December 2011
The big call – now is the time to buy UK equities
Next year the Office of Budget Responsibility forecasts that the UK government will pay £47 billion in interest to its creditors. According to our data all the companies in the FTSE 350 will pay out £76 billion in dividends in 2012.
Ignoring any changes to the capital value behind these income streams it would be logical to argue that a typical UK investment portfolio would mirror this split. On that basis the split would be roughly 40% in gilts and 60% in UK equities. Indeed, that is probably a close approximation to many portfolios, whether private or institutional. However, if we start drilling a little deeper we see things are not that simple. We know 40% of UK shares are held by overseas investors so the UK as a whole must be underweight UK equities. That means it might have foreign shares to make up the difference or, more likely, they are overweight in bonds, especially gilts.
All of us are familiar with the trait of running your winners and either grimacing at, or selling, the losers in a portfolio. After the near twenty year bull market in gilts and eleven year bear market in equities it would not be surprising to see most portfolios are now overweight in gilts. Despite the economic storms gilts have been a surprisingly safe haven and have rewarded their owners with impressive capital gains. Moreover, surveying the international scene it is hard to identify a foreign debt market that looks either safer or offers better value. Whatever happens with the actual notes and coins the divergence in European bond markets has already demonstrated that the concept of a single European currency has failed. Sovereign euro debt is no longer equal and it can only be a matter of time before the realisation that not all euros are equal becomes widespread. There is now significant risk of full or partial sovereign defaults.
If you can’t trust politicians to pay their debts who can you trust?
Apparently moneylenders of old always charged kingdoms more to borrow than fellow merchants. After all, they could always claim their goods in the event of a default or have the miscreants slung into jail. It wasn’t so easy to use such methods on a recalcitrant king.
Maybe the time has come to go back to those valuation standards. Although as a working assumption it is wise to treat all corporate executives with caution they are at least, generally, working for shareholders and their interests are aligned. That is often not the case with politicians who can easily direct voter anger towards sovereign lenders as the cause of their problems.
It is true that the outlook for UK debt is better than for some other countries because it still controls its own currency and interest rates. But the economic situation remains dire and the Autumn Statement from the Government predicts that the stock of UK debt will rise from its current level of £1,044 billion to £1,515 billion by 2017. In other words the gilt market is going to expand by 50% in the next five years.
Investors might welcome this development as the Government will have to increase its interest payments to £65.5 billion. Lenders are going to receive a lot more income. There is, though, one fly in the ointment. Usually, when the supply of a good or service increases its price goes down. How will lenders react to a 50% increase in the stock of debt and will 10 year gilts still only yield 2% in 2017?
Of course the outlook for equities is clouded by the poor prospects for the world economy and it would be a brave analyst who forecasts rapidly rising profits. Even so, that diverse income stream from the 300 companies in the FTSE 350 is sourced from all over the world and, in aggregate,is probably pretty reliable. Indeed, it is possibly safer than a number of foreign sovereign bond markets. While there is frequent angst about the inclusion of overseas stocks into the UK market it has enabled this exchange to expand, typically with resource exploitation in emerging markets. These activities usually have higher margins, and hence better cash flow, than mature metal bashers in developed economies that face brutal competition. Even if the dividend stream does not rise much, the compounding effect of that cash flow will benefit shareholders in the same way it has done for the last 100 years. It is those cash returns, not capital growth, that have provided equity returns to shareholders.
The best thing UK investors, as a group, can do now is buy back the UK equities they have sold to foreigners over the last few decades. They need to secure that income for themselves before overseas investors realise how valuable it is.
November 2011
Active, passive or hybrid
Deng Xiaoping once claimed that it didn’t matter if a cat was a black or white; as long as it caught mice it was a good cat. To some extent the debate about passive and active funds has descended into polemical rhetoric reminiscent of the struggles between communism and capitalism. Opinions have become so entrenched that some advocates of one type refuse to consider using a member of the rival group. Such intransigence is not helpful to the people that really matter; the investors. They should be advised by those prepared to look at all the options. Moreover, the gap between the two groups is becoming harder to define as funds in both cohorts evolve to adjust to the new realities of the market place. Some active managers are cutting fees to compete with passive funds and some passive funds are not that passive. In a changing world the old labels are no longer so accurate.
To complicate matters new funds have been developed that are neither fish nor fowl and are hard to ascribe to either category and even harder to name. Is it best to call them active trackers, passive actives, blended, melange, mixed, process driven, asset allocation, crossbreed, crossover, mongrel, combination, compound, amalgam, mulatto or maybe just hybrid?
As in any debate it is always helpful to define terms before trying to resolve the issues. While many people think they know instinctively what an active fund is it is a lot harder to construct a definition. Besides, what actually do we mean by passive anyway?
A common description of an active fund is one that aspires to beat the market, which of course begs the question of what is “the market”. A widespread assumption is that it is the appropriate stock market index, typically the FTSE 100 or FT All Share. The first challenge here is to make sure the index is the total return measure so that it includes reinvested dividends and not just the simple capital index. As an aside it is worth pointing out that a number of structured products exploit this seemingly arcane difference to set benchmarks that the providers know they have a better chance of beating. They hope investors won’t notice them pocketing the dividends. Absolute return funds are especially good at exploiting such differences.
A minor point is that to make a true comparison an active fund should only select stocks from within that index. In practise many active funds include foreign stocks, AIM listed companies or even bonds that are not constituents of, say, the FT All Share. Some of them also use derivatives. In practise many active funds invest outside their strict universe and, in effect, pinch beta from another market then claim it as alpha in their own. Such alpha rustlers make cross border raids by investing in, say, US tobacco companies and use that performance boost to claim superior returns against a UK benchmark.
Whatever the issues with active funds the world of passive investing is even murkier. At first glance passive funds are easier to define, partly because their sponsors make a point of referencing the index they are benchmarked to. That said, passive funds do use derivatives, albeit in the interests of efficient dealing for IPOs, rights issues and changes to the underlying index. However, once that line is crossed it is not difficult to see that it can progress to include the complex area of trading that proved so embarrassing and expensive to UBS in September. Into this world we also have to address the confusing issue of ETF labelling. It is no longer sufficient to label something as an ETF. It has, at the least, to be classified as either a physical, synthetic or over collateralised ETF. If a bank has to go such a length to describe them it is clear that these are far from passive products. In addition aspects such as counterparty risk, trading and monitoring of collateral requirements need to be considered. Moreover, investors need to keep an eye on the credit rating of the sponsoring bank. Buying something from a AA rated institution is fine. But in these fast moving times ratings can change in a matter of weeks or days and what was once blue chip is now junk. That is not very reassuring for those long term investors building up a pension pot using these vehicles.
However, the ground is being muddied by the new breed of funds that bridge the gap between active and passive that blur the dividing lines. These funds use tightly defined investment processes that either select a sub-set of stocks in an index or invest in the whole index in a particular way. At the moment this space is dominated by DFA, but also includes IUKD, RAFI and The Munro Fund. While it is easy to define the constituents it is harder to ascribe a label to the group.
Some of these new funds make life harder for investors at the start by inventing their own index. That requires boffins to spend time and effort on analysing data and repackaging it. This immediately introduces a degree of opacity which is compounded by the secretive way some of the processes are executed. That too involves some element of active trading.
The gold standard benchmark of any investment collective must be the underlying index that it is benchmarked to. While they may be flawed in using market capitalisation they are simple to understand and widely followed. Any collective vehicle that seeks to replicate or beat the returns of that index should do in a way that investors understand. What is crucial is that the process is replicable and eliminates as much human subjectivity as possible. That way the underlying bias of the process can be demonstrated and measured against the benchmark. Where active funds differ most from passive funds is the frequent change of managers. Such a change can dramatically change the style of fund and introduces a totally different set of biases into the fund. That makes longer run comparisons of active funds difficult if not irrelevant.
Passive funds have the advantage here in that the process continues irrespective of the name on the fact sheet. This is one clue to the difference between passive and active. Passive funds have a constant process so any deviations in relative returns are a function of the market not the mechanism. With active funds it is never quite clear how much of the relative difference is due to the manager or the style in the market. A classic example was in 2009 and 2010 when the dash to trash rally that followed the Quantitative Easing rally favoured mid cap growth stocks at the expense of large cap value. Distinguishing how much value active managers added to the style bias in this rally was difficult. In the case of hybrid funds it was easier to see which process worked in that environment and which ones got left behind. This makes it easier for fund pickers to select the funds that did well, or the ones that might do well when markets change, as they have since the first quarter of 2011.
It does, though, lead to the bizarre situation that analysis of passive funds then becomes one of analysing past performance just as with active funds. This is despite advocates of passive funds telling us that past performance is no guide to future returns. Somewhat confusingly some fee based managers use this measure when considering the new range of hybrid funds.
Hybrid funds in the UK have a relatively short trading history so some argue that it is too early to make comparisons. Moreover, attribution analysis of hybrid funds is not simple because it derives from two sources: the underlying process and the prevailing market bias such as to value or growth, bug cap or small cap. The problem is that in the short term market bias can overwhelm the underlying process. Because hybrid funds are process driven analysts don’t have to worry that the process might have changed. So in that regard they are closer to passive funds than active ones. Herein lies the true distinction between active and passive. In an active fund it is not easy to measure how much value a manger has added relative to the underlying bias in the market. But you can with a passive fund.
All of this demonstrates that really there is no clear difference between active and passive and the rise of hybrid funds makes the distinction even fuzzier. It seems that there is a continuum from black to white with lots of grey in the middle. Perhaps the best way to identify where a fund sits on that spectrum would be through its portfolio turnover rate. But few funds declare that.
If Deng Xiaoping was still alive today and investing in collectives he probably wouldn’t care too much if it was an active, passive or hybrid fund. As long as it did what it promised he would surely regard it as a good fund whatever it was called.
October 2011
How Fundamental Tracker Investment Management will implement the UK Stewardship Code
At the Institute of Chartered Secretaries and Administrators Corporate Governance Conference on 18 March 2009, the former Chairman of the Financial Reporting Council, Sir Christopher Hogg, stated that the financial crisis was a result of “a massive failure of governance at every level involved, going way beyond, though not excusing the failures of corporate governance in publicly-quoted UK banks.”
The UK Stewardship Code 2010 (the Code) was introduced by the Financial Reporting Council (FRC) in an attempt to encourage a longer-term and more enthusiastic involvement in company ownership. The Code aims to enhance the quality of engagement between institutional investors and companies to help improve long-term returns to shareholders and the efficient exercise of governance responsibilities.
The Stewardship Code is published and overseen by the FRC which is the independent regulator overseeing financial reporting, accounting and auditing and corporate governance. Although it is not mandatory the FRC encourages those service providers to disclose how they carry out the wishes of their clients by applying the principles of the Code that are relevant to their activities.
This document explains Fundamental Tracker Investment Management Ltd.’s approach to the Stewardship Code.
Stewardship policy
Principle 1 - Institutional investors should publicly disclose their policy on how they will discharge their stewardship responsibilities
- This document represents our public response to voting policy and outlines how FTIM meets the Stewardship Code.
- FTIM does not wish to comply fully with all the Stewardship Code due to the amount of resources that would be necessary for full compliance.
- Due to the costs involved, the voting system in place will only be used on the most important issues.
- FTIM aspires to be in a position to ‘comply’ fully with the code when resources allow.
Principle 2 - Institutional investors should have a robust policy on managing conflicts of interest in relation to stewardship and this policy should be publicly disclosed
- We recognise the importance of managing conflicts of interest on behalf of our clients when voting. At present, and for the foreseeable future, we see little scope for conflicts of interest to arise because we use a tightly defined investment process that is not subjective.
Principle 3 - Institutional investors should monitor their investee companies
- Our investment process is driven by our model which selects stocks in a purely objective fashion. Weights and holdings are checked daily against the model which itself is adjusted on a monthly basis.
- Corporate events are monitored by us and captured in a Daily Market Commentary which is published on the website. This keeps us abreast of the activities of our invested companies.
- Our custodians, through ProxyEdge®, will notify us of forthcoming voting issues such as EGMs and AGMs. We will note any significant issues of stewardship that require our attention and vote accordingly.
Principle 4 -Institutional investors should establish clear guidelines on when and how they will escalate their activities as a method of protecting and enhancing shareholder value.
- Unlike other fund managers we do not have the ultimate option of selling shares in a company where we believe corporate governance issues are undermining the value of the company.
- Because of this we are unlikely to be offered the chance to have confidential discussions with companies where we intend to vote against the board. For that reason we would not expect to be ever invited to be taken “inside” and given price sensitive information. Instead we will inform the company chairman by letter and publish all such correspondence on our website.
- Issues where we would expect to make our views known are likely to focus on executive remuneration but we will remain open to suggestions from our shareholders on this and other issues. Contact us at enquiries@themunrofund.com]
Principle 5 - Institutional investors should be willing to act collectively with other investors where appropriate
- FTIM is open to working with other institutions and shareholders where appropriate. Presently we are not part of any institutional lobbying networks but we will endeavour to use our contacts in the industry to act in the best interests of shareholders but ensuring that we are not deemed to be part of a concert party.
Principle 6 - Institutional investors should have a clear policy on voting and disclosure of voting activity.
- Our policy is to pay particular interest to important matters within investee companies that we feel need to be addressed through voting and by communicating with the company’s chairman.
- FTIM uses a third party voting platform provided by our custodians called ProxyEdge®. There is a charge for every vote cast and hence our voting will be targeted.
Principle 7 - Institutional investors should report periodically on their stewardship and voting activities.
- Any voting or action taken with regard to an issue will be reported on our website (www.themunrofund.com).
September 2011
Fundamental Tracking; The Story So Far.
Nearly four years ago a new investing concept was launched in the UK. The fact only £2.3m is managed using this technique might indicate that it has failed. However, analysis of the data suggests a different conclusion.
First it is worth understanding what fundamental tracking is, and what its ambitions are. The arguments in favour of passive investing are well rehearsed and well known. It is not so much that EMH works but that the time and effort to beat the index is not repaid by better risk adjusted returns. It argues that you can beat the market, but only by taking excessive risk that now and then turns round and wipe out all the gains. Worse, you never know in advance which particular strategy will be rewarded in the future. What is clear is that there is little persistency of styles from one year to the next. In short, active investing can work, but the time, effort and cost often absorbs all the gains at the gross level and leaves the investor little better off at the net level.
Until four years ago the only alternative was to use an index tracker that simply followed the constituents up and down. Its principal merit was low cost which instantly gave it a head start of 1% or more a year over its active peers. No one pretended it was a very clever solution but it had the merit of beating most of the opposition. There is though a fatal flaw in index funds and one that can only be resolved by making a Faustian pact with hedge funds. Allocating capital by price, as index funds do, means that there is an irresistible pull of money towards the most expensive shares.
The consequences of that were eloquently displayed in the millennium tech bubble when concept stocks popped in and out of indices depending on their popularity with no regard to their underlying profitability. If nothing else the tech bubble demonstrated the veracity of Ben Graham’s aphorism that in the short term the stock market is a voting machine. Anyone who has ever participated in an investment committee or joined an investment club will appreciate that democracy has drawbacks as a method for selecting shares. Essentially, an index fund represents the summation of all the opinions in the market about each and every stock and is a measure of its popularity.
While this is often a good guide to its prospects from time to time the market gets carried away with irrational exuberance and attributes unusually high values to certain stocks. Index funds then became a mechanism to attract even more capital to that stock creating a positive feedback loop that must eventually become unstable. Calling the top of any share is a mug’s game but once the decline starts it attracts the attention of the symbiotic partners of index funds; the hedge funds. They get involved because index funds lend out stock to generate additional income. Using borrowed stock hedge funds can then short those shares and exaggerate the decline. So we have a system that exaggerates the upside and the downside. Isn’t capitalism wonderful?
Surely it would make sense to design a system that allocates capital properly in the first place.
Such a system would eliminate the upward momentum caused by the popularity effect of allocating capital by price. In addition it would not need hedge funds to unwind excessive valuations and cause sharp downward volatility. Moreover, by having a frame of reference that is not related to share price it provides a device for actually taking advantage of volatility. If a share is deemed too highly priced a fund that looks at the fundamentals will only have a modest exposure to it, and will reduce its exposure the more expensive it gets. Similarly, a stock with sound long term prospects might be hit by bad news that could occupy a lot of column inches but does not materially affect the company. In November 2010 a Qantas jet had to make a forced landing because of the failure of a Rolls-Royce engine. The engine maker’s shares dropped sharply from 640p to 580p but have subsequently recovered to 640p. In hindsight that event provided an excellent opportunity to add more Rolls-Royce to a portfolio. A fundamental tracker can do that. A conventional market cap weighted fund simply follows the stock down and back up again without taking any action.
The second half of Ben Graham’s aphorism is that in the long term the stock market is a weighing machine and there is abundant evidence that it weighs dividends more than any other single factor. That is why The Munro Fund, the only fundamental tracker fund, uses dividends. Be clear on this, it uses dividends, not yield.
What this does is to give a clear guide on how much the fund should hold in each stock. Normally the differences between what the fund holds and what a conventional index tracker holds is not large. That provides confirmation that, by and large, the market is pretty good at allocating capital. There are though some stocks where the market gets unduly bullish or bearish and that is when a fundamental tracker adds value over an index fund.
And, after four years, the evidence is coming through that this is indeed the case. Over the last year the fund has lagged the index by 0.3%. What is revealing about this statistic is that this is net of fees. While the fund has an AMC of only 0.5% its small size means that it labours under a TER of 1.6%. If the fund was a reasonable size, with a TER close to the AMC, it would have beaten the index. When measured over a shorter period the outperformance is more evident, 2% ahead over the last six months. Over three years the performance is behind that of the index again by the cumulative difference between the AMC and the TER. In gross terms the process works.
Where the process really differentiates itself though is not so much in performance as in risk. This better outturn over the index has been delivered with lower volatility than the market, the index and every other passive fund. Its standard deviation is 7% less than the index and 4% than its peers in the UK All Companies sector, many of which are multi-asset funds that would naturally have much lower volatility.
It is important to make one last point. The last four years have not been kind to funds with a value bias, as a fundamental tracker has. The implosion of the banks in 2008 took out almost 20% of the dividend stream into the UK market in the space of few months. In 2010 the accident to a BP oil well resulted in about 5% of the projected dividend income being withheld. Worst of all was the QE programme in the UK and US that pushed money into commodities and revitalised small cap stocks that were near death because of a lack of liquidity. The resultant rally in small cap, growth and eventually momentum stocks from March 2009 to January 2011 left value stocks trailing in their dust. A gradual rebalancing back to more normal markets started in February 2011 and was accelerated by the correction in August 2011. Even so, many value stocks still look over-discounted and many anomalies remain. There is still plenty of room for fundamental tracking to add a lot more value in the years to come.
August 2011
The Treasury Committee has missed the elephant in the room
The Treasury Committee has issued its report on the Retail Distribution Review. Disappointingly it has missed the elephant in the room.
The bulk of investment products are now distributed directly or indirectly by IFAs through platforms. Nowhere in its report does the Committee address this issue which eloquently demonstrates that it has failed to grasp how the industry works. Instead it focuses its attention on the issues of an ageing and poorly informed industry that is a sales force masquerading as an advice network.
While there are real issues about the quality of advice provided to the public the main problem the country faces is a lack of savings, not the wrong type of savings. In an environment where defined benefit pensions are now mostly restricted to those employed by the state the urgent need is for individuals to at least save something, even if it is perhaps not the best available. Surely any advice is better than no advice. The admission by Hector Sants of the FSA that he expects, and is comfortable with, a 30% reduction in the number of IFAs as a consequence of the introduction of the RDR is a chilling demonstration of how out of touch this organisation is with those it is supposed to be protecting.
If people are to be encouraged to save for their own future, and it is hard to argue otherwise, then surely the Government should ensure that it is as easy as possible for them to do so. The current structure has grown like topsy driven by the vested interests of the established product provider and distributors, not the consumers or new low cost product providers.
In other industries, airlines for example, new entrants have been able to win business by offering lower prices directly to travellers by promoting themselves through the press and new media. Imagine how much progress Ryanair and easyJet would have made if they had not been allowed to advertise their prices and were forced to sell only through travel agents? Cutting out the middle man has been a key part of the process in reducing the cost of air travel.
That option is not available to investment product providers because of the requirements imposed by the FSA and this has entrenched the position of the middle man, the IFA. In addition tax wrappers such as ISAs and SIPPs have reinforced their role. However, for a variety of reasons IFAs generally use a platform to hold their investments and this second agent between the investor and the product provider is where the chain is most opaque. The exact relationships between the IFA, the platform and the product provider are not publicly disclosed, and certainly not to the investor, and yet this is exactly where the greatest scope for conflicts of interest lie. The FSA has ignored this and the Treasury Committee seems not to have appreciated the scope of the problem at all.
Its only acknowledgement of the issue is its comment that it sees no justification for intermediaries to continue receiving trail commission without the provision of ongoing advice. Is it not aware that one of the largest distributors of funds in the country has built an extremely successful business model by doing exactly that? It is understandable that the Committee has listened to the representations of many IFAs about qualifications but that is a side issue in relation to the fundamentally flawed structure of the industry and how funds are distributed.
The Committee used part of my submission in its report to illustrate the lack of incentive for IFAs to sell lower cost products. Why would an IFA sell a fund that has an annual management charge (amc) of 0.5% and no trail commission when it can sell a fund with a 1.5% amc and keep a trail of 0.5% as well as provide the platform with a slice of the trail? There is simply no incentive for the platforms to sell low cost funds when they are not paid to do so. In short, there is not enough fat in the system for the IFA and the platform to take a worthwhile cut. In this case there is a genuine market failure of the retail distribution system to sell low cost funds that don’t pay trail.
However, there are some options. One might be to oblige platforms to carry a certain percentage of low cost, typically passive, funds. A better solution is to have a more informed public. One of the aims of the FSA was to promote financial awareness. This has not been a high priority but it is to be hoped that its successor, the Financial Conduct Authority, will inherit this ambition. In most industries a large element of the education process has been provided through advertising and marketing material. After all, if consumers can understand the complexities of computers, mobile phones and cars, and use that technical data to make selections, surely they can do the same for collective investments. Where the Government wishes to change behaviour, such as encouraging the use of fuel efficient cars, it mandated that adverts had to carry fuel consumption data.
In the same way the FCA could require all adverts for investment products to include some basic data such as the total expense ratio for example. Such hard data would be far more informative than telling investors that prices can go up as well as down.
The RDR has a laudable aim and it needs to be introduced as quickly as possible. Delaying it to allow a few more IFAs to take exams completely misses the point if the fundamental underlying structure fails to provide the public with what it needs; low cost access to simple investment products. Platforms can help provide that if they move away from charging both product providers and users. All they have to do is make their business blind to the product being sold by charging a percentage of the total funds under administration. That way they maintain their incentive to increase assets under administration but do it by selling a higher volume of cheaper funds. It works for airline seats, why not investments?
The difference between airline seats and savings is not just about a better deal for the public. It is about the fundamental switch from funding pensions by employers and the state to individuals. Failure to do that will mean higher taxes for longer. The state has to make this transfer of liabilities as easy, and cheap, as possible. Market forces will work in time but that is not a luxury the Government can afford. It needs to use regulation to expedite the process.
July 2011
Risk was rewarded last year, but it won’t always be.
Performance matters, everyone knows that and nowhere is that more important than in fund management. Apart from multi-asset funds the aim of every collective investment vehicle must be to deliver a better return than the relevant index, or at least a relevant conventional market cap based index fund.
To achieve that aim an active fund has to take more risk, and that can be done in two ways, assuming the portfolio is only constructed from constituents of the index. The manager can either elect not to hold certain stocks that he or she thinks will underperform or he or she can hold larger weights in stocks he expects to do better.
Not holding some shares opens the possibility that something you don't own suddenly does very well. Anyone not holding Lloyds at the end of June would have missed its 7% gain in a week. The other possibility is that something you do own suddenly goes bad for a whole variety of reasons and leaves the fund in a worse position compared with an index fund that only has a modest position.
In any event both tactics increase risk as a trade-off for the expectation of higher return. Indeed, risk is the only variable that can be changed in this race so it not surprising that competing fund managers will progressively increase risk relative to their competitors to get ahead. This is fine while the market is rewarding risk, higher risk generates higher rewards. There are no prizes for being risk averse in a bull market. And there has been a strong one since QE started two years ago.
As a consequence high risk funds currently dominate the league tables. This has created the rather unusual effect that as group the IMA UK All Companies sector has outperformed the FT All Share index over the last year. In the year to the end of May the All Companies Sector was up 21.2% compared to a 20.4% rise in the FT All Share Index, and that is after costs.
This seems rather odd given that because the funds invest in the index they are the index. How can they beat themselves, especially after costs? There are two answers. Firstly, many funds in the UK All Companies sector invest outside the index. They could be in different asset classes like bonds, foreign shares or listed on AIM. In other words they pinch some beta from other asset classes.
The second reason for the outperformance of the sector over the index is down to simple arithmetic. The average return for the 300 odd funds in the sector is calculated as a simple average. In other words each fund, be it a £40 million or a £10 billion, one has an equal weight in determining the total. In a risk friendly world the small fund taking big bets on small stocks is likely to do very well against a large fund that more or less mimics the index. In contrast index returns are calculated on a weighted average basis. That means a modest return from a large cap stock may have a bigger impact than a stupendous performance from a small cap share. But that effect might be diluted in a large fund.
Over time of course these differences will be ironed out as the Market alternates between loving and hating risk. In the end long term returns will be determined by dividends, as it has done for the last 100 years, which is a low risk strategy. One day investors may tire of trying to judge the market's appetite for risk and just opt for an asset allocation strategy that delivers the returns of the asset class with the lowest possible risk. But it is not there yet.
June 2011
The Right Weight for Glencore.
The big event in May for the London stock market was the IPO of Glencore. Many investors are unsettled about the logic of listing companies on the LSE that have little or no economic footprint in the UK. Indeed, some macro- investors make a point of obtaining their UK exposure through the FTSE 250 index rather than the FTSE 100 or the FTSE All Share because they feel it is less contaminated by overseas earnings. Quantifying Britishness is not easy. Is Catlin more British than Diageo? Both are based in the UK and both make most of their money outside the UK. Even purely domestic companies like ITV benefit when overseas visitors watch their programmes.
The reality is that the UK, and especially London, is the offshore financial hub for Europe and has always been the prime destination for companies seeking to raise large amounts of capital. This applies especially to high risk equity capital for emerging markets and dates back to the nineteenth century when London provided funds for mines in South Africa and railroads in the USA. Glencore ticks both boxes with its exposure to commodities and to developing countries.
A more intricate argument exists around how much a fund should hold in the stock. Conventional market capitalisation trackers will follow the formulae used by FTSE to calculate its indices. That simply takes the market capitalisation of each stock (the number of shares multiplied by the share price) and divides it by the sum of the market capitalisation of all the other shares in the index. That means the higher the valuation the higher the weight. Allocating anything by price means you always end up spending more on the most expensive items.
In other words it is like going into Tesco with £10 to spend on a mix of vegetables and ending up with a lot more asparagus than potatoes. Fine for footballers wives but illogical for most shoppers.
FTSE do make an adjustment to the figure it uses in its calculations to reflect the amount of stock that you are actually able to purchase. In a way it is a bit like adjusting your shopping basket to allow for the stuff on display that you can’t buy. In the case of Glencore this is quite substantial because only a small amount of shares were sold in the issue, the rest being retained by the partners who are locked in at least until November. To allow for this FTSE applied an investibility weighting of 12%. So instead of using the full market cap of £36b the adjusted number is £4.3b which is equal to 0.23% of the FTSE 350 index. An unadjusted figure would be 1.9%.
Note that so far none of these calculations have any direct connection to the underlying financial data of the company.
Where a fundamental tracker differs from a market capitalisation tracker is to establish a direct link to the finances of the company. In the case of The Munro Fund the measure used is the total amount that the company is expected to pay out as a dividend in the next financial year. Glencore said in its prospectus that it intended to pay $350m at its maiden interim dividend and that the interim payment would account for one third of the total. So it looks as if it will pay about $1,000m, or about £610m, in dividends this year. Next year the only three analysts that have published forecasts expect a payment of $ 0.157 per share or about £674m.
Now that we have a figure, albeit an estimate, it can be incorporated into the database for the other companies in the FTSE 350. At the beginning of June the sum of all the individual analysts’ estimates of dividends for the next financial year is £74.2b. Of that Glencore’s contribution is 0.91%.
So, as of 6th June, The Munro has a holding of 0.91% in Glencore.
Unlike FTSE this process does not adjust for free float. It makes no difference to the fund, or any other investor, who else owns the shares. All it needs to know is what its percentage ownership should be and the share of the cash flow it is entitled to. Whether the other shareholders are partners, individuals, hedge funds or pension funds is immaterial.
As a result The Munro Fund has a holding in Glencore that is about three or four times larger than most funds, on the assumption that most active funds are more or less closet trackers. No one knows which weight is right, because no one knows what will happen to commodity prices, exchange rates or the Chinese economy next year.
Lots of people will have views on each and all of these parameters and that will be reflected in the valuations they place on the shares and hence weight in the FTSE. In effect the share price measure opinion.
In contrast a fundamental weight is derived from the amalgamation of all the data that exists and is placed in a logical order. Moreover, this process will be repeated in July and every month afterwards so any changes by the analysts, however small, will be picked up and incorporated into the next model and the fund updated accordingly.
The beauty of the fundamental approach is that it allows the fund to trade against opinion as reflected by the share price. If opinion turns negative, and drives the price down, a fundamentally weighted fund will take advantage of that weakness to add more shares in order to maintain its weight at the desired level.
One thing is clear though. Glencore is a large company and seems set to pay out as much in dividends as BAE Systems. Why should it not have the same weight in the portfolio?
May 2011
Does news help us to manage a portfolio?.
Most stock market participants are news junkies. Every little morsel of data is assimilated to try and get an edge on the right price for a security or an asset class. These days, in a world of 24 hour news, there is no end to it, although how much of it is news rather than recycled press releases, gossip and speculation is more debatable. In the financial world news can be hugely valuable, which is why regulators go to such lengths to control it. Corporate results are released on a carefully controlled timetable and only through recognised channels. The ultimate news is “inside information” and that is rigorously controlled everywhere, even though the evidence suggests it doesn’t prevent it.
Apart from corporate news there is also geopolitical news. How will civil unrest in one country affect oil prices and what impact might elections have on taxes and government policy. Many claim this is the meat and drink of money management and managers are devoted to ensuring that they know exactly what is going on and making sure their clients know that.
It is worth considering though just how important news is in managing money. After all while everyone might wait with bated breath for a results announcement in practice share prices do not tend to move a lot in trading after the event. The common off the cuff remarks from analysts to a set of results is more often than not a dismissive “In line with expectations”. The best summation of the approach to result’s releases was the oxymoronic question once posed by a salesman to an analyst: “Are you expecting any surprises?”
The quest for news is a fundamental part of man’s curiosity about recent events and for clues as to what might happen next. In reality the humdrum flow of news does not make much difference to day to day portfolio management. For a start financial data is always out of date. At best results are released weeks after the end of a reporting period and in some cases it can be months. That means the financial conditions relevant to those results might be fifteen months old. That is a lifetime in markets. More importantly trying to predict business conditions is extremely difficult, let alone how companies will be impacted by them. The best that can be hoped for is the steady continuation of the existing environment.
In practice companies plod along delivering routine results accompanied by fairly mundane statements which analysts pore over to extract some morsel of data that might make a difference to the share price in 18 months time. In practice this task is all but impossible for the simple reason that so many people are doing it and every discrepancy is exploited. This is the iron logic of the Efficient Market Hypothesis.
Nevertheless, that is not to say the market is perfectly priced. On April 21st 2010 the Macondo 252 well that BP was drilling in the Gulf of Mexico blew up spectacularly. Not only did it impact the dividend for 2010 that disaster will probably shape dividend and company strategy for the next twenty years. But how many analysts recommended selling the shares when the news broke?
In terms of wealth destruction few events can match the implosion of the banks in 2008. But you wouldn’t have sensed that from reading the results announcements from the banks in 2007. To some extent companies have to dress up their public announcements. Even so, the statements from Chuck Prince, CEO of Citicorp, that it was “still dancing” in 2007, or the dividend increase announced by Fred Goodwin at RBS in early 2008 must surely define financial hubris. The real news event that presaged the crash was a short statement from some French hedge funds in the early summer of 2007 that they were suspending redemptions because of liquidity issues.
Most news is reassuring and does not prompt immediate any action. In contrast this news on liquidity and Macondo should have been triggers for trades. The fact that few people did so is perhaps more a reflection of the news overload that we all suffer. How do we know which piece of news is important, and should prompt some activity, and which news merely reassures us that our current position is the correct one?
In practice there is no mechanism to filter news. It is up to the individual to assess each item in turn for its importance, but who has the time to do that? The scale of the task, even for a manager focussed only on UK equities, is staggering. There are almost 700 companies in the UK All Share Index excluding investment trusts. Each reports results twice a year so there are 1,400 sets of results to be digested in the 200 working days available. On top of that each will deliver trading updates at the end of each reporting period. Then there are corporate actions such as rights issues and takeovers. Before we even get to political and economic data the portfolio manager is faced with 15 items of news ever day. Add in events like the death of Bin Laden or the Bouazizi inspired civil unrest in the Arab world and the information overload becomes overwhelming.
It is possible to limit the task by restricting the universe to the larger companies. After all, a 1% move in a company like Vodafone that makes up 5% of the index is much more significant than a 10% move in share like Drax that only accounts for 0.1%. However, focussing on the larger stocks makes it even more difficult to trade on unique information because they are such well researched stocks. What will the 41st analyst to cover Vodafone find that the other 40 haven’t?
In terms of responding to the political news around the world we have seen in recent months perhaps Chinese Premier Zhou Enlai got it right when he was asked what he thought about the French Revolution. He said it was too soon to tell. Focussing on what we know is more rewarding than speculating on what we don’t.
April 2011
Blue collar research best for big caps, white collar research for small caps.
Equity research is viewed as a highly intellectual occupation that combines a forensic approach to accounting and an ability to explain complex business models in a simple elegant manner. And it is. Ferreting around in the notes to the accounts, or cross examining executives to get to the kernel of what drives a business can be deeply satisfying. In the same way the detailed knowledge a sector analyst has of his business can be quite awesome.
The problem is stuff happens that isn’t in the accounts or part of a competitor’s business plan. Nassim Taleb took a whole book to explain the phenomenon of “Black Swans”. Donald Rumsfeld captured the concept in one phrase when he described the “unknown unknowns” that can so disrupt life. A global view of the supply and demand for oil and a huge spreadsheet forecasting BP’s cash flow was made instantly irrelevant when its Macondo 252 well blew up in the Gulf of Mexico last year. The shares went from 655p to 302p and the company cut its dividend. An explosion on a platform that is drilling into flammable hydrocarbons at great depth and pressure is not really a Black Swan event. It is a dangerous operation and capable of going badly wrong. It is a tribute to the industry that it happens so rarely.
Hiccups such as these are not rare. The bank crisis of 2008 was perhaps exceptional but few analysts forecast it and even fewer managers sold all their bank shares in anticipation. Even those that did still got caught in the market turmoil and suffered along with those who held on. That just reminds us that over 90% of the variability of portfolio returns comes from the asset class and not stock selection as Brinson and others proved in the seminal paper of 1986.
Even though people like picking stocks the reality is that for most managers it is a rather unproductive game. No one would have favoured Shell over BP because it was “safer”. Indeed, Shell itself came very close to a similar incident in the North Sea later in the year. In the same way trying to choose between GlaxoSmithKline and AstraZeneca or rival stocks in any number of sectors is a hugely labour intensive process with no guarantee of getting the right result. Eventually, the exercise becomes less an inspired insight into the prospects of an industry or a company than a large discounted cash flow spreadsheet based on some assumptions that have very precious little hard data behind them.
The white collar analyst and manager simply cannot process all the news flow from even the 100 companies in the FTSE 100 with their twice yearly results, trading updates, corporate actions and geopolitical events. Like nailing jelly to the wall there is simply too much going on to be sure that his attention is focussed in the right place and not missing something more important elsewhere.
In contrast the blue collar worker who simply processes the available data in a methodical and systematic way has a good chance of delivering steady, if unspectacular, returns on a consistent basis. This new breed of process driven, or asset allocation strategy funds, such as The Munro Fund, iShares Dividend Plus or the RAFI UK, might be seen by some as the eating the lunch of the traditional portfolio manager.
This is not the case. Instead, it takes away the drudgery of stock picking between large, well researched stocks. Even better, it generates an arithmetic logic for individual position weights. The time this frees up can be used for active asset allocation which, remember, is where 90% of the variance in returns comes from. Having a simple cheap fund at the core of a portfolio also allows the manager to take bigger risks, and hence potentially bigger returns, around the edges.
Stock picking is not dead and will never die. It is time consuming though. Trying to add a lot of value from the big caps is hard work when the information playing field is so flat. There are much better pickings in the small caps if managers can devote the resources to really understanding what a company’s business model is. The business model for BP is simple; find oil, sell it and don’t upset the President of the United States or the Russians. Small companies are different. They have a huge variety of niches they exploit on a unique basis. Getting your head round these is not always easy, but it can be very rewarding for the true white collar researcher who cares to take the time.
March 2011
Low volatility helps returns and lets you sleep at night
It is often said about journeys that it is beter to travel than to arrive. The quality of the ride is more important than the end point. In the case of managing money the very opposite is true because you never know how rough the journey will be before you start. On top of that it is sometimes necessary to get off your financial route at an unscheduled stop brought about by an unexpected development. In that case you would prefer your enforced disembarkation to be a smooth exit, not a perilous parachute jump at low altitude.
All investment funds promise you great returns if you stay the course and accept the rough with the smooth. In the long run the equity premium over bonds is what you get paid for the uncertainty of the short term. But if the destination is the same for all funds then why accept the bumpy ride that a volatile fund will give you? Although many funds promise to beat other funds, and the index, in reality the majority of collective investments more or less deliver the returns of the asset class plus or minus a bit. However, the way they deliver those returns can be remarkably different. Some are like a roller coaster soaring from peak to trough and back again while others, like us, give a more sedate experience.
On top of that wild ride high volatility funds have another drawback. They have to work harder to generate the same net return because after a 20% fall in a security it needs to recover by 25% to get back to its initial value. One that only fell by 10% can get back to its starting point after an 11% recovery, which is easier to achieve, and more probable. After all, if the starting point of both funds had the same degree of uncertainty about the future then the same must apply at the trough.
That might sound as though there is no point in trying to discriminate between funds. On the contrary; there is every reason to do so. If a fund has low volatility because of the way it is designed and run it will always be less volatile than one that just takes what the market throws its way.
The way to lock in low volatility is to use a process that manages risk and the best way to do that is ignore share prices in constructing a portfolio. Having portfolio weights determined in some way other than share price or market capitalisation means that the fund is able to exploit market volatility to smooth its returns. If, for example, it is calculated that Anglo American should have a portfolio weight of 0.95% any movement in that share price relative to the index provides an opportunity to buy more if it goes down or sell some out if it goes up.
In this way risk can be accurately contained and the volatility of the portfolio is reduced. Using a frame of reference that is based on a fundamental analysis of each stock and its place in the whole market enables a portfolio to benefit from volatility and extract a small amount of value each time Mr Market gets too exuberant over a share or, equally, too depressed.
A classic example occurred when HSBC announced its results for 2010 and declared its final dividend. Having been as high as 730p the week before the announcement the shares plunged to 655p at the end of the week. The dividend was exactly as predicted but the tone of the directors comments, which many viewed as entirely sensible, depressed investors and bumped trading up to 120m shares a day, four time the normal volume. Anyone who invests on time horizon of decades, as we do, found the event rather puzzling but entirely beneficial as it enabled us to buy more shares in order to rebuild the portfolio weight back to 7%, the same as its model weight. On the day of the results the fall in the share price had reduced the portfolio weight from its desired 7.07% to only 6.85%. Consequently we bought some at 669.5p and, later in the week, bought more at 655.6p to restore the fund to its desired weight.
We like volatility because we exploit it to add value. Averaging down and top slicing demonstrably reduces volatility of The Munro Fund and will, in the long run, be accretive to returns. That is what makes us different.
February 2011
Resources trump technology for cash generation
Long term studies of returns from the stock market consistently demonstrate that the bulk of the returns, about 90% according to the Barclays Equity Gilt study, come from dividends and reinvested dividends. On this basis it makes sense to seek out the highest dividend payers and focus portfolios on the strongest cash generators.
It might be logical to think that companies that generate the most cash would be modern, high margin technology businesses. After all, these are the ones politicians and commentators are saying will provide the jobs and the income for the future and offer the most potential for growth. This argument reaches its apogee when it comes to green technology. According to its advocates this sector can provide us with industrial nirvana with an endless demand for workers and throwing off prodigious amounts of cash. The reality is rather different.
If we look at exactly where the cash comes from in today’s economy we see a very different picture; and one that is more low-tech than high-tech. Taking the FTSE 350 as a broad measure of the UK economy (although it isn’t but it has the data we need) the massive amount of cash generated by resource exploitation is immediately apparent. Oil extraction and mining together account for over a quarter, 27.5% to be exact, of the cash that analysts forecast will be paid out as dividends this year. Anyone who has worked in or understands these industries will know that they are in fact anything but “basic”. The geophysics and geochemistry needed to find new deposits is highly developed and the engineering required to build and operate an oil rig, a mine, a refinery or a processing plant is immense and is only possible through the extensive use of technology.
Finance is the next biggest source of cash flow for the market with a contribution estimated at 18.3%. Although it is less than the 25% it used to provide in 2007 before several large banks collapsed it is still a sizeable chunk. Although aided enormously by computers the business of lending money is as old as human civilisation.
It isn’t until we get to the third largest sector, telecoms, that we come across an industry that can rightly be called new and high tech. Mobile and fixed communications together supply 9.0% of the cash, and the bulk of that these days comes from mobile telephony and not fixed line services. These of course are just operators, not the manufacturers of handsets and networks where the real technology lies.
The fourth sector is almost as big. Pharmaceutical’s provides 8.0% of the cash and is even newer than telecoms. It does have high gross margins and massive research and development spend, although there are questions as to how sustainable those margins are as governments seek to drive down health care costs.
Growing and making food and drink has always been man’s first priority and that still generates 5.7% of the cash flow. Next on the list is the need to keep us warm and serviced. Utilities account for 5.5% of the cash generation. Much of the technology deployed here is rather stale but the challenges of modern society are triggering large capital expenditure on new kit to deal with the changes in how electricity will be generated and used in the future.
Right behind this sector is tobacco providing 5.3% of the cash and definitely on the low tech side. Staying with entertainment Travel, Leisure and Media provide a substantial 4.3% of the cash flow. While a lot of technology might be deployed in aircraft, trains, communication systems and films they are a means to an end, not an end in themselves. The Aerospace sector itself only makes up 1.6% of the cash into the market and software an almost irrelevant 0.3%. Needless to say green technology does not even rate an entry.
Constructing a portfolio around this distribution of cash flow might seem rather backward looking. After all it rather ignores the growth opportunities in new industries. In practice securing commanding positions in mature businesses is usually an excellent way creating of a prodigious amount of cash flow than can be passed back to shareholders for them to invest in the next big thing.
While the theory of investing in companies that have strong cash flows is well proven the last few years have not been very rewarding for such an approach. In the wake of the Global Financial Crisis interest rates were slashed and then huge amounts of cash were injected through Quantitative Easing. This had the effect of making higher risk assets, such as small capitalisation and growth shares much more attractive. That is the main reason the FTSE 250 and the FTSE Small Cap indices, home to many technology companies, have outperformed the FTSE 100 by 42% and 40% respectively since the beginning of 2009. Other high risk assets such as commodities and emerging markets have also benefited from this wall of cheap money. While the valuations of these assets might have risen over that time frame their fundamental cash generation capabilities have not changed significantly.
At some point more normal monetary conditions will prevail. That will be when the importance of cash flow will once again be the dominant factor in stock and asset selection. It will come; we just don’t know when.
January 2011
The false hope of equity income funds
Everyone wants income these days. On top of that they want to preserve their capital at a time, where in the UK, inflation is eroding the value of cash at 3% a year. The obvious answer is to buy high yielding equities. That way you get the dividend yield of the market and the capital growth from owning equities as well as the inflation beating increases in dividends over the years. The ever popular Equity Income Sector is testament to the appeal of the concept to investors. However, the logic is deeply flawed.
Most market aphorisms are rubbish. This one though has the ring of veracity to it.
“Any share yielding 10% isn’t yielding 10%”
The market has priced the shares to yield that because, collectively, the corpus of knowledge about it indicates that the dividend is not sustainable. While that may be an extreme example it does tell us that any stock that offers a yield in excess of the current market yield of 3%, for the FTSE 350, is regarded as likely either to cut its dividend or grow it more slowly than its peers.
The logic is brutal, but equity income funds cannot offer high income and capital growth. At best they can do one or the other and, at worst, they might not deliver either.
Consider this. The current constituents of the FTSE 350, excluding investment trusts, are forecast to pay out £68 billion in dividends next year. At the current valuation of £1,850 billion that indicates the market has a prospective yield of 3.7%. If we exclude the possibility of polluting this universe of 300 stocks by including foreign shares and bonds, as many equity income funds do, how could we increase the yield from this collection of stocks? Any pure UK equity fund has to, and can only, draw from this universe. The index can therefore be viewed as one large fund.
The first thing to point out is that the income from this group cannot be increased. That figure of £68 billion is derived by aggregating all the forecasts from all the analysts covering this universe. That is not to say it will be right, but it is the best estimate from the available data.
So if the income cannot be increased the only way to increase the yield is to reduce the amount of capital needed to buy that income. Instead of paying £1,850 billion to buy £68 billion of income we can try and get the same income for less money. The obvious first step is to eliminate all shares that are not forecast to pay a dividend. In total these 75 shares are worth £74 billion. So removing these shares reduces the cost to £1,776 billion and increases the yield to 3.8%. That is hardly much of an improvement, especially when it removes shares like Cairn Energy that could potentially be significant dividend payers in the future. So the lower price comes with a risk that the smaller universe may not grow as much in the future as the untainted original.
To make a significant increase in the yield of a fund replicating the FTSE 350 it is clear that the only way to do it is to reduce the capital by more than the income. In other words reduce the size of the portfolio so that the capital is, say, 10% smaller but the income is only 5% less. Taking the argument to its logical conclusion you would end up trimming all low yielding stocks until you were eventually reduced to one super high yielding share. All very well except for the massive risk of a BP, RBS, HBOS type event and seeing the dividend cut.
It is clear from this mental exercise in taking the argument to its extreme that there is a simple trade-off between income and risk. Sure, you can increase yield, in the short term, but at the expense of potentially missing out on future dividend increases and long term capital growth. The smaller the subset of the universe you choose the higher risk of your capital underperforming the index.
While the market might not be 100% efficient it is pretty good at getting the bulk of it right; eventually. Trying to get more of that return through income and assuming high yield stocks are mispriced is a recipe for disappointment in the long term. Dividends can only be increased if the company grows at least as fast as the payout, if not more rapidly. The converse of that, to have rising dividends from an unchanged capital base, would lead to the ridiculous situation of small stocks with massive yields.
In reality the only benchmark for an equity fund is the total return of the index. The category of equity income is a nonsensical and should be relabelled as a multi-asset category, such as cautious growth, to allow it to include bonds.
The equity income label for funds is misleading. The IMA should bury it.