The results are in and they are not pleasant. In a dreary third quarter funds across Europe suffered steep declines, with main market indices posting daily changes large enough to make even the most hardened market participants blanch.
The headline news was, of course, the continued lock-up of world credit markets, slowing growth in major economies, and the failure or near-failure of major financial institutions. Faced with these facts, investors chose to shun risk – this is reflected in the de-rating of smaller-cap shares in Britain and abroad, and the strength of gilts over corporate and high-yield issues in the fixed interest world.
Although the world’s attention was focused on the gathering storm in the financial services arena, it was not the hardest-hit sector in the quarter. Indeed, the direst consequences of the global slowdown were felt in the once booming resources area.
This makes sense. Resource prices had rocketed on the strength of booming demand from China and constrained supplies. Share prices in these areas followed suit, with energy and mining shares rising sharply. Many funds played these trends, perhaps without thinking about the sustainability of commodity price increases. Some managers pointed out mining shares looked cheap on a price/earnings (P/E) basis but, positing an “E” based on record pricing rather than a normalised level was not prudent.
Funds in the Morningstar Sector Equity: Energy and Sector Equity: Industrial Materials categories dropped the most, reflecting the sharp falls in mining and energy issues such as BP, Xstrata, Rio Tinto, and BHP Billiton. The average British available for sale (AFS) industrial materials fund fell 34% in the quarter. The average British AFS energy fund dropped 27%. In contrast the average financials offering fell just 8%.
Consumers also displayed a preference for sectors perceived to be uncorrelated to the global economy, such as biotech and healthcare. These funds delivered average gains of 9% and 5%, respectively, with Franklin Biotech Discovery leading the way. Among financials offerings, Henderson Horizon Global Financials, down 23%, was by far the worst performer in the category for the period. Among the most resilient were Philip Gibbs’ Jupiter Financial Opportunities (down 2.76%) and JPM Global Financials (down 0.34%).
The economic sector trends noted above helped define the performance patterns seen in funds focused on different areas of the globe. Latin America offerings in the British AFS universe fell 30% on average in the quarter, hurt by their exposure to sliding resources issues. The same was true for energy-heavy Russian funds, which also had renewed political risk to cope with as President Dmitry Medvedev took Russia into a military conflict in Georgia and Vladimir Putin, Russia’s prime minister, made thinly veiled threats against Mechel, a nickel miner.
The market experienced wild gyrations in the Micex and RTS benchmark indices, and both exchanges halted trading for a time. In all, the average British AFS Russia equity fund plummeted 42% in the period. Neptune saw its Russia and Greater Russia fund fall 36% in the quarter and its Global Equity and Global Alpha funds were also hurt by Russian exposure.
In Europe, investors fled small caps and other higher-risk shares in favour of the perceived safety of larger-cap fare. This was reflected in fund performance across the British AFS universe. Among British equity funds, the average fund in the Morningstar UK large-cap growth category dropped 18%, in part because of relatively elevated exposure to resources issues and generally higher price-risk built in to the stocks owned by these funds. The average UK small-cap equity fund also fell sharply, by 15.8%. The average UK large-cap blend equity fund posted a 13.8% decline, and the average UK large-cap value fund fell “just” 10.3%.
In similar fashion, the typical Europe large-cap blend equity fund fell 13.54%, compared with an 18% drop for the average Europe small-cap equity fund in the period. Invesco’s Neil Woodford, who runs by far the most money of any British equity manager across his funds, posted a strong quarter, losing just 6% from Invesco Perpetual Income and Invesco Perpetual High Income, thanks in part to his avoidance of mining issues.
American equity offerings were comparatively strong in the period, in large part because of the benefit they gained from the dollar’s strengthening relative to the pound. The average American large-cap blend fund fell 3.03%, while the average American large-cap growth fund fell 0.44%. In a key difference from Europe, the average American small-cap fund fared better than large-cap offerings, posting a 0.44% gain.
Chinese shares continued their precipitous slide, with the average fund dropping 19.2% in the period amid slowing growth, disproving the decoupling hypothesis. Financial shares were hit by the credit crunch: ICBC and Bank of China have disclosed, with three other listed Chinese banks, a combined exposure of about $454m (£265m) to Lehman Brothers. These troubled assets are not significant in terms of the companies’ asset bases, but they were significant enough to trigger a massive sell-off of Asian financials. Indian shares were the exception to the rule: the average India equity fund dropped just 4.4% in the quarter, suggesting that investors in Indian shares had sold off too steeply earlier in the year relative to other markets in the region.
Among bond funds, taking any kind of credit risk proved a poor bet as spreads continued to widen. The average fund in the Morningstar Sterling Corporate Bond category fell 2.5% and the average Sterling High Yield fund dropped 5.04%. In contrast, the Morningstar Sterling Government Bond category rose 3.63% in the period as investors flocked to the safety of government debt. This pattern was reflected across credit markets, with the primary differentiator between markets being relative currency performance. For a British investor, for example, an American bond fund would have proved a good bet with the dollar appreciating more than 8% versus the pound in the quarter.