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.

For a moment this week it looked as if investors were going to ignore the market volatility of the past week or so, but overnight the US market put paid to that.  However, it is more likely that the conditions underlying the volatility - including rising US 10 year bond rates, falling unemployment levels raising the potential for a breakout in wages fuelled inflation, and the outcome of the US/China trade war - aren't going to change in a hurry.

Overlay these conditions with a market until recently trading at all-time highs, driven by low rates, improving earnings and dominated by tech stocks with stretched valuations, tax cuts flowing through, and an increase in infrastructure spending which is likely to run for the next decade at least, and it becomes less a case of potential for volatility, as a certainty.

Thus with the ASX200's Accumulation Index recording a negative return of -1.26% in September, and in all likelihood worse than that once October is done and dusted, the outlook for the actively managed fund space is going to be varied. Whilst index funds and ETF's will bear the brunt of the negative performance, falling in line with the market, we are already seeing the divergent performance of active funds based on September's results.

The average reported September return of funds in AFM's database is -0.33% almost 1% better than the ASX200, with 70% outperforming the market, and 32% recording positive results. Averages can be misleading, as the range of September's returns to date varies from +9.85% to -12.09%, the latter due to the market's rout in India.

While averages can be misleading, we all use them. After all, the performance of the ASX200 is the weighted average of all 200 stocks. We have recently analysed a range of key performance numbers over a range of time frames, and after wading through all the numbers one of the most telling results was just that: Averages don't tell the full story.

For instance, over the past 10 years, average annualised performance based on a fund's year of inception (with one exception) has been gradually increasing since 2007, while increasing dramatically for funds launched in 2017 to well over 25%.

Allocating each fund into quintiles based on performance shows an even larger discrepancy. Meanwhile breaking down each fund's performance based on their track record - Year 1, Year 2, Year 3 etc, clearly shows funds perform best during their early years - particularly year 1.

This has long been accepted, although not always understood exactly why. It raises the paradox however that although funds perform better in their early years, research houses, consultants, dealer groups and platforms traditionally insist that a fund has at least a 3 year track record - and in some cases 5 - prior to investing in or recommending them.

Whatever conservative or risk-averse logic is involved, the investor misses out on the fund's first three years - and their best period of performance.

Imitation is the sincerest form of flattery…

Here at Hedge Clippings we spend much of our week reading a wide selection of monthly reports and articles from fund managers. Then we spend at least some of each Friday trying to ensure we have gleaned enough of their market insight to gather our thoughts and try to appear coherent in our weekly musings.

For the past few months the Hayne Royal Commission, ably assisted by those in their sights in the witness box, have made our weekly subject matter a simple, if somewhat repetitive, choice. This week the market turmoil has put even badly behaving (but now we note, somewhat contrite) bankers in the shadows. While we would claim to have warned of some impending market volatility each week, we were never game to predict its timing.

So this week, rather than try to compose the "why" and "what next" for markets, we're going to simply reproduce an excellent, concise summary received from Marcel von Pfyffer from Arminius Capital whose intelligence and market savvy we respect. It is much simpler than trying to re-write it, with the risk of missing the point, or being accused of plagiarism. 

It is headed, somewhat disturbingly, The Next Bear Market Has Just Begun:

"For the last six months we have been warning our investors that the end was nigh for the US bull market which has appreciated by a colossal +423% for the S&P500 TR index from 6 March 2009 to 21 September 2018. Arminius Capital ALPS fund investors have benefitted from this since the fund's inception in 2014, until we became very concerned at the end of the first quarter 2018 and began to materially add to (increasingly expensive) hedges. The recent rises in US 10 year bond yields and falls in global equities have signalled that the long bull market is over.

The coming global bear market will not be like the GFC. It wasn't caused by a US housing bubble, it won't cause a US and European banking crisis, and it won't be limited to developed economies. But the US and other share markets will fall by 20% or more, many companies will go bust, and a recession will follow.

We can't yet predict how long this bear market will last. It may be over in three months (like the 1987 crash), or it may drag out for eighteen months (like the GFC). No two crises' manifestation or duration is ever the same. In Australia it will be complicated by the housing downturn and the retreat of commodity prices. Oil and gas producers, however, will do well. It will certainly damage all portfolios (individual investors, superannuation & pension funds, speculators & traders) which don't have short positions or derivative protection.

The Trump Administration has made the bear market worse by its foolish policies. The trade war with China is already increasing US costs and causing hardships to some US industries. Further retaliation by both sides will make matters worse and most likely not remedy the one fact the US, EU & Japan all have openly acknowledged and agree upon: that the global trade playing field is not level - in China's favour.

In particular, The Donald's decision to re-impose sanctions on Iran have propelled oil prices upward. The effect of sanctions will be to cut Iran's oil production from 2.5 million barrels per day to between 1.0-1.5 million barrels per day. China will continue to import Iranian oil, carried in Chinese ships, and Iran has four decades of experience in evading US sanctions. But there is not enough spare production capacity in the world to make up the lost Iranian production, so oil prices are rising, and may soon reach USD$100 per barrel again. US and Australian motorists are going to be paying more!

One of the reasons we are confident that the next bear market is under way is the behaviour of the technology sector. Tech stocks have led the way down in the US, and most of them do not have the earnings or dividends to justify a price floor. Over the last eight years, the tech sector has grown to make up 25% of the S&P500 index, so the sector and the index have a long way to fall. The big tech stocks - such as Facebook, Apple, Amazon, Netflix, and Google will still be in business, but they will be a lot smaller, just as they were after the dotcom boom and the GFC."

The Arminius Capital ALPS Fund is short several US tech stocks, as well as many other US, European, Japanese, and Australian stocks. Just as absolute return and hedge funds provided downside protection during the GFC (falling on average less than half the ASX200's -45%) we expect that once again these funds will perform significantly better than the market, and adhere to their ethos of long term capital preservation.

The hopes expressed in last week's Hedge Clippings - namely that the Hayne Royal Commission's final report due next February won't focus on increasing regulations, but will rather insist on accountability for poor - and possibly criminal behaviour - seem to have been given a good chance of coming to pass if the interim report is anything to go by.

Whilst we have to admit to only skimming some sections of the 1,000 page, three-volume interim report released last Friday, we have read enough to continue to be significantly impressed by its overall direction, and to see no reason we won't be equally impressed by the final version. Commissioner Hayne clearly recognises what the underlying problems are - namely conflict of interest, greed and regulators who need to act to prosecute - and prosecute hard from the top down - rather than to add ever increasing regulations on the industry.

If anything, removing existing carve-outs such as grandfathered commissions would be more useful than adding more laws.

Apart from the Commission's ability to put wrongdoers firmly in the spotlight, what the HRC has exposed is the previous difficulty encountered by customers when bringing their grievances to the attention of the regulators. We would expect the final report to also include recommendations regarding beefing up the FOS, or simplifying and speeding up the processes around it.

In spite of calls by the Federal Opposition to extend the HRC and the work of Commissioner Hayne AC QC, and his team, it sounds as if he'd rather finish it up as scheduled next February, and let the Government (hopefully) get on with the task of implementation of the recommendations.  Simply extending, and presumably finding more of the same, won't add to what's been uncovered already.

Elsewhere this week the US 10 Year bond rate reached multi-year highs as the Fed tightened again, with expectations of a further one or two moves over the balance of this year. The US economy is surging, and with unemployment sub 4% the question is when will inflation kick in, and at what level will 10-year bonds spoil the equity party? Anecdotally most fund managers we hear from believe a correction is overdue, but none are quite prepared to say when.

Anyone who has followed the goings on at the Royal Commission into Financial Services over the past six months or so won't have been surprised at the damning indictment of nearly every aspect of the banking, financial advice, mortgage broking or insurance sectors when Mr Hayne's Interim Report was delivered to the government earlier this afternoon. In fact unless you've been on the moon over the past six months you would have had a pretty good idea of the report's conclusion - the sector has been loaded towards the industry participant - the big end of town - and against the consumer.

It seems pointless to try to cover all but the overall gist of the lengthy 3 volume interim report. The real issue going forward is to what extent the politicians will actually follow through with the Interim Report's recommendations, even before the final version is delivered early next year. Early comments from the new Treasurer, Josh Frydenberg suggests he will take firm action, but without being overly cynical, he is a politician after all.  Maybe the upcoming election will ensure stern words are followed by firm action.

Meanwhile, untold damage been done to the standing and reputation of the financial services sector in the eyes of the consumer, although to many it merely confirmed what they perhaps already suspected. What it did fully expose was the massive conflict of interest between corporate profit and personal gain on one hand, and the best - or at least a fair and reasonable - outcome for the customer on the other.

Actual recommendations will no doubt be the subject of the final report, after Mr Hayne has grilled the CEOs of the various banks and other institutions, which we presume is due to take place in Round 7 of the public hearings scheduled for the last two weeks of November, under the overall title of "policy questions arising from the first six rounds". Whilst to date it is only the CEO and chair of AMP who have felt the full fallout of their time in front of the HRC, the bottom line is that responsibility for corporate culture ultimately lies with the board.

It is obvious that board and therefore company cultures over the last couple of decades have been slanted strongly towards the pursuit of corporate profit, achieved through an increased market share in the now well understood, but flawed concept of vertical integration, coupled with a system of commissions and bonuses which have created the massive conflicts of interest.

Where the balance lies between corporate profit, looking after investors, and doing the right thing by customers is difficult to judge, and probably even more difficult to legislate for. We just hope that the final outcome of Commissioner Hayne's report - be it the interim or final version - will not result in additional layers of excessive regulation, but will result in a clear delineation which allows criminal prosecution of the guilty parties where, and when it occurs.

The HRC has produced (amongst other things) some memorable moments over the past 6 months, ranging from the destruction of the AMP's reputation, and that of its chairperson, the collapse of a witness in the midst of his testimony (which might have saved him from further immediate embarrassment), and overall the understanding that the consumer invariably comes second in dealings with the banking system.

The past two weeks have shone a similar light on the insurance sector, with equally horrific tales of appalling, and in some cases allegedly criminal behaviour, generally inflicted on those most vulnerable. Maybe, as one who has had to deal with an insurance company over a claim, or been on the end of a sales call, there weren't expected to be too many surprises, but surprises there were.

Charging deceased people premiums? Tick. Denying claims without just cause? Tick. What was of concern was the size of the organisations, and the seniority of those in the know, with the ability, but not the inclination, to prevent such practices. 

If one had to have sympathy for a witness appearing before the HRC however, it was today's victim, Sally Loane, CEO of the Financial Services Council, the peak industry body with the unenviable task of representing, amongst others, the insurance sector. Without being the perpetrator of the actions of her members, she was made to look responsible for endorsing their collective misdeeds.

It made for uncomfortable TV, and will no doubt be replayed again and again on tonight's news and current affairs channels.  With nowhere to go without condemning or damning her members, Loane resembled someone crossing a river full of crocodiles on a tightrope, whilst dodging well-aimed spears from the other side, all the while with no protection other than "I'm the CEO, and have an expert better able to answer that technicality".

Of course in her position, one question was unanswerable: Why is the insurance industry not subject to the same law that requires directors (and others) to "deal honestly, efficiently and fairly" as required by the Corporations Act?

The problem, however, is that even when applied to the rest of the banking and financial services sector, the issue seems to have been well and truly swept under the (boardroom) carpet.

Moving away for the HRC (which by the way is due to produce its interim report in time for next week's "Hedge Clippings") this week saw the US 10 year bond rate poke its head above the 3% mark again. With multiple opinions on the downward direction of Australia's housing market, one thing remains clear: The rising housing tide we've seen was caused significantly, if not totally, by 10 years of unrealistically low interest rates, and easy credit. 

As those rates rise, and easy credit becomes a distant memory, so that tide will recede, most likely very quickly. Add to that the threat of Bill Shorten and a potential limit on negative gearing, and the outgoing tide may become a flood, with resultant effects on the economy as a whole.

GFC turns 10, Hedge Funds Rock turns 17!

10 years on from the collapse of Lehman Brothers, the trigger that fired a bullet that was to become known as the Global Financial Crisis, and there are a number of voices warning that whilst everything in the garden may seem rosy, there are worries that markets are heading for further turbulence.

As the recent AFM Insights article from Arminius Capital explains, the US equity market has risen by 350% from its March 2009 low, but the real growth has been in debt, thanks to central banks flooding the system with credit, and allowing eager corporate and individual borrowers to take advantage of impossibly low interest rates.

Other voices are spreading the same cautionary tale. At this week's Australian AIMA (Alternative Investment Management Association) conference, a number of respected voices, including Regal's Philip King, warned of the dangers of the valuations of some growth stocks which he fears will be unsustainable in due course. 

While King is warning of the danger, he is also looking forward to the opportunity - or opportunities - which will present themselves on the short side. Given the track record of Regal's various funds, which have provided twelve-month returns of between 28% and 74%, and annualised returns ranging from 13% to 35% over a long period which included the GFC, albeit with commensurate volatility, it would be well worth listening to King's voice of experience.

The AIMA conference was followed by last night's 17th annual Hedge Funds Rock event, which combined recognition of the best performing managers across eight categories, along with raising funds for well worth charities, including Redkite which supports the families of children with cancer - with the total raised over 17 years now well over $2 million. Like the industry itself, this event has evolved over the past 17 years from a bunch of managers letting their hair down at Sydney's legendary Basement, through to last night's excellent event for almost 500 held at the Westin's Ballroom.

The award for the individual contribution to the Australian hedge fund industry went to Bronte Capital's John Hempton. For those not aware, Hempton's skills have been particularly evident in uncovering dodgy, if not fraudulent, accounting, and shorting overvalued companies. One person who will not be impressed either by the industry's recognition of Hempton, or by his expertise on the short side, would be Harvey Norman's Gerry Harvey, who once again this week came out spitting chips about the level of short sales in his beloved company.

Without going into the rights or wrongs of short selling, Hedge Clippings' view is that the best way to avoid short sellers is to clean up one's balance sheet, have accurate and transparent accounts, and focus on managing the business at hand (and in Harvey's case that means retailing, not farming). Of course that doesn't cover the situation of short sellers of stocks that are considered vastly overvalued, but if anything they are helping to ensure that valuations don't become even further stretched.

Sometimes on a Friday Hedge Clippings wonders what on earth we're going to write about. Then you get days like today where there is plenty. I guess it's either a feast or famine.

So where to start? Well, it looks as if Donald Trump is going to be upping the ante by confirming his $200 billion trade wall (that was supposed to be "war", but I guess "wall" will do just as well) with China. It is yet to be determined whether this is going to develop from a significant skirmish into a full-blown battle, and also, depending on one's point of view, whether the damage will hit the Chinese or the American economy the most.

The current view is China the most, but the answer is quite possibly both, and of course, the rest of the world will suffer serious collateral damage. However, irrespective of one's view of Trump's rhetoric, it is unlikely to be empty as he tries to prevent what he sees as China's domination of, if not the world economy, at least that of most emerging markets. Depending on whether you are American or Chinese will no doubt determine which side of the fence you sit.

Overnight Trump received an unexpected vote of confidence, or reference if you like, from Kim Jong-un who is reportedly aiming at denuclearising North Korea before the end of the Donald's first term. China's President Xi Jinping may not be so easy.

Back home in Australia ASIC seems to have been encouraged by the Hayne Royal Commission, announcing legal action against NAB for charging customers fees for no service. Expect more of the same as ASIC moves from a policy of behind doors negotiation and penalties, through to putting perpetrators in court, even before the end of the HRC. The difficulties of getting an actual conviction however, and what the court may or may not decide as retribution for any proven wrongdoing, remain to be seen.

As predicted in last week's Hedge Clippings, two other big banks played catch up with the rate rise from Westpac, and adding a couple of bps for good measure, while the RBA kept interest rates on hold as expected on Tuesday, signalling that the economy was in good shape. By Wednesday it was evident just how good a shape the economy was in, with revised numbers lifting GDP by 3.4% over the year to June. There doesn't appear to be a negative cloud on the domestic economic horizon at the moment (unlike the political one) unless the slowdown in the housing market, which the RBA has been seeking for some time, accelerates further and overly damages consumer confidence.

Finally, there were warnings regarding the dangers of passive investing. We would have to declare a vested interest in this regard as we specialise in the actively managed fund sector. Whilst we can certainly see the benefits of passive investing as a way of reducing investment costs, it can distort valuations, particularly in rising markets, based on the premise of "a rising tide lifting all ships".

The risk of passive investing however comes as markets turn downwards, when index and passive funds will see indiscriminate outflows. Just as the rising tide lifts all ships, so too it lowers them when it falls. That's when actively managed and hedge funds come to the fore, (and thus justifying their fees) by protecting capital and hopefully without adding to the outflows.

While on the subject of performance, we frequently normally keep fund performance updates to a fairly dry commentary. However, the Bennelong Long Short Equity Management's (BLSEM) August performance of 10.59% (see report) was something special, even if the manager was at pains to point out that it should not be taken as normal. We can safely mention this fund as it is closed to new investors, but it is a terrific example of how a well-managed hedge fund can work. The fund has returned 16.77% annualised after all fees over 16 years since its inception in February 2002.

An important measure of a fund's risk is the Down Capture Ratio or DCR - in BLSEM's case of minus 201%. For those not familiar with the Down Capture Ratio, a DCR of 100% indicates that the fund falls in line with the market in negative months. A figure of less than 100% indicates that the fund falls less than the market. A negative number indicates that the fund rises when the market goes down. Negative Down Capture Ratios are rare but not unknown, and one of -201% is extraordinary, particularly over a period of 16 years. This was no flash in the pan!

There was plenty of teeth gnashing this week over Westpac's "out of cycle" mortgage rate rise, including from the new PM and his equally new treasurer. It's always amazing how banks are to blame when rates rise, while the politicians of the day (ok, they last a little longer than a day, but you never know) take the credit when rates fall.

While banks are fair game when they misbehave, mislead ASIC (ok that was NAB and AMP, but same, same), charge clients fees for no service etc., what is essential is that their basic operations - i.e. the margin between their cost of funding and the rate they charge their customers - are profitable. Note we didn't say fair and reasonable!

So if their funding costs (particularly offshore) are increasing, the obvious result is that mortgage rates will rise as well. We're in a global village, and the banks' offshore funding sources - estimated to be 35% - are global as well.

Given that rates have been so low for so long, and that we've seen US rates rise (and about to do so again), there should be no surprise that eventually they will increase. There have been plenty of warnings. The problem is that while rates may be moving up, and lending practices have been tightening over the past 12 months, the banks have been falling over themselves for the previous 8-10 years to shovel credit onto the willing consumer, thereby driving up household debt to record levels, and helping to fire the furnace under residential property.

Of course consumers should shop around, but that won't help them much, simply because the other banks and lenders will follow suit sooner rather than later. And while the RBA cash rate may not shift off its current floor of 1.5% for a while, with US rates tipped to rise as soon as next month the only way from here is up.

Meanwhile back to the Hayne Royal Commission: Amidst all the drama and revelations from the HRC over the past six months, what has been amazing is the sheer volume of intelligence that the Commissioner and his Counsel seemed to have lined up to skewer some hapless witness or another.

It stands to reason that much, if not most of this would have been sourced from the regulators - ASIC and APRA, and the FOS. Which begs a question: If the regulators had the information, why weren't they able to line the naughty boys and girls up themselves?

Was it the system, the regulations, a lack of resources, a lack of intention, or what?

Hedge Clippings' most likely answer is that many in the financial services sector treat ASIC and APRA, the corporate cops, the way most motorists treat the highway patrol (until they need them).  There would seem to be an attitude of "get away with what you can, when you can, and hope you don't get caught". Australians have a long history - dating back to the earliest days of the first fleet - of having a well-honed disregard for regulations and authority. Maybe it's all just a game to see how far you can go.

That's worked up until now.  The HRC should lead to some miscreants facing criminal prosecutions - and the resulting time in the sin bin that may well follow!

Where's the leadership we deserve?

At a time when the government needed leadership, unity and stability, the combination of personal ambition and the desire for revenge delivered exactly the opposite. Irrespective of who one believed should be in the top job, the country deserved better, and only time will tell if it gets it.

Personalities, and personal ambition, and in our view a misreading of the mood of the majority of people in the street, has resulted in the running of the country put to one side, while a bunch of self-centered politicians have indulged themselves, in just the same way as their predecessors did.

The real tragedy is that the economy, while not booming, is sound and growing, employment is growing, inflation and interest rates are low (probably too low) and taxation, except for the "big" end of town, is coming down. The federal budget is forecast to make it back to a surplus way ahead of forecast, and given the potential change of government at the next election, that's probably now in doubt.

If there's one good (?) thing to come out of the debacle in Canberra it's probably that the chief destabiliser and those pulling the strings didn't win, although they'll no doubt be happy enough they've dispatched the one person - now the previous PM - they didn't want to win. The question is will they now be satisfied and pull their heads in, or will they work to destabilise another moderate?

If there's one good (?) thing to come out of the week's media focus it is that the Hayne Royal Commission wasn't on the front pages.

Meanwhile AMP's appointment gets out thumbs up - experience and ability, and hopefully prepared to make the changes necessary - or enforced by the HRC and future legislation. Hedge Clippings has previously been critical of both AMP and David Murray, but this is a good and smart move. However, there's still a long, long way to go.