Choice moves

Can active fund management produce good returns during times of volatility by predicting the sectors that have some immunity to market turmoil – not just quarter by quarter, but in the long term? Simon Keane investigates

Billed as a solution to a bear market, focus funds were the buzz between 2001-02. The fund management industry, having happily ridden the rising markets of the late 1990s as one, was starting to fragment and differentiate itself. Those who brought out focus funds accused rivals of not striving for absolute returns. It was time, they said, for good old-fashioned stockpickers.

Out of this was spawned a new family of funds with aggressive, select, focus and alpha in their names. A manager’s ability to pick the winning shares against a retreating FTSE All-Share was the key selling point. Forget broadly-spread portfolios with 100-plus stocks, this new breed of fund was going to take 20-40 conviction bets and significantly deviate from the index. Then the bull markets returned.

As British equities rose from their March 2003 lows and continued a steady ascent until the middle of last year, any British equity fund was going to make money. The case for active management was weakening again. It was apparent in the previous bull run with the launch of the Virgin tracker fund in the late 1990s, now questions were being asked again about whether the higher fees of active management were worth it.

But things are changing once again. Even in the best-case scenario of America avoiding recession, many are expecting nothing more than a flat British equity market during 2008 looking past the volatility in between. The time for a focused approach has returned. So who are the good active managers in the Investment Management Association’s (IMA) UK All Companies sector? And what, if anything, can their performance record tells us about their ability to make returns in the year ahead?

Many focus funds have already proved their worth. Managers like Richard Buxton (Schroder UK Alpha Plus) have consistently remained in the top quartile of their IMA UK All Companies peer group over one and three years. But not all of these fund managers, Buxton included, have continued to perform well since last summer. The summer marked the first rumblings of the credit crisis. If it has not already done so this crisis is threatening to drag the American economy into recession.

But – as some fund managers have shown us – it has not been impossible to make positive returns. So while this was a period, in the words of Rob Burdett, multi-manager at Thames River Capital, that “caught a lot of managers out,” others have progressed against the backdrop of a retreating All-Share. Focus fund managers that stand out in recent months (see table, page 28) include Steve Hewitt and Mark Westwood at Threadneedle Investment Services, Ken Hsia at Investec Asset Management, Ben Russen from Newton Investment Management, Peter Cockburn at Scottish Widows Investment Management (Swip), Mark Lyttleton of BlackRock Merrill Lynch Investment Managers and Resolution Asset Management’s Ralph Brook-Fox.

All these managers have portfolios in the IMA All Companies sector that made a positive return in the fourth quarter of 2007 versus a 1% fall in the average fund and FTSE All-Share. They have also outperformed over the past three years, all of them being top quartile in the three-year period to December 31, 2007. Some suggest that these managers just happened to run into this period already sitting on long-established underweight positions in financials and overweights in basic materials. But the story is more complex and supports the assertion of these managers that they were making successful active decisions up to and during the second half of 2007.

In general these managers positioned their portfolios towards the defensive “recession proof” stocks that generally constitute the FTSE 100. Top-down factors had become a more important driver of share prices than bottom-up, company specific factors. By rotating out of mid caps and into the blue chips, these managers were responding to this change in sentiment. As the subprime losses of America’s big banks came to light, all banks stopped lending to each other crippling money markets worldwide (in Britain’s case this was best illustrated by the London Inter-Bank Offer Rate (Libor) jumping 10% between August and December to 6.6%). If banks were not supplying capital the impact on the real economy would inevitably follow.

Mid and small caps were sold down indiscriminately, as the market stopped focusing on earnings growth potential and more on the security of those earnings. But the managers on our list were not just getting the big top-down calls right – they are also taking the right bets at the sector level. For instance, within banks these managers, as a group, were light on Royal Bank of Scotland (RBS), Barclays, HBOS and Lloyds TSB but holding Standard Chartered and HSBC. Add to this short-term trading abilities – indicated by a willingness to move into and out of cash to ride the market rebounds – and you probably have their recipe for success in the last quarter of 2007.

Looking through the volatility of the British market since the summer, one emerging trend is the reassertion of the FTSE 100 over the mid and small caps. Broadly speaking, since the FTSE All-Share topped out on June 15, 2007 it has suffered two big sell-offs, the first one over June and July as the depth of the problems in the subprime markets began to reveal, and then in January as a secondary wave of credit crunch-induced problems came to light in the shape of America’s monoline insurers, most notably with Ambac, which was forced to pull a $1 billion (£500m) bond issue. Since the market bottomed on August 16, 2007 following the first big sell-off, the blue chips have outperformed the mid caps, reversing the trend seen over the previous three years whereby the mid-sized companies wiped the floor with the FTSE 100.

Threadneedle’s Mark Westwood was typical of the fourth-quarter performers by increasing his FTSE 100 weighting: “I did sell down the mid caps, I moved more defensive, it was not just in the fourth quarter, it was in the summer months onwards.” By adding to companies like National Grid and Vodafone he says that entering the fourth quarter, 70% of his portfolio was in the blue chips compared with about 60% at the end of July. Peter Cockburn, who in September was appointed manager of the Swip UK Opportunities fund, said the Swip process was “finding value up the market cap” during the autumn. By adding to positions in GlaxoSmithKline, Capita and Johnson Matthey the portfolio’s FTSE 100 weighting went from 55% to 65% between the end of September and end of October.

These managers were selling down the UK-focused cyclical companies linked to the consumer like house builders and general retailers reducing their mid cap exposure at the right time. But, as the performance of the banks demonstrated, just being in blue chips itself was insufficient. Last year saw the dramatic widening in the variation of performances between different sectors. In 2006 the difference in performance between the best and worst sectors was 56%. Oil equipment, services and distribution, was best up 47% (ignoring industrial metals given it only had one significant constituent being Corus) and the worst, technology hardware & equipment, down 9%. By 2007 the difference in performance was 88%. Mining was best, up 50% while real estate was worst, down 38% (ignoring forestry and paper which only has one constituent).

To have avoided four of the mega cap banks RBS, Barclays, HBOS and Lloyds TSB was a key call. Accounting for a good slug of the FTSE All-Share, the dismal performance of these four will have had a disproportionate effect on the index and many managers within the IMA UK All Companies.

Some might say it was luck, the managers who did well in the fourth quarter were already sitting on established underweight positions in financials. And it is fair to say in Mark Westwood’s case he did not actively avoid the banks, as he had been underweight financials for all of 2007. But Newton’s Ben Russon says he moved out of Barclays during September and October as, says Ralph Brook-Fox, did he from RBS – although he did continue to hold Barclays. But it was not just about blanket avoidance as selective positioning within banks, towards the Asian-focused HSBC and Standard Chartered (Hewitt, Russon, Lyttleton and Westwood) that generally paid these managers well. Standard Chartered rose 16% during the final quarter of 2007 against falls of between 13-20% from RBS, Barclays, HBOS and Lloyds TSB.

These managers were also playing beneficiaries of volatile markets within the general financial sector of financials – illustrating that money could be made despite the industry segment’s dismal performance. Many of them were holding ICAP, an institutional brokerage, which has benefited from the huge trading volumes accompanying extreme volatility in the equity, credit and foreign exchange markets and Man Group, a hedge fund manager, whose ability to short set it apart from the traditional quoted fund managers, which were all heavily sold down in the fourth quarter.

The idea that those who did well in the fourth quarter were passively running positions in the miners would also be incorrect. Examining the basic materials industry segment of the FTSE All-Share (which is dominated by the mining sector) it rose 2.9% over the last quarter of 2007 having put on 45% over the previous three quarters. The gain in the final quarter can be attributable to Rio Tinto, which put on 26% following a bid from BHP, and to a lesser extent Xstrata, which rose 10% on talk that Brazil’s Vale was lining up an offer. BHP along with Anglo American fell 12% and 6% respectively during the final quarter of 2007. But two of the managers on our list had no mining stocks in their top 10 holdings (Investec’s Ken Hsia and Ben Russon from Newton). Meanwhile, Threadneedle’s Steve Hewitt was actively moving around the miners, as it turned out correctly selling BHP in November following the Rio bid, and markedly increasing his fund’s exposure to Xstrata. Ralph Brook-Fox was about half-weighted in mining (5.4% of his portfolio at 31 December versus 10% of the index) having correctly selected Rio Tinto (5.1% of his 5.4% overall position) over the other three mining mega caps.

High volatility has been a defining feature of markets since the summer of 2007. As a general rule managers within the IMA UK All Companies sector are not good traders – a reluctance to use their new powers to short, as conferred under Ucits III perhaps a good example of this. To take advantage of short-term rallies managers have to be prepared to move their portfolios in and out of cash and it is interesting that a good proportion of the managers who outperformed over the final quarter of 2007 took large cash positions at one point or another.

At December 31, 5.8% of Mark Lyttleton’s Merrill Lynch UK Dynamic fund was in cash. “That’s much higher than the average fund manager, which was 2-3%,” says Thames River’s Rob Burdett. Steve Hewitt’s Threadneedle UK Accelerando was the second-best performing fund in the UK All Companies over the final quarter of 2007 and he was holding a huge 21.8% portion of the portfolio in cash as at November 30. Mark Westwood over on the Threadneedle UK Select fund says he has been trading the rallies most recently taking a position in Lloyds TSB following the sell-off on January 21. That fall, the largest one-day decline in the FTSE 100 since 9/11, came after news from America that Ambac, a monoline insurer, had pulled a $1 billion bond issue. On the Tuesday there was an emergency three-quarter point cut in the Fed funds rate and by the end of the week the FTSE 100 – Lloyds included – had regained all its losses. It would have been impossible to have foreseen the American rate cut, but even the casual observer of equity markets knows that bounces usually follow such big sell-offs.

Having singled out managers who performed well over the final quarter of 2007, what about those focus funds that fared poorly? Richard Buxton, saw his Schroder UK Alpha Plus fund dip 2.2%, placing the fund firmly third quartile for that period. Buxton is taking what can fairly be described as a contrarian view in believing that the worst of an economic downturn is already in share prices. The monetary and fiscal stimulus packages of the American authorities will resuscitate the credit markets and avoid a severe economic downturn. While he expects a ‘few more months of market volatility,’ the bull market is not yet over, in Buxton’s view.

The mid cap cyclicals like Charter and Invensys that Buxton has continued to hold despite their hammering, are in his mind, well placed to benefit from an “aggressive bounce-back” in the British equity market over the next 12-18 months. And who is to say he is wrong. A highly-rated manager – Burdett says “he’s one you should buy into during dips in performance” – who has consistently outperformed over one and three-year time-frames (69% return in the three years to December 31, 2007 making it ninth best performing fund in IMA UK All Companies) has Buxton sacrificed a couple of quarters for a year’s outperformance?

What the case of Buxton says is that, while a good pointer to the potential stars, performances during the market woes can only say so much. Like Buxton, there are many respected managers flagging value opportunities created by the market’s retreat. However, with the consensus among market commentators being that America is heading towards recession, if not a prolonged downturn, managers who have performed well since the summer will continue to do so for a few more quarters.

Active managers outperform trackers

The WM Company, a fund performance measurement specialist, has looked at the record of passive versus actively-managed pension funds over the 10-year period 1997 to 2006. The average actively-managed fund performed in line with the average tracker fund over the period, both returning 8% a year, compared with 7.9% from the FTSE All-Share (before fees).

But within that 10-year time-frame there were periods when the active managers significantly under and outperformed the market compared with their passive counterparts. As a general rule the active managers tended to do better in the bear years and either a little better or much worse in the bull years.

The most disappointing year for active managers was 1998 when, with the technology bubble in full train, the average active fund returned 12%, 1.7% less than the average passively-run fund, which put on 13.7% in line with that year’s 13.8% gain in the FTSE All-Share. In 2000 however, as the All-Share fell 5.9%, the active managers held their ground. The average actively-managed portfolio dropped 4.1%, outperforming the average passive fund (down 5.5%) by 1.4%.

The trade-off, however, was a wide distribution of returns from the active managers, meaning a manager had to have picked the correct one ahead of 2000 or risked more seriously underperforming the market than if he had picked the wrong manager in 1998.

Can managers beat the market?

The managers who performed well in the fourth quarter of 2007 called early what could be the start of a new extended phase of FTSE 100 outperformance versus the mid caps. Top-down “thematic” considerations (what would the fall-out of the credit crisis be on the real economy and all companies’ earnings?) became the driver of share prices rather than bottom-up factors such as company X’s ability to grow earnings versus Y’s.

The bears, predicting recession as banks ceased lending, were flagging wholesale earnings downgrade – no one would escape. But mid and small caps, particularly those exposed to Britain’s house building and consumer sectors, had the most to lose and were indiscriminately sold off in favour of blue chips whose earnings growth, while less alluring, is more predictable.

This change, says Rob Burdett, a fund manager at Thames River Capital’s multi-manager, team, “caught a lot of managers out”. He singles out the thematic approach of John Wood, manager of JOHCM UK Opportunities, for performing well over the past quarter of 2007. Wood used to run Newton UK Opportunities before Ben Russon took over in July 2005.

On coping with the year ahead Burdett says managers will “need a willingness to rotate away from the benchmark”. In addition, those who move in and out of cash, in other words dip in and out of the market and capitalise on the bounces, will be at a premium. Burdett notes “there are few traders in UK All Companies” with nerve for this.

But is trying to second-guess markets on a quarter-by-quarter basis a long-term recipe for success? Peter Hugh-Smith, managing director at Russell Investments, a third party multi-manager, questions whether the managers who performed well in the last quarter of 2007 can repeat their success.

“It’s difficult for managers to move aggressively around the market and we tend to avoid those sorts of managers since they make heroic calls,” says Hugh-Smith. “Thinking ‘the mid cap run has had it, I’m going to move to large caps,’ is a very heroic call and if it goes wrong your performance stats get slaughtered.

“If you look at the typical Russell fund you tend to find lots of distinct managers with very defined processes so you might have one that is in mid caps which did very well over the past few years and now is suffering.”

The implication of this is that fund managers actively moving around the FTSE All-Share will not consistently work.

British equities – flat markets ahead

The big question hanging over markets is whether the American economy is heading towards recession. But even if the American economy avoids a serious downturn strategists are only expecting modest or zero gains from British equities.

The British equity market is about 10% below where it started 2007 with the FTSE All-Share at about 2,960 versus its 3,287 open in January and the FTSE 100 at about 5,790 versus 6,457.

Tony Dolphin, director of economics and asset allocation at Henderson Global Investors, says: “If the US economy skirts recession and things are looking up towards the end of the year with the housing market stabilising and business confidence up, equity markets may end 2008 with modest gains compared to the start of the year.”

Peter Hugh-Smith, managing director at Russell Investments, a third-party multi-manager, says: “Should the huge pump-priming of the Fed [Federal Reserve] start to pay off and if this is just a slowdown then I think we will end 2008 between today’s levels and where we started the year.”

So which part of the FTSE All-Share will outperform? Rob Burdett, fund manager at Thames River Capital’s multi-manager team points to the blue chips. “We are more FTSE 100 biased, choosing managers who are in the more substantial parts of the market and less cyclical areas,” says Burdett (pictured, left). “The recession-proof names like utilities and tobacco and consumer non-cyclical names such as Unilever.”

Dolphin (pictured, top) says it would take a full-blown recession before the FTSE 250 or SmallCap indices begin outperforming: “Mid caps do well once we come out of a recession and there are two to three years or good growth ahead.

“If we saw the economy slow down then we’re probably not looking at two to three years of strong growth since inflation worries are coming back. We’re only going to get the small caps outperforming once we’ve had a full recession.”