The International Investment South Africa Forum brought together hedge fund managers, financial columnists and currency specialists - the only topic not to be mentioned was the tax amnesty - covered instead on p.34
History and Impact of hedge funds
In the opening address of the International Investment South Africa Forum 2003, David Smith, chief investment director, multi-manager, at Global Asset Management, gave a very clear warning of the impact of history on the hedge fund world.
From the foundations of the industry by a journalist, Alfred Jones, in 1949 the industry has grown to 6,000 hedge funds, managing $650bn. But if you look at the organic growth of the industry from 1989, when it had a conservatively estimated $65bn of assets, and a performance return rate of 15% a year then there has only been $11bn a year in capital inflows. To Smith, therefore, this was not a sign of a bubble forming.
But there is mis-information about the hedge fund industry because the vast majority of players were new entrants. To Smith a big fallacy was that the 1990s exceptional returns would automatically continue, as returns in previous decades were good and bad but not exceptionally good.
The second trend in the industry was an increasing concentration of assets in a few players, including GAM. Smith assumed $650bn in total but the top 61 hedge funds of funds equalled $233bn, with another $100bn in another 1,000 funds. So hedge funds of funds managed 40% of total assets, from 20% in the mid-90s. But in the mid-80s, the concentration had been 40%.
He said: "These hedge funds of funds decide the hedge fund winners, or which hedge funds are allowed to have a chance of winning. Without big buyers it is doubtful you can survive. There is a critical mass to research and creating a hedge fund - a minimum $5bn is needed just to service and have the back and front office people you need to take this [Fof] business. It is far more complicated and capital intensive now."
Hedge funds are not a homogeneous asset class only a 'loose federation of egos'. GAM splits the class into arbitrage, trading and equity hedge strategies, although he warned delegates to view this classification with scepticism (see chart one).
To Smith and GAM it was more important to understand the hedge fund manager and the process rather than the sector classification - and to remember sectors have a nasty habit of becoming correlated in a crisis.
But whether being a funds of funds adds value, Smith illustrated that the mean return from a random selection of individual hedge funds by a monkey would have outperformed the professionals (see chart two). He said: "The professional managers had lower volatility but was this worth the give up in performance?
"History of fund of funds leads me to believe that one has to question whether performance justifies the concept. In fact the average fund of funds is a concept and not a performance reality."
Smith said GAM was not average and used a bottom-up, research-driven approach and concentrated portfolios of managers rather than short-term tactical asset allocation.
Looking ahead, Smith warned the US markets were following Japan's last decade as demographics and savings rates in the US now matched Japan then and could trade sideways as it had done in the past - a little bit of history possibly repeating!
To few people are there many obvious similarities between Sweden and South Africa but to Arne Hassell, chief investment officer at Coronation International, the London-based arm of Coronation Fund Managers, there is one connection - a volatile currency.
Hassell, who spent 12 years growing up in Sweden, which has seen as much movement as the rand in the past, said it was important to look at hedge funds as part of a total portfolio. But for South African advisers he said the questions were: how big the foreign portfolio should be; out of that, how much to invest in hedge funds; and what currency exposure to have?
Hassell warned it was easy to think the first equalled the third. But "it makes sense to separate all three" as he demonstrated through the chart opposite (see chart four). Hedge funds have had an annualised 12% compound returns. But as the rand fluctuated it was better to go unhedged back in the rand. In fact, from 1990 to date, the MSCI index returned 9.9% but seven percentage points of that was due to the currency and as the rand strengthens it would be back to remain in the foreign currency.
However, a currency overlay could improve returns without adding risk. Hassell said: "Currency as risky as the index - for example, the dollar/rand movements, have been 16%, on an annualised basis since August 1996. So a 25% overlay could add four percentage points in returns." But the ultimate why to avoid currency risk would have been for the Swedish krona to have joined the euro.
Small cap stocks
Having taken a battering after the late 90s emerging markets crises, South African small cap stocks are looking up, according to Chris Gilmour, associate editor at the Financial Mail.
Small caps are those 350 equities listed on the Johannesburg Stock Exchange outside of the top100 by market cap. But although the majority in number they only make up only 6% of total market value (see chart three).
After the 1998 crisis small caps were caught up in backwash and rather discarded, losing 8.5%. Gilmour said this was because of a "flight to quality and institutional investors not wanting them." But from 2001 the top 40 market has returned 12%, with small caps up 49% and mid-section 52% up.
But small caps are still reasonably priced, with a p/e of 11.6 and a dividend yield of five. The companies with the best opportunities are those tapping into the local feel-good factor as interest rates have fallen by five percentage points in the past few months.
Gilmour rated Astrapak, AVI, Cashbuild, City Lodge, Edcon and Spur.
And in conclusion said: "Small and mid- cap stocks are cheap and offer great value in many instances. But coverage is poor and liquidity is often low so investors must do their own homework, often in isolation, but the rewards could be great."
Fund manager skills and asset allocation
To Paul Forsyth, chief executive of Forsyth Partners, a fund research and funds of funds firm, asset allocation and individual fund manager brilliance are equally important for the client.
Before putting together a group of managers it is important to get asset allocation between bonds, cash, equities and alternatives right, he said. This is the crucial driver of performance and movement between asset classes can materially affect performance. Timing is also important, however; knowing when to make changes.
Forsyth said: "Do not give up good asset allocation by poor manager selection."
Fund manager performance can help lift average performance to something a little more stellar. And past performance works in certain circumstances: when there is no changes in a fund's mandate, manager responsibility or manager.
Anthony Bolton, who manages the Fidelity Special Situations fund and has outperformed his benchmark for the last 18 years was a great example, Forsyth said (see chart five).
The key factors in a manager's rating came from strength of investment process over time, people and past performance over three years. Beyond that, turnover in manager and mandate makes it unreliable.
So one factor to keep an eye on is changes in a fund manager . In practice Forsyth picked the HSBC GIF UK Equity Fund to look at the Tim Russell effect. From December 1996 to February 1998 the fund broadly performed in line with the benchmark FTSE All Share index. But in October 1998 Tim Russell joined from Lazards and added significant value, which he maintained in difficult market conditions.
Forsyth said: "Our view would have been to sell Lazards and buy HSBC when he changed." He then introduced the Cazenove UK Equity fund, which had underperformed UK All Share while Russell had been at HSBC. But then in January 2003 he joined the Cazenove fund, whose performance jumped up 18%, outperforming the FTSE All Share and HSBC.
"Asset allocation is critical and timing is critical at both asset allocation and the fund level. But it is best not take huge bets on asset allocation and try and make money by picking the right managers to look after the portfolio in the long-term," he added.
Passive investing was built on the fact that most active fund managers underperform their benchmarks after fees. As a result people have removed the benchmark risk by using passive investing to replicate the benchmark at lower fees, although this does very little to deal with the absolute risk that the benchmark will fall in value, according to personal observations by Craig Bodenstab, head of global trading at Orbis, a Bermuda-domiciled fund range.
He said: "There are more funds than shares, so arguably your job is more difficult than ours."
He said the investment industry is built on short term trading. Portfolio turnover in 1960 was 16% a year - six years on average to completely change your holdings. In 2002 it was 110%, for example 11 months.
"My impression is that is speculating. Only broker firms and investment houses benefit from this," Bodenstab said.
The core of the argument is whether active fund management benefits clients. In 20 years the S&P500 returned 13% but the average mutual fund make 10%. The three percentage points difference is in the charges. "Which might not sound a lot but when compounded this is sobering," he added.
Even more sobering, he said was that the average fund investor in this period only made 2% "because short-term performance sells."
"It is very difficult to sell a fund that has done badly as we have conditioned our clients that things that do well will continue: almost like Newton's theory of light that things will continue indefinitely along that path.
"Stock markets are unpredictable so what better to sell is there than short-term performance? So why sell active managers? Because we are over-confident about their performance and can charge higher fees,." he said.
It is logical, therefore, for all investors to index but because of the way the indices are built it means they buy high sell low. Japan, for example, made up 45% of passive portfolios at peak. Now it is less than 10%.
So Bodenstab encouraged the delegates to go back to the managers and buy those who bought assets at discount to long-term worth - the gap between price and underlying value. "It is imperative we tell our clients to think that way because buying or selling funds because they have been the best or worst performers is probably not a good way to build long-term wealth," he added.
A South African firm has begun charging fees for financial advice. Greg Sneddon, a financial planner at McConnell Sneddon moved from commissions to fees 12 months previously, after setting up the firm in 2001 discussed his job and said it is really hard work.
"A fee-paying practice needs a set way of operation, so clients know what to expect and that is consistent and repeatable."
According to Sneddon, financial planning is a six-step, internationally recognised process where the objective is measurable advice that results in a plan to manage current and achieve future financial needs and goals of the client. It is not about product or sales and transaction should therefore not be the basis of remuneration, he said.
Financial planning implies at least an annual review, which for 200 clients means a review every working day. But the reason to change was because: "Public want objective advice and my experience is there is greater client loyalty when they are paying you a fee. And a lot more demanding.
"But the perception in the press and fees are good and commission is bad. On a typical life policy fees saved clients money when compared to commissions," he said.
To move to a new, sustainable financial planning model you need to get paid for everything. Sneddon said he charged clients R300 an hour. "Two thousand clients at R3000 a year equal R600,000 and that is a good business," he added.
Sneddon takes fee for initial consultation and work, a fee for the annual review and an annual fee on clients' portfolios.
But he gave a long list of barriers to change. He emphasised it was very difficult to change existing model with clients as they have become used to it. Sneddon suggested the annual review meeting as a good time.
For existing clients, it is best to start with a retainer fee then a debit order on annuity income. It is non-negotiable for new clients. Administrating the new practice is difficult and there are high overheads and expenses while income drops initially. Clients must be kept informed, he added, and if they say they can get it for free elsewhere say they are being 'positioned in order to secure good faith to sell you something at a later stage.' There is always a price to pay somewhere down the line.
But he said advisers needed to be flexible as John Maynard Keynes said: "When somebody shows me I am wrong I change my mind - what do you do?"
Asset management industry in SA
David Gleason, a financial columnist in South Africa, summed up the investors' mood about the asset management industry with a tale about a professional golfer investing for 10 years who has lost R40,000 out of his 150,000 capital in four years.
"He is blowing clouds of fire."
Gleason said this anger may have been due to too high expectations. But these expectations came from the asset management industry telling him, he added.
This exaggeration of likely returns was partly due to competition. Why, Gleason said, "would one asset manager make repeated warnings and dampen expectations when the chap next door is doing the exact opposite? He will lose business."
Gleason said the industry needed to learn to address common issues with a united approach. Part of the asset managers' problem was their reliance on equities.
In the last five years, bonds have returned an annual compound 20%, while equities have returned 6 percentage points less. On a R1.5trillion savings pool this represents a massive forgone opportunity, he stated.
As to why South Africa fund managers have been locked into equities as an asset class, Gleason said it was not enough attention to asset allocation. "This is critical,." he said
They ignored bonds because mandates were handed to them by consulting actuaries; research analysts were concentrated in equities; and they earned more commission on equities than bonds.
He cited the UK firm, Boots's decision to move its pension fund's assets from equities to bonds as a signal yardstick for all asset managers.
It is uncertain whether bonds will continue to outperform as some managers think equities will recover, although there was no consensus, he added.
Gleason summed up the rules for the industry as being: asset allocation; more attention to alternative asset classes and not being wedded to equities; training sales staff not to make promises they cannot fulfil; and communication to those whose money asset managers look after.
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Follows active fee cuts in June