Rodney Sebire

A key observation from this year’s review cycle has been the low levels of income distributions from Zenith’s International Fixed Interest (IFI) – Bonds universe. Despite the increased attractiveness of bonds and the reflation of real global bond yields, cash distributions haven’t kept up, as investors are patiently waiting for fund managers to “show them the money!”.

Fixed income’s role in balanced portfolios

 A core allocation to fixed income plays a critical role in diversifying balanced portfolios, including generating positive real returns, lowering volatility and providing a regular source of income. However, the delivery of cash distributions to the end investor is often an ‘after thought’, as fund managers focus on total returns and outperforming benchmarks. While that approach makes sense from a portfolio management perspective, it can create challenges for income-focused investors.

This distribution drought – what’s happening?

To illustrate the lack of recent distributions, the following chart plots the median yield-to-maturity (YTM) at the start of a financial year and the actual income distributions for the 12-month period for Zenith’s IFI – Bonds universe over the past five financial years.

Source: Zenith Investment Partners, Managers

Cash distributions have averaged less than 1% over the past three years, despite portfolio yields increasing materially, following the 2022 bond market sell-off. While YTM is an imperfect measure of future distributions and includes forecast capital appreciation, it’s widely used by fund managers as a guide to future returns.

For those retirees that rely on investment income to support their lifestyle, fund pension payments this shortfall presents a real challenge. Advisers are being forced to find alternative sources of liquidity, including selling defensive and growth assets to meet cashflow requirements and pension payments.

Why are cash distributions falling?

So, what is driving the reduction in cash distributions? Are portfolio managers overseeing portfolios with a requisite focus on generating income for the end investor? The answer to these questions lies in complex areas of tax legislation, fund accounting and also market-related factors such as movements in the Australian dollar (relative to the US dollar and other major currency pairs), bond market volatility and the role of active portfolio management.

1. Current movements & the taxation trap

Currency movements or the depreciating Australian dollar have been the largest driver of the recent declines in distributions, which is partly due to the taxation regime governing funds in Australia. Gains on fixed income securities and currency instruments are generally taxable on a realisation basis (excluding those managers that make a Taxation of Financial Arrangements (TOFA) – fair value election). Here’s how it plays out:

• Currency hedging is done using short-term FX forwards (typically three months), while bonds are held for years.
• When the AUD falls against the USD (or other currencies), realised FX losses immediately offset income in that financial year.
  The corresponding bond value increase (in AUD terms) isn’t realised until the bond matures—often years later.

Based on our research, the timing mismatch between the average tenor of FX forwards and the holding period of bonds, coupled with the depreciating Australian dollar have been the main contributor to the recent decline in fund distributions. The timing mismatch can benefit investors, when the Australian dollar is strengthening relative to the US dollar and other major currencies. As the chart illustrates, global bond funds delivered income distributions that materially exceeded starting yields over the 2020 and 2021 financial years.

2. More trading, more realisation events

In addition to currency, the recent period of elevated bond market activity has resulted in more active trading and positioning changes across managers, creating more realisation events and the potential for trading losses to offset income. For example:

• A manager may hold an overweight position in US Treasury bonds and elect to hedge the position with a short position in US 10-year Treasury futures, based on a view of an upcoming non-farm payrolls data release.
• If the bet doesn’t come off, a loss on the futures position will be realised, resulting in a revenue loss, reducing the level of distributable income.

The impact of trading and turnover on bond portfolios and ultimately distributable income, varies across managers, closely linking to each manager’s investment philosophies and processes. More traditional bond managers, investing in physical bonds and focusing on longer-term trends in inflation and monetary policy, tend to exhibit more stable distribution profiles. In comparison, active managers that frequently adjust portfolios and use derivatives, including futures, interest rate swaps and credit derivatives can introduce more income volatility.

How can managers improve the stability of income distributions?

The most practical solution for managers to mitigate the impact of currency on distributable income is to make a TOFA election, which allows for the matching of FX gains or losses to the financial year period when the underlying bond is sold or matures.

TOFA elections, if administered correctly, are complex to implement requiring significant investment in back-office processes and systems. Further, the election requires ongoing hedge effectiveness testing, defining hedge ratios and processes for rebalancing and monitoring. The process becomes more complex again if active currency positions are utilised, with each position required to be identified as either a hedge or a profit seeking trade. As such, global bond managers have been reticent to make the election, with only a few managers displaying the operational expertise to administer such an election.

From a portfolio management perspective, improving income stability would require managers to:

• Make fewer active trading decisions.
• Reduce turnover in portfolios.
• Shift investment philosophies to prioritise distribution stability over pure outperformance.

While possible, these changes are difficult to implement in practice, as they may conflict with a manager’s broader strategy and performance objectives.

Finding the right fixed income strategy

Selecting the most appropriate fixed income strategy is a multi-faceted decision, spanning forecast returns and volatility, correlation to equity markets and the more client-centric decisions such as frequency of distributions, redemption liquidity and the stability of income. If stable distributions are a priority, consider these tips:

• Prioritise domestic fixed income:
  • Domestic fixed interest strategies, with limited non-AUD portfolio holdings and the investment process is more of a ‘buy and hold’ approach with less directional views.
  • However, many domestic fixed interest managers hold offshore securities and hedge non-Australian dollar exposure, which introduces the risk of currency volatility.

• Check for a TOFA election:
  • Confirm if a TOFA election has been made.
  • Understand the timing method that is being applied, noting that a ‘fair value’ election will not mitigate the risk of income distribution volatility.

• Consider master/feeder fund structures: 
  • In these structures, currency hedging transactions are managed offshore  in tax light jurisdictions.
  • Profit and losses on currency transactions are only recognised in the underlying fund net asset value (NAV), rather than impacting Australian taxable income.
  • Under a Be aware of the responsible entity’s approach to distributing income, noting that this is a discretionary decision, typically governed by a distribution policy. Some managers set explicit distribution targets, while others only distribute coupon income and retain trading gains.

Managing expectations in fixed income

The decline in cash distributions from global bond funds isn’t necessarily a reflection of poor management—it’s largely a by product of tax laws, currency movements, and market volatility. While managers can take steps to smooth income, advisers should be mindful of how different strategies align with their clients’ income needs.

For those seeking a steadier income stream, understanding fund structures, currency hedging approaches, and taxation nuances is critical. And as always, diversification remains the best tool to navigate the Bermuda Triangle of income distributions.

By Rodney Sebire, head of alternatives and global fixed income.

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Interest in the private debt sector started with domestic managers providing loans to traditional corporate borrowers and real estate developers. It has since expanded to include offshore managers setting up funds, feeding into global loan portfolios. Today, private debt funds are a cornerstone of most defensive portfolios and an important complement to publicly traded bonds.

However, private debt is unique. Consistent headline returns can hide the risks that lie beneath the surface. Paradoxically, two managers could end up delivering similar return outcomes, but with varying risk profiles and default sensitivities. As the ancient philosopher, Seneca famously quoted “fallaces sunt rerum species” –  appearance can be deceptive.

As the impact of higher interest rates and declining consumer spending continues to impact corporate profitability, we are approaching an inflexion point. The spotlight will be placed on private debt managers and the robustness of their lending processes. Investors may soon learn that private debt returns are in fact, a ‘two-way street’!

What is private debt?

Private debt is relatively simple; a lender provides a loan to a company, property developer or private equity (PE) sponsor to finance its operations, construction project or merger and acquisition (M&A) activity. Alternatively, loans can refinance existing debt or optimise a company’s debt/equity mix.

When a loan is funded, the lender receives an original issue discount (OID), which is an upfront fee where the loan amount is slightly below the par value that is repaid at maturity (e.g. 1% to 2%). Over the life of the loan, the borrower makes interest repayments, typically expressed as a spread above the Bank Bill Swap Rate (BBSW) and at maturity, repays the loan. Depending on the borrower’s risk profile, seniority level and tenor, the spread over BBSW can range between 4% p.a. to 8% per annum.

Types of private debt

Private debt encompasses a wide range of lending purposes, each with its own risk/return profile and specialisation requirements:

Navigating the private debt universe

Navigating the private debt universe can be a minefield for advisers given the different lending types and associated risks. Managers employ a range of strategies, some specialising in senior secured lending while others invest in junior or mezzanine loans or a combination of both.

The ability to compare performance across managers is difficult given the private, bilateral nature of corporate lending and the differences between individual loans, covenants and security packages. A manager with an impeccable track record of no ‘technical’ defaults may pass the first review, but this may not reveal the number of loan restructures, payment deferrals or covenant relief provided to borrowers.

In stable environments, returns from private debt are predictable, delivering consistent monthly returns with limited capital volatility. However, in challenging environments, the type of lending, quality of underwriting, level of covenant protections and security packages quickly separates good managers from those with relaxed standards.

The current challenges in the healthcare sector illustrate how excessive debt, rising borrowing costs, and declining revenues, can lead to debt restructures to protect equity investments. Despite a long history of low corporate defaults, future outcomes can be unpredictable. Monitoring trends in borrower leverage, interest coverage, covenant waivers and those borrowers converting from paying cash interest to capitalising interest (PIK interest) is crucial to identifying future problems.

Selecting the right private debt fund

Including a private debt fund in a client’s portfolio is complex it involves identifying the expected risk/return, performance in negative equity environments, and alignment to the client’s growth or defensive allocation. The reliability of cash distributions and regular access to capital are key considerations. What if a manager were to freeze redemptions, would this create asset allocation imbalances and broader liquidity challenges?

Fees and costs have always been a murky topic, with many funds not subject to the RG97 fee disclosure regime. The payment or collection of fees across managers varies significantly, including the types of fees charged and the beneficiary of those fees. Managers may retain a portion of the borrower-paid margins or penalty interest.

In many instances, the costs of a private debt fund exceed 2% p.a., subject to the type of lending and a manager’s approach to sharing lending fees with investors. This remains a key focus area for Zenith and an area where we are yet to gain complete comfort (apart from a small number of institutional quality managers that we have on our Approved Product List (APL)), noting that the universe has yet to achieve uniformity in terms of disclosure practices.

The two-way street

The growth of the private debt sector has been positive for the adviser market, providing access to funds that generate attractive risk-adjusted returns, with structural protection and with minimal mark-to-market volatility.  Despite this, we can’t lose sight of the fact that private debt is an illiquid, sub-investment grade asset class with default risk. A thorough understanding of the lending process and how managers protect capital is crucial. The smallest detail around a security package or a covenant can ultimately save an investor from losses in a default scenario.

If higher interest rates persist for a couple more years, the pressure will be on borrowers and ultimately private debt managers, and it could be a matter of time before investors learn a painful lesson that private debt returns are in fact, a ‘two-way’ street.

By Rodney Sebire, head of alternatives and global fixed income

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ESG or sustainability aspects can be captured by managers in a multitude of ways ranging from traditional negative screening of undesirable industries (e.g. tobacco) through to sustainable investing, where the underlying securities are directly related to an environmental or social outcome.

In an Australian fixed interest (AFI) context, sustainable investing typically focuses on the purchase of green, social or sustainable bonds, where the cash proceeds of the bond are used to finance eligible environmental or social projects (or a combination of both). These bonds are typically issued by entities as part of broader funding programs.

We’ve observed an increase in AFI managers investing in sustainable bonds, both as part of traditional AFI portfolios and through dedicated sustainable or impact bond funds. So, do sustainable bonds exhibit more attractive risk/return characteristics compared to traditional or vanilla bonds? Does prioritising the sustainable sector introduce additional portfolio risks? And what are some of the additional considerations that advisers should be cognisant of when allocating to different managers?

Background

The history of sustainable bonds dates to 2007 when the European Investment Bank issued a Climate Awareness Bond, with the proceeds dedicated to renewable energy and energy efficiency projects. Since then, global issuance has increased at an exponential rate, with cumulative green bond issuance surpassing $US 1.23 trillion at the end of April 2021.^[1]

Sustainable bonds ensure cash proceeds are used for the purpose of financing eligible environmental and/or social projects. While projects vary, bonds can be broadly categorised as follows:

• Green – where proceeds are exclusively applied to finance or re-finance projects or assets having environmental objectives, such as renewable energy, pollution prevention, clean transportation and sustainable water.
• Social – used to finance projects that achieve social outcomes, such as access to essential services, including education, affordable housing or micro-finance.
• Sustainability – proceeds from a bond may be applied to projects that have both positive environmental and social benefits.

Within each cohort, there are different types of bonds including general obligation bonds and asset-backed or secured bonds. General obligation bonds are backed by the general credit worthiness of the issuer and its ability to satisfy its coupon obligations from its revenues and cashflows.

Asset-backed or secured bonds are directly tied to the performance of the underlying assets, such as a wind farm or a solar project, with the assets typically held in a special purpose entity. Moreover, some bonds offer recourse to both the company and specified assets, with these bonds referred to as ‘dual recourse’.

Defining sustainable bonds

To be classified as a sustainable or green bond, companies generally follow a set of guidelines and disclosure principles that enable investors to determine if the bond is consistent with its respective environmental or social philosophy objectives. While the industry is self-regulated, most issuers comply with the International Capital Market Association (ICMA) which has codified a set of guidelines and level of disclosure that each issuer is expected to follow.

These principles are outlined in the ICMA Green Bond Principles 2018, the Sustainability Bond Guidelines 2018 and the Social Bond Principles 2020. The industry is also supported by several industry bodies and initiatives, such as the Climate Bond Initiative (CBI) that can provide external verification of each bond’s compliance with the relevant principles.

Across each set of principles, ICMA has outlined the following key components:

• Use of proceeds – the bond’s documentation should outline how the bond’s proceeds are to be applied and the corresponding environmental or social benefit. In the case of the Green Bond Principles, ICMA recognises several categories of eligibility for green projects, such as climate change mitigation, adaptation, natural resource and biodiversity conservation and pollution prevention. These are typically summarised into a list of Eligible Assets.
• Project evaluation and selection – issuers of sustainable bonds are expected to outline their environmental or social objectives, how these have been determined and how a project is consistent with the ‘use of proceeds’ categories detailed earlier.
• Management of proceeds – the proceeds from the bond issue should be segregated from the broader finances of the issuer, allowing tracking of the net proceeds and how these are being applied to ‘Eligible Assets’.
• Reporting – Issuers are expected to maintain up-to-date records on the use of proceeds, including an annual report summarising the green or social projects that have been financed. To align with best practice, issuers should disclose metrics (where practical) summarising the project benefits. This can include greenhouse gas emissions produced, electricity generation, energy capacity etc).

The ICMA principles play an important role in promoting consistency and transparency across the sustainable bond universe. Notwithstanding this, ‘green’ or ‘social washing’ remains an ongoing concern as corporates seek to align themselves with socially conscious investors, whilst allowing themselves maximum flexibility with respect to classifying projects.

Australian sustainable bond market

The Australian sustainable bond market has experienced strong growth as government authorities, financial institutions and companies issue a range of green, social and sustainable bonds. The expansion of the market has enabled these institutions to showcase their sustainable credentials and access the potential pricing and investor diversification benefits attributable to the asset class. As at the end of April 2021, the sustainable bond market has grown to $A 29 billion across 46 individual bonds.

Historically, global supra-nationals issuing kangaroo bonds have dominated the sector, however, as the focus on sustainable investing increases and state governments fund energy transition programs, we’ve observed a proportional increase of semi-government and corporate bonds.

Selecting the most appropriate sustainable or ESG strategy

Selecting the most appropriate ESG or sustainable strategy is a multi-faceted decision, typically combining philosophical considerations with traditional qualitative and quantitative inputs. For some clients, a sustainability or ESG decision can be the most important and primary screen, with only those funds passing the filter considered for investment. In our opinion, the current maturation of the sustainable bond universe has the potential to alter not only how some managers structure their portfolios, but the potential sources of excess returns captured.

By Rodney Sebire, Head of Alternatives & Global Fixed Income Research

———-

[1] Green Bond Pricing in the Primary Market: July – December 2020, Climate Bonds Initiative

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Rodney Sebire

One of the key implications of COVID has been the growth in government debt issuance globally and the coordinated quantitative easing programs across central banks.  As government bond yields across the globe continue to grind lower (despite a recent uptick), the ‘search for yield’ thematic has accelerated, as advisers seek more innovative ways to generate attractive returns from the defensive component of client portfolios.

Emerging market debt (EMD) is one of the few asset classes that continues to offer attractive real yields; providing advisers with the opportunity to diversify away from highly synchronised G10 bond markets.  The current level of real yields in EMD are significantly higher compared to developed markets, with the following chart comparing the current levels and the median and historical ranges.

With higher real yields, we’ve observed a greater propensity for traditional International Fixed Interest (IFI) managers to invest in EMD, both as a source of extra yield and portfolio diversification. With approximately 25% of the bonds in the Bloomberg Barclays Global Aggregate Index trading with negative yields, the relative valuation of EMD is compelling and we expect more managers to allocate to the sector over time.

Additionally, the number of specialist EMD strategies available in the wholesale market continues to increase as advisers become more comfortable with the asset class and fund managers seek to meet this demand. Let’s look at EMD in more detail and some of the key considerations for including in client portfolios.

Background

EMD refers to debt or bonds issued by those countries whose economies are considered as developing or emerging, typically including countries from Eastern Europe, Africa, Latin America, Russia, the Middle East and Asia (excluding Japan). There is no universal definition of ‘emerging’ given a large percentage of sovereign issuers are rated investment grade and above.

Accessing the EMD sector can be achieved in multiple ways including via local debt (i.e. issued in the currency of the country), hard currency debt – that is, debt issued primarily in US dollars and/or Euros, or corporate debt. Here’s a brief overview of each.

EMD markets behave similarly to developed bond markets, in that central banks employ monetary policy and use interest rates and fiscal policy as the primary tools to modulate economic growth and ultimately inflation. Akin to analysing a corporate balance sheet, emerging market countries exhibit a range of qualitative attributes and financial balance sheet metrics that enable fund managers to perform detailed due diligence and ultimately attach a risk premium to each bond.

Incorporating EMD in Portfolios

EMD can be accessed as part of a broader IFI strategy or via specialist funds that invest directly in the sector.  In terms of the former, this could be via an IFI – unconstrained manager that specialises in relative value decisions between developed versus emerging markets.

One of the key benefits of accessing EMD via specialist funds, is the low correlation to traditional equity and bond markets and ability to dampen volatility during risk-off environments. Moreover, the asset class is driven by a range of idiosyncratic return factors, such as EM inflation, sovereign fiscal policies, debt levels versus GDP, commodity prices, US dollar movements and overall financial stability.

In terms of the risk/return characteristics of EMD LC and HC, the following table compares EMD LC with HC.

As detailed earlier, EMD LC returns include both a bond (capital gains and coupon) and currency component, with the proportional contribution of each changing through the cycle. EM currency valuations or real exchange rates can offer significant valuation upside, providing a significant buffer to returns. The following chart decomposes the relative monthly contributions from bonds and currencies and the rolling two-year correlation between each return stream for the period 1 Jan 2003 to 31 Jan 2021.

The currency component of EMD is sensitive to a range of factors, most notably the global appetite for risk and spillover effects from developments in the US. Therefore, EMD LC can behave like to a short US dollar position (i.e. outperform (underperform) when the US dollar depreciates (appreciates)), in that the asset class tends to underperform when demand for the US dollar is strong.

From an Australian investor’s perspective, investing in EMD LC (in AUD) captures the diversification benefit derived from investing via Australian dollars – similar to investing in global equities on an unhedged basis. As a commodity currency, the Australian dollar depreciates during ‘risk-off’ events (i.e. positively correlates with EM currencies), resulting in the value of EM Bonds appreciating – when restated back in AUD terms. This tends to reduce the drawdown sensitivity and overall volatility of the EMD LC asset class.

The low yield paradigm presents a range of challenges for advisers in terms of building IFI portfolios that generate attractive income streams and provide diversification to growth asset classes. EMD is an asset class that continues to grow in popularity, offering higher real yields and diversification away from heavily managed, developed bond markets.

For Australian investors, EMD LC (in AUD) tends to offer the most attractive risk-adjusted returns and constrained drawdowns, while EMD HC offers higher returns, but with more credit risk and sensitivity to traditional asset classes. Alternatively, EMD can be accessed by specialist Unconstrained (or Multi-Sector credit funds) managers, who are adept at selecting the most attractive EM issuers and the optimal points in the cycle to invest.

By Rodney Sebire, Head of Alternatives and Global Fixed Income Research

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Rodney Sebire

Zenith has just released its Australian Long/Short Sector Review, and over the twelve months to 31 May 2015, Zenith’s Australian Long/Short –  Active Extension and Variable Beta managers delivered an average return of 10.2%, outperforming the Australian equity market (as represented by the S&P/ASX 300 Accumulation Index) by 0.3%.

This outperformance was achieved with an average of approximately 80% market exposure and lower volatility (as measured by Standard Deviation) than the broader market.

According to Rodney Sebire, Senior Investment Analyst, and Zenith’s lead analyst on the sector, the market environment has been favourable for long/short managers. “Some of the key determinants for success in long/short have been in place – a low correlation of performance between industry sectors and high performance dispersion within sectors.”
Sebire went on to add “By way of example, the Healthcare and Telecommunication sectors returned 33% and 24% respectively over the last twelve months, versus Energy and Consumer Staples, which returned -15% and -7%, respectively.  And there hasn’t been a lack of opportunities on the short side.  From a market value perspective, Woolworths and Orica were two of the most heavily shorted companies. Woolworths has suffered from declining margins and losses from its Masters business, while Orica navigated a change in CEO and declining demand for its explosives products”.

Over the next twelve months, Zenith expects the conducive environment for long/short investing to continue.  Sebire notes “Zenith expects further mean reversion in those sectors that have been artificially inflated by the yield trade; the likes of Financials (Banks), Telecommunications, Healthcare and Property.  We believe this should create opportunities for appropriately skilled long/short managers.”

In this year’s sector report, Zenith outlines its approach to using Australian long/short strategies in client portfolios, which includes a detailed review of the potential diversification benefits.  As part of the analysis, Zenith analyses the “levers” that a long/short manager can pull to generate excess returns.

Summary of the Zenith 2015 Australian Shares Long/Short Sector Review:

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Rodney Sebire, Zenith Head of Alternatives Research said “For the 12 months ending 30 September 2014, the average annual return for CTA funds was 17.1%, with a weighted average volatility of 8.3% as measured by Standard Deviation. In comparison, the weighted average return for global macro funds was 0.4%, which was achieved with an average Standard Deviation of 7.3%.  The CTA’s have been able to profit from pronounced trends in the bond and energy sectors.  Long positioning in the bond sector profited from declining yields in markets, meanwhile short positioning in the energy sector accrued gains as the oil price fell from $US 107 to $US 70 per barrel.

Global macro investing has been more problematic with compressing asset volatilities and zero interest policies, making it difficult for managers to generate returns” said Sebire.  “The biggest variable with respect to improved performance is a normalised level of asset volatility and greater performance dispersion across asset classes and regions.

In September and October of this year, we saw some tepid signs that volatility could be returning to more elevated levels.

Looking forward to 2015, Zenith expects the US Federal Reserve to commence its tightening cycle, albeit the timing is unclear. The timing will be contingent on inflation moving closer to the Fed’s target of 2% and a higher utilisation of labour resources. This should provide a broader opportunity set, particularly as macroeconomic policies diverge across regions.’ Sebire said.

“Further deviation between developed markets and emerging markets could also provide attractive opportunities for appropriately skilled global macro managers. Some of the countries that contributed to the instability earlier in the year (Brazil, India, Indonesia, and South Africa) continue to face challenging economic conditions.

A shock in Emerging Market bonds could place pressure on Emerging Market currencies, which ultimately transmit through to equity markets.

In sum, the global macro universe has endured an extremely difficult period. Despite this, the peer group has largely protected capital, with selective managers delivering sound returns. Going forward, we see an improved opportunity set for the strategy, which should prove beneficial for appropriately skilled managers” said Sebire.

Summary of the Zenith 2014 CTA and Macro Sector Review

From an initial investment universe of 24 products, 11 were assigned a positive rating: 1 was rated

“Highly Recommended”; 9 “Recommended”; and 1 was assigned an “Approved” rating.

The following tables highlight:

• Additions to Zenith’s Approved List
• Rating changes, and
• Zenith’s full CTA and Macro sector Approved List

Additions to Zenith’s Approved List:

Fund Name                                          New Rating

Triple3 Volatility Advantage Fund       Recommended

Imperia Asia Fund                                   Approved

Rating Changes to Zenith’s Approved List:

Fund Name                                        New Rating                Previous Rating

Man GLG Global Macro (AUD)         Recommended              Highly Recommended

CTA and Macro sector Approved List:

Fund Name                                                                       APIR Category          Rating

AQR Wholesale Managed Futures – Class 1P                    PER0634AU CTA        Recommended

Aspect Diversified Futures Fund – Class A FSF               1086AU CTA                 Recommended

BlackRock Scientific Global Markets Fund                       BGL0045AU Macro     Recommended

GMO Systematic Global Macro Trust – Class B                GMO0006AU Macro   Highly Recommended

Imperia Asia Fund                                                                  IIG0037AU Other         Approved

Man AHL Alpha (AUD)                                                         MAN0002AU CTA       Recommended

Man GLG Global Macro (AUD)                                           MAN0008AU Macro    Recommended

MST Global Fund Information Memorandum Macro                                              Recommended

Pengana Absolute Return Asia Pacific Fund                    PCL0004AU Other        Recommended

Triple3 Volatility Advantage Fund                                      GSF0009AU Other       Recommended

Winton Global Alpha Fund                                                   MAQ0482AU CTA        Recommended

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Impressively, these funds generated returns comfortably in excess of their cash benchmark with significantly lower volatility than the Australian equity market.

The median return for Zenith rated managers was 9.5% compared to 10.2% for the S&P/ASX 300 Accumulation Index, and 2.8% for the UBS Bank Bill Index.

The median level of volatility (as measured by Standard Deviation) was 6.1% compared to the S&P/ASX 300 Accumulation Index of 11.2%.

On a risk-adjusted basis, returns were equally impressive with the median manager delivering a Sharpe ratio of 1.25 for the one year period ending February 2014. This is above Zenith’s long-term expectations (approximately one) for the strategy.

Pleasingly, all managers delivered returns with an extremely low beta or exposure to the Australian share market.

According to Rodney Sebire, a Senior Investment Analyst at Zenith Investment Partners, “The majority of equity market neutral managers reviewed seek to neutralise sector biases by identifying long and short positions within the same sector. While identifying offsetting trades was not always straightforward, most managers demonstrated the ability to adapt and find companies with common return drivers. Furthermore, some managers used multiple positions where they had less conviction on one side of a trade.”

Sebire also added, “To attract the research focus of the managers, a sector needs to exhibit strong price dispersion between its constituents. Intuitively, those sectors where the performance of one company has a direct impact on the performance of another company (or competitor), tend to offer the greatest opportunities.

Market Neutral funds generally delivered strong returns for the 12 months to February 2014 on the back of a strong level in stock dispersion in the market as a whole, and within various sectors. For example, the Consumer Discretionary sector was an extremely profitable sector over the last 12 months.

While the 12 month return for the S&P/ASX 300 Consumer Discretionary sector was 25.6% for the period ending February 2014, the performance of its underlying constituents was significantly different.

From an initial universe of 8 Australian equity market neutral funds: 2 were rated “Highly Recommended”, 2 received a “Recommended” rating and 1 was assigned an “Approved” rating.

Zenith’s complete Approved List for both sectors, broken out by style, and including Zenith’s conviction rankings is shown in the following tables:

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