The Most Volatile 12 Months in the Last 10 Years - How Did Active Managers Fare?

Australian Fund Monitors

25 February 2021

The 12 months through the end of January marks one of the most volatile periods for equity markets in the last 10 years.

• In March 2020 the ASX 200 Total Return Index recorded its largest single monthly fall in 10 years falling -20.65%, while February 2020 it fell by -7.96%, the 3^rd largest fall in 10 years.
• Fortunately for investors, the last 12 months also included the 2 largest single month gains over the last 10 years with the ASX 200 Total Return Index bouncing back in April by 8.78%, and again in November by 10.21%.
• For all that volatility - or perhaps because of it - the ASX200 Total Return Index fell by -3.11% over the 12 months.

While not quite as volatile, global markets returned similar statistics.

• In 2020 AFM's Global Equity Index had 10-year record monthly loss in March of -8.07%, and -5.57% in February.
• As expected, the Global Index also bounced back in April by 4.15%, and then had the second-best month in the last 10 years in November.

The bulk of investors in Australia get exposure to these 2 markets via both passive and active fund managers. The outcome for passive equity investments is shown in the points above - in other words investors in a "passive" ETF will broadly match the index, after allowing for fees, but how did Active Managers both globally and domestically perform through this period? Looking at Long Only Managers we note the following points:

• 79 of the 97 or 81% of Australian Equity Funds beat the index through the 12 months, and all but 11 of these funds beat the index over the last 3 years, showing they have been able to sustain outperformance through the cycle.
• 23 Australian Equity funds lost more than 25% in March 2020, but 18 of these went on to record an outperformance over the index over 12 months.
• The defining statistic for those Australian Equity funds that outperformed was their "Up-Capture Ratio" which measures their cumulative performance during the market's positive months. The average Up-Capture Ratio for the top 20 performers was 193.6 (any number over 100 shows outperformance, so 193.6 means they rose at almost double the rate of the market, confirming significant value can be derived from active management.
• Global funds found the going far more difficult with 36 out of 53 funds outperforming the global market (68%). However, one third of the funds that outperformed in the last 12 months failed to beat the benchmark in the previous 3 years.
• As with Australian Equities, many Global funds - 33 in total - underperformed in March, while only 22 of these went on to outperform over the full 12 months.
• One of the key statistics for Global funds that did outperform was their Down-Capture Ratio, which measures their cumulative return when the market is falling. Unlike Australian Equity Funds, their most successful Global peers were those that gained against the market during the negative months. The average Down Capture Ratio for the 15 best performing funds was just 43.4 showing that these funds on average only fell less than half as much as the index when markets were negative.

The data shows that volatility can be a friend for Australian Equity funds, although that volatility may test the mettle of many investors. For Global fund investors it may be useful to note the quote from Warren Buffett - "Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1".

Of course, we all know that's easier said than done. However, one way to reduce volatility, or avoid large losses, is to ensure diversification across markets, strategies and asset classes, and ensuring that the correlation of those diversified funds is as low as possible.

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Australian Fund Monitors' CEO, Chris Gosselin, speaks with Robert Swift from Delft Partners about the Delft Global High Conviction Strategy. Since inception in August 2011, the Strategy has risen +14.93% p.a. with an annualised volatility of 11.78%. Over that period, the Strategy has achieved Sharpe and Sortino ratios of 1.08 and 1.97 respectively, highlighting its capacity to achieve good risk-adjusted returns while avoiding the market's downside volatility.

Longlead was founded in 2014 and is a specialist long/short equity manager with a core focus on Asia & Australia. The team at Longlead have recently released and Australian Domiciled Wholesale Unit Trust based on their existing Longlead Absolute Return Fund.

The Longlead Absolute Return Fund was started in July 2017 and has returned 29.24% per annum since inception. For most investors the proof of an absolute return manager is in their performance during down markets, and Longlead have provided investors with a positive return 64% of the time when Asian Pacific markets are negative, generating significant outperformance.

Bubble, bubble, toil and no trouble!

Montgomery Investment Management

February 2021

There are a number of arguments being advanced to suggest the stock market is in a gigantic bubble that is at risk of bursting imminently. Some of the arguments relate to broad overvaluation, the tidal wave of overpriced IPOs that double on listing, and the observation that interest rates remaining low forever is tantamount to the unrealistic, and previously unrealised, expectation of high rates of earnings growth being sustained forever.

For this article however I want to look at the market's valuation compared to bond yields to help understand the extent of any euphoria in markets that may cause them to be at risk of imminent collapse.

Australian ten-year bonds have traded almost in lockstep with their global peers over recent decades, and since the early to mid 1980's bond yields have been in inexorable decline.

Source: Tradingeconomics

According to Bloomberg, the ten-year Australian bond yield is 1.17 per cent. The bond yield will move independently of short-term cash rates set by the Reserve Bank of Australia, so while the RBA Governor Philip Lowe has made it clear that the overnight cash rate of 0.1 per cent will not be moving for some years or until inflation is "sustainably" in the target band of 2-3 per cent, that does not mean the yield curve cannot steepen with ten-year bond yields rising.

Nevertheless, the starting point for one method of assessing equity market valuation is the ten-year bond yield. To that yield we add an equity market risk premium. On this number there is much conjecture. The equity market risk premium is the average return that investors require over the risk-free rate (ten-year treasury bonds for example) for accepting the higher variability in returns that are typical of equity investments. In other words, the Equity Market Risk Premium reflects a minimum threshold that motivates investors to invest.

Investors and academics have long debated this number, which of course changes over time. Turning to the RBA again, and its June 2019 Finance Bulletin - The Australian Equity Market over the Past Century[1], reveals the following:

"Using the updated dividends data, the new historical series (extended with available data for more recent time periods) imply that the total nominal return on equities (i.e. the sum of capital gains and dividends) has been around 10 per cent, per year over the past 100 years (based on a geometric average which allows for compounding over time). In real terms - i.e. after accounting for inflation - the average annual return was about 6 per cent. There have not been material differences in returns across sectors over this time, although of course there have been periods in which sectors have performed differently. Over the same period, the total nominal return on long-term government bonds has been around 6 per cent, implying an average equity risk premium (excess return of equities over safe assets) of around 4 per cent."

So, to the bond yield of 1.17 per cent, we should add four per cent for the equity market risk premium. The product of the two is of course 5.17 per cent. This is the theoretical fair value Earnings Yield for the market.

The Earnings Yield is of course merely the inverse of the Price Earnings ratio so, by dividing 100 by the earnings yield we can arrive at a theoretical fair PE for the market of 19.34 times earnings.

If the 1-year forward PE of the market is much higher than this, investors are willing to accept a narrower than reasonable future return above bonds, given the risk of investing in equities.

According to Bloomberg at 12.17 pm on 3 February 2021, the 1-year forward PE for the ASX200 (excluding loss making companies) is 19.26.  By including loss making companies the 1-year forward PE is 20.55 times suggesting there is only marginal enthusiasm for equities overall.

This picture of course changes throughout each day. As bond yields rise, the fair value of the market falls, and the reverse occurs when bond yields decline. If bonds yields do begin marching materially higher the risk for the market rises, even if the market itself does not rise. This is because the fair value PE would decline moving further below current levels.

Today, as it stands however, on this measure at least, it doesn't appear that the Australian stock market is in a bubble.

[1] https://www.rba.gov.au/publications/bulletin/2019/jun/the-australian-equity-market-over-the-past-century.html