Lonsec’s review of the global equities sector covered both actively managed and passive or index strategies. The report found that there were a number of new ‘value’ strategies significantly boosting the choice for investors. Further, ‘smart beta’ products, which straddle the active/passive divide, have grown in prominence.

Rui Fernandes, Senior Investment Analyst at Lonsec, said the strong returns from the global equities have appealed to an increasing number of investors, especially self-directed investors.

“As measured by MSCI AC World ex Australia Index, the global equities sector returned an impressive 23.63% p.a. for the three years to March 2015 and 13.89% p.a. for the five years,” Mr Fernandes said. “Although the pace of these returns is expected to moderate as the Fed raises interest rates in the US, a global equities exposure continues to retain its place as a core component of any diversified and well-constructed portfolio.”

Notwithstanding, valuations across a range of markets when compared to historical averages appeared less appealing seven years into a US bull-market as the Federal Reserve ponders lifting rates and investors are advised to regularly review Lonsec’s Quarterly Outlook for updated views.

Mr Fernandes noted investors now had more direct access – through structures such as ETFs, Listed Investment Companies and Managed Accounts – driven by rising demand for direct ownership by self-directed investors, more specifically SMSFs.

“Australian SMSFs are now holding nearly one-third of all superannuation money in Australia,” Mr Fernandes said. “Although the product structure in the global equities sector remains dominated by unlisted managed funds, SMSFs now have a number of choices to have access to global equities.”

“mFund, growth in ETF options, listed investment companies and separately managed accounts are providing an increasing number of direct access points for SMSFs.”

“There has also been an increase in the use of feeder-fund product structures in the global equities sector in recent years. This is an easier and quicker route for manufacturers/distributors that have a limited footprint in the Australian market to offer ‘ready-made’ strategies, an approach which will likely see continued growth. However, it is less costly for providers to retreat from products that have not met their business objectives.”

While Lonsec welcomes the arrival of more new product choices and greater access in this market, it also brings more challenges for financial advisers.

“The more choices you have the more complicated things become,” said Mr Fernandes. “As each choice has its benefits and drawbacks, the challenge for financial planners is to find the right way that aligns with their clients’ needs.”

Mr Fernandes also suggested planners and investors to have a plan for dealing with currency exposures as currency movements can add another layer of complexity in the global equities sector.

“In terms of currencies, global equity investors should remain focused on the AUD/USD cross-rate, particularly as US equities constitute the lion’s share of global equity benchmarks,” Mr Fernandes said.

Other key findings of the report include:

• Valuations, relative to history, across key regional markets assessed appeared to have less headroom for expansion than in previous years.
• Quantitative strategies have delivered strong results post the Financial Crisis, outperforming the ACWI ex Australia but not their traditional World ex Australia benchmark.
• Judging simply by the respective indices, small caps have outperformed larger cap stocks by at least 2% p.a. over the three, five and seven years.
• Magellan Financial Group (A$37.19 billion FUM as at May 2015) and Platinum Asset Management (A$29.42 billion FUM as at May 2015) are dominant players and have carved out a special place in the sector with their respective products being, anecdotally, are somewhat the ‘go to’ strategies for advisers.

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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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Lonsec reviews the Long Short Global Equities sector.

Investment research house Lonsec Research Pty Ltd (Lonsec) recently completed its review of the Long Short Global Equities sector, reviewing 16 financial products.

This included two financial products new to Lonsec’s coverage: the Morphic Global Opportunities Fund (a recently launched strategy by Hunter Hall alumni) and the Platinum International Health Care Fund.

“Long/short investing is ostensibly based on the notion that, by unshackling fund managers from one of the most fundamental investment constraints (i.e. long-only investing), in theory; this should provide these active managers with greater chance of outperforming,” said Lonsec’s Senior Investment Analyst, Rui Fernandes.

“The reasoning being that in lifting the short constraint this would open up a whole new way for active managers to express their views on stocks. They can like a stock and own it; dislike it and avoid it; or hate it and short it.”

Regulatory change impacts sector

Regulatory change has firmly touched the sector, although the full impact remains unclear at this time.

ASIC released Regulatory Guide 240 in September 2012 dealing with enhanced disclosure requirements for hedge funds. The requirements of RG240 had been due to take effect from May 2013, however in response to additional industry feedback the start date has been postponed to 1 February 2014 to allow for further consultation between the regulator and industry players.

“The key issue for long/short funds is that they may be captured within the definition of a hedge fund, which has ripple effects,” said Fernandes.

“Firstly, there is the potential for platforms to revisit their own categorisation of products, which could have an impact on how products are used by financial advisers.”

“Notably, in Lonsec’s discussions with fund managers they mentioned that the general response from platform providers and key clients was that, provided the investment philosophy and process remained the same, it would be ‘business as usual’.”

“Secondly, this is likely to touch on the day-to-day relationship between financial advisers and their clients. The suitability of a product within a client’s portfolio could come into question where ASIC has now defined a product as a ‘hedge fund’ and a client’s risk parameters prohibit sophisticated ‘hedge fund’ or alternative investments.”

Lonsec also spoke to fund managers in terms of their prospective intentions to change financial products in order to avoid being captured by RG240. All fund managers which were queried maintained that they would not be revising their strategies (e.g. cancelling stock shorting) in order to avoid ‘hedge fund’ classification with this option typically ruled out early.

Unexpected competition

“Long short funds have typically been used by financial advisers as lower volatility or downside protection plays on, for instance, global or Asian equities,” said Fernandes.

“This is because of the flexibility that most strategies have in terms of not only varying their equity market exposure, but also ability to use a range of sophisticated techniques to dampen risks.”

Institutional investors have had access to another class of strategy which has sought to outperform the market through downside protection and with notably less volatility. Quantitative managed volatility equity strategies have been available institutionally for a number of years now; however access to these strategies in the wholesale/retail marketplace has only recently occurred.

“Those managed volatility products researched by Lonsec tend to be notably cheaper than these long short offerings—both in terms of ongoing annual fees and performance fees,” said Fernandes.

“Despite the computer-driven investment approach, they could be argued to be less complex. For instance, managed volatility strategies are long-only products which do not use any derivative overlays and are fully invested at all times.”

Investors likely have mixed emotions towards quantitative strategies given the significant difficulty, generally, this approach to investing experienced during the Global Financial Crisis. A bias against quantitative management could certainly rule out managed volatility strategies from consideration.

Further, the track record of these financial products in Australia is very short which may limit their appeal to some.

“For financial advisers who are using long short global strategies in client portfolios on the basis of downside protection and lower volatility, managed volatility strategies can offer a compelling after-fee case which may grow stronger in time as track records lengthen,” said Fernandes.

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Since the GFC, risk – or investor avesion to risk – has increasingly been driving investment decisions and product innovation in global equity funds.

 “Globally, equity markets have yo-yoed, continually switching between greed and fear, optimism and despair,” said Rui Fernandes, Lonsec Senior Investment Analyst.

“The result has been product manufacturers busying themselves developing new solutions or reframing existing ones for risk-wary investors.”

The Lonsec Global Equity Sector Review highlights a number of emerging strategies.

“Quantitative managers are developing products that attempt to manage the volatility of the return stream,” said Fernandes.

“For the first time Lonsec included coverage of the Analytic Global managed Volatility Fund as part of this review. The underlying crux of this strategy is that the compounding power of low beta stocks, coupled with their lower volatility, should mean that the portfolio can outperform its benchmark but with less volatility or risk.”

Managed volatility strategies offer the prospect of market-like returns but with less volatility, which is where the attention has been over the past few years. In addition to the Analytic product, Lonsec is aware of a number of other managed volatility quantitative strategies in the pipeline.

“It is worthwhile keeping in mind that this style of investing is relatively new and while simulated results are encouraging, they are just that – simulations,” said Fernandes.

Aside from managed volatility, another trend to emerge during the review is the growing popularity of dividend-based global equities strategies. While not new, they have become more fashionable in recent years as international investors grapple with low yields and volatility across assets.

“Before the GFC, stable dividend paying companies were boring and uncool,” said Fernandes. “They weren’t the exciting go-go businesses associated with innovation and growth.

“Similarly, there has been a shift in emphasis to the virtues of ‘quality’ companies within many existing strategies, with the desirability of stable and growing earnings streams, low debt and high ROE suddenly more attractive.”

The almost universal shift in discussion to so called quality companies was one of the more pronounced features of this year’s review. 

“Lonsec has noticed an increased emphasis, most pronounced during this review cycle, by fund managers to highlight the ‘quality’ aspect of their portfolios. Quality does have a trade off though. Investors usually pay a premium to invest in companies with a solid track record of delivering growth,” said Fernandes.

“The concern then becomes whether the almost uniform appetite for quality has been increasing the prices of these stocks and creating a ’quality bubble’.

“This phenomenon is not new and was last seen in the US during the 1960s and 1970s with the ‘Nifty Fifty’ – these were large stable growth companies whose price multiples grew with investor interest.

“We discussed this with fund managers during review meetings and while most felt this wasn’t likely, it did give them reason to pause and reflect,” Fernandes concluded.

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Rui Fernandes, Senior Investment Analyst who led this review commented, “The number of funds reviewed in this sector is a reflection of the limited options available to Australian investors when compared to global long only funds (Lonsec researches 36 of these).”

“When comparing the long/short global and Australian sectors, a clear concentration in the number of underlying investment managers is evident.”

Platinum Asset Management, which dominates this space (by AUM and breadth of product range), is a significant factor in this outcome – Lonsec currently researches six products managed by this firm.

“Another interesting observation from this sector review is the domination of ‘home grown’ investment managers,” said Fernandes.

“Out of the eight underlying investment managers across the Global and Asian sub-sectors, five of these are Australian businesses with most having their investment operations in Sydney.”

“This contrasts with long-only Global and Asian equity funds where multi-city located investment teams are common and solely an Australian presence a rarity.”

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Great minds think alike
Lonsec observed that the average fundamental manager, where data was supplied, managed its portfolio with an ‘active share’ ratio in excess of 60%. ‘Active share’ measures a portfolio’s divergence from the benchmark (in terms of stock holding names and weights) and pleasingly indicates that the average fundamental manager was definitely active in its portfolio management approach.

By contrast, due to the typical larger number of holdings and quantitative benchmark relative risk management, Lonsec notes that the average quantitative manager was less active overall as judged by the active share ratios being typically less than 60%.

Diving deeper into the portfolios, Lonsec reviewed the ‘Top 10’ holdings, as at June 2010, of the 26 fundamental products researched. An extract of the findings is detailed in the table below. The ‘Top 10’ stocks are considered to be a fundamental manager’s highest conviction positions and held the largest absolute/active weights.

Roche (a Swiss pharmaceutical company) was the stock which engendered the most consistent high conviction levels. This stock featured in the ‘Top 10’ of seven of the 26 portfolios analysed (i.e. 27% of all portfolios). Moreover, given that Roche appears to be such a well regarded stock it is quite likely that it would also make an appearance in many other portfolios outside of the ‘Top 10’.

The degree of ‘commonality’ across ‘Top 10’ holdings is a curious and surprising outcome. Notionally, there is the potential for 260 stocks to occupy the highest conviction positions (26 x 10). However, an outcome of Lonsec’s analysis was the identification of there being only 172 different stocks across the ‘Top 10’ of the 26 portfolios. The MSCI World Index is constituted by over 1,500 stocks.

The funds management industry’s process-driven stock assessments, with similar modelling and assumption methodologies, may be a significant driver of this outcome. However, there is also the possibility that an undeterminable degree of ‘herding’ (e.g. safety in numbers) may also be a cause, if not a conscious one.

Investment teams stabilise
In last year’s report Lonsec noted that managers had mirrored the companies they invested in and sought to control costs with consequences for their investment teams. Investment teams were, on the whole, relatively stable. Managers highlighted that cost management-induced and performance-related turnover had largely played itself out. Voluntary turnover has been witnessed across some managers, but the overall trend has been muted. It is likely that this will be tested if the halcyon bull market days of 2006-07 return.

Further, in response to the changing global growth dynamics, managers have been flagging their intention to ‘beef up’ their Asian coverage—either through relocations from European or US offices, or through new regional appointments. This will be an interesting dynamic to watch, particularly as investment banks are also seeking to increase their presence in emerging markets, such as the Asia region, to capture their share of the advisory and transaction fees on offer and compete with buy-side firms for talent.

Location and perspective
One of the themes from the previous year’s sector review was the subtle difference in investment views, depending on where a manager was located. To refresh, US-based managers were, by and large, more constructive on the US and global economies than their counterparts operating from London and Edinburgh.

This year, however, most managers (regardless of location) tended to be mildly positive on the outlook for global markets. Notwithstanding, the Edinburgh-based Scots again stood out for their generally cautious tone. Interestingly, UK-based managers observed that the local population was relatively optimistic and appeared to be largely ‘deaf’ to the impending fiscal austerity that loomed in the UK over the near term.

Asia still sparkling
Managers were mostly constructive on the Emerging Asia region, believing that these markets as a whole exhibit favourable demographics and governments have learned valuable lessons from the 1997 Asian Financial Crisis. Many see the main opportunity to be the rise of the middle class and increased consumption through the step-up in per capita income. This is believed to touch many sectors, ranging from Financials (the belief being that the population is ‘under-banked’ and still reliant on a ‘cash’ economy which should benefit institutions like Standard Chartered) and Consumer Discretionary (e.g. increased consumption of luxury goods such as Louis Vuitton handbags).

An interesting anecdote Lonsec was told concerns Louis Vuitton: the luxury brand’s Hong Kong-based store apparently has the greatest amount of floor space globally of its outlets and has a limit on the number of handbags people can purchase. The main clientele is understood to be tourists from Mainland China who can arbitrage the tax differential (these products sell at a cheaper rate in Hong Kong than on the Mainland) and on-sell the bags once home for a profit. Money never sleeps!

Increased optimism reflected in portfolios
The increase in manager optimism generally translated into increased risk appetite. This was most notable in the Industrials sector, where most managers increased their absolute exposure to this sector. Industrials is an umbrella sector which encompasses a wide range of diverse industries, albeit it is considered to be cyclical and economically sensitive.

Lonsec also observed a notable rotation towards US stocks, with most of this being funded from Continental Europe and the UK. Most managers believed that the threat of a ‘double dip’ recession in the US, which had largely dominated markets during 2010, had largely subsided through successive fiscal and monetary policy stimulatory programmes.

Portfolios Stabilise
Lonsec observed that across the ‘average’ fundamental manager, from the period between December 2008 and June 2010, the stock turnover in portfolios increased through the first half of 2009 (with some overrunning the expected ceiling level), and peaked in the June 2009 quarter. However, since then there has been a notable decline in average stock turnover. Managers attributed this phenomenon to the general decline in market volatility across equity markets. Although, slightly contradictory, there were some managers which also noted that stocks were ‘highly correlated’ during this period, which hampered their ability to outperform their benchmark. Managers also highlighted that they believed that corporate earnings ‘visibility’ had improved, thereby instilling greater confidence.

Correspondingly, the number of stocks in portfolios experienced a similar upward trend from December 2008 through to June 2010. Broadly, stock holdings were seen to have risen throughout 2009 and largely stabilised in H1-2010. Managers attributed this rise to risk management and the spreading of ‘risky’ bets. To a large extent, Lonsec is sympathetic to this argument (increase stock numbers due to rise in volatility and uncertainty); however, this is also arguably reflective of a broad loss of conviction and increased wariness following a difficult few years.

Emerging Markets – more than one way to ‘play’ the story
While most products are managed against a MSCI World index variant (developed world-only benchmarks), product mandates typically allow managers to invest outside their benchmark and buy Emerging Market stocks, subject to threshold limits. Further, while managers may disagree on the ‘cheapness’ or ‘richness’ of Emerging Markets stocks in general, as noted earlier, most do not dispute the long-term trends that are favourable for these investments.

That said, managers generally fell into two camps: (1) those that ‘played’ emerging markets directly and (2) those that were more indirect. For example, Nestle—a developed market consumer staple stock—proved popular, with a general thesis being one of incremental growth being sourced from Emerging Markets. Tobacco stocks (such as Phillip Morris International) were also popular for a similar reason.

Managers had a degree of direct Emerging Market exposure at the time of review. Further, while Lonsec is sympathetic to the argument of accessing (historically volatile) Emerging Markets growth through developed markets companies, Lonsec has observed that the tendency of managers to emphasise this aspect of their rationale for holding a stock has increased, as the popularity of Emerging Markets has increased. Moreover, while a developed market stock may have incremental growth from emerging markets; this does not represent a ‘pure’ exposure.

Lonsec highlights the examples of BHP and Rio Tinto in Australia, arguably two domestic stocks that stand to benefit greatly from continued Emerging Markets growth, but whose market values were severely negatively impacted when the Australian Government proposed the idea of a new domestic tax. Arguably, Australia itself is starting to resemble an Emerging Market dependent company.

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