Lonsec’s latest Global Equity Fund Sector Review included 36 large cap and three small cap funds.
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Of these, nine large cap funds attained Lonsec’s top rating, Highly Recommended, including T. Rowe Price Global Equity Fund, Arrowstreet Global Equity Fund, Templeton Global Equities Fund, Aberdeen International Equity Fund (upgraded) and new entrant to Lonsec‟s universe, IFP Global Franchise Fund.
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Rui Fernandes, Senior Investment Analyst responsible for reviewing the sector, commented, “The distribution of product ratings were broadly stable across both the most recent and the previous sector review seasons.”

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Sector themes and observations

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Great minds think alike

“The degree of ‘commonality’ across Top 10 holdings is a curious and surprising outcome,” said Fernandes.
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“Only 172 different stocks held these highest conviction positions across the 26 portfolios – a remarkable observation considering that notionally, there is the potential for 260 different stocks (26×10) to occupy these positions out of some 1,500 in the MSCI World Index.”
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Companies that featured in several portfolios included Roche (which featured most prominently across the “Top 10‟ holdings, notably across seven of 26), Phillip Morris International, Nestle, Pfizer, Vodafone, Apple, Google, Hewlett Packard, Johnson & Johnson, and Wells Fargo.
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Fernandes commented, “The funds management industry’s process-driven stock assessments, with similar modelling and assumption methodologies, may be a significant driver of this outcome.”
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“However, there is also the possibility that an undeterminable degree of  ‘herding’ (e.g. safety in numbers) may also be the cause, which may or may not be a conscious decision by investment managers.”
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Investment teams and portfolios stabilise

In last year’s report Lonsec noted that investment managers had mirrored the companies they invested in by seeking to control costs, with consequences for their investment teams. By contrast, this year’s review observed that investment teams were, on the whole, relatively stable.
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“Voluntary turnover has been witnessed across some managers but overall the trend has been muted,” said Fernandes.
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In last year’s report Lonsec noted that investment managers had mirrored the companies they invested in by seeking to control costs, with consequences for their investment teams. By contrast, this year’s review observed that investment teams were, on the whole, relatively stable.
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“Voluntary turnover has been witnessed across some managers but overall the trend has been muted,” said Fernandes.

“In response to the changing global growth dynamics, managers have been flagging their intention to ‘beef up’ their Asian coverage, either with transfers from their European or US offices or new regional appointments.”

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Asia still sparkling

Most investment managers tended to be mildly positive on the overall outlook for global markets, a noticeable change from the cautionary tone observed in last year’s review. However, the outlook for Asia, particularly for the Emerging Asian Region, was positive and continued to be the brightest star in the investment landscape.
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Fernandes observed, “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 and Consumer Discretionary.”

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Emerging markets – more than one way to ‘play’ the story

“While managers may disagree on the ‘cheapness’ or ‘richness’ (in terms of price) of emerging markets stocks in general, most did not dispute the long-term trends that are favourable for these investments,” commented Fernandes.
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“Managers generally fell into two camps – those that ‘played’ emerging market stocks directly and those ‘played’ them indirectly. For example, Nestle is a developed-market consumer staple stock whose incremental growth has been sourced from emerging markets. The incremental growth from emerging economies was a key attraction of the stock.”
The Lonsec report highlights that most managers had a degree of direct emerging market exposure at the time of review

Of the 26 qualitative products reviewed in this sector, Lonsec observed that there was a notable degree of “commonality” in the “Top 10” holdings as at June 2010 – the stocks considered to be a fundamental manager’s highest conviction positions, being the largest absolute/active weights.

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“A traditional small cap fund invests primarily in the S&P/ASX Small Ordinaries Index, where a mid cap fund invests predominantly in the S&P/ASX51-150 segment.”

“Lonsec reviews five microcap funds, which typically invest in small stocks outside the S&P/ASX Small Ordinaries Index. Microcap stocks are generally a relatively immature business, offer the highest level of risk and are usually quite illiquid – but potentially offer the highest level of growth opportunity.”

Of the 36 funds reviewed, five attained Lonsec’s top rating, Highly Recommended; one midcap fund, the Ausbil Australian Emerging Leaders Fund and four small cap funds – Hyperion Small Growth Companies Fund, Pengana Emerging Companies Fund, Schroders Australian Smaller Companies Fund and the UBS Emerging Companies Fund.

“Six new funds were added to Lonsec’s small cap Australian equity universe in this review, including two microcap funds, the Ausbil Microcap Fund and the Macquarie Australian Microcap Fund,” said Ngin.

Sector observations

Strong gains….if you were in the right place

“The S&P/ASX Small Ordinaries Accumulation Index gained a solid 13.1% in 2010 – a far cry from the 53.2% loss in 2008 and the 57.4% gain in 2009,” observed Ngin.

“However there is a mixed story – the S&P/ASX Small Industrials Accumulation Index returned just 2.2%, while the S&P/ASX Small Resources Accumulation Index returned a strong 30.7% return for the year.”

The Lonsec review found that the “average” small cap manager in its universe is underweight the resources sector, largely due to a “quality” bias in their investment process. “This can be incompatible with small cap resources stocks where the company may not be generating cashflow or earnings, or may be a higher risk, single mine business,” said Ngin.

Midcap stocks continued to struggle compared to small cap stocks, with the S&P/ASX Midcap 50 Index returning just 4% in 2010. In contrast, funds that were able to invest in the other end of spectrum in microcap stocks were the strongest performers, with the S&P/ASX Emerging Companies Index returning 25.7% over the same period.

Limited IPO activity in this sector

Historically, IPOs have been a major source of investment ideas for small cap managers; however 2009 was a relatively quiet year with just $7.5 billion in IPOs across large and small caps. While 2010 saw $25 billion in IPOs, most was in large caps – or small resources.

“The lack of new industrial stocks is of some concern,” commented Ngin.

“This is compounded by the departure of some industrials, such as JBHiFi, which became a midcap stock and therefore out of the investment universe for most small cap managers.”

Other IPOs – such as Rebel Sport – have been put on the backburner after the lacklustre performance of high profile industrial IPOs such as Myer, Kathmandu and QR National.

Fund flows continue to be flat

While funds under management continued to grow, this was largely due to market movement – actual inflows were relatively flat. This is consistent with the findings of Lonsec’s recent large cap review.

“Unlike the large cap sector, the small cap universe has not been subject to competition from low cost ETFs and index style products,” said Ngin.

“These products are much less likely to impact the small cap universe as the argument for passive index style products is substantially weaker in this sector.”

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