The three banks with September financial years - ANZ, NAB and Westpac - are almost back to normal. Cash profits and return on equity are still below FY19 levels, but it is clear that the COVID-19 crisis has not left any scars on the banking system. Most importantly, the banks' capital positions are once again "unquestionably strong": an average Common Equity Tier 1 (CET1) ratio of 12.7%, up from 11.4% in FY20, means that all the banks can afford share buybacks.

So far, however, organic growth is modest. Most of the recovery in cash earnings came from the $820m writeback of provisions built up last year. The banks are still paying "customer remediation costs" for their crimes of fees for no service and other horrors revealed by the Hayne Royal Commission, but these should end in FY22. The ratio of operating costs to income is still too high, and the banks will need another two to three years to achieve their cost reduction targets.

The fundamental problem is that banking is no longer as profitable as it used to be, thanks to increased competition, tighter regulation, and higher capital requirements. The KPMG chart below shows how the banks' average net interest margin (NIM) has slid steadily downward, from 3.0% two decades ago to only 1.86% now.

In order to preserve their margins, the banks need to simultaneously cut their operating costs and increase their capital spending to improve their processes. CBA is leading the pack in both of these objectives, which is why it is the only one of the Big Four to have returned to its 2016 share price. Shareholders of the other three banks are well aware of the size of their capital losses over the last five years. This is also why CBA's dividend yield is less than 4.0% while the other three yield between 4.5% and 5.0%.

FY22 results are likely to be similar to this year - modest organic growth, with profits buoyed by provision writebacks. But there will be complications. The first is that wholesale funding costs will increase as US and Australian interest rates rise, and the banks will lose some of the deposit inflow which was triggered by the COVID-19 panic. The second is that the Australian regulators will probably impose macroprudential controls to slow the pace of house price rises and to discourage borrowers from taking on excessive debt. The third is that the rise in CPI inflation will affect different sectors of the Australian economy in different ways, and may put an end to the improvement in loan delinquency rates.

Our analysis suggests that the banks are fairly priced at present, as a sector with low earnings growth but also low risk. In the long run, the recent changes in industry structure will mean that bank earnings will grow more slowly than most companies in the S&P/ASX200 Index, making the banks attractive for income rather than capital growth.

ANZ's cash profit of $6.2bn (218c per share) slightly exceeded market expectations, because stronger markets income offset a 4% increase in costs as well as ongoing customer remediation costs. The full-year dividend of 142c was higher than 60c in FY20 but still below 160c in FY19. During the latest half-year, ANZ's residential loan book declined by 1% against system growth of 4%. This disparity highlights the inadequacies of ANZ's mortgage processing systems, which the bank has acknowledged and is devoting capex to improving. FY22 earnings and dividends are expected to be flat, but ANZ is trading on a lower P/E than the other three, so the medium term may see some price gains through re-rating.

Commonwealth Bank's trading update for the September quarter disappointed the market, with the CBA share price falling 8%. Despite above-system loan growth, cash profit for the quarter was flat at $2.2bn and net interest margin fell significantly. A single quarter is not necessarily an indicator of the 2022 result, but it does reinforce our view that the banks face a difficult competitive environment.

NAB reported a $6.6bn cash profit (199c per share) and lifted its full-year dividend to 127c (a 64% payout ratio), which was better than 60c in FY20 but still below 166c in FY19. The result was free of notable items and other one-offs. Management indicated that future dividends would be 65% to 75% of cash earnings. During the half-year, NAB grew its gross loans and advances (GLA) as fast as system growth or faster. The bank has simplified and automated its mortgage approval process: 30% of Simple Home Loans are expected to be approved in one hour, and 60% within one day.

Westpac is lagging behind the other three big banks. FY21 cash earnings of $5.4bn (146c per share) are equivalent to a return on equity of 7.6%, well behind the Big Four average of 9.9%. Westpac's cash earnings suffered from a notable items charge of $1.6bn, and the September 2021 half year was disappointing, with expenses rising and margins falling. The FY22 dividend of 118c (an 81% payout ratio) was better than 31c in FY20 but well below 174c in FY19. The share price has fallen 9% since the result - the market clearly does not believe that Westpac will achieve its announced cost reduction targets on time.

Introduction
Experience in the industry has shown that many Australians are often stuck with sub-optimal investments and institutions managing their money, often without knowing why or what else to do.  They routinely don't invest with the better fund managers and investments and the investment industry and regulatory setup - far from helping them, is actually restraining them.  When it is your money, you deserve to know there is a better alternative.

Routinely the industry including super funds, advisers, researchers and investors produce subpar performance by restricting their clients to sub-optimal investment solutions or simply chasing past great performance, pushing money in to an asset or fund manager at the wrong time and after they've done well and are at high risk of mean reverting.  I'm sure that's happened to you too, either of your own volition or on the encouragement of a wayward advisor or institution (comments welcome).

Investors then complain that active management doesn't work for them, when actually what doesn't work is the system and people they're using.  In fact, active management can and should routinely work extremely well if you access the best parts of the investment architecture and a better investment process, and the better aligned and more experienced and authentic people rather than the professional marketers and sales firms.

While I could write an article about all the industry incentives that fail investors and why the system won't improve any time soon (in fact, it's getting worse), this article will hone in on just a couple of key and common mistakes investors make.  It is by no means comprehensive and is not investment advice, but it potentially gives you a better chance of investing much more effectively and informs you about where you might be going wrong.

PROBLEM 1 - Institution Versus Boutique
Large corporates and institutions often don't invest money well.   Why?  They have a different culture, incentives and motivations than you do which means they aren't as well aligned as they should be with you and your interests.  For example, often they are focused on asset gathering and are marketing led rather than investment led, when you just want someone to perform well and act in your interests and not just in theirs.  Frequently they are too big, and investing a lot of money really well is more difficult for numerous reasons.  Large organisations have a focus on empire building, short term shareholder returns and the retention of their assets rather than industry best practice and adapting to a changing world.  Very commonly organisations simply talk the talk rather than walk the walk.  Organisational culture and nature also often mean that while they may temporarily employ good people that want the big names on their CV while they're young and inexperienced, the best people will often be looking to move on and elsewhere as soon as they can.

SOLUTION 1: Don't simply blindly invest with large corporates and institutions unless you have a strong reason to, because this stacks the odds against you.
Instead follow what the most authentic and performance orientated people do and prioritise boutique fund managers.  Boutique managers are routinely much better aligned with investors.  They are often investing their own friends' and family money, are more aligned with performance rather than simply asset gathering, and routinely have an investment culture instead of a marketing and sales culture.

Furthermore, they don't need to waste time in managing up to be promoted, or on internal corporate meetings, and often are more experienced and investment savvy.  They often leverage a broad industry network (and are part of a large more diverse virtual organisation rather than a restricted corporate one) and can cherry pick the best people to align with to produce a successful performance culture.

Ultimately most boutiques can only thrive and survive if they add value to investors, because they operate in a competitive industry when their money is not captured or static in the system like it is with large super funds, corporates and institutions.  Boutiques can add value in numerous ways directly aligned with investors interest, such as being truly active and overweighting great assets and investments rather than being beholden to other influences or suffering "death by committee" or management meetings.  Boutique managers hence stack the odds more in your favour.  Early-stage boutique managers are often even better as they are super motivated to perform and won't have excessive assets or competing interests to manage.

PROBLEM 2 - Retail versus Wholesale
Common retail investment solutions such as large superannuation funds and retail funds - those readily and widely available to retail clients, are routinely sub-optimal.

Retail managers are weighed down by an increasingly heavy-handed regulatory regime which can distract from or preclude entirely the main game of good investing.  They are more beholden to numerous intermediaries including regulators, researchers, platforms and commercial interests and often need to "slot in" to narrow ideas of what a fund manager should be - including sometimes being very restricted in how they invest or what they can invest in, to the point when they can be structurally relatively ineffective.  For example, the new regulatory regime affecting super funds will in future strongly encourage an even more benchmark-based investment approach rather than a more client centric outcome-based investing approach.  This creates strong asset class dependency on long only public equities and more binary type outcomes for your investments, not what you probably really want for your hard-earned capital.

Ironically, much of the compliance and restrictions are implemented in the name of "investor protection"; however, this can be thought as being protection from diversity and a better investment return!  No wonder retail investors complain they don't have access to the best investments; because quite simply they don't.

SOLUTION 2: Look for good wholesale funds who are aligned with your interests and obviously investment orientated rather than being asset gatherers.
If you qualify as a wholesale client under the Corporations Act such as having $250,000 annual salary over the last two years or $2.5 million net assets, it is generally not a great idea to invest your funds the same way as retail client funds.  Avoid advisers and institutions that want to invest you this way for their convenience, when they should be doing so much better for you by treating you appropriately if you are a wholesale client and taking advantage of the large benefits this offers.

There is a good reason why the wealthiest and most successful run their own SMSFs rather than invest with mainstream superannuation funds.  This way they can invest in the best investment solutions out there, rather than be restricted to the more constrained and mediocre ones, although sometimes they don't know how to fully take advantage of this.

There are many ways wholesale funds can demonstrate that they are capable and aligned with investors, and the more they can demonstrate this the better…

Ways to Assess Fund Manager Alignment with Optimal Investor Outcomes
Proof of better fund manager alignment can be found in many ways.  Some of these include:

Fees

1. Charging low base fees with the fund manager making their money from performance fees (rather than high management fees and continual asset gathering to increase fee collection, irrespective of investor returns and volatility).

2. The manager only charges performance fees if they make you a positive return, as charging performance fees over a benchmark that doesn't matter to your goals and that goes backwards isn't great alignment if investment markets turn down.

Nimble Managers

3. Having low funds under management and strict capacity limits on the funds under management that the manager will manage across different investment offerings.

4. Having few or only one investment fund in which the fund manager substantively invests their own family and friends and which you too can invest alongside them.

Track Record and Clear Articulation

5. A history of valuable work experience and previous strong and consistent performance in other roles, and no question mark about the manager's authenticity or focus on what matters to you.

6. The ability to explain to investors how they will add value and have added valued in the past, and how they have learnt from markets and their mistakes and won't make these again.

Superior Risk Management

7. Superior risk management through genuine diversification and other methods such as using options for hedging risk.  Good managers can be, but don't necessarily need to be higher risk and may in fact demonstrate or target lower risks than the average, which better aligns with investor goals for capital preservation.

Culture

8. A recognition that the fund manager's approach is not the only good way to manage money and that the manager doesn't suffer from hubris.  For example, the fund manager may be humble enough to invest with other fund managers for diversification and value added rather than pretending they have all the answers with their in-house solutions across every asset class (given this is unrealistic).

Conclusion
Take Advantage of a Wonderful Environment for Great Active Management

These are exciting times right now for good active investing across multiple asset classes and strategies.  The opportunity set is huge and there are gains to be made and important risks that need to be managed.  We continue to search for new active boutique fund managers to invest with that can demonstrate to us that they offer specialist expertise and are a sophisticated value-adding operator, and importantly are aligned with investors in our fund.

If you haven't had a great experience so far in what has been a spectacularly positive investment environment, look for a better alternative.  Hopefully, this article will help you with some suggestions about how you can approach this challenge and invest more effectively in future.  Your comments and feedback are welcome and we're happy to discuss further as required.