laid the foundations for the strong absolute returns that have been achieved in recent years.”

Active versus passive

Within the A-REIT sector, the average Lonsec manager has been able to justify their ‘active’ fees charged – having generated alpha of 1.1% annually over five years and 1.6% in the 12 months to the end of June. Active managers have successfully fought back against the low cost index strategies that have proliferated over the period.

Lonsec noted that, in a fee competitive environment, A-REIT funds increased their ‘active share ’(i.e. the percentage of the portfolio that differs from the relevant benchmark) through 2013: in particular, more ‘benchmark aware’ managers (i.e. those that face the greatest competition from low cost index funds and exchange-traded funds) made a concerted effort to lift their level of active share.

Nevertheless, Lonsec is agnostic about the ‘active versus passive’ debate in the A-REITs sector. Lonsec accepts that, for more fee conscious investors, an index approach to A-REITs can make sense if investors are comfortable holding such a large exposure to the retail sector.

Conversely, Lonsec believes that investors who are looking for alpha from their A-REIT exposure should consider an active manager. “There are several aspects that we seek from active managers”, notes Mr Green. “These include experience ‘through the cycle’, as well as proprietary commercial property experience. We also look for a less ‘benchmark aware’ approach, which means that the manager can take meaningful positions away from the ‘top ten’. Finally, we like to see the depth of research coverage, so that the manager can thoroughly investigate smaller, or non-index, opportunities.”

 Other key findings of the report include:

• There have been limited new entrants in the sector outside of the ETF/index space.
• Many A-REIT fund managers that are focusing on the sector have been creative in attempts to reduce concentration risk. Some have invested in globally listed property securities or listed infrastructure securities. Others have taken larger active positions in A-REITs that lie outside the ‘top ten.’
• The merger of Westfield Retail Trust (WRT) with Westfield Group’s (WDC) Australian and New Zealand businesses to form Scentre Group (SCG) reduced the need for the A-REIT fund managers to spend a disproportionate amount of time analysing one stock. Before the deal, WDC and WRT accounted respectively for 27% and 10% of the benchmark. Afterwards, SCG accounted for 19% of the index; the slimmed down Westfield Corporation, for 16%.

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The Triple3 Volatility Advantage Fund, which is distributed in the Australian market by Grant Samuel Funds Management, aims to generate long-term absolute returns with its volatility-focused strategy to capture alpha from highly liquid exchange-traded VIX options, which are negatively correlated to equities.

“The “Recommended” rating indicates that Lonsec has strong conviction the financial product can generate risk-adjusted returns in line with relevant objectives and that the financial product is considered an appropriate entry point to this asset class or strategy.

“The Fund is relatively simple in design and has intuitive appeal,” Lonsec says.

“It invests in exchange traded VIX options which are liquid and regularly priced. The Fund is heavily concentrated in just a few securities; VIX options, cash and cash-like securities, however given the nature of the strategy, Lonsec considers this to be an appropriate approach.

“From a broader portfolio construction perspective, the Fund is an appealing diversifier from traditional equity market risk.

“The Fund is expected to be causally negatively correlated to US equities when needed most (in times of falling equity markets),” Lonsec says.

Damien McIntyre, director and head of distribution with Grant Samuel Funds Management, says the rating is timely, and will increase the appeal of the Fund to the retail market.

“Investing in volatility is at the forefront of investor activity in the United States, and this is increasingly being reflected in the investment range available there.

“There are 22 VIX based exchange traded products that operate in the US market.  But until the launch of the Triple 3 Volatility Advantage Fund there was not one VIX based product in the Australian market.

“Investing in volatility provides the ability to diversify in ways that asset classes can’t, and Australian investors can invest in volatility through this Fund,” Mr McIntyre says

The Fund also has a AA rating from van Eyk.

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Lonsec releases its 2014 Global Emerging Markets and Regional Equities Sector Review.

Lonsec yesterday released its 2014 Global Emerging Markets and Regional Equities Sector Review, highlighting a challenging year for emerging market investors in 2013 with ongoing concerns about the impact of  ‘tapering’ by the US Federal Reserve; and slowing growth and/or current account deficits in the ‘Fragile Five’ markets of Brazil, India, Indonesia, South Africa and Turkey.

In spite of this, the emerging market benchmark performed creditably during 2013, rising by 13%, with returns in AUD terms boosted further by the slight slippage in the currency. However, this was well below returns delivered by domestic and global (developed) equity markets – and in USD terms represented the poorest year of performance for emerging markets versus developed equities since 1998.

In terms of ratings, there were four rating upgrades and two downgrades among the 40 funds assessed. Five funds were assigned Lonsec’s premier ‘Highly Recommended’ rating.

“There was a large dispersion of performance among active emerging market managers over the year, with decision-making around holdings in the ‘Fragile Five’ economies having a particularly strong bearing on investor returns,” said Steven Sweeney, Senior Investment Analyst at Lonsec and principal author of the report. ”This highlights the importance of managers supplementing their bottom-up research process with a consideration of ‘top down’ or macro factors within the applicable investment process.”

Lonsec recommends that investors, and their advisers, use specialist emerging markets managers who have dedicated resourcing and tailored investment approaches as opposed to global equities managers who focus on traditional developed markets.

“Our higher rated managers will tend to be singularly focused on this asset class. They will have people on the ground in emerging markets and/or a substantial program of company visits, and will not see emerging markets as a bolt-on to other strategies,” Mr Sweeney said.

Lonsec also advocates active over passive investment strategies in emerging markets, although it recognises that there are a growing range of investment options for those seeking index exposure.

”Emerging Markets is an asset class where investors should afford managers greater freedom to add insight in portfolio construction, and pay fees for active management. Skilled emerging market managers really can add value through the decisions that they make,” Mr Sweeney concluded.

 Other key findings of the report include:

• Investment in Frontier Markets – developing, pre-EM economies like Nigeria, Pakistan and Vietnam – remains minor and generally non-existent.
• Asian equities – which makes up over 60% of the emerging markets benchmark – continued to outperform other significant economies in 2013 such as Brazil and Russia.
• For all the talk of the economic decoupling of EM economies from the influence of the US and the West, recent history confirms that EM performance remains hostage to US economic sentiment.
• BRIC economies continue to struggle to recapture the positive momentum of a decade ago with each contending with various economic flare-ups.
• Political risk remains a clear and present danger for emerging markets investors. Geopolitical events tend to dominate emerging markets, more so than in advanced economies. Weakening AUD boosts returns.
• The AUD has weakened over the past 18 months falling from $1.04 against the USD at the beginning of 2013 to US 0.89c at the end of the year. The majority of funds are unhedged which has aided performance for Australian investors.

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Continued growth of SMA platforms in coming years: Lonsec

Lonsec has undertaken new research into Australia’s  separately managed account (SMA) platforms in recognition of the increasingly important role SMAs play in offering investors heightened transparency and greater control over their investments.

In response to strong interest from its clients, Lonsec conducted what it believes to be the first comprehensive research into SMA platforms in Australia.

SMAs are normally non-discretionary in nature, in that the operator of the platform executes changes to model portfolios, but does not make the investment decision. By contrast, Individual Managed Accounts (IMAs) are normally run on a discretionary basis. Providers must be licenced as Managed Discretionary Account (MDA) operators.

Lonsec assigned ‘Approved’ ratings to each of the five SMA platforms it reviewed. The five SMA operators collectively account for over $2 billion in assets under management and over half of the total SMA market (defined as funds tracking model portfolios).

According to Michael Elsworth, Lonsec’s General Manager – Specialised Research, the SMA market falls into two broad categories: the large banks surveyed tend to view their SMA platforms as adjuncts to their wrap administration platforms, generally offering a narrower range of model portfolios. Meanwhile, specialist financial services groups, with strong orientation towards technology, are competing with the established players, in part by offering a more extensive range of model portfolios.

Both larger banks and specialist financial services companies committed to growing their SMA businesses over the next two years.

“In essence, usage of SMAs will likely grow thanks to both greater demand from advisory groups and other investors and to new and competitive solutions that are delivered by banks and other companies that are strategically committed to SMAs,” Mr Elsworth said.

Lonsec took a two-pronged approach to the research, reviewing investment managers and their model portfolios while also looking at the administrative services provided by the platforms and the underlying technology.

In assessing the investment managers, Lonsec looked at the communication between the managers and the operators of the SMA platforms. Lonsec also considered the suitability of the model portfolios for use in SMAs.

A key finding was that the SMA operators are not all alike in the ways in which they communicate with model portfolio managers: nor are they alike in the ways in which they communicate with advisers and investors.

“This new research defines the language and key concepts underlying SMAs in Australia and we expect the research to grow and become a sector in its own right over coming years,” Mr Elsworth concluded.

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Lonsec said its ratings upgrade reflects its increased confidence in PM Capital’s approach:  “Lonsec has been impressed the underlying consistency of the PM philosophy and the conviction of the investment views.”

“The fund’s contrarian style often sees PM CAPITAL investigating companies that have fallen out of favour with the broader market on the premise that negative factors are often short term and a company’s value will be restored in time.”

Lonsec notes that Paul Moore, PM CAPITAL’s Chief Investment Officer, is a highly experienced and seasoned investor and believes that his approach to funds management has been consistent over his long career. Included in the Lonsec report are the following observations:

“Lonsec considers PM Capital’s alignment of interest with investors is high… There is a strong culture of ‘eating your own cooking’ and staff investment in strategies… a significant portion of PM Capital’s retained earnings are also invested in the firm’s funds – adding to incentives to preserve capital”

PM CAPITAL’s CEO, Chris Donohoe said that “the return to recommended status is a reflection of both strong fund performance and corporate changes. These include a repurchase of non-working staff shares and a wider allocation of staff shares, lower fees and tightening risk management and portfolio guidelines. “

Donohoe said “over the last six months PM CAPITAL has raised $230M in two offshore equity LICs and our offshore equity FUM will move beyond $1Bn in August. The growth in demand for global equities is logical and ultimately based off the view that compared to the local market there is a greater breadth of opportunity, a better risk reward and all at a time when the currency is in the top quartile – it just makes sense”.

PM CAPITAL Absolute Performance Fund has achieved a total return of 209.4% since its inception in October 1998, which compares favourably against the MSCI World Index (Net Dividends Reinvested, AUD) total return of 46.9% (as at 30 November 2013). The Fund has returned 19.4% per annum over the previous 3 years.

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New reviews highlight portfolio changes needed to maximise portfolio outcomes

Eleanor Menniti

Investment research house Lonsec Research (Lonsec) has announced key changes to its portfolios following the latest Strategic Asset Allocation (SAA) Review and Model Portfolio Review.

Lonsec leverages its research capability to provide advisers portfolio management guidance through a range of Core Model Portfolios. SAA recommendations are reviewed biennially and Lonsec’s model portfolios are reviewed semi-annually as part of the portfolio rebalancing process. It considers key market and product themes affecting the risk profiles of the portfolios which range from secure to high growth.

Lonsec has announced a series of changes to its own portfolios to reflect broader market trends:

• A reduction in overall total return targets due to lower long term expected return forecasts for most asset classes including global listed property, global bonds and cash
• A more balanced allocation between global and Australian equities, which reflects narrowing long term expected returns for the two asset classes
• Increased allocation to alternative assets to help investors achieve portfolio diversification and provide protection in market downturns
• Inclusion of conservative alternatives – in conjunction with growth alternatives – to provide more defensive returns, as the product offerings within this space increases.

Lonsec’s Investment Consultant Eleanor Menniti noted investors’ ongoing proactive hunt for yield in this low return environment, but warns against specifically targeting asset classes that provides tangible income at an attractive rate without taking into account the need for diversification.

“Being solely focused on income return could lead to portfolio overexposure in certain sectors – a prime example of this is current investor concentration in bank stocks. This strategy increased sensitivity to a few factors, meaning that while the market might behave well most of the time, the portfolio would suffer if those specific factors were reversed,” Ms Menniti said.

“Investors are also ignoring the impact of capital volatility on total returns as they look at yield in isolation to other market factors.”

The research house has also made a number of changes to the manager line-up within the Core Model Portfolios, mostly within global equities and alternatives. A number of these changes were made in recognition of new strategies that have recently become available to Australian retail investors, which Lonsec believes provide a differentiated approach and aligns to the underlying philosophy supporting the portfolios.

Lonsec’s investment approach is based on the SAA framework that strong returns are achieved through diversified asset classes and investment approaches over a long term investment horizon. The review notes alternatives will play a vital role for investors to achieve their objectives, allowing them to diversify their risk exposure for traditional assets.

“A common view is that alternatives are return boosters in a low return environment, when improved performance is linked to the diversification benefits this asset class provides rather than the inherent nature of the assets or the investment style used,” Ms Menniti said.

“Lonsec has positioned the portfolio with exposure across a range of approaches to ensure portfolio performance is not tied to one specific market environment,” she concluded.

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Lonsec finds investors benefit from active investment approach

Infrastructure performed strongly in early 2014: Lonsec

Investment in listed infrastructure funds has continued to grow over the past year, buoyed by strong long term performance, increasing investor awareness and a preference for defensive equities in the face of conflicting macro themes, according to a report by investment research house Lonsec Research (Lonsec).

Lonsec’s Infrastructure Securities Sector Review rated 15 funds and found a majority of fund managers exceeded the 8.5% per annum long-term return forecasts of Lonsec-rated fund managers. Over a five year period to March 2014, the sector has averaged a return of 18.2% per annum, although the report warns it is unlikely for this type of performance to be repeated.

The report observed that while global infrastructure stocks generally lagged broader equities in 2013, the sector has

as investors shifted to less risky securities in the face of mixed US economic data and expectations that interest rates would remain lower for longer.

Expectations of rising US interest rates over the past year have filtered through to interest rate sensitive assets such as infrastructure stocks, leading to comparatively higher volatility than previous years.

Lonsec’s Senior Investment Analyst Andrew Coutts said while interest rate risk affects the infrastructure sector because many assets are backed by relatively high levels of debt finance, managers can actively adjust their allocation to specific assets to manage exposures.

“Infrastructure assets tend to be unique, with each offering a different risk-return profile in sectors varying from airports and roads to utilities and communications, so by investing in companies across subsectors, investors can diversify this risk,” Mr Coutts said.

This is a case in support of active management, with Lonsec suggesting investments in assets with strong market positions, sustainable growth opportunities, inflation protected income and relatively low or hedged debt levels to minimise risk.”

Other key highlights Mr Coutts noted from the report:

• Europe was the top global listed infrastructure performer by region, as the area was bolstered by receding fiscal austerity and sovereign bond yields falling to multi-year lows
• Majority of emerging market equities underperformed developed world equities amidst concerns of China’s economy slowly and further quantitative easing by the US Federal Reserve
• Growth is expected to be underpinned by resilient demand for services and long term structural drivers including urbanisation, globalisation of trade, mobilisation of data and securitisation of energy supplies

Lonsec notes infrastructure is a strong asset class to help investors achieve portfolio diversification, offering reasonable levels of long term expected growth with higher yields than equity. It also has the benefit of being underpinned by physical assets which can offer protection against inflation.

“Infrastructure is appealing as it is expected to deliver an attractive yield and provide a relatively strong return at lower risk than equities and global property. However, considering the correlation with broader equities of the sector, Lonsec considers infrastructure a growth asset and recommends inclusion within the balanced and growth options within a strategic asset allocation framework,” Mr Coutts concluded.

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Global equities sector: highest number of new entrants since before GFC.

A report by investment research house Lonsec Research (Lonsec) has revealed that over the past 12 months the global equities sector has seen the highest number of new entrants since before the onset of the Global Financial Crisis.

Lonsec’s Global Equities Sector Review found that product choice in the global equities sector was experiencing strong growth and that choice has been buoyed by new entrants in the local market rather than simply an increase in available products from already established players.

Rui Fernandes, Senior Investment Analyst, Lonsec said that when you consider Australia’s investment landscape it is easy to understand why there are more managers offering more products

“Australia has a large and growing pool of assets and the recent rallies from major international bourses such as the S&P 500 and the Nikkei have attracted investors to the global equities story,” Mr Fernandes said.

“The large asset pool (A$1.8 trillion as at December 2013^[1]) and mandated growth through the superannuation guarantee scheme make Australia a particularly attractive market for offshore manufacturers. Setting aside the business opportunity for global managers, there has also been a strong investment case for global equities in general due to opportunities from offshore equity markets but also given the purchasing power of the Australian dollar,” Mr Fernandes said.

While offering investors greater choice, The Lonsec Review demonstrates that the notable increase in global equities presents both opportunities and challenges for financial planners.

“The new additions create many opportunities for planners by providing investors with greater choice and increased access to different products and markets.

“However, more choice can lead to complications and there is an increased responsibility for financial planners to know which option is going to meet the need of their clients in terms of individual risk appetite and desired investment outcomes.

In response to the number of new entrants and products in the market, Lonsec has broken down its global equities sector into more granular bite sized pieces to ensure it provides planners the most comprehensive review of this growing sector

“The global equities investment landscape has evolved, and is more complex, but in saying that it now offers more interesting ideas than at any time in the past which would benefit from careful consideration—be it more nuanced portfolio use of newly available index strategies or investing into a greater breadth of unconstrained products,” Mr Fernandes said.

“The growth in options across the sector coupled with some favourable tailwinds should reward planners who take a fresh look at investments in this space.”

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Lukasz de Pourbaix

Investment research house Lonsec Research Pty Ltd (Lonsec) and global actuarial and consulting firm Milliman yesterday  announced that Telstra Super Financial Planning (a wholly-owned subsidiary of Telstra Super), has become the first financial services group to sign up to Lonsec Retire, a collaboration between Lonsec and Milliman that provides financial advisers with access to contemporary investment strategies to help them meet the investment needs of retirees.

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Lonsec and Milliman form panel to assist advisers.

Investment research house Lonsec Research (Lonsec) together with global actuarial and consulting firm Milliman have formed an industry panel consisting of six financial product providers to assist financial planners navigate through the complex issues relating to investing in retirement.

BT Investment Management, Colonial First State, Macquarie, Metlife, MLC and Plato Investment Management, have joined forces with Lonsec and Milliman to participate on the industry panel, which aims to provide financial planners with thought leadership on a variety of topics relevant to constructing portfolios in retirement.

The establishment of the industry panel follows the recent launch of Lonsec Retire. 

a collaboration between Lonsec and Milliman aimed at providing financial planners with a central access point for the latest thinking and practical portfolio solutions to assist financial planners in meeting the investment needs of retirees.

Lukasz de Pourbaix, General Manager – Lonsec Investment Consulting, said the selection process for the industry panel considered a number of factors including a proven commitment to addressing the investment challenges facing retirees and the necessary resources and ability to provide a diverse range of views in relation to retirement issues. “We are very pleased with the positive response we have had to the industry panel from subscribers to Lonsec Retire. We believe that the calibre and diversity of the selected panel members is a further endorsement of the path we have chosen to take.”

Wade Matterson, Practice Leader at Milliman said that “retirement is a significant issue domestically and globally and therefore requires a broad industry approach to tackling the challenges facing retirees. The formation of an industry panel is a step in this direction and will add a valuable resource for advisers in the retirement space”.

Financial planners will be able to access the industry panel thought material via the Lonsec Retire website on a subscription basis.

The website offers an extensive service across three advice modules – Research, Solutions and Industry Panel – providing white papers and detailed research on topics such as longevity risk, the politics of pensions and sequencing risk.

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