The growing demand for transparency, increased liquidity, fee structure changes, and lower stock-market beta products have increased competition in the sector. The classic fund of hedge fund (FOHF) model—offering investors “access” to a diversifying set of alpha managers, albeit at a higher cost and with reduced liquidity—is being challenged, especially where performance has been poor.

“During the GFC, many multi-manager/FOHF products failed to deliver absolute returns or diversifying protection from equity market sell-offs, raising significant doubts in investors’ minds as to the core value premise of the format. High profile due diligence failures compounded its unattractiveness, along with relatively high fee structures. In addition, some products using single-manager multi-strategy and active multi-manager models that incorporate tactical exchange-traded fund (ETF) and index-like allocations have outperformed the “alpha manager” FOHF model,” said S&P Fund Services analyst Michael Armitage.

He added: “We view the “allocate and pray” feeder FOHF model as dead. In future, we expect offerings that fail to compete in terms of active oversight, transparent risk management, product-level liquidity, and competitive fees to lose out to the growing competition from newer funds designed from the ground-up to deliver on these features. There were several upgrades in this year’s sector review as we recognised funds with some of these product advantages and gained conviction in other offerings that had shown extended track records since our previous reviews.”

The Alternative Strategies – Multi Asset – Diversified Multi-Manager And Multi Asset – Multi-Strategy Sector Report published today, together with reports for all funds rated as part of the review, are available on S&P’s subscriber website www.fundsinsights.com

We also withdrew our ratings on the following four headline funds:

The post Investors demand more competitive offerings from Alternative Strategies – Multi Asset Sector appeared first on AdviserVoice.

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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The good news for stock investors first. The Jakarta Composite index rallied 46% last year, after soaring 87% in 2009, as investors chased stocks benefiting from an economy rejuvenated by reform. Since he was elected to power in 2004 (and re-elected in 2009), President Susilo Bambang Yudhoyono has implemented financial, tax, customs and capital market reforms and introduced stimulus measures to shepherd southeast Asia’s largest economy through the global recession.

The result was that Indonesia’s economy grew at an average annual pace of 5.5% in the past three years, a fair achievement during a global recession. Investors thought the world’s fourth most-populous country of 240 million people could maintain that growth rate in coming years.

But that thinking didn’t last too long into 2011. On January 3, the Central Bureau of Statistics said consumer prices in Indonesia jumped 6.96% in 2010. Stocks fell on a view that the central Bank Indonesia will need to raise the benchmark reference rate by 100 basis points over 2011, to slow the economy and lower consumer inflation to under 6%.

The slide in stock prices was exacerbated, almost perversely, on January 5 when Bank Indonesia at its monthly policy-setting meeting left the reference rate unchanged at 6.5% for a 17th consecutive month. Investors fretted that a larger overall rate increase would be needed in the long run if the central bank didn’t attack inflationary pressures quickly. Over the three trading days from January 7 to January 11, the market plunged more than 8%. For January, the index dropped 7.9%, a decline beaten only by India’s slump of 10.6%.

Stocks did better over February because the Bank Indonesia finally acted against inflation, raising the reference rate by a quarter point to 6.75% on February 4. The Jakarta Composite Index gained 1.8% in February, to be Asia’s third-best performer for the month, but still ended the month as Asia’s third-worst performer so far in 2011.

The main action Indonesian authorities took last year to curb inflation was to order banks to set aside more reserves. The central bank kept interest rates on hold because core inflation, at just 4.3% in 2010, is under its 5% target. The bank has been cautious about raising rates because it is concerned that higher rates will encourage speculative foreign inflows and expects the jump in food prices that is fanning inflation to be only temporary.

Heavy rains in recent months have disrupted food production across the archipelago and boosted the price of staples. Rice is reported to have risen about 10% recently, while the country’s favourite spice of chilli pepper has nearly trebled in price. Food comprises about 20% of the basket of goods used to calculate inflation in Indonesia.

An upbeat future

But hey – even if inflation and interest rates rise this year, optimism abounds about a country that fewer than 15 years ago almost collapsed politically and economically – even if it still has many challenges such as a lack of infrastructure and an abundance of red tape.

Politically the Muslim country is stable. After overthrowing 31 years of the Suharto dictatorship in 1998, the country has turned itself into a secular democracy and controlled extremist voices. So successful has this transformation been that the country is touted, along with Turkey, as a model for Muslim countries in North Africa that have overthrown autocratic regimes in recent weeks.

It’s not just investors who are upbeat about an economy that is posting a current-account surplus of around 1% of GDP, where the government’s finances are under control, and where inflation, while troublesome, is well below the double digits recorded as recently as 2002.

In December, the government articulated an economic vision for 2025 that sees Indonesia as one of the 10 largest economies in the world with a per capita GDP of US$12,800 to US$16,160, from about US$4,000 now. The IMF expects the economy to grow between 6% and 7% in the coming four years.

On February 25, Fitch Ratings raised its outlook on the country’s sovereign rating, to imply that Indonesia’s debt is soon to be classed as investment grade. Fitch at the moment rates Indonesian debt BB+, its highest non-investment-grade, or junk, rating.

In December, Moody’s Investors Service upgraded Indonesia’s sovereign rating one notch to Ba1, its highest non-investment-grade rating, because of the government’s improving debt position and the country’s build-up of foreign reserves, which stood at US$96.2 billion on December 31.

“The economic policy framework remains increasingly well positioned to deal with evolving macroeconomic challenges and potential shocks,” Moody’s said in a release, foreshadowing the upgrade.2

Including, stock investors take note, the challenge of inflation.

Jakarta Composite versus MSCI Asia ex-Japan Index since start of 2009

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Mark Burgess, incoming Chief Investment Officer at Threadneedle, looks ahead to 2011: “Our central case for 2011 is one of reasonable global growth led by emerging markets. Against this backdrop world equity markets look good value, particularly against government bonds. In addition, many companies have strong, healthy balance sheets and are sitting on large cash piles, having held back on investment during the recession. We expect corporates globally to start to use this cash to increase capex, raise dividends, buy-back stock or undertake merger and acquisition activity. We believe that emerging markets will continue to grow and outperform the rest of the world, helping to fuel demand for consumer goods and commodities.

“At the same time we must be mindful of the risks to this scenario. The credit crisis elicited a range of untested policy responses and we are yet to see the full consequences of these policies. The banking sector globally needs to continue to raise capital, which will restrain credit expansion and hence economic growth. In emerging markets there is the potential for growth to turn into a bubble and inflation to become a risk. Globally, markets remain fragile and any major shocks could cause volatility.

“This volatility should create opportunities for nimble, experienced investors with a proven ability to look through short-term noise and indentify long-term winners.”

INVESTMENT THEMES FOR 2011

Policy responses to remain a key driver of markets

Growing economic divergences highlight critical global imbalances that require intervention. The Eurozone is in crisis, China is tightening policy and the actions of developed markets threaten to spark currency wars. These issues all demand that policymakers adopt appropriate measures in a timely manner, yet policy response remains the single most difficult risk to assess. We believe that the ride will be bumpy but that policymakers will eventually arrive at the right place, allowing supportive fundamentals and ample liquidity to support asset prices.

• The European Central Bank must act urgently, as it has been reactive and fallen behind the curve in protecting the Eurozone. The ECB should recognise that policy must support the weaker economies and not simply be tuned to the mantra of “one size fits all”. This will necessitate a policy that is far too easy for stronger members, but the viability of the monetary union is at stake. We believe the ECB is likely to adopt some combination of lower rates, below-market rate loans to troubled economies, liquidity provisions and outright bond purchases.
• As QE becomes a more prevalent policy tool it is certain to evoke fears of competitive currency devaluation. There will likely be growing calls for capital controls in many developing economies reluctant to see an unwanted surge of liquidity into their economies. Such steps should not undermine the global growth story, but will likely stoke higher volatility across markets.
• China’s deflationary boom is turning inflationary, representing a paradigm shift in the economy at the heart of global imbalances. The ability of Chinese policymakers to tighten policy without rattling investors will require more skill than in past cycles.
• Ongoing de-leveraging continues to unleash powerful deflationary forces, which should allow developed economies to sustain modest growth whilst pursuing reflationary policies.

QE consequences

Quantitative easing has unleashed a wave of liquidity that must find a home. At the same time, it has stirred strong opposition in some quarters.

• QE2 is explicitly targeting asset prices and liquidity is likely to find its way into the areas offering the best value and potential returns. Currently this means higher risk assets such as equities. This is one of the reasons why we remain overweight in equities versus bonds.
• Specifically, emerging market equities and bonds are likely to be well supported. We may be in the early stages of a bubble in these assets.
• Subsequent waves of QE will become increasingly difficult to defend on the world stage. This could tip the current phase of currency devaluation into full-blown protectionism. Stocks with significant overseas earnings could suffer in this scenario (this is not our central case).

“Emerging market exposure is a consensus trade, but it can continue to reap rewards throughout 2011. It doesn’t make sense to stand in the way of this tide of liquidity.” Sarah Arkle, Chief Investment Officer (Vice Chairman from Jan 2011)

Stock picks: Sun Hung Kai, Barrick Gold

Untested policies

The credit crisis elicited a range of innovative and untested policy responses. This is likely to lead to ongoing volatility, rotation and unforeseen consequences.

• An important skill in 2011 will be the ability to look through short-term volatility to see the longer-term pricing anomalies.
• Ongoing uncertainty means that it will be more important than ever to be aware of risks in portfolios and ensure that all risks are understood and intended.
• Active management and stock picking are likely to add significant value in 2011.

“We are in completely uncharted waters here. Investors expecting a reversion to mean may be disappointed.” Jim Cielinski, Head of Fixed Income

The haves and the have-nots

Two-speed economies are developing at a global (emerging vs developed world), European (core vs periphery) and US level (skilled vs unskilled workforce). These distortions create socio-political tensions but also provide opportunities in a number of sectors.

• US unemployment remains high but in certain sectors, wage bargaining power is evident. When analysing companies, we will be emphasising their ability to retain talented staff without instigating wage inflation.
• With interest rates at all-time lows and QE2 targeting higher asset prices, employed, asset-rich consumers with mortgages should feel wealthier in 2011. This will support high-end consumer discretionary stocks.
• European banks with exposure to the periphery have been de-rated significantly. This creates the scope for a sharp rally if solvency fears are addressed decisively by the ECB. We remain underweight but continue to monitor the sector closely.

“You can’t take someone that was laying bricks on a building site in 2007 and put them into Google’s product development team. Specialist skills are in short supply and will be rewarded in 2011.” Cormac Weldon, Head of US Equities

Stock picks: Tiffany, Polo Ralph Lauren

The search for yield

We believe that inflation is not a risk in the developed world and that interest rates will be kept at historic lows in these markets. As such, government bond yields are unlikely to rise significantly and investors will seek income in higher-yielding areas.

• Emerging market and corporate bond valuations remain attractive relative to their improving fundamentals. We continue to favour these bonds over government issues in fixed income.
• Income stocks are likely to be in favour in equities. Moreover, companies that are reinstating or raising their dividends are likely to be re-rated.

“Why would I lend money to the UK government at 3.5% when I can get 5.1% with the prospect of dividend and capital growth from AstraZeneca?” Leigh Harrison, Head of Equities

Stock picks: AstraZeneca, Vodafone, BT

The emerging market consumer

Emerging markets will continue to produce superior growth in 2011 and growing wealth among consumers in these markets will support demand in a number of areas.

• We continue to invest in luxury goods stocks in Europe, where robust earnings growth has seen multiples decline despite rising share prices.
• More recently, we have expanded this theme into European premium auto stocks, eg BMW, where the valuation is attractive relative to its Asian joint venture partners.
• Banks in under-penetrated markets such as Indonesia and India are likely to attract capital as investors follow through the consumer theme.

“Luxury goods stocks were the first beneficiaries of growing emerging market wealth. The developing consumer credit cycle will create bigger ticket opportunities as this theme matures.” William Davies, Head of European Equities

Stock picks: BMW, Bank Rakyat

The return of capex

Companies have been very cautious in their investment plans in this cycle, preferring to maintain high levels of cash. Corporate balance sheets are strengthening and capital expenditure to depreciation ratios are at all time lows. We believe this trend will change in 2011.

• Improving economic confidence and high commodity prices are likely to drive increased capex in the extractive industries. Industrial stocks will be among the key beneficiaries.
• The replacement of ageing IT infrastructure at a wide range of companies will support earnings in the software and hardware sub-sectors.

“Mining equipment companies have been buffeted by changes in economic sentiment in 2010. They are attractively valued and there is scope for significant upgrades to earnings.” Simon Brazier, Co-Head of UK Equities

Stock picks: IMI, Komatsu

Mergers and acquisitions

Cash balances are high, valuations are attractive and companies will crystallise value in the market by undertaking earnings-enhancing corporate activity such as m&a. Meanwhile, private equity companies are under pressure to invest. Emerging market corporates are also likely to take advantage of currency strength to acquire footholds in companies in the developed world. This, together with share buy-backs, will drive a significant phase of m&a.

• Companies with unique assets, superior growth or access to proprietary technology will be among the main takeover targets.
• Management quality and valuation may not always be key drivers: small and mid-caps are likely to attract interest despite full relative valuations.
• Companies deploying cash in shareholder-friendly ways are likely to outperform as investors become more focused on the efficient use of capital.

“2011 could be the year when a household western name gets taken over by an emerging market rival.” Jeremy Podger, Head of Global Equities

Stock picks: Mid-cap resources, industrial companies

Commodity prices will remain underpinned

The outlook for commodity prices is positive, given the recovery in the world economy and the dominance of resource-hungry emerging markets in the global growth profile.

• Commodity-rich nations will continue to witness capital inflows, further strengthening FX positions and credit worthiness. This should support equity valuations and further spread tightening in fixed income.
• Companies using more expensive raw materials in their production processes will witness margin pressures.
• Rising commodity prices could be a source of inflationary pressure.

“Our growth forecasts imply additional demand of around 1.5m to 2m barrels of oil per day in 2011. If it becomes apparent that OPEC does not have sufficient spare capacity to meet this demand, the oil price could move sharply higher.” David Donora, Head of Commodities

• Mark Burgess becomes Chief Investment Officer from Jan 2011, when current CIO Sarah Arkle moves into her role as Vice Chairman.

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Recently, trading speeds on stock markets have increased dramatically as technology has been brought to bear on decision making as well as the matching and execution of trades. High speed computers can now gather data, make a decision by applying complex algorithms and execute a trade, all in much less than 1,000th of the time taken to blink an eye.

The growth in HFT over the past 6 years has been extraordinary, and HFT trades now make up more than 50% of all share transactions in the USA.

This article by Charles Duhigg published by The New York Times on July 23, 2009 provides a good example of how HFT operates.

“Stock Traders Find Speed Pays, in Milliseconds.”

“It was July 15, and Intel, the computer chip giant, had reporting robust earnings the night before. Some investors, smelling opportunity, set out to buy shares in the semiconductor company Broadcom. (Their activities were described by an investor at a major Wall Street firm who spoke on the condition of anonymity to protect his job.) The slower traders faced a quandary: If they sought to buy a large number of shares at once, they would tip their hand and risk driving up Broadcom’s price. So, as is often the case on Wall Street, they divided their orders into dozens of small batches, hoping to cover their tracks. One second after the market opened, shares of Broadcom started changing hands at $26.20.

The slower traders began issuing buy orders. But rather than being shown to all potential sellers at the same time, some of those orders were most likely routed to a collection of high-frequency traders for just 30 milliseconds — 0.03 seconds — in what are known as flash orders. While markets are supposed to ensure transparency by showing orders to everyone simultaneously, a loophole in regulations allows marketplaces like NASDAQ to show traders some orders ahead of everyone else in exchange for a fee.

In less than half a second, high-frequency traders gained a valuable insight: the hunger for Broadcom was growing. Their computers began buying up Broadcom shares and then reselling them to the slower investors at higher prices. The overall price of Broadcom began to rise.

Soon, thousands of orders began flooding the markets as high-frequency software went into high gear. Automatic programs began issuing and cancelling tiny orders within milliseconds to determine how much the slower traders were willing to pay. The high-frequency computers quickly determined that some investors’ upper limit was $26.40. The price shot to $26.39, and high-frequency programs began offering to sell hundreds of thousands of shares.

The result is that the slower-moving investors paid $1.4 million for about 56,000 shares or $7,800 more than if they had been able to move as quickly as the high-frequency traders.
Multiply such trades across thousands of stocks a day, and the profits are substantial. High-frequency traders generated about $21 billion in profits last year, the Tabb Group, a research firm, estimates.”

History

In 1997 the NYSE stopped quoting stocks in eighths of a dollar and moved to increments of 1 cent. This reduced the revenue the market makers earn from the bid/offer spread, so the exchange began paying rebates to high-frequency brokerages if they bought shares at the best public prices.  This provided a financial incentive for the development of the high frequency, high volume, low margin approach that characterises HFT.

Meanwhile, HFT was supported by significant upgrades to trading systems in many exchanges, designed to dramatically cut transactions times.  Going even further, the extremely short period of time that it takes for a piece of information to travel from one computer to another in a network, which is known as “latency”, was shortened even more as exchanges began to rent space right next to the trading platforms in their own data centres. In consequence, many firms can now process an order in less than 3 millionths of a second.

Australia and Asia have been relative latecomers to HFT. Hong Kong is making a significant investment in the required technology, and our part of the world looks like the next region for explosive growth in this area.

It looks as though this growth will continue, with HFT not only spreading geographically but to other markets as well. HFT is now well established and growing in foreign exchange, futures and options markets, and bond markets are also joining in.

Infrastructure

Low latency infrastructure now looks for improvements in the millionths of a second range, and “extremely low latency” is the expression used for the best of it. Low latency provides information, including about competing bids and offers, microseconds faster than higher latency systems.

In Tseung Kwan in Hong Kong, work is underway on a data centre where stocks, futures, options and currencies can be traded on computers metres away from Hong Kong Exchanges’ own systems which are used to handle trades. The cost will be high and milliseconds will be saved, but in the world of HFT, milliseconds are precious.

The concept is referred to as co-location and it is being adopted widely. In Australia, the ASX plans to dramatically expand its co-location services with a new $32 million data centre which is due to be completed in August 2011.

Financial market news is also now being formatted by firms such as Bloomberg so that it can be delivered to, and read and analysed by, computers almost instantaneously after release.  Beyond even that, algorithms are now being designed to interpret stories and to make judgements about the likely effect of those stories on market sentiment.
In 2008 Dow Jones ran ads in the Wall street journal, proud that they had managed to report an interest rate cut by the Bank of England 2 seconds faster than their competitors.  In the world of HFT, 2 seconds is a very long time.

Strategies

Algorithmic trading can be applied to virtually any investment strategy, including pure speculation and trend following, passive benchmarking to replicate an index’s return or  exotically named techniques such as “Stealth”, “Iceberg”, “Dagger”, “Guerrilla”, “Sniper” and “Sniffer.

Typical HFT strategies involve a mix of high turnover of capital, very short holding times, multiple trades each day, very small returns per trade and all positions being closed out at the end of every day.

“Latency arbitrage” is a contentious strategy. It exploits knowledge that the trading system of a particular exchange is about to slow down under a processing load, providing a trader with an opportunity to set up a buy or sell order in advance. The method of ensuring that the processing load is then actually experienced is called “quote stuffing”.

Algorithmic trading strategies often attempt to reduce costs by breaking large orders into several smaller ones which are then placed into the market progressively, a method known as “iceberging”. The algorithm called Stealth tries to find the large hidden orders that hide behind tiny obvious ones (icebergs) and to profit by subverting the intent of the iceberger. In this case, we have a science fiction-like battle of wits between two computers.

Some strategies are called “gaming” because they depend on the programming skills of other traders. “Dark pools” are alternative market-places where trading is anonymous, and most orders are “iceberged”. “Sharks” “ping” small market orders into dark pools, concluding if they are filled that they have discovered an “iceberg”.

Flash Orders

Some markets allow HFT traders to look at orders for very short periods of time (of the order of 30 milliseconds) before they are shown to everyone else. This is enough time, as we have seen, for traders to conduct a transaction and turn a profit by very quickly trading shares they know will soon be in high demand. The aim is to earn small amounts per trade on very large numbers of trades, sometimes millions of times a day.

The markets defend this practice as providing liquidity. Others claim that it allows one trader to probe the market with tiny orders that are immediately cancelled to provide an opportunity others don’t have of gaining insight into the other side’s willingness to pay. On the face of it, it looks like an unfair advantage.

A turning point seems to have occurred on May 6 in the USA, when an event took place which became known as the “flash crash”. Rapidly delivered, computer generated orders were widely held to be responsible for sending the Dow Jones Industrial Average down by 1,000 points in 20 minutes. This has led many commentators to question whether there is any inherent difference between flash orders and the misbehaviour called “front-running”.

Nanex has plotted the flows of orders from HFT traders, and they form very distinctive and unusual patterns which have been given names such as “Bandsaw II” and the “Boston Zapper”.

Polarised Opinion

HFT has supporters and detractors, but the growth seems to roll on in disregard of the arguments for and against.

Fully automated markets such as NASDAQ, Direct Edge and BATS, in the US, have prospered at the expense of less automated markets such as the NYSE, providing a warning to other world markets of the dangers of being left behind.  The expansion of volumes and contraction of margins has led to economies of scale, in turn generating pressure for lower commissions and fees, and mergers or consolidation of financial exchanges.

Finally, HFT seems to benefit from and also cause, in a loop, fragmentation of markets.  Fragmentation produces diverse trading venues with slightly different trading systems, speeds and fee schedules, providing opportunities for traders to exploit the differences through their computer algorithms.

Perhaps the clearest evidence of the changes and fragmentation that dark pools, and platforms like Chi-X Europe are causing is the fact the London Stock Exchange now accounts for only 55% of trading in the stocks that comprise the FTSE 100 index. This should give the ASX and all market participants pause for thought as Australia prepares to ramp up its involvement in this area and alternative exchanges to the ASX are introduced.

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The Global Emerging Markets (GEMs) and Regional Equities sector now encompasses 20 funds, an expanding universe with six new funds being formally rated by Lonsec. This growth reflects a combination of continued product development for retail investors in this category and a desire to increase product choice in a growth sector for advisers and their clients.
Allocation

Lonsec’s continued belief that GEMs and regional funds can play an important role in a well diversified investment strategy has been further reinforced by the recent sector review. However, just like the sector itself, deciding how much is a responsible allocation to GEMs is not for the faint hearted.

Spoilt for choice

Australian investors looking to gain exposure to emerging markets have no shortage of options. Single country funds, regional funds, emerging markets funds, BRIC funds, emerging markets ETFs, commodity ETFs, and even individual resource stocks to touch on a few.

Indeed some could argue that the Australian stock market behaves like an emerging market, as do global equity funds that have the capacity to invest in emerging markets. Given the Australian stock market is dominated by resource stocks, investors with a significant holding of Australian shares should be aware that they may already have extensive exposure to emerging market themes.
If you consider the characteristics, the Australian market shares its characteristics with many of the larger economies in the MSCI Emerging Markets Index which by their composition are also exposed to the fortunes of commodities – for example, Brazil (16% of the MSCI EM index), South Africa (8%) and Russia (6%).

Performance considerations

Over the long term, emerging markets indices have delivered higher returns than developed global equities, albeit with higher volatility. In looking at the historical performance returns, the temptation could be to dive in with a chunky exposure. However, due to the increased volatility associated with GEMs, it is important to consider your clients’ risk appetite and the likely tenure of any investment.

In a recent market update, Templeton stated that most institutional clients allocate somewhere between 3-8% of their total portfolios to emerging markets. Allocations are further complicated by the crowded trade scenario, the notion that via Australian resource stocks investors are already heavily exposed to China and emerging market-related themes, and investors need to be mindful not to double up exposure to those themes.

Challenges for emerging economies

Emerging markets remain transitional economies, generally growing at growth rates above the global average and are often portrayed as tomorrow‘s advanced economies. Governments in these markets are generally implementing economic reform programs to attract greater levels of foreign direct investment, and in turn promote increased local investment.

There are numerous challenges confronting these booming economies and progress is rarely linear. These governments must strive to absorb the rising capital inflows, reduce reliance on exports while encouraging domestic spending, nurture a stable political and social backdrop enabling the majority of the population to participate in increasing prosperity and seek to avoid a boom-bust scenario. The Chinese government‘s attempts to dampen speculation in the property market are evidence of the challenges facing these economies.

Should an emerging economy reach sufficient progress, it can move towards developed status (as the likes of Singapore and Hong Kong have achieved). Israel is the most recent upwardly mobile economy to make the transition from developing to advanced status. MSCI Barra reclassified the MSCI Israel Index from the MSCI Emerging Markets Index (MSCI EM) to the MSCI World Index in May 2010.
At the same time, the Index guardian deferred Korea‘s promotion, citing the need for progress on the currency, regulatory and perceived anti-competitive practices. Taiwan has also been identified as a candidate for developed market status at the mid-2010 review.

This highlights that the transition from emerging market status is not always smooth sailing but can provide opportunity for astute investor to participate in this growth. Lonsec recognises that the risks associated with emerging market investing are not for everyone, being aware of the potential hurdles that may strike investments is paramount to a well managed investment portfolio for investors.

How to access emerging markets

In terms of positioning, there is no doubt that China—as the largest economy in the MSCI EM index—remains central to the prospects for Asian and emerging market equities. Interestingly, Lonsec did not discern too much hysteria or negativity about China‘s economic prospects among investment managers in this review cycle. Certainly, there were some concerns about rampant property speculation and the impact on the broader economy including the capital strength of Chinese banks. However, the mood on the ground contrasted strongly with much of the obsessive rhetoric of the Australian financial press and commentators sweating on a run on Chinese equity prices and broader economic collapse.

While China is somewhat of a buzzword that has many investors craving a level of exposure, it is worth noting that typically, to date, Lonsec‘s higher rated global emerging market managers tend to be characterised as less benchmark aware in their investment approach and reside over broader mandates in terms of countries in which they can invest. Emerging markets tend to be inefficient (more so than developed) and less heavily researched this allows fundamental, active managers to exploit insights gained from direct company contact and the research effort in general.

Emerging market investors have numerous readily available investment options to obtain market exposure (ETFs covering regions and single countries) and might be willing to consider allocating to active managers that have mandates which provide for greater freedom in portfolio construction to add insight.

While there are numerous choices available for investors Lonsec recommends advisors take careful note of the nature of any potential vehicle under consideration, as highlighted earlier the opportunity set for Australian investors is not only ever-growing, but increasingly diverse. While Lonsec considers an emerging markets exposure to be a logical inclusion in a well diversified portfolio, caution should also be taken to ensure the nature of investment is appropriate for the client.

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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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This will undoubtedly place the adviser in a most challenging position – on the one hand, yes, their services are desperately needed. On the other hand, the adviser has been under seemingly continual scrutiny, change and indeed challenge for the last few years. While the pace and magnitude of change in the advisory profession shows no real signs of abating, the anecdotal feedback we are receiving continues to confirm that market sentiment is slowly improving and confidence is on the rise.

Given all of this, it appears to us that Australian principals are now faced with an interesting dilemma. How do they react to such a market? However, perhaps an even more fundamental question should be – how well placed are they to do what they have to do, to look after their clients as well as their own practice?

Of course, there won’t be a ‘one size fits all’ answer to these questions. And while it is always wise to have one eye on the forces shaping the environment of tomorrow, it also prudent to understand where the marketplace is today and how it is changing over the short term. It is here that the key findings from the recently released Business Health Future Ready IV* research paper provides real insight.

• Since 2002, Business Health has released a series of white papers providing a comprehensive insight into the health of the Australian advisory industry and its preparedness for the future. These papers have become known as the Future Ready analysis. The fourth in this series, Future Ready IV, was released earlier this year and is based on the consolidated analysis from Business Health’s HealthCheck data warehouse which now contains information on over 2,000 Australian practices.

As can be seen from the following graph, when comparing the ‘health’ of practices today to the position in 2007, we have seen incremental improvements in some areas, but at a high level, there seems to have been little progress.

While the stronger practices seem to have gotten stronger (the number of firms adjudged in the elite Super Fit category was up from 16% of the marketplace to 20%), the number of firms rated Healthy or better dropped from 82% to 75%. On the other hand, the number of Poor and Average Health practices has actually increased over the past two years – they now stand at 25% of our data set, up from 18% in 2007.

Although in many regards this still represents a strong result (the Business Health best practice benchmarks are unapologetically set quite high), and Australian firms remain at the forefront of global practice management, the fact remains that one in four of the better firms in this country are still in need of a stronger “health” plan.

While each practice is unique and the challenges (and hence solutions) vary from firm to firm, without doubt, the tumultuous market conditions of late, have had an enormous impact. Many principals have (in most cases quite rightly) had to divert much of their management focus and attention into addressing other more immediate concerns, causing a lot of the practice management initiatives to stall.

In future issues we will take a look at various aspects of running a practice – the key profit drivers; what’s working, what isn’t. And to help AdviserVoice readers monitor the changes occurring within the advisory profession, we are delighted to announce that Business Health has compiled the first ever Australian Practice Health Index. We will be releasing the Index in the next issue of AdviserVoice and will thereafter look to explore any changes occurring to it in future issues.

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• The Reserve Bank Bulletin released yesterday has provided a breakdown of the ownership of Aussie equities.
• The portfolio allocations between households and institutional investors differ significantly. Mum and Dad investors hold 65 per cent of their portfolio in financial stocks – more than double the portfolio allocation of institutional investors.
• The large equity raisings during the GFC has resulted in foreign investors now owning around 40 per cent of the Australian market – in line with the holdings of institutional investors.

Click here to download the document (pdf)

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Income-based strategies are likely to become more appealing to investors as companies restore their dividends and come under increasing pressure to pay out their cash piles, according to Russell Investments.

“Now is a great time for investors to consider moving back into Australian shares. With corporate balance sheets being restored, dividends are returning to normal and overall yields are competitive against term deposits,” said Scott Bennett, portfolio manager at Russell Investments.

This reporting season saw an increase in dividends for the first time in 12 months, with the majority of companies delivering dividends in line with or better than market expectations – a welcome relief from the previous two reporting seasons where many companies cut their dividends to conserve cash.

The banking sector increased the most, up 32% over the previous period. Many resource companies resumed dividends as well, signaling renewed confidence in commodity and energy pricing.

“We are seeing a turning point for dividends. As a result we expect a rise in income-based strategies as the market heads into a period of lower growth where a greater proportion of investors’ total returns could be driven by dividend income,” Mr Bennett said.

Mr Bennett explained that income strategies will be particularly useful for SMSF investors as they begin implementing their transition to retirement strategies.

In fact dividend yields are currently performing better than 90 day bank bills. Based on IBES consensus forecasts the Australian market is currently yielding a gross of 5.4% (after franking credits) compared to 90 day bank bills which are currently yielding 4.8%.

The Russell Australia High Dividend Index, an index that is representative of a high yield strategy, is currently yielding above the market average at 6.7% (gross) based on IBES consensus forecasts. The index selects companies that have a high expected dividend yield but which also meet other characteristics, including a history of paying dividends; dividend growth; and consistent earnings.

Buybacks are back

According to Russell, share buybacks is another area SMSF investors should consider for income strategies. These are set to increase as companies move away from conservative balance sheets that’s characterised the last couple of years.

“Following an extended period of capital-raisings from Australian companies, we have started to see a reversal in the trend with the likes of Woolworths and CSL recently returning capital to investors,” said Mr Bennett.

Over the two calendar years 2008 and 2009, Australian companies raised more than $110bn, according to the ASX. Australian companies had 6.5% of their assets in cash at 30 June 2010; compared with 4.3% at 30 June 2008, according to Macquarie.

However excess cash can have a negative effect on a company’s return on capital, so Russell foresees increasing shareholder pressure for companies to either put the cash to work, through M&A activity, or return it to shareholders via a special dividend or buyback.

“Woolworths’ recent off-market buyback is an example of an attractive strategy for SMSFs, as the majority of the buyback price was treated as a fully-franked dividend, therefore allowing significant tax benefits for investors,” Mr Bennett said.

To help facilitate this growing investor appetite, Russell Investments has developed several investment strategies that have been specifically designed to extract a higher level of income from an Australian equity portfolio. These strategies include Australia’s first ever dividend-focused Exchange Traded Fund, Russell High Dividend Australian Shares ETF (ASX ticker code – RDV).

It is also looking to launch a multi-manager income fund that will combine several unique income-focused strategies in a diversified portfolio.

“We have seen a positive season for dividends, and now is the time for investors to consider how a dividend approach can benefit them,” Mr Bennett concluded.

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