Simon Ho

Triple3 Partners have warned that quantitative easing, an expected increase in global interest rates and falling oil prices will present investors with a challenging set of circumstances in 2015.

“The investment environment for 2015 will be very different to last year, and investors should be prepared for new challenges as well as new opportunities,” says Mr Simon Ho, founder and chief investment officer of Triple3 Partners.

Mr Ho is the manager of the Triple3 Volatility Advantage Fund, which is distributed in the Australian market by Grant Samuel Funds Management.

“The actions last week of the European Central Bank, which surprised the market to the upside, were significant and set the scene for the volatility that lies ahead,” Mr Ho says.

“After two very benign years in global markets, there will be volatility and movement in asset prices that we haven’t seen in some time.

“Until now, the focus has been on quantitative easing (QE) and markets are inflated as a result of QE, which is what you would expect. Now the focus will move beyond QE and global markets will no longer be seen as a homogenised mass.

“Following five years of a US equity bull market run, which in the last stage in 2014 saw an expansion of PE ratios, suggesting prices were increasing without justification, more volatility will be evident.”

This will be partly as an unwinding of QE, and partly as a result of the US Federal Reserve increasing interest rates. The collapse of the oil price is also very significant.

“After a period of laying dormant, foreign exchange markets will also experience volatility. The Euro is being battered and the decrease in the oil price means the currencies of those economies heavily reliant on oil production will suffer.

“Those emerging markets that are reliant on oil production will see more volatility.

“Russia is already suffering from the sanctions against it. But other oil production counties, such as Venezuela, will also be affected.

“Similarly, as Chinese growth rates – which are already at their lowest levels since 1990 – continue to slow, commodities such as iron ore and coal will continue to be under pressure.”

Mr Ho says this expected volatility creates opportunities for investors.

“Although most investors see volatility as simply a measure of risk, it is also an asset class in and of itself, and one that offers investors portfolio returns that are largely uncorrelated to equities,” Mr Ho says.

Mr Damien McIntyre, director and head of distribution with Grant Samuel Funds Management, says an investment in volatility can be accessed through VIX options, which have been one of the fastest growing option markets in recent years.

The VIX Index, also called the Fear Index, measures expected volatility on the S&P500 Index over the next 30 days.  If investors expect that the market will move sharply (either up or down), the VIX will give a high reading.

“Volatility is usually negatively correlated to equity markets, so that when equity markets fall, volatility tends to rise, and vice versa. Investing in options on the VIX Index allow investors to access this negative correlation, which cannot be as reliably harnessed in other asset classes, making VIX well suited to targeting returns that are negatively correlated to the S&P500,” Mr McIntyre says.

“VIX options now rank up with the world’s most liquid – and have been known to trade over 1 million options contracts per day,” Mr Ho says.

The Triple3 Volatility Advantage Fund aims to generate long-term absolute returns with its volatility-focused strategy to capture alpha from these highly liquid exchange-traded VIX options.

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And, looking further ahead, excessive defensive positioning may leave investors poorly placed to make up losses let alone reap gains once the market does turn.

So said Mustafa Sagun, Chief Investment Officer of Principal Global Investors (Principal) Equities, on a recent visit to Australia where he met with institutional investors and analysts.

“Investors are understandably falling back on conventional risk management tactics to counter volatility in the market. While approaches such as minimum variance and risk parity certainly have their merits, they tend to be purely quantitative algorithmic strategies and as such are inherently perpetually defensive,” Mr Sagun said.

Mr Sagun went on to explain that such highly defensive approaches  fail to capitalise on situations that can and do occur even in volatile markets, when in certain “risky” areas valuations have become so depressed that the amount of further downside risk is actually quite low and the opportunity to add active returns is high.

“The nub of the issue is that most investors probably can’t achieve their goals solely from so-called “safe assets” and some degree of equity exposure is warranted.   You simply can’t achieve the better return potential of equities without taking risk. And the flipside of locking out risk in super defensive portfolios will eventually also be locking out returns.  Combine that with the herd effect of many investors rushing into defensive positions and the consequent demand-driven price rises and you get investors paying over-the-odds and likely to be disappointed in the long run.”

To address these concerns, Principal advocates an opportunistic unconstrained global equity approach, using a systematic methodology to identify growth opportunities at attractive relative prices while still achieving lower volatility compared to the market averages. And, said Mr Sagun, the generally negative mood of the market can work in favour of those seeking out such opportunities.

“The fact that the market is so concerned and thus paying too much for defensives means there is an even greater differential between the expensive defensives and the cheap cyclicals. That provides a significant safety net because buying growth stocks cheaply protects capital – and positions you to participate more fully in the upside when the bull market returns.”

By way of a recent example, Mr Sagun cited Hong Kong real estate stocks which were being pessimistically priced, with price multiples that implied an expected 40% drop in Hong Kong property values. However, the Principal team’s detailed research into the specifics of the Hong Kong market led to a more optimistic view, pricing in a much smaller reduction. In Principal’s view these stocks represented a prime opportunity. 

“What we did there was to exploit the extreme volatility anomalies that are occurring in this market, and taking advantage of the extreme corrections that inevitably follow,” said Mr Sagun.

He also stressed that only stocks that meet Principal’s required fundamental quality criteria are considered as part of this unconstrained opportunistic strategy.

“Features such as quality earnings streams and good earnings growth remain pivotal, no matter what the environment. What it comes down to is that whereas opportunities driven by extreme valuation dispersion such as the Hong Kong example might only rarely emerge during a year in an ‘ordinary’ market. However, with investor sentiment remaining quite fragile, and with more government intervention in markets, cycles have become far shorter. That means more of these opportunities are cropping up more often. What we are doing is developing a consistent framework that analyses the rapidly changing risk premiums so we can identify these opportunities as they arise rather than locking ourselves out altogether with a purely defensive play.”

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This season the market has delivered a 9% increase in dividends to investors compared to the previous reporting season. The growth has been captured by Russell’s high dividend and high value indexes as per data from the semi-annual reconstitution of these indexes, released today.

The Russell Australia High Dividend Index, which forms the basis of the Russell High Dividend Australian Shares ETF (RDV), has benefitted from the dividend growth by capturing companies with an emphasis on forward looking dividends and those with more stable earnings profiles. A table of the new top holdings in both indexes is included in the notes to editors.

“In this period of lower growth forecasts and heightened volatility, companies are taking the prudent approach and returning capital to shareholders instead of reinvesting cash. This has resulted in Australian companies delivering actual income for investors,” said Scott Bennett, Russell Portfolio Manager.

For investors in RDV this has provided an additional 2% (including franking credits) in income than the market, well above current term deposit rates. Some of the surprising income performers identified in the semi-annual reconstitution of the Russell Australia High Dividend Index are:

• BHP – increased its dividends as a result of the April buyback and confirmed strong dividends going forward. This is consistent with the RDV index methodology of increasing exposure to companies with solid dividend prospects.
• Newcrest – paid a dividend of $0.20 per share and announced a special dividend of $0.20. While noting the yield on Newcrest is still low, its dividend has benefitted from the stronger price of gold. Newcrest has had strong dividend growth over the last five years rising from $0.05/share to $0.50/share.
• Coal & Allied Industries (CNA) – CNA accepted a joint takeover bid which will result in a grossed up dividend of $11.42 per share, with a share price of $122.50 providing an attractive 10% dividend.

Value to be found in resources as financials lose “cheap” appeal
Regarding the Russell Australia High Value Index, Mr Bennett said the index has been selling down its exposure to banks which have recently outperformed the market and instead buying into resources which have recently underperformed.

“In stock movements this translates into buys of BHP and Rio and selling down the banks, in-line with our strategy of providing investors with an easy access point to a disciplined buy low, sell high, investment strategy,” he said.

The index, designed to systematically buy companies trading “cheaper” and sell those whose prices look “expensive” relative to the broader market, had recently changed its position from earlier in the year as the value opportunities shifted.

“Contrary to the direction taken by many investors earlier in the year, Russell’s High Value Index saw value in financials at a time when market watchers were shying away, and went underweight resources while they were experiencing a rally,” Mr Bennett said.

The strategy has paid off with the index outperforming the broader market since its launch in April 2011.

Russell ETFs outperform
The strong performance of Russell’s proprietary indexes has also helped its custom built ETFs – the Russell High Dividend Australian Shares ETF (RDV) and Australian Value ETF (RVL) – to outperform the broader market. RDV has delivered investors a 7% yield (annualised) before franking credits, close to 2% more than the broader market. And RVL, launched in April, has outperformed the broader market by 0.8% by identifying relatively cheap and undervalued stocks.

“The performance of Russell’s ETFs shows us even during trying market conditions, there are other opportunities for investors than traditional capitalisation weighted indexes,” Mr Bennett concluded.

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Dominic Rossi, Global Chief Investment Officer Equities at Fidelity Worldwide Investment – “At times like these, it can be difficult for investors to know what to do.  Markets have reacted badly to the US Federal Reserve Bank’s (Fed) policy statement and European sovereign debt issues continue to rumble on.

“We should expect news over the next few weeks to deteriorate further.  As we go into the earnings season shortly, there will be more missed forecasts and guidance
from companies will be uncertain and gloomy.

“For investors, valuations will come in to play at some stage. Yields will be well covered because balance sheets are strong.

“It is clear now that the Fed cannot bail equity markets out any more and any interest rate cuts by the European Central Bank (ECB) may not have much of an impact
on markets.

“The solution on the fiscal front will be either Greek default or Germany accepting that it has to fund debt restructuring and so reduce the quantity of debt in Greece.
This will be a prototype for other European countries.

“At times like these, investors should remember the strong get stronger. We will see M&A pick up in Europe. There is little capital around and so the threat for
companies from new competition is disappearing. Markets will have to consolidate so that oligopolies or duopolies are created and the remaining companies have strong
cash flow and don’t have to rely on the debt markets.

“This is a carbon copy of what happened in emerging markets 15 years ago. Equity will shrink as well-financed companies grow by acquiring others and buy back their
own equity. In time, this will stabilise equities.”

Amit Lodha, Portfolio Manager Fidelity Global Equities Fund – “I think equity valuations are cheap.  A number of stocks can be bought at cheaper valuations than in 2008, but with stronger balance sheets.

“However, the probability of recession in Europe – and the world – continues to rise every day and we see no resolution to the sovereign debt crisis. Without bank
lending, growth will be slower. That risk results in loose monetary policy in the developed world which, in turn, equals higher inflation in emerging markets.  That
inflation is a tax on consumption growth and reduces the likelihood of significant monetary easing to drive growth.

“The property sector in China, in particular, continues to make me nervous. Resources companies say they see no slowdown in China. However, land developers have
started to make fewer purchases. The demand today for cement, steel and copper is for sites purchased 6-12 months ago. If no land is being purchased today, that sets
up a pretty negative scenario 6-12 months down the line from now, unless we see some significant easing of restrictions in China.

“Given the transition of power that will take place in China in 2012, I think the Communist Party will focus on controlling inflation rather than going for growth.
This means growth could be slower, hence me being cautious on materials investment, as well as the outlook for economies closely linked to the emerging markets, like
Australia, South Africa, Russia and Germany.

“My preference is to be invested in commodity-related equities that benefit from consumption rather than capex (capital expenditure) spending.

“While rising inflation is a worry, increased gross domestic product (GDP) per capita will drive the emerging economies more towards consumption-driven growth.
Copper, energy and potash fit this bill, while I find aluminium, steel and iron ore less interesting. Gold is now the other side of the financials trade. If the
sovereign debt crisis can be resolved, we will see lower gold prices.

“Unfortunately, I think resolution will come only through printing more money longer term. The end goal is therefore higher inflation longer-term. I remain bullish on
the opportunity this presents today. I think miners are cheap versus bullion prices and my focus is therefore on gold mining companies driving growth in production.

“I also like platinum as a commodity as it offers a link to gold, plus a link to the industrial economy through its use in automobiles.

“All in all, I remain a structural bull of emerging markets as in a growth starved world, longer term, companies that can profit from the growth in these markets
(irrespective of their domicile of listing) will trade at a premium. Emerging market central banks may be tightening now to fend off inflation but they have the
flexibility to cut again to drive growth, if need be, and especially if food inflation eases. They still have unused firepower. In contrast, developed world
central banks are running out of options that won’t just lead to further inflation. As a result, I continue to invest in those equities best placed to benefit from
this.”

Martha Wang, Portfolio Manager Fidelity China Fund – “The latest concern has been over signs of increasing leverage ratios of Chinese property companies which
enhances the likelihood of further fund tightening for property developers. In addition, China coal, oil and gas names also suffered due to fears of a potential
increase in tax on these companies. Despite these spots of negative signals, the outlook for China’s economy is positive given the recent indications of peaking of
the food component in the Chinese CPI data. Moreover, the weakness in manufacturing indicates that China’s policy tightening is taking effect.

“Although China is not insulated from the global slowdown, looking at its growth since the 2007 global financial crisis, the country appears to be in a stronger
position than the rest of the world. The fact that the Chinese government has been tightening aggressively while the rest of the developed markets are still in
doldrums, indicates that the pace of growth in these markets is diverging. Despite the current sequential slowness in manufacturing, China’s output is 50% above the
pre-2008 crisis level.

“The country has shown remarkable resilience during the last crisis provides comfort. Currently, China’s ‘A’ and ‘H’ share markets are very attractive compared
to regional peers and relative to history, trading below their historical average P/E level. Given that China is nearing the end of its tightening cycle we expect the
‘H’ share market to experience a strong rebound when the government starts to loosen its policy.”

Teera Chanpongsang, Portfolio Manager of the Fidelity India Fund – “The sharp fall in US and European equities has put downward pressure on Emerging Asian equities. The sell off was led by industrials, materials, oil and gas sectors that reflects growing investor concerns about an economic recovery in the West.

“Emerging Asian economies are not immune to a softer economic recovery in the West but I believe the region’s strong domestic fundamentals and structural growth
drivers will continue to lead to superior growth. In fact, the prospects of a slower recovery in the West should make Emerging Asian growth rates look even more
attractive to investors.

“In addition, the fall in commodity and oil prices should further ease inflationary pressures, and in particular improve India’s fiscal position due to reduction in
import costs. That said Emerging Asian equities continue to have a high correlation to global markets and might remain volatile in the near term. However, in the long
term we can expect the region’s strong fundamentals and superior growth profile to lead to better returns than developed markets.”

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