Three new funds were added to Lonsec’s universe in 2010 – the Zurich Investments Global Property Securities Fund (Recommended), BT Global Property Securities Fund (Investment Grade) and the Resolution Capital Global Property Securities Fund (Investment Grade).

Key themes from the 2010 review

Performance dispersion

Global real estate securities rallied over the year, driven by an increase in market confidence and renewed appetite for risk. Thembi Matabiswana, the Lonsec analyst who spearheaded the review, commented, “We found that those fund managers holding high levels of cash were more likely to outperform the benchmark over the longer period.”

“Cash levels were generally in the upper ranges of permissible and historical levels which support this view.”

Lonsec accepts that higher than normal cash levels are to be expected given the possibility of increased redemption requests and the more defensive portfolio positioning of many managers. However, advisers should take care when reviewing fund performance so as not to confuse strong fund performance due to high cash levels with strong fund performance due to stock picking skill.

While absolute returns have been positive in the 12 months to 30 November 2010 (average 20.9%), over a three year time horizon performance has been poor. When comparing managers across the sector, the dispersion between performances over the longer term continues to be high.

“Over the three years to 30 November 2010, ING was the top performer. This outperformance was largely driven by the manager‟s emphasis on top-down macroeconomic variables and effective re-positioning of its portfolio to accommodate changing market cycles,” said Matabiswana.

Access to equity and debt markets

REITs continued to tap both equity and debt markets throughout 2010, representing a material increase in activity from 2009. European real-estate securities in particular experienced a significant turnaround during the third quarter, driven by improving economic data and broad anticipation of additional quantitative easing programs.

“A report prepared by Jones Lang LaSalle stated that Europe dominated cross-border investment activity over the first half of 2010,” said Matabiswana.

“The report specifies that global real-estate investment totalled US$132 billion, almost double for the same period in 2009, with more than 50% of this occurring cross-border in Europe.”

As it stands, REITs continue to enjoy far superior access to capital compared to their unlisted real-estate counterparts and are therefore well positioned both offensively and defensively as economic recovery continues to strengthen or worsen.

Currency headwinds

The Australian dollar has experienced a significant amount of volatility over the last two years. The largest fall was seen over the three months to October 2008, where the Australian dollar dropped from a high of 91 cents in July to as low as 60c. With all the funds in the review offering fully hedged products, most of them have been unable to pay distributions as a result.

This is because July 2008 saw tax law changes that required all classes of income to be included in the calculation of taxable income. This included realised currency hedge gains/losses. Realised currency losses, in some instances, reduce the level of distributions that a fund can pay, if significant enough to cause a net loss on its taxable income. Importantly, currency losses continue to be carried forward until they are completely offset by future income.

“Therefore, for most of the hedged funds, such currency losses will continue to be carried forward until they are completely offset by future income. It is therefore possible that some funds‟ future distributions may continue to be affected by previous currency losses,” said Matabiswana.

“AMP and RREEF were the exceptions as these managers have continued to pay distributions; they have done this by funding the hedging losses through the sale of stock in the portfolio.”

In fact, both approaches should result in a similar outcome and not have a material effect on total returns. Those funds that will reduce or not pay distributions will benefit by a commensurate increase in their Net Asset Value (NAV) per unit. Those funds that do pay distributions will fund this by selling down a portion of their portfolio. This will act to reduce their NAV equal to this distribution amount.
Greater conviction at the regional level, for a more active global portfolio

In the past Lonsec has criticised managers for not being active enough at a global portfolio level. Managers’ active positions relative to their benchmarks were considered too small when compared to other sectors. This continues to be the case with high fees for mid conviction “active management”.

This is particularly disappointing given the extensive investment teams and resources afforded to most “active” global property securities fund managers.

“Some managers, such as RREEF and Principal, have acknowledged this. These managers have undertaken further research at a portfolio construction level and found that in order for an active position to be significant at a global level, there would have to be sufficient flexibility to take even larger regional bets,” said Matabiswana.

“These managers have adjusted their risk management systems accordingly, as well as encouraging regional teams to take larger active positions. Lonsec continues to encourage this evolution in portfolio construction, as long as it is supported by adequate resourcing and the appropriate tools and systems.”

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Defensive stocks have proved to be the best choice for dividend yields in the Russell Australia High Dividend Index reconstitution, while old favourites such as Fosters, Qantas and Telstra were down-weighted. The reconstitution has added eight new high-yield stocks mainly in consumer discretionary, energy, materials and processing sectors, but financial stocks (including REITs) dominate its top ten exposures.

The Russell Australia High Dividend Index (RAHDI) comprises Australian blue-chip companies with a bias towards those that have a high expected dividend yield. The companies within the index also meet other characteristics including: a history of paying dividends; dividend growth and consistent earnings. This was the first annual reconstitution of the RAHDI, since it was launched earlier this year by Russell Investments, one of the world’s largest index providers. The index forms the basis of Russell’s High Dividend Australian Shares ETF (RDV), listed on the ASX.

Defensive stocks like Metcash, Goodman Fielder, Transurban, QBE and Tab Corporation rated well. “Overall RAHDI has a 10% higher exposure to defensive names than the broader market1, so it’s not surprising that these defensive favourites figure highly,” said Scott Bennett, portfolio manager at Russell Investments. “Goodman Fielder for example increased its weighting due to its high forecast yield (over 8% after franking credits) and more defensive qualities.”

Meanwhile the index reduced exposure to Fosters and Qantas following dividend cuts in the August reporting season. “While they are expected to resume dividends in 2011, there are other companies that carry a higher weight in the index,” said Mr Bennett.

Telstra was also not favoured despite its high yield. “Telstra continues to trade on an extreme yield of 14.5%2 after franking credits have been included. It is likely to experience reduced margins in its mobile phone, which the market is anticipating will put pressure on its dividend going forward. RAHDI is specifically designed not to chase companies that are trading on extreme yields and, as a result, Telstra continues to be held only at market weight,” Mr Bennett said.

Financials dominate but shift towards real estate

Sector-wise, financials still have the largest overall exposure, making up 48.3% of the index, based on that sector’s high dividend yields. However, at the September reconstitution there was a shift away from banks and into real estate investment trusts (REITs), with increased exposure in Stockland, Mirvac and CFS Retail Property Trust.

“Yields on REITs are beginning to look more attractive as they restore their balance sheets and reduce gearing, allowing them to focus on returning income to shareholders,” said Mr Bennett.

Materials had the biggest turnover with three companies added: Incitec Pivot, Newcrest Mining and Sims Metal Manangement while two were removed: Aquarius Platinum and Oz Minerals. “Within the metals and mining sector, the steel companies, Bluescope and Onesteel, are rating the best with both companies expected to grow their dividends significantly over the next three years,” said Mr Bennett.

The one-year forward yield on the Russell Australia High Dividend Index after the reconstitution is 7.2%, (gross with franking credits). After taking into account franking credits the Russell Australia High Dividend Index is currently trading at a 1.5% premium over the broader Australian sharemarket yield.
 
The Russell High Dividend Australian Shares ETF (RDV) has now added $69 million under management as at 18 October 2010.

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