Hedge Clippings believes that while performance is always important, awareness of and avoidance of risk can be essential, particularly if it result in significant or permanent loss of capital. With that in mind, this week we turned our minds to two current risk thematics.

Manager and Market Risk

Obviously 2018 was a difficult year for equity markets, with a positive start before tripping and falling badly in the final quarter. In spite of that, just under 30% of funds who have reported their December results to date returned positive performance for 2018, and just under 50% outperformed the ASX200 Accumulation Index (which fell -2.84%) which www.fundmonitors.com use as a standard comparison.

There has been plenty written in the press about how actively managed funds have disappointed investors in 2018, and in many cases that's true. So how does the average investor make the choice?

As every offer document will be at pains to point out (and as required by ASIC) past performance is no guarantee of future performance. However, the difficulty is that if you can't use past performance as a guide, what do you use? Although we don't recommend the punting analogy, there is a good reason that the form guide to the races is published!

What the form guide will not highlight, and careful analysis of a fund's past performance will, is that risk and downside past performance is just as important as positive returns, if not more so. Certainly, both should be looked at in combination along with each investor's risk tolerance and return objectives.

However, the figures above are a stark reminder that in addition to manager selection based on reliable research, holding a diversified portfolio of funds is an equally important component when investing in actively managed funds. In many ways this is no different to successfully investing in listed equities directly, which requires thorough research and a diversified portfolio. One of the often unrealised benefits of holding a number of managed funds is that they in turn can provide far greater diversification than can comfortably be managed by most individual investors.

As we frequently point out one of the best ways of reducing risk, whether it be when investing directly in individual equities, or managed funds, is to diversify your investments. It is true that in some cases this can dampen your returns, but more importantly, provided funds are carefully selected to have a low correlation to each other, investing in say 5, 10 or more managed funds, and thus potentially between 200 to 1,000 individual companies, will provide a significantly lower volatility and risk of capital loss.

This approach also provides the opportunity for diversification across asset classes such as equities, fixed income or property, in addition to geographic diversification if required. Within equities it also provides the opportunity to choose or avoid market sectors, such as large caps, small caps, or resources.

Selecting a fund manager purely based on their returns without having at least one eye, or possibly both, on their risk profile, and therefore the potential for loss of capital, is risky indeed.

Market & Geo-political Risk

While overall looking at markets there still seems to be significant risk, this is compounded by an ongoing and heightened political risk. The US shutdown continues as Trump plays chicken with the Democrat-controlled lower house. The longer this goes on the more entrenched the opinion of each, along with the reputational loss of not winning the argument, and the loss of voter trust along with it.

Of course, with the shutdown also comes a significant loss of consumer sentiment, and with limited government information being released it is difficult to tell to what extent it is impacting the US economy. Needless to say, it is likely to be significant.

Crossing back to China, an admission (at last) that the "longer for stronger" argument would come to an end sooner or later. Whether that is being caused by Trumps trade policies, concerns over industrial espionage or just the inevitable can be debated. Probably a combination of all three.

Meanwhile in Europe, Brexit is continuing to wreak havoc not only in the UK, but also on the mainland with figures overnight confirming the deteriorating outlook in both Germany and France. As far as Brexit is concerned even the experts have given up making predictions on the outcomes, leaving it to the bookies to figure the odds for each outcome. Most Brits we talk to seems to be reverting to the WW2 slogan of "Keep Calm and Carry On" but that may be wearing a little thin.

In Australia the risk also remains political with an upcoming election where elements of the Liberal party are doing their damnedest to lose.

And on that happy and somewhat uncertain note, we wish all readers a Happy Australia Day tomorrow, whenever you think it should be celebrated, or even if you think it shouldn't!

Happy New Year 2019, and welcome back from Hedge Clippings after a most welcome, albeit weight gaining, three week break.

Maybe it's advancing years, maybe the combined effects of the festive season (or a combination of the two), or possibly the avalanche of information which builds up while one's away, but it was difficult to know quite where to start for the first edition of Hedge Clippings of the year. Certainly, there are a larger than usual number of fund performance updates to follow these comments, so a brief word on performance for 2018.

It will go down as a year of two parts - the first three quarters, most of which were positive, followed by a horror final quarter as a combination of factors finally cracked the advance of the bull market which commenced post GFC in 2009. The decline in the property market was inevitable but cemented by the revelations and implications of the Hayne Royal Commission.  

In spite of reports in the media from some quarters, as far as fund performances are concerned there were some outstanding results given the backdrop of equity markets, both locally and overseas. At this stage it is too early to accurately define year-end results as only 35% of funds' December returns are in. However, based on what we know to date 30% of December results were positive, with around 40% of funds providing a positive result for the year, and 67% outperforming the ASX200 Accumulation Index.

Experience tells me that these numbers might slip somewhat once all 430 funds now in the www.fundmonitors.com database have lodged returns, but those figures are far from the wipe out headlines in sections of the media.

Elsewhere much of the information avalanche (maybe some we will claim the term "infolanche" if it hasn't been taken elsewhere) concerned more of the same, consisting of mainly negative news of geo-political issues which seem to be dominating print and screen.  Without dissecting each at this time of the week, let's just list the major ones which will make markets - and managing money - difficult over the next 12 months (at least!):
 

1. Brexit's causing uncertainty. What a shambles, impacting not only on the UK but also the EU economy. Whatever the outcome a large proportion of the population will be deeply divided and dissatisfied.  In fact, it is quite possible that the final outcome will please no-one.
2. US Government shutdown uncertainty (short term), and depending on how long it drags on the more serious it becomes and, we suspect, the more entrenched the opposing sides will become.
3. US/China trade negotiation uncertainty, although more likely than not to be resolved eventually, hopefully sooner than later. However, there's a strong risk that additional damage is being done to an already wavering growth rate in China.
4. Australian Election outcome, which seems pretty certain, and not a positive from an investment perspective - franking credits, negative gearing, Bill Shorten's class warfare rhetoric etc.
5. Australian property: Continuing negativity thanks to economic and electoral uncertainty, plus one of the highest levels of household debt/property price ratios in the developed world.
6. The Hayne Royal Commission findings due on February 1 are unlikely to help consumer and investor sentiment, increase focus on the financial sector and therefore further potential damage to property, or management's bonuses!
7. Consumer confidence (or lack thereof) based on all of the above, but in particular items 4, 5 & 6.

Finally, and there's certainly insufficient time or space to do it justice here, the Productivity Commission's report into at least parts of the Superannuation system. We welcome the report's focus on increased transparency and on investors' and workers' retirement outcomes being paramount, but there's a need for a total review of super, including its complexity and the confusion that results, much of which we believe is responsible for the lack of engagement by the average worker. 

There's a long way to go before this debate is over, but the squealing from various vested interests, both industry, for profit and political, leads one to think the Productivity Commission is on the right track!

This is our last "Hedge Clippings" for the year.  Thank you for your support and feedback over 2018, we hope our various Friday afternoon musings have been to your liking - or at least if not, of interest.  We'll be back after the break, but in the meantime would like to take this opportunity of wishing you and your families a Happy Christmas and a Healthy and Prosperous New Year.

Looking back it was a year when the music stopped on a number of fronts - although it had been becoming pretty discordant for some time. It's been a year when geopolitics has been the dominant theme - or themes, with markets and economists trying to work out what's next, and getting the wobbles in the process:

Brexit - David Cameron will be remembered for making an offer he didn't need to, and giving 36% of the UK electorate control over an outcome he didn't want. It was always going to be ugly, but it has turned out to be a disaster where no one is likely to be happy with whatever the eventual outcome holds. What on earth was he thinking?  The truth is he probably wasn't, so he neatly sidestepped his responsibility, leaving it to his stoic but hapless successor to sort out the mess he created.

Trump - Where do you start?  The Donald seems immune to any kind of advice or what one might call statesmanlike behaviour. He thrives on confrontation and apportioning blame and responsibility for his mistakes to others - aides, Chiefs of Staff, Lawyers - and even the Federal Reserve.  He has certainly achieved certain gaols - to what extent they'll be of the own goal variety (or maybe that should be in goal?) remain to be seen.

China - The music hasn't stopped but it is getting louder! The Chinese Communist Party finally seems to be being held to account for wanting to dominate the world's economy, and is not liking the pushback it is receiving from the incumbents.

Australia - A combination of the Hayne Royal Commission, and the revolving door at the Lodge are threatening what's been a record economic run. The HRC has helped to put the skids under an overly heated residential property market - something the Reserve Bank had been trying to do more subtlety for a while. Either way the above combinations - along with the strong chance of a change of government next year - are likely to see consumer confidence erode further, with the risk that the economic record comes to an end.

The music may not have stopped, but the tune will have changed significantly.

There's not much good news around to welcome Santa!

Nearly every economist got this week's GDP figures for the September quarter wrong (+0.3% and 2.8% YoY). Now there's speculation that the R word will be back on the agenda. And if not a Recession, then possibly a slowdown, and rate cuts down the track from the RBA if the December quarter figures are equally disappointing. That's a big turnaround in expectations, even if most experts weren't expecting an upward movement in rates any time soon.

Anecdotally, based on going to a department store earlier this week, and worse still, a shopping mall, (which Hedge Clippings generally tries to avoid like the plague unless absolutely necessary) there doesn't seem to be much Christmas cheer running through retailers' cash registers. Maybe consumers are all shopping online, maybe they're waiting until the last moment (like yours truly), but quite possibly they're just pulling their heads in.

Why?  Because as noted above, there's not much good news around unless you're an extreme, and possibly unrealistic optimist!

• As recently as May this year one of the (so called) expert real estate commentators downgraded their 2018 housing price forecast on a weighted capital city basis to between -2% to +2%. Fast forward just 6 months and with the property market down 10% they're realising a further 10% fall is not out of the question as banks pull their heads (sorry, lending criteria) in and faith in the financial markets has been tested by the exposure of the Hayne Royal Commission on the front pages and TV nightly news.

• Irrespective of one's political preferences there's a general lack of confidence in our glorious pollies, and an election, and a change in government is just around the corner.

• Globally the Trump / China spat is far from resolved, creating uncertainty in US markets. Brexit is uncertainty personified, and even the German economy - not long ago the envy of the world - is suffering.

• In the US, 10 year bond yields, having recently threatened to rise above 3.5% and spoil the equity market's party, are now threatening to fall below 3% based on concerns about a US slowdown in 2019.  The yield curve is close to inverting as 10 and 2 year bond rates are dangerously close to each other.

• Every US recession for more than half a century has been preceded by an inversion of the curve, although to be accurate not every inversion has been succeeded by a recession.

Could the unthinkable - an end to Australia's record growth run - happen? Hopefully not, but there are enough signs, and opinions pointing in that direction, that it would be unwise to rule it out completely.

Major Themes for 2018

In years to come, when looking back, (hindsight being a wonderful thing) there are going to be a number of dominant themes which affected markets in 2018.  One of those, namely the threat of impending increases in interest rates in the US, was clearly evident this week as Federal Reserve Chair Jerome Powell hosed down the market's hawkish expectations, resulting in a massive "relief rally" as equity investors, who had been nervous all year, pinned their ears back and pushed the market sharply higher.

Unfortunately one of the other big themes (or concerns) hanging over the market, namely the impending US/China tariff war, overcame their optimism ahead of the G20 meeting in Argentina. Welcome to Donald Diplomacy, Huff, Puff and Threat. Every war has an armistice, and in this case it remains to be seen if the initial skirmishes and threats prevent the war actually starting, or whether it will escalate come January 2019.

However, if the messages out of the G20 are positive, particularly if added to the Fed's more benign outlook, then expect a bumper Christmas rally to end the year.

In Australia, one of the great themes of the year has been the revelations from the HRC, with the final round of public hearings concluding today ahead of Commissioner Hayne's final report due in February. With the exception of Macquarie's Nicholas Moore, none of the bank CEO's or Chairmen did their (or their organisations') reputations any favours. In particular Ken Henry shone for all the wrong reasons when he presumably decided he'd had enough of copping flak, and was going to take a different approach. We'd rate his performance as a 9/10 for effort, and a 1/10 for success. 

The other theme for 2018 was falling residential property values. Combining the problems of the banking and financial services sector with an over-indebted consumer, an oversupplied market well overdue for a correction, and brakes put in Chinese buyers' access to credit, resulted in the inevitable correction which will no doubt continue for at least a year, and possibly more.

Finally, politics will go down (unfortunately) as a theme to remember for 2018. Be it The Donald, Brexit, or the revolving door at the Lodge, it is not encouraging optimism.

As we said at the beginning, hindsight's a wonderful thing. Predicting the future is fraught with difficulty, so we'll leave that to another day!

Just because a problem is obvious it doesn't mean it's going to be solved. 
 
Hedge Clippings would love to claim the above adage as our own and would also be more than happy to credit the author if only we could recall in which of the thousands of emails we receive each week we found it. In any event it struck a chord based on the chorus of negative possibilities and opinions that are currently doing the rounds.
 
It is worth noting that based on what we are seeing, reading and hearing we are more in the glass "half empty" than "half full" camp, and in one conversation with a "half full" (metaphorically speaking) investor over the past week we pondered which, if any, of the following scenarios might be more positive in 6 or 12 months' time than they are now.
 
Australian Property/Equities:
 
Problem: Negative influences coming from oversupply (units) and reduced demand (particularly from Chinese buyers), potential reductions in immigration, tightening credit from banks following the Hayne Royal Commission, low wages growth, higher mortgage costs as fixed deals turn to variable, higher US interest rates impacting bank's cost of funds, and reduction in negative gearing if there's a (likely) change in government next year.
 
Solution/Outlook: Glass half full, and a reminder not to listen to property experts who as recently as April this year couldn't, or wouldn't, see the writing on the wall.
 
Australian Economy:
 
Problem: The Australian economy is the envy of the world - growth forecast around 3%, low interest rates, low unemployment, but also a hostage to global, and particularly China's, fortunes. See above - if the property market weakens further it will impact significantly on consumer sentiment, spending, and thus unemployment. Any slowdown and the RBA has nowhere to move. 
 
Solution/Outlook: Glass half full. And then there's the federal election.
 
US Economy/Equities:
 
Problem: Rising interest rates, stretched valuations, The Donald, and after the recent mid-term elections no longer fully in control, potential expiry of tax and infrastructure short term "sugar pill", trade policy, Chinese tariff war.
 
Solution/Outlook:  Glass half full. Anyone able to predict "double down" Donald please let us know.
 
US/China Tariff War:
 
Problem: As above - who's going to blink first, Donald or Xi? There's a good chance that if it gets worse before it's resolved, Donald might have scored an own goal.
 
Solution/Outlook:  Could go either way. If solved expect a bounce, but could get worse before it gets better.
 
Chinese Economy:
 
Problem:  As above - the tariff war is likely to hurt China more than the US, it's slowing, although still a significant force. There's more than just the tariff issue at play, including mountains of debt.
 
Solution/Outlook: The government is doing everything it can - and they can do more than most to solve problems as they don't have to face elections - but they can't control everything. 
 
Brexit/Europe: 
 
Problem: The UK's previously dominant position as a (the) global financial centre is irreversibly damaged, and with it a significant section of the economy is relocating to the EU.
 
Solution/Outlook: Whatever the outcome, no one's going to be happy! Definitely half full, and a reminder that David Cameron must have had a brain snap when he announced the Brexit referendum!
 
In Summary:
 
In case you're wondering if we're alone in these thoughts, last night we listened to Dr John Hewson give his economic outlook at EY's Annual Hedge Fund Symposium. Being a self-confessed economist, he was able to quote reams of facts and figures which yours truly couldn't memorise at the time, or if he could, couldn't a couple of glasses of chardonnay later. However, it's fair to say he was definitely in the glass half empty camp.
 
For what it's worth, while happy to identify the problems, the good Doctor wasn't forthcoming on how to solve any of them either. How times have changed since he left politics!

Times are tough!

Markets remain tough. China is slowing ahead of the tariffs kicking in at 25% in January, the UK is anything but a United Kingdom, valuations (particularly tech and growth) are stretched, banks are tightening credit whilst the property market is awash with unsold units and an upcoming election next year could, and probably will, significantly change negative gearing, imputation credits and the labour market, the ASX is back to levels of 12 months ago, and volatility has spiked.

What makes a good fund manager in tough times?

It would be trite to reply to this question with the obvious answer "one who doesn't lose my capital", but in reality that's about it. However, the "why" and "how" behind the answer is less obvious. Given that markets are undoubtedly in the midst of tough times at the moment it is worth taking a deeper dive into a fund's quantitative performance and risk analytics to look behind the numbers.

This week we hosted a joint presentation from two different fund managers, Dean Fergie from Cyan, and Rodney Brott from DS Capital. Both are "boutiques", running concentrated portfolios and managing relatively small amounts of capital on behalf of both themselves and their investors. That gives a clue to one answer - invest with managers who have a significant amount of the own capital at risk alongside their investors and don't run other PA positions outside the fund. Both Dean and Rodney started their funds primarily to manage their own capital the way they'd like to, and so are literally putting their money where their mouths are.

Both funds have relatively small amounts of FUM by industry standards and as a result can not only be more nimble but can invest in smaller cap stocks without taking huge liquidity risks. Moving outside the ASX200 not only avoids the large cap stocks which are fully covered by brokers' and institutional research, and therefore are more efficiently priced, but also avoids the rising (and falling) tide effect of index and passive investing. It also increases choice, which of course can be a double-edged sword as it requires significant research to find the hidden gems amongst the dirt.  

Both have the flexibility to move out of the market to cash when deemed appropriate, although in practical terms this means generally in the range of 20 to 40%. "Appropriate" means not only when the market as a whole is risky, but also when they can't find quality companies in which to invest at attractive valuations.

Quality companies and attractive valuations means having a deep understanding of the sector, the company, and its competitors, and involves multiple company visits and "eyeballing" management as well as analysing their financials from which to finally invest in as few as 30 to 40 positions. Understanding was a recurring theme, not only understanding why to invest and what price represents value, but also understanding changes to their original investment thesis, or valuation metrics, and therefore when it is time to reduce or exit a position.

Speaking to one of the investors present at the lunch afterwards, the ability to sell a stock is where he felt the best managers have a real edge over the individual investor. Good managers don't use hope as a strategy, and when circumstances, news or valuations change, they're prepared to cut the position accordingly.

Finally, with approximately 58% of all equity funds having reported their October results, 54% of those have outperformed the ASX200 Accumulation Index's October return of -6.05%, whilst only 2% have managed to achieve positive returns. Of the funds that outperformed the market in October, the average return was -1.39%, with returns ranging from -5.94% up to +7.81%.

In October, global equity markets reflected investors' concerns, with the S&P500 falling -6.84% and flowing through to the ASX200, which also dropped -6.05% for the month. On top of September's decline of -1.26%, it was a case of thank goodness it's now November, and to date at least, a return to some kind of stability.

With only just over 20% of October funds in AFM's database having reported so far, there have been the usual wide range of results. Of those that have reported, just over 50% outperformed the ASX. Meanwhile only 10% have provided positive returns, with those not surprisingly dominated by fixed income, credit or managed futures funds, and NWQ's new global liquid alternatives fund of funds leading the way with a positive return of +3.51%. Other results catching our attention included Harvest Lane's Absolute Return Fund and ARCO's Absolute Trust, which fell only 0.11% and 0.68% respectively. While both results were marginally negative, it is unlikely their investors would have been overly disappointed.

Over 12 months to the end of October the ASX is now in negative territory, with many funds matching that, emphasising the point we always make that averages can be deceptive, and careful fund selection - and diversification - is vital!

Meanwhile this week, to nobody's surprise the RBA kept rates on hold, saving the property market from further stress. As usual there are those who are forecasting further falls, and others who take a more positive view, which we suppose is what makes a market!

Hedge Clippings is probably more in the glass half empty camp on property prices, although there is no single residential market in Australia, with a range of conditions in individual suburbs across each city that vary dramatically. In some, such as units away from the CBD, there have already been reports of falls in values of 30%, most probably reflecting a combination of oversupply and tightening of lending standards by the big banks. Elsewhere, where the supply and demand are more balanced, quality will no doubt prove the difference.

Our concern is this:  IF (ok, it's an IF) the economy falters in 2019 - possibly as a result of a change of government, and therefore policy changes such as the removal of franking credits, negative gearing, the final outcome of the Hayne RC, or simply a fear of the unknown - the housing market will fall further. If so, consumer confidence will fall with it, and the RBA will have little room, or the option, to cut rates.

Hedge Clippings was in Melbourne earlier this week, and amongst other things attended Super Ratings' Annual Superannuation Fund Conference and Awards. As our readers would know, Hedge Clippings and www.fundmonitors.com has a focus on the managed fund sector, rather than superannuation funds, but for obvious reasons there's a strong alignment, or at least a common area of interest, between the two.

It was, as usual, a well organised, informative and interesting event.  Labelled the Super Ratings "Day of Confrontation", it featured presentations from the CEO of Richmond Football Club, and also the new Assistant Treasurer, the Hon. Stuart Robert MP, who looked and sounded somewhat familiar. Although yours truly couldn't quite place him, we put that down to his relatively recent appointment following the unfortunate shenanigans within the Liberal Party.

Mr Robert was certainly forthright, and a strong proponent of choice when it came to employees being able to select where their superannuation contributions were directed. Just as well, for we also heard there are 622 superannuation products available in Australia and NZ, that 28% of accounts have balances of less than $10,000, and that one quarter of them are unsustainable.

As one of the panel speakers commented, 40% of the population have literacy levels that make understanding issues difficult, and financial illiteracy levels are double that. One was left wondering if member choice is actually a good thing, but as the majority of those in the room were from industry super funds, Hedge Clippings thought it wise not to raise that question - at least not out loud.

Mr Robert seemed to be on a verbal roll (he is a politician after all), but then surprisingly seemed to contradict himself by saying the best place to have been invested over the past 10 years would have been in an ASX Index ETF, which of course requires no active investment skills at all and would have lost 6% in October alone. This point was no doubt not well received by the assembled audience of award winning super fund managers and trustees, but we assume they too were too polite to question his judgement in this regard.

However, while we all like the idea of choice, it is not necessarily beneficial, particularly taking some of the points above; 622 products is one hell of a choice, especially if financial literacy is at best a rare commodity, and more than a quarter of accounts have balances of less than $10,000. One would have thought all those accounts could be collectively managed by the Future Fund, at minimal cost (or zero fees), whose returns have been close to double that of the average industry or for-profit super fund.

As noted above, we had trouble placing the strongly opinionated Assistant Treasurer, the Hon Stuart Robert. However, he seemed to pop up all over the place later in the week at all sorts of presentations and events, all in front (and centre) of the media. Eventually Uncle Google came to our rescue with this link.

He's the MP with a Masters Degree in Information Technology who has been charging the tax payer around $2,000 a month in home internet usage, totalling almost $38,000. We presume he had a choice of internet service provider, but judging by the cost, didn't do his research very well.

Market volatility - back with a vengeance!

Last week's Hedge Clippings briefly touched on market volatility (interestingly it was 19 October, the anniversary of the 1987 crash) and the risk of averages when grouping funds. Given the continuing volatility this week, and with the expectation of more to come, it's worth focusing on the best way to analyse a fund's downside risk.

There are a number of risk factors apart from volatility or standard deviation which are pretty well understood and known.  Basics such as maximum drawdown, % positive and negative months, worst month etc. are frequently used and quoted.

However a couple we look at that are neither well known, or it seems frequently quoted are Up Capture and Down Capture ratios. Put simply, a fund's up capture ratio over a specific time period (the longer the better) shows how much of the market's positive performance a fund "captures". And importantly given we're talking about volatile markets, the down capture ratio measures how much of the market's negative performance a fund captures.

The key to accurately measuring each is not to simply measure the average positive or negative performance of the fund vs. the market.  Instead, each is calculated by measuring the market's cumulative performance for all its positive or negative months, and then calculating the cumulative performance of the fund over those same months, and expressing that as a percentage, with a result of 100% meaning the fund tracks the index exactly.

For up capture, any number less than 100% means the fund underperforms in positive markets, and if the number is greater than  100%, the fund outperforms when the market is rising.

More importantly in the current environment, for down capture, a result less than 100% means the fund falls less than the market, while a negative number means the fund provides positive returns when the market falls.

Comparing and analysing funds is never easy, but by looking at the down capture ratios of different funds over various time periods will provide a useful guide when putting together a portfolio of funds.

Two important factors to remember of course are that the longer the track record of the fund, the more data points that are available to measure, and thus more instances of rising and falling markets - and secondly, that while a useful tool to understand a fund's performance, it is only past performance being measured.