Opinion: The next to feel investor wrath will be advisors and trustees
Opinion: The next to feel investor wrath will be advisors and trustees
3rd Apr 09, 6:04pm
By Neville Bennett The advisors to many trust funds around the country have a lot to answer to for. Their returns have been terrible. They have lost wealth. They have also failed to provide the income many trusts need to pay out redemptions or rewards to the fund's beneficiaries. The advice one gets as a trustee, and I am not being specific about the advisors I in am contact with, tends to be very bullish about equities. They allocate them even to conservative funds, and miss out on their objective when markets dive. They could meet their objective from fixed interest investments but they often add equities to get a bit of cream. Chasing the cream is their undoing. Fund managers are in an inherently difficult position. They measure their funds performance against clear benchmarks. Beating the benchmark is an important matter for a portion of compensation depends on relative performance. A fund manager who scores well relative to peers will claim a bonus, even if the fund loses 25% of its money, when competitors lose 26%! These managers are "relative' investors who relate performance to indices. Some managers promise "absolute returns" and get a bonus only when they make money. My inclinations are absolute because I regard being a trustee as an almost sacred task of being a good steward. I also want cream, but my first duty is to make money; never lose it. The Ernst and Young NZ Absolute Returns Index increased 21% this year. Of course, I admire Warren Buffet's search for "value" in companies. "Buy and Hold" works in bull markets, but not in deep recessions or a depression. He should have sold down equities at the top of the bull cycle and have waited to re-invest at the bottom. The same goes for fund advisors who are wedded to portfolio theory with a larger allocation to shares. Their answer to falling returns is that the market will bounce back. Perhaps it will, we are still waiting for the Nasdaq to bounce from its present level of 1500 to its peak of 5000 in 2000. The key strategy in the current situation is to preserve capital and be ready, and this may take several years, to get into equities again when the bottom is reached, capital investment resumes, IPO's return, and earnings lift. To reiterate an earlier piece on the "sucker's rally" ( Blog, March 20 ) this is a time for caution. Meanwhile, one can keep studying the market. Passive or Active? Trustees are commonly recommended to adopt actively managed funds, of cash, fixed interest or of equities. Advisors often strongly suggest that active are worth a premium over a passive fund. Actually, the active results have, in general, disappointed over the last two years. The problem is inherent because active managers cannot beat an index benchmark per se because their fund must first deduct expenses from their result. They take on a high level of risk to obtain a higher marginal yield. Bond funds, for example, contain a low level of sovereign bonds because they are relatively low yielding. Managers increase the risk by adopting corporate bonds, often of a BBB- risk level. Provided they have a good spread of risk over a diverse portfolio, that is almost acceptable in a bull market as profits are high, sales are high, and the corporate can fulfill its obligations to its creditors. So the fund manager buys a swag of corporates of BBB- rated bonds. He then thinks:" What if my competitors also buy a similar portfolio?" Disaster, he is unlikely to outperform his rivals. Why not get some collateralized packages with higher yields still? Why not interest rate swaps? Bond funds have been risky this year. Some have delivered a negative returns (e.g. Pimco Global Bonds); to the chagrin of trustees who expect positive fixed-interest returns as the engine room of the portfolio. Trustees do not necessarily expect a high yield from equities, an increase in capital value will do, but they do want income from fixed interest, sometimes for dispersal. A fund manager also devotes a proportion of the portfolio to cash. This is problematic. Cash has several purposes. It covers redemptions and can also provide an income stream. A cash fund will have a benchmark of perhaps the 90 "“day Bill Index, either to equal or be superior to it. A manager cannot beat the 90-day benchmark by investing in 90-day bills because his expenses have to come out of the fund. Cash funds therefore might be composed of only 30% 90-day bills. The remainder is short-term fixed interest issued by business rather than the State. It is higher yielding, because of the higher risks associated with financing cars, property or CDO etc. Cash funds have become very vulnerable to the downturn. Cash has a similar redemption function in equity portfolios. But a cash holding in an active equity fund can lead to a significantly large deviation from the benchmark. For example, if a New Zealand equity fund undertakes to beat the NZX 50, and the manager holds 5% in cash, he will under-perform in bull markets because most equities produce a net return of greater than 5%. Cash is a drag in a bull market. Conversely, the manager with cash will outperform in a bear market when the bulk of equities are down. Cash therefore can lead to significant under- or over-performance. An active equity manager has a choice from many strategies to try to defeat an index. Quite commonly the manager chooses to avoid the big stocks in an index because they seem a little inflexible or in the wrong industry. He might opt for small cap stocks, or tilt towards technology, or agriculture, or property or manufacturing. If he guesses good growth areas, the fund will outperform. If the weighting is small caps, the manager will outperform, other things being equal, when the big caps under-perform and vice versa. The difference in costs between active and passive is important in periods of low market volatility. Other factors involved are size (market capitalization) and style( p/e ratios, price/book ratios). But the evidence is that in very volatile markets, there will be very varied manager performance. My point is that active managers are continually chasing superior returns at the margin. They get by in bull markets for investors are forgiving when returns are positive. But bear markets heighten risk, and what seemed a nice little earner may become a dog. It is not just the bankers that bought dogs, many lurk in funds. I predict that the anger now shown to bankers, will later be directed to financial advisors who have destroyed so much wealth, and have reduced the income of trusts far below their liquidity needs. Disclosure: Neville Bennett is a Director of Socrates Fund Management, and Consultant to Breaker Bay Group. http://www.indexuniverse.com/publications/journalofindexes/articles/146-march-april-2009/5438-the-active-passive-debate.html http://www.pimco-funds.com/ff_reports/Global%20Bond%20Fund%20(Unhedged)%20Institutional.pdf "”"”"”"”"” * Neville Bennett was a long-time Senior Lecturer in History at the University of Canterbury, where he taught since 1971. His focus is economic history and markets. He is also a columnist for the NBR where a version of this item first appeared.