FIN206 Topic 4: Managing an equity portfolio

Sellers

Sellers could utilise SPI futures to: • protect the portfolio without disturbing specific holdings — this is especially the case for short term protection • produce income where the futures premium is considered to be inflated (sell futures because they are overpriced) • speculate on a falling market (expect the market to fall) • maintain the physical equity holdings and therefore entitlement to dividends while hedging a portfolio • protect an underwriting, sub-underwriting or other committed position. In essence this also hedging a long equities position/commitment.

Style indices

Some of the major index providers, such as MSCI, S&P and Russell Investments, produce indices based on style. Stocks within the indices are selected on predefined style characteristics. These indices provide a general indication as to how a particular style has performed over time. They provide a useful benchmark against which to measure the performance of managers who purport to follow a particular style.

Passive enhanced indexing

The use of passive enhanced index managers is validated by empirical testing of the strategies which shows that, as a general rule, the excess returns seem to be significantly positive in relation to the underlying benchmark that the portfolio is looking to track. The strategies consist of using the following observations in the markets: • Index constituent timing — when the weight of a company is changed on an index, or the company is entering/exiting an index; of investors creates price effects because of higher supply of (or passive index funds tend to implement the change at the index effective date. This trading activity on a specific date by a group increased demand for) the equities. One strategy employed is to implement the index changes to the portfolio at different times to the benchmark index effective date. This is done using the portfolio as a liquidity supplier of the equities at the time of a shift in indices other than their own index. For example, an index in the Unites States may offer liquidity on an index change in the Russel 1000 Index when it tracks the S&P500 using the stocks that occur in both indices. This is a well-known strategy that is used by many other investors, and has the risk that there is excess liquidity supply which negates the benefit of this activity. Maintaining positions that offer liquidity over a longer period obviously involves an additional and substantial risk of capturing value changes that are not related to the index change. For example, an index fund may be selling stock of a company that moves into an unrelated index to benefit from the increased demand for the stock. It may then be exposed as the market declines sharply. It is therefore important to confine the risk as far as possible to the effects for which exposure is sought. • Index constituent forecasting — a second strategy involves the publication of index changes. Most equities involved in index changes show a price change, both because of expectations that passive index funds will boost supply/demand and because of a change in the relevant equities' liquidity discount/premium. This is because when an equity is incorporated in an index, the turnover of the equity tends to increase and its liquidity discount tends to decline. The reverse is true if the equity is removed from the index. A portfolio manager who is able to anticipate which equities are involved in index changes can, potentially, profit on early trades. • Initial public offerings (IPOs) — a third strategy takes advantage of the fact that it is often profitable to subscribe to IPOs particularly when there is a good chance that the new equities will be included in a widely tracked index. • Multiple listings — a fourth strategy is based on the fact that often one type/class of stock seems cheap (or expensive) in relation to other types/classes of stock in the same company. It may then be profitable to buy or sell different types or classes. Examples of such types/classes are: - international issues of locally listed stocks with the possibility of conversion to the local stocks when random or systematic price differences occur - dual-listed stocks, where the shares have the same voting rights and underlying dividend flow, but which are listed on different stock exchanges, may involve a temporary price difference, for instance, because of difference in liquidity. Similar strategies are also used to buy or sell equities within the same industry if the equities have a sufficiently high and stable correlation so those particular differences in price developments will be offset with high degree of probability. All these strategies are used to provide additional, small returns with low risk, while keeping the funds tracking error very close to that of the index.

Franking credits

A further important factor for domestic investors is the tax advantaged status of Australian shares. In the 1980s, Australia implemented a dividend imputation system that removes double taxation of corporate profits via a franking credit system. Thus, if a company earns $100 million and pays $30 million of tax, it can then pay out $70 million plus $30 million in franking credits to its shareholders. The shareholders will then report $70 million plus $30 million of gross earnings to the Australian Taxation Office, with $30 million of taxes already paid (tax offset for the shareholder). This system ensures that every individual taxpayer will pay their own marginal income tax rate on these corporate earnings and receive a full credit for all tax already paid by the company. Companies making dividend payments to other companies can pass on franking credits. The net effect of this system is that as far as domestic investors are concerned, there is effectively no company tax on domestic profits. This does not apply to foreign investors in Australia, or Australians investing overseas — in these cases there is double taxation, first of the company and then of the individual. This makes domestic shares more valuable to domestic investors than foreign assets.

Transaction costs

A significant component of brokerage costs relates to services provided by brokers in relation to research which is of value to active fund managers. Nevertheless, the trend in brokerage rates has been down, with the average institutional investor now trading at a brokerage rate of about 20 basis points or less for a one-way transaction. The recent emergence in Australia of client-directed trading, (whereby a percentage of the nominated commission agreed to by the manager with the executing broker is rebated to the client on whose behalf the manager is acting), begs the question as to whether the general level of brokerage rates remain too high. Another significant component of transaction costs is the execution spread. Block trades and portfolio specials have developed as brokers have deployed their own capital to facilitate a smooth cost-effective transition of portfolios at a known price. Recent years have seen the emergence of competition to the Australian Securities Exchange (ASX). Chi-X, Liquinet and so-called 'dark pools' algorithms run by traditional broking houses allow institutional investors to trade anonymously and at lower costs in the Australian market. Many of these alternatives are essentially IT platforms that allow (at a low cost) interested sellers and buyers to indicate their desire to trade certain volumes at certain prices and which then match these sellers and buyers without any human intervention. Currently a small percentage of the Australian market turnover is traded this way. In Australia, all such trades — like all traditional transactions — are recorded at the ASX. This so-called 'one-tape' policy, allows all market participants to see the volumes and prices traded.

Using futures over trading shares

An assessment of the direction and magnitude of any movement of the share market over an elected futures period is clearly vital. Once the assessment is made, the advantages of using futures over trading physical equities are: • lower transaction costs • high leverage • ability to gain an appropriate spread across stock and market factors • rapid change in portfolio required, often for a short period • no need to choose individual stocks as there are futures contracts not just for individual stocks but also the entire market • additional liquidity.

Risk and return differentials

Any return differential has to be considered in light of the risk that was taken to achieve that extra return. The key questions to ask are: • Has the average active manager been able to outperform the index in the past, on a risk-adjusted basis? • If so, will this continue into the future? • Is it possible to select a manager who will, on average, outperform the average manager on a risk-adjusted basis?

Risk management

Equity managers must consider risks at the portfolio level as well as investment risks associated with individual securities. In addition there are a number of other risks which an equity manager must consider. These have been grouped under: • operational risks • environment, social and governance (ESG) • policies and behaviours.

Passive versus active equity management

Equity portfolio management can be described as either active or passive. Passive management, or indexing, started in the US in the early 1970s with Vanguard being an early key advocate in this field. The aim was to track the performance of the benchmark index as closely as possible, rather than spending a lot of money on research in an effort to beat it. As the name suggests, passive management involves building a portfolio to replicate an index and then largely leaving it alone. Other than adjustments when the composition of the index changes, or the size of the fund changes, it is basically a buy and hold strategy. Active management involves actively managing a portfolio and, through superior research or skill, aiming to achieve a result above the index. A passive portfolio seeks to match the index whereas an active portfolio seeks to beat it.

Example: Option strategies

If a manager has $2 million to invest and wishes to purchase some BHP Billiton (BHP) shares, instead of outlaying the total $2 million on purchasing some 50,000 BHP shares at $40.00 each, the manager could purchase 50 three-month $40.00 call option contracts (1000 shares per contract) at $1.30 for an outlay of $65,000 and invest the balance of $1,935,000 in the money market.

Example: Option writing

If a manager has 250,000 BHP shares in a portfolio and believes the share price of $40.00 could go down but is not prepared to sell the shares (perhaps for tax reasons), the manager could protect their downside somewhat by writing (selling) 250 $40.00 call option contracts at $1.30 and therefore generate $325,000 in income. It should, however, be noted that to achieve this increased protection a manager accepts a reduced opportunity for profit if the shares go above $40.00.

Environment, social and governance

Integration of ESG involves the following steps: • ask for corporate disclosure on ESG (about a quarter of the top 500 companies in Australia produce a sustainability report) • encourage companies to manage ESG risks and opportunities • explore ways to integrate ESG analysis in investment decision-making • retain proxy and governance advisers (such as GovernanceMetrics International) and specialist environmental advisors (such as Trucost), to assist in the monitoring and assessment of ESG issues. ESG factors need to be viewed as part of the business case. Factors such as how the ESG risks are managed and opportunities utilised can have an impact on value and on the stock price. Interestingly, research has highlighted that ESG strategies might outperform their respective benchmarks (Zoltan et al. 2015). This study, based on the global equity market, shows that a significant part of the sample outperformance was not explained by style factors, and thus may have been attributable primarily to ESG factors. However, some of the less significant active factor exposures were quite stable and persistent, and thus also contributed to the performance of the portfolios.

Company stock specific

Management Management factors include its strategic direction and corporate governance, experience, expertise, teamwork and track record. Market position When evaluating market position, considerations should include maintainable market share, pricing power and maintainable corporate earnings. Operating leverage The extent to which sales, and therefore earnings, respond to changes in the economic environment via changes in labour and capital productivity is significant in evaluating a company. Financial leverage Financial leverage is shown by the extent to which operating leverage is magnified by the fixed or variable cost of debt financing, and the impact of this leveraging on capital adequacy under the various economic and operating environments. Solvency Solvency (or insolvency) is the ability/inability to meet current monetary obligations with existing cash flows and/or lines of credit.

Capitalisation of earnings — PE ratio focus

Market practice in relation to earnings capitalisation factors tends to focus on price-to-earnings ratios (PE ratios). A company's PE ratio is simply the ratio of a company's stock price to its earnings. Similarly, the calculation of the market's PE ratio is simply the ratio of the market's earnings (as calculated by reference to an earnings series based on a representative basket of stocks in an index, e.g. the S&P/ASX 200) relative to the price level of the index. The selection of an appropriate PE ratio for application to a company's earnings will therefore be influenced by the market average PE ratio and the stock-specific factors that suggest a higher or lower PE for the company. While the calculation of current PEs is a simple matter, the determination as to whether the current PE multiples are appropriate requires further analysis. Many market participants will review PEs in the context of historical observations. However, at any point in time the 'P' and the 'E' are subject to variables of interest rates, inflation and the economic cycle. Therefore, any objective analysis of historical PEs requires certain adjustments to the raw PE data series to enable comparison of historic PEs on a 'like' basis. For example, in the calculation of an index PE, say the All Ordinaries, adjustments can be made to the underlying earnings series to allow for the impact of the economic cycle (e.g. exclusion of loss-making companies in the index averages) and to allow for the quality of earnings (e.g. more relevant operating earnings versus accounting book profits). If one adjusts the index series for these factors, then historical observations of index PEs can be undertaken on a basis using comparable data. Similarly, one can observe a close correlation between earnings yields (the inverse of PEs) and bond yields. This is hardly surprising, as one would expect that a move to lower interest rates on risk-free securities would result in a move to lower required returns on riskier assets such as shares. The theoretical basis for identifying the appropriate discount or capitalisation (cap) rate for each company is frequently discussed in connection with the capital asset pricing model (CAPM), which draws on the concept of a risk premium for each stock over the risk-free return. Within the CAPM this risk premium depends only on the systematic risk of the stock (the beta). Refer to Topic 2. On completion of asset valuations, one can compare the assessed value with the current market price. The difference between the two values represents a measure of mispricing. Accordingly, one can then rank companies ('stock ranking') in terms of relative mispricing to identify at any one time stocks that appear overvalued or undervalued and rank them from most overvalued (currently least attractive investments) to most undervalued (most attractive). Similar value comparisons can be undertaken by using other criteria such as price/book, or by using variants of PE ratios such as price/cash flow, enterprise value/sales and enterprise value/EBIT. Price/cash flow is a particularly popular metric as it focuses on cash flows available to the company rather than accounting earnings which include non-cash accrual adjustments some of which are somewhat subjective and can distort earnings relative to the cash actually being generated by a company.

Global equity market indicators

One of the most commonly used measurements of the overall market opportunity set is provided by Morgan Stanley Capital Index (MSCI). MSCI provides for example the MSCI World ex Australia index for Australian investors who already have a separate domestic allocation to Australia and wish to allocate to other developed markets, or the MSCI All Country World index (ACWI) which also includes emerging markets. This is a common index used by global fund managers and other investors to allocate capital to stocks around the world. Given that institutional investors are increasingly measured against their performance relative to the MSCI benchmark, it is a hugely influential guide to the relative capital attractiveness of equity markets around the world.

Buyers

SPI futures could be used by buyers to: • establish an asset allocation position more quickly and less expensively than by purchasing physical (futures contracts have lower transaction costs than physical securities). • implement a position quicker than buying physical securities as this makes the futures market particularly attractive for positions expected to be held for a short time only • access the extra liquidity available in the futures market • release cash by selling shares and replacing with futures • speculate on a rising market • take advantage of futures mispricing/arbitrage opportunities (i.e. futures prices too low relative to the S&P/ASX 200 index) .

MSCI All Country World index (ACWI)

The ACWI represents the performance of small- to large-cap stocks from developed and emerging markets. The index covers approximately 85% of the global investable equity opportunity set, tracking around 2,500 stocks. As can be seen from Figure 1, the US and information technology remain the dominant country and sector as the top 10 shares by market capitalization include Apple, Microsoft, Facebook, Amazon, Johnson & Johnson, Exxon Mobil, JP Morgan Chase & Co., Alphabet, Wells Fargo & Co., and Bank of America. The top 10 companies account for a total free float adjusted market cap of over $4 trillion, or about 10% of the total market cap of the index.

MSCI Quality Indices

The MSCI Quality Indices for example, identify quality as a combination of ROE, debt-to equity ratios and earnings variability. This is defined as the standard deviation of year-over-year earnings-per-share growth over the previous five years. The S&P Quality Rankings although proprietary, are known to be comprised of earnings and dividend metrics. Asset managers such as AQR Capital Management have extended the work of Novy-Marx to include total profits over assets and gross margins plus free cash flow over assets. Finally, there is the F-score developed by Piotroski (2000), and which has gained widespread use and which utilises nine metrics including net income, operating cash flow, return on assets, stability of earnings, leverage, liquidity issuance, gross margins and asset turnover.

Benefits of passive management

The key commercial arguments for passive management are: • lower investment management fees • lower turnover leading to lower transaction costs (both in terms of brokerage and buy/sell spreads and through the deferment of capital gains tax liabilities). Most long term active fund managers would have at least 25-30% stock turnover p.a. with many having around 50% per annum. Quite a number of fund managers can have turnovers of 100% or even greater (especially hedge fund managers). This would be considered a very high level of turnover • lower risk of significant underperformance relative to the index. It should be noted that active management does not necessarily add to the overall volatility (absolute risk) of returns.

Purchase of an option as an alternative to the physical share

The purchase of a call option enables the buyer to control the number of shares covered by the option. During the period of the option, the price may increase, giving the buyer the opportunity to either exercise and take up the shares covered by the option or sell the option as a closing transaction, hence realising a profit or loss. This, of course, is dependent on the performance of the underlying security's share price.

Option writing to hedge a position

To provide protection in the event of market decline, an option writing (selling) program may be used in conjunction with a stock portfolio. Managers may hesitate to liquidate their portfolio even in uncertain market conditions, as they feel that the market will eventually move in their favour. One way that call options can facilitate the achievement of a long-term stock objective is by providing partial protection against an anticipated decline through the writing of scrip-covered options.

Active fundamental management investment styles

Within a framework of a particular investment style, a manager can utilise a process that is driven primarily by investment research focused on individual companies (referred to as a 'bottom-up' process or stock picking) or one informed more by macro-economic, strategic, demographic or thematic considerations (a 'top-down' process). In real life, bottom-up analysis is significantly more popular than top-down processes. Some bottom-up stockers include a partial top-down process but most do not. Returns analysis based on style may provide a better indication of a manager's ability to add value than a broad market benchmark. In short, it can illuminate whether an investment manager has added value because they are making value-adding investment decisions, or whether their apparent good performance arises from the mere chance that their particular style is performing well compared with the overall market. Style analysis provides for more accurate manager evaluation, in that managers are not rewarded or penalised for making a consistent and logical style bet.

3 competitive advantages for companies

• cost leadership — when 'a firm sets out to be the low-cost producer in its industry. Low-cost producers typically sell a standard, no frills product and place considerable emphasis on reaping scale or absolute cost advantages from all sources' (pp. 12-13) • differentiation — when 'a firm seeks to be unique in its industry along some dimensions that are widely valued by buyers. It selects one or more attributes that many buyers in an industry perceive as important, and uniquely positions itself to meet those needs' (p. 14) • focus — when 'the focuser selects a segment or group of segments in the industry and tailors its strategy to serving them to the exclusion of others' (p. 15).

Momentum approach

'Momentum' investment is based on the notion that if one can identify strong price trends (and also strong earnings trends) in a security, there is the possibility of making abnormal returns based on the likely persistence of these trends. The proposition that securities that have risen in price will continue to do so over the short-term is supported by academic research. However, over the medium or longer terms means that reversion appears to be the norm (stocks whose price has risen strongly tend to eventually underperform and vice versa). A pure momentum-based investor will incur very high turnover costs, due to the very short-term nature of the effect to be exploited (portfolio turnover can often be over 100% p.a.), and is susceptible to sudden swings in market sentiment.

The futures market

A futures contract is a legally binding agreement calling either for the forward delivery of a specified asset (e.g. equities) at a specified future date at a fixed price, or cash settlement, when a physical commodity is not involved. The crucial element of the futures contract is the separation of the timing of a transaction (contract is entered into now) from the price (price is determined today and applies at the end of the contract expiry period) attaching to it. Hedger When the party is concerned in carrying the physical transaction and takes out a futures contract to ensure a locked in or fixed price at delivery (contract expiry), then the party is considered to be a 'hedger'. Speculator The second major participator in the futures market is the 'speculator' whose aim is to profit by correctly predicting price movements (taking a view). The speculator affects this objective through leverage in the market, (i.e. investing only a nominal sum — deposit of approximately 2-5%) in relation to the value of the transaction on final settlement or delivery. The speculator, in effect, bears the risk that the hedger is attempting to avoid by taking the opposite side of the transaction.

Use of variables

All fundamental-based active investment managers will, to a greater or lesser extent, take account of these factors during their daily research routine. The issue is whether (and how) these factors are incorporated in the decision-making process on a consistent, disciplined and timely basis. One further note of caution: the basis for confidently expecting strong returns from equities over the long term is based on the past long-term performance relationship between equities and risk-free assets. Short-term market performance can be very disappointing, and such underperformance can be exacerbated by the market's over-reactions to seemingly good or bad news relating to this performance. In this sense it is can be stated that the 'fundamentals' have disconnected from the 'market'. This means that the expected /forecast/assessed fundamental value of a company is deviating significantly from the actual, current share price. This can result in stocks being temporarily oversold (price fallen too low) or overbought (price increase too high). A disciplined investment approach consistently applied over the long term is more likely to benefit from expected long-term market moves as fund managers take advantage of those short-term pricing situations when the assessed fundamental value deviates substantially from the share market price.

Foundations of Factor Investing

An investment factor is any characteristic relating to a group of securities that is important in explaining their return and risk profiles. A large body of academic research highlights that long-term equity portfolio performance can be explained by these investment factors. This research has been prevalent for over 40 years. Certain factors have historically earned a long-term risk premium and represent exposure to systematic sources of risk with factor investing as an investment process looking to harvest these risk premia through exposure to the relevant factors. 'MSCI currently identify six equity risk premia factors: value, low size, low volatility, high yield, quality and momentum. These factors are grounded in academic research and have sound explanations as to why they historically have provided a premium. In addition, MSCI has created a family of factor indexes that are designed to reflect the performance of those six equity risk premia factors. In turn, indexation has provided a powerful way for investors to access factors in cost-effective and transparent ways. Factor allocations can be implemented passively using factor indexes, which may bring potential cost savings to institutional investors. Furthermore, factor indexes bring transparency to factor allocations, which helps alleviate the well-known problem of manager style drift and has positive implications for risk management. We note that factor indexes should not be viewed as replacements for market cap indexes. Market capitalisation weighted indexes represent both the opportunity set of investors as well as their aggregate holdings. Market cap weighted indexes are also the only reference for a truly passive, macro consistent, buy and hold investment strategy. They aim to capture the long-term equity risk premium with structurally low turnover, very high trading liquidity and extremely large investment capacity. In contrast, factor indexes rebalance away from a neutral market cap starting point. As such, they represent the result of an active view or decision. Investors must form their own belief about what explains the historical premium and whether it is likely to persist. Factor returns have also been highly cyclical. These systematic factors have been sensitive to macroeconomic and market forces and have underperformed the overall market for long periods of time. However, they have not all reacted to the same drivers and, hence, any one of them can have low correlations relative to other factors. Diversification across factors has historically reduced the length of these periods of underperformance. Thus, the MSCI Factor Indexes provide building blocks that allow investors to assemble multi-factor allocations based on their preferences for performance and risk, their investment beliefs on individual factors, and their investability constraints.'

Financial forecasts and fundamental evaluation

Based on the above information and after consideration of the above risk variables, estimates can be made of the likely: • size and direction of corporate revenues, margins and interest rates • earnings (profits), cash flows and dividends of a company • financial condition of a company's balance sheet (i.e. gearing). Note that in deriving these estimates, fundamental fund managers will aim to forecast long term, maintainable or 'sustainable earnings'. This means looking beyond any short term factors (temporary weakness in sales, one off cost impacts, etc.). The reason for this is that fund managers typically take a longer term view/have a long term investment horizon. Fund managers typically state their forecast (and investment horizon) as being at least 2-3 years with 3 years being the most common, for others it is up to 5 years. In addition to forecasting the financial performance of the economy, industry and company, any fundamental assessment of a company's value must also be informed by the factors that translate the financial performance into asset values (i.e. forecasts for the value of the company and thus its share price). Furthermore another important factor is what the expected earnings are worth (i.e. how much should an investor pay for the forecast stream of earnings over time)? Some of the better known methods of calculating these asset values using the above earnings, cash flows and dividend information include: • capitalisation of maintainable earnings • dividend discount model • discounted cash flows (DCFs).

Contrarian investing

Contrarian investing is an investment style based on the premise that a stock or market is not going to move in the direction that is anticipated by the majority of market participants. Contrarian investors are independent thinkers who tend to move against the crowd and aim to exploit Behavioural Biases (e.g. the herding of crowds, anchoring on the past). The contrarian approach is based on a belief that fundamental analysis and technical analysis tend to create a consensus approach to values, which is not always accurate. The idea is that stock prices are sometimes beaten down for reasons that do not correspond with a firm's long-term earnings potential. Conversely, stock prices are sometimes inflated based on 'hype' that exceeds a realistic assessment of a firm's long-term earnings potential. Consequently, contrarians bet against those popular investment trends that appear, to the contrarian, to have gone too far. This approach shares some overlap with value investing but tends to be a more extreme version. Contrarians typically need to have very strong conviction in their belief — that they are right and the majority of participants have made errors in their thinking. They also typically need to be prepared to keep these contrary convictions (not falter) for an extended period of time as it can take several years for the market to correct its thinking and come around to the contrarian's view. Thus contrarian investors (like value investors) will typically buy into a stock early, sometimes several years early, (i.e. well ahead of a recovery in price). Thus, it is often said that contrarian (and value) investors can 'appear to be wrong for a long time' until the market comes around to their viewpoint.

What are you looking for in Brokers?

Expectations from brokers need to be clear. For example, is it ideas (buy/sell) from the dealers and analysts that is needed; or information (spreadsheet models, earnings forecasts etc.)? The client should not accept what is not wanted. Bear in mind, however, that some brokers are good at ideas; others are good at providing information; and others are strong on dealing and finding stock. Organisations should shop around and find brokers whose strengths most closely fit its needs. As well, dealers within any given broking house will have different ways of working and some will more closely fit the organisation's style than others. If the organisation is not getting on with one contact, it can always ask to try someone else. One further point to bear in mind about stockbroking firms is that they enjoy significant returns to scale. They can afford to employ some of the best stock analysts in Australia, because they are servicing the entire funds management community. In placing orders with brokers it should be remembered that brokerage rates are negotiable and should be negotiated to arrive at a mutually satisfactory rate. Orders can be placed with price limits or on any other agreed basis. Brokers commonly deal both as agent and as principal. Under ASX rules all principal dealings by brokers are required to be disclosed at the time of the transaction and must be conducted at a 'net' price (no brokerage charged). There are computer programs available to monitor the effectiveness of brokers and dealers in the execution of their business.

Active equity management

For active management to be worthwhile, it needs to add enough value to offset the combined impact of the advantages of passive management listed above, in particular the much higher active management fees. The crux of the matter is whether or not this is a reasonable expectation. Active equity managers need to have a very clear rationale for the strategy they are using. They are taking a position based on the belief that the market is, at times, inefficient in a way that they can determine and exploit. They need to be confident that their relative return will be positive after costs. Remember, for one manager to systematically outperform, the average of everyone else must underperform and this is before costs and fees are even considered (i.e. gross relative returns). It is quite possible that, because of superior research and scale economies, an institutional manager can fairly consistently outperform other investors in the market. On the other hand, these other investors (e.g. central banks, sovereign wealth funds, individual investors) may be relying on superior flexibility, the lack of short-term performance pressures and the absence of committee-based decision-making to consistently outperform the traditional institutional managers. Consider also that within the broader investment community, some investors of large portfolios may outperform the major stock indexes, while many others underperform. Some studies in the US have indicated that as few as one-quarter of professional managers have, over the last two decades, outperformed the relevant index (Vanguard 2017 - see the Vanguard study below). Clearly all investors cannot outperform the market average. As well, because of the existence of brokerage costs, the average investor in the market must, by definition, underperform the market overall. While a survey of a limited number of participants may well show a general outperformance of an index, this could not be so for all investors in the market overall. Indeed, on occasion, all managers in a particular survey may exhibit underperformance and, as a consequence, the industry may witness periodic bouts of investor disillusionment. Against this pessimistic view of professional management are the facts that the presence of retail investors, possibly less well-informed foreigners, corporate players with strategic motives and the actions of S&P in constructing the index itself, all in principle, provide ways for the professional investors to beat the index.

Reasons for investing offshore

For most large institutional investors, an allocation to overseas shares is preferred as Australia represents only 2% of global market capitalisation and may have insufficient market capacity for them to invest. Given their larger fund size this provides diversification in terms of additional economies and industries, as well as the potential to invest in high growth through emerging markets like China and India. It also provides additional choice of stocks and styles for active management. However, for retail and SMSF investors, these often tend to have a domestic bias as they like franking credits, are more familiar with domestic stocks which are often in protected industries. Also they may prefer not to have exposure to currency or low growth economies like Japan. In addition, they view the Australian market as less efficient than e.g. the US market, thereby offering additional reward for stock selection.

Fundamental analysis

Fundamental or qualitative analysis operates on the premise that all stocks have inherent determinable values that are frequently but temporarily incorrectly priced by the market. The fundamental analyst will therefore evaluate stocks with a view to determining which stocks are at any point mispriced and therefore represent attractive investment opportunities. Implicit in the approach of fundamental assessment or evaluation of a company is the capacity to quantify the expected returns from an investment. Such quantifications of expected returns lend themselves to a ready comparison with returns expected from other stocks as well as other asset classes including cash and bonds. The fundamental analysis of company values has been around for decades and was popularised by the text of Graham and Dodd (Security Analysis) published in 1934. Fundamental analysis involves both an assessment of a company's financial performance and a valuation of that performance. At the end of the research process, the fundamental manager essentially makes a qualitative judgement call on the company (e.g. buy, sell, hold), in other words, the manager makes a professional assessment by weighing up all the facts and forecasts of their research. A fundamental manager is only as good as the research that lets them identify opportunities in mispriced securities. Given this extensive use of research, it should add to the effective cost of managing the fund

Value of technical analysis for fund managers

Furthermore, given the strong academic evidence against technical analysis, wholesale/institutional investors in particular are unlikely to be comfortable with a purely or predominantly technical analysis-based approach. What, then, is the value of technical analysis to the fund manager? Cross-check Firstly, in their simplest form, charts are a cross-check against the fundamentals. If the supposed facts are very positive for a particular share, share market or commodity, yet market values continue to plummet, this points to the need for a closer inspection of so-called 'facts'. The converse is also true where a market shows far more positive signs than expected. Relativities Secondly, fund managers can use charts to bring out the relative performance of, for example, stocks, sectors and share markets. Changes in direction Thirdly, charts correctly presented on a log scale will signal changes in direction. These are particularly important where longstanding trends are broken which may signify exhaustion or the beginning of a recovery. Market behaviour and timing of transactions Fourthly, charts may help fund managers to determine entry and exit points and the possible extent of market moves, and to gain an appreciation of the typical behaviour of a particular price series. For example, a value manager may have recently become interested in a stock because it has seen a sharp fall in its share price. The manager believes the stock has been oversold and is good value. However value managers have a tendency to invest to early and buy into a falling price trend (negative price momentum) as the stocks they are typically attracted to have fallen out of favour with the market. However, if technical analysis suggests there is likely to be more heavy selling pressure (i.e. more negative price momentum) the value manager may choose to be patient and wait a bit longer before investing. While technical analysis (or charting) continues to be used in the marketplace, it is worth noting that few, if any; professional managers would attempt to advertise their funds today on the basis of technical analysi

Macro-economic factors

Growth General levels of current and future economic activity have an impact on corporate profit share and profit growth. Note that over a number of decades, corporate profit share has fluctuated very roughly in line with real growth in the economy, while in the long run the stock market indexes fluctuate around the long-term upward trend in earnings (profits) per share. Any evaluation of economic activity at a macro level needs to take account of sustainable trend growth rates, including the relationship between savings and investment (the external balance) and any resultant growth constraints, position in the economic cycle (above or below trend output) and impact of fiscal and monetary policies. Inflation It is worth noting here that while inflation works against equities in the short term, as investors react to the lower quality of earnings and potential impact of higher interest rates, the risk of inflation can also destroy the attractiveness of bonds as a long-term store of wealth. Owners of equity will, over the long run, be insulated from the erosion of value by inflation due to their ownership of real assets within a company whilst bonds and cash (except inflation linked bonds) are nominal assets and their valuations are more detrimentally eroded by inflation. Interest rates It should be noted that there is a linkage between the level of economic activity, inflation and interest rates. Changes in the level of interest rates (in particular through monetary policy actions of the Central Bank) can affect the overall level of economic activity (feedback loop) and also, where debt financing is used, can impact on pre-tax earnings.

GARP investing

Growth at a reasonable price (GARP) is an investment style that tries to combine the best of both worlds from the value and growth investment styles. GARP investors look for businesses with a strong growth profile, but will only buy them if they are available at a reasonable price. One of the difficulties with this approach is that a manager may buy a stock which has a strong (but reducing) growth rate and the market may punish the company for a lower growth rate (i.e. price falls). The manager may see it as an opportunity to pick up a growth stock for a good price however, with time, the price sometimes falls even further if it company continues to disappoint the market with its lower growth rate (often the growth rate falls further).

Growth investing

Growth investing involves selecting stocks with good growth potential. Growth investors emphasise higher than average compounding growth in earnings or assets. In other words, a growth investor will focus more on future earnings. Growth investors are focused on future potential with much less concern for the current price. Metrics that a manager may emphasise in their investment process include forecast EPS (earnings per share growth), forecast sales growth, sustainable growth, PEG ratio (price to earnings growth). A key issue with this approach is that the manager needs to be wary to not overpay for the growth opportunity. Growth stocks are often the darlings of a market and seen as 'glamour stocks'. As stocks continue to produce good growth in profits (i.e. good profit results above expectations, otherwise known as a positive earnings surprise or positive earnings momentum ) investor expectations increase and expectations are for an even better result next time (i.e. to not disappoint). A series of positive earnings surprises and strong earnings momentum means these stocks experience very good price growth (i.e. strong positive price momentum). These stocks can be then priced to perfection and if there is a negative earnings surprise the share price can be punished dramatically. If the price falls dramatically and is considered a temporary fall, the stock may become attractive to a GARP investor (see next section). Good examples of growth stocks in 2015 included US and European Healthcare stocks and US information technology companies — one of the clearest examples being Apple. Growth stocks are more typically found in sectors with strong innovation or high R&D spending.

Piotroski F-score

He defined quality by developing a scoring for stocks on nine metrics. Each metric that is met is scored one point as a sign of quality, and if it is not met then zero is assigned, as this would be the sign against quality. The scores are aggregated to a score out of nine for each stock with a higher score, indicating higher quality. The nine individual measures of the Piotroski F-score are detailed below to provide insights into the measures that are regarded as relevant when assessing equity quality: 1. current year positive return on assets 2. current year positive operating cash flow 3. higher return on assets in the current year than the return on assets in the previous year 4. cash flow from operations greater than net income (this is a measure of accrual discussed below) 5. lower ratio of long term debt to assets in the current year compared to the previous year 6. higher current ratio this year compared to the previous year, a liquidity measure 7. no new shares were issued in the last year 8. a higher gross margin compared to the previous year 9. a higher asset turnover ratio compared to the previous year. His investment strategy is simply to select value stocks with high F-Score signals. He found that high F-Score value stocks beat the market by 13.4% per year versus 5.9% for the entire value quintile. This means that the high F-Score value stocks beat the average value stock by 7.5% per year (13.4% less 5.9%). The high F-Score value portfolio also contains a higher proportion of winners than the average portfolio. Clearly the F-Score discriminates between eventual winners and losers. Piotroski's F-Score is therefore a useful and intuitive metric for value investors. The resulting returns to cheap, financially strong stocks are outstanding, albeit limited to stocks with small and medium market capitalisation.

The influence of the US market

Historically, the Australian share market has often followed the lead of the US share market, whether that be in daily, weekly, monthly, quarterly or annual terms. One reason why the US plays a dominant part in local share price trends is because it is by far the largest stock market in the world and is considered a leader in financial and technological innovation. In addition, the US remains the largest economy in the world, ahead of China and Japan. Secondly, US companies are among the largest in the world and often have a global reach (e.g. Microsoft, Apple, Exxon Mobil, Ford Motor, General Electric, Coca-Cola, Microsoft, Walmart, etc.). Thirdly, sentiment and trends in the largest market in the world are easily transmitted each morning to all other markets.

Selling shares/purchase of options

Holders of stocks who are nervous about the state of the market could adopt the following strategy: • sell the shares • purchase call options • place the balance of funds in the money market. There are many other strategies available in the options market.

Settlements

In Australia, settlement is conducted electronically using the CHESS system on the second working day after the date of the trade (T+2) although T+1 trades can be booked in special circumstances.

Conclusions on portfolio management strategy

In summary, over the last five years the actual performance evidence shows the average Australian share manager has added enough value to justify themselves as an alternative to passive management. The task for an active manager is to convince clients that the methods and procedures applied will deliver consistent and superior risk-adjusted, long-term performance in the future. However investment textbooks would 'academically' suggest that beating the market is a zero-sum game (in fact a negative-sum game after transaction costs are taken into account). For every winner there has to be a loser. Similar analyses based on data for US equity managers have shown that, over the longer term, the median US equity manager will tend to underperform the index by a margin roughly equal to transaction costs. The US market is a highly efficient market.

Risk of equities

It is worth reviewing the fundamental reason for the higher risks of equities. Equity holders (share-holders) hold the residual value of a company (last claimant to get paid out of cash flows) and thus experience much greater volatility than debt holders, who have the first claim to any cash flows. Note that: • equity returns are not bounded on the upside • equity holders can lose large parts or all of their value • debt holders will lose any money if the asset value falls below the debt value — this event has the special names of bankruptcy or corporate insolvency. There is no equivalent special term to describe losses by equity holders — instead equity losses are a normal part of markets and business.

Topic learning outcomes

On completing this topic, students should be able to: • discuss the main characteristics of equities as an asset class • analyse the different investment styles for managing an equity portfolio • describe the risks associated with investing in equities • analyse the risk management techniques to manage the risks of investing in equities • discuss current trends and developments in the equities asset class.

Operational risks

Operational risk is the risk that deficiencies in the effectiveness and accuracy of the fund manager's information systems or internal controls result in material loss. Care must be taken to ensure that all transactions are authorised and that decisions are implemented on a basis that is consistent with the rationale for the initial decision. It encompasses delegation of functions and clear definition of relationships between the investment professionals within an organisation. Contingency plans, in particular a disaster recovery plan, should be in place to ensure that business continuity is not impaired by any systems failure.

Influence of China

Over the last few years the link to the US market has weakened somewhat. While the Australian market still often follows the daily ups and downs of the US, news from China increasingly influences the direction of the local market. Indeed, China's influence over all global markets is rapidly increasing and even the direction of Wall Street is now sometimes strongly influenced by events in China. Developments in China are of particular relevance in the Australian share market. This is because of the importance of China to the Australian resources sector (since this sector is a significant component of the Australian Stock Exchange and the Australian economy). In addition, the US and Australian monetary cycles have somewhat diverged. After the Global Financial Crisis, the US deleveraged and restructured, whereas Australia avoided a recession, but for example did not deflate the housing bubble.

Technical analysis

Technical analysis, also known as charting, might be simply described as the study of historical price and volume data and their derivatives. The object of this is to predict future market behaviour at the micro or macro levels. It is applicable wherever there are freely traded markets, be they shares, commodities and currencies, options or futures contracts. The underlying theory of this approach is: • the price/volume relationships/patterns (often given names) give a clue to inherent price strength or weakness (i.e. clues about future price momentum) • price series describe trends and patterns from which certain conclusions can be drawn on an empirical basis. It must be noted that these basic premises of technical analysis are inconsistent with the weak form of the efficient market hypothesis, which has found widespread support in the academic literature on investment markets. Technical analysts range from purists to those who believe that charts are one useful tool among many in making investment decisions. For the purist, all that needs to be known about markets is revealed in the charts. Any fundamental information impinging on, for example, the nature of a company's business or its financial statements and management forecasts, or the price-to-earnings multiple, yield or asset backing of the inherent shares is worthless baggage that has no value in price forecasting. Technical analysts generally belong to groups of believers in particular systems or methods. These include those who hold that markets follow readable paths. Examples of this are: • the patterns described by Edwards, McGee and Bassetti (2007) in Technical analysis of stock trends • the intricacies of the Elliott wave principle • the work of Gann • the derivatives developed by Welles Wilder (1978) in New concepts in technical trading systems and others). However, many chart watchers are content to simply follow the development of trends, being aware of the relative strength of, for example, one share to another or to the market, or one commodity to another. Technical analysis tends to have more influence in the futures markets than the physical because of the rapidity of trading in futures and the absence of minute-by-minute changes in the underlying fundamentals influencing commodities, bonds, foreign exchange and share index contracts.

The options market

The Australian options market provides private and institutional investors with the opportunity to deal in options in selected stocks, similar to trading in other securities. The investor is provided with a secondary market, enabling the investor to achieve a variety of investment objectives through the use of options trading. There are numerous strategies available to investors and portfolio managers in the options markets. Options may in fact be exchange-traded or OTC in nature. The main option exchange in Australia is the Australian Securities Exchange. Options available to trade include index options, equity options, interest rate options, energy options and agriculture options.

Code of ethics

The Financial Services Council (FSC) Code of Ethics & Code of Conduct provides a useful overview of some critical issues relating to professional conduct, client relationships and investor protection. Key issues to be addressed by investment managers are: • professional standards, integrity and financial resources • management agreements, mandates, record-keeping, client reporting and custodian arrangements • performance measurement and reporting • dealing and use of derivatives • advertising • insider trading and 'Chinese walls' • compliance issues and monitoring. The Code is designed to be a practical minimum standard for fund managers. It is important to take the time to become familiar with it.

Share Price Index (SPI) futures

The SPI futures contract is based on the Australian Securities Exchange's S&P/ASX 200 Index, the most widely accepted proxy for the Australian share market. As a substitute for holding shares, the SPI futures provide a mechanism whereby portfolio managers, who are exposed to the share market, may manage risks from price changes. Managers may find it difficult to change share market exposure quickly without affecting the level of the market. SPI futures enable this to be done quickly and efficiently at low cost. Hedging Portfolio managers can in theory hedge against a general market fall by selling SPI futures (short futures) with equal value to that of their existing portfolio currently held (long equities). In the event of a fall, their portfolio losses would be offset by futures gains, and vice versa if the market rose. (i.e. the price movements of the short futures exposure offsets the long equities exposure). A manager can make this asset allocation move a lot less expensively as the transaction costs on the future contract will be a lot lower than physically liquidating the equities. This is especially the case if the manager thinks the general market fall will be a short lived event as it could then also incur additional transaction costs if it decides to rebuy the securities after the market fall. The transaction can also be implemented a lot quicker than physically selling the securities. This is particularly important if the manager thinks the general market fall is imminent.

Quantitative style

The advent of more powerful computers in the 1990s led to the development of a new investment style called 'quantitative' (or quant for short). This investment process originated with academic work carried out at UCLA. Using a statistical approach, it attempted to explain share price movements on various exchanges using long data series of, for example: • the following explanatory variables company earnings • book values • earnings revisions • earnings momentum • PE ratios • price to cash flows • price to net tangible assets (NTAs). One of the significant conclusions of this work was that some of these factors (e.g. the low PE ratio used by value investors) have in the past been statistically significant predictors of superior share price performance. This led to the emergence of 'quant funds' (both in the US and Australia), which employ factor screens to identify stocks that appear attractive investment opportunities based on the manager's selected criteria — the criteria are typically called factors. Often managers use a 4 factor model that incorporates the following factors/variables/criteria — value, growth, momentum, quality. For each factor they will typically select multiple quantitative measures/ratios to represent each. The attraction of such 'black-box' models is that they completely eliminate human subjectivity and dispense with the expense associated with traditional fundamental analysis. Critics point to the dangers, however, of a stock selection model that is not informed by detailed forecasts for a company, industry and economic analysis. thus relies on statistically estimating historical relationships based on time series analysis and assuming those relationships continue into the future. Another critique is that factors chosen will initially seek to work, providing 'positive alpha' signals or positive alpha scores (i.e. statistically significant in producing positive outperformance). However, as the metrics become more widely adopted by the quant investment community, the 'signals' fade and become immaterial, no longer producing positive alpha. Thus it is extremely important for successful quant funds management, that a quant manager has a strong research agenda — continually testing the effectiveness of its existing signals, dropping those that lose effectiveness and finding new signals.

Quality investing

The concept of quality has been deeply entrenched in other asset classes for decades. How this idea relates to stock selection has received considerable attention recently as an alternative to growth and value strategies. The thinking has been to augment value strategies (which are largely based on financial metrics as an initial filter) with a further set of quality attributes. The major issue that arises is what set of attributes constitutes quality? Further questions: • Are all definitions of quality equal and what constitutes the 'best' definition of quality? Is quality a reliable predictor of equity returns? • Is there a rational explanation for why investors should be rewarded for holding high-quality stocks? • Are the returns to quality investing consistent or are they highly period specific? • Should index investors be concerned about quality? Unlike other equity factors such as value or size, there is no generally agreed definition of what constitutes quality from an equity investor's perspective. Although the intuitive notion is that high-quality companies should have better overall performance than low-quality companies, their differentiating characteristics are open to debate. Despite years of research investors have made little progress in developing a core theory of equity quality. Practitioners and academics alike often simply relate quality to some measure of profitability which they believe to reflect quality outcomes. Examples include: • Novy-Marx, who define profitability as the ratio of gross profits (revenue minus cost of goods sold) to assets • Fama and French who use the ratio of equity income to book value. This is approximately in line with Dimensional Fund Advisors's direct profitability measure, defined as operating income (before depreciation and amortisation) minus interest expense (scaled by book value). Numerous other authors and asset managers simply equate quality and profitability to return on equity (ROE). However, more recently the discussion has moved to extend beyond a single quality measure based on a single profitability measure in to a multi-factor definition.

Brokers

The first question that needs to be addressed is: how many brokers to talk to? One approach is to try to talk to everyone, to get on all their mailing lists and to do as much research as possible. However, if the custom is spread over every available broker, it is unlikely that a particularly close or beneficial relationship will be built with any one of them. Some institutions use a panel system. This involves selecting the five or six brokers who are found most helpful. It is then sensible to deal only with them. Such a panel system is manageable, encourages brokers to work hard (to stay on the panel), and has minimal opportunity costs (in that the brokers who are not used would probably have little to add at the margin). Note that in Australia the top 10 brokers account for 75% of traded volumes. In setting up the panel, it is necessary to clearly flag to the brokers what the requirements are — it is their business to look after the needs of the organisation, but they can only respond to the signals given. For example, if brokers are needed to look after share analysts, it is advisable to give analysts a say in who goes on the panel; if a fund has an industrial bias, allocate fewer points for resource research; for short-term trading, long-term valuation considerations may be less relevant, and so on. Another possible approach is to talk to only one or two brokers. Some reasonably-sized funds do this, the rationale being that if these brokers are looked after (to the extent of assigning each of them half), the business would benefit by being the first to see the broker's lines of stock, get the first call from analysts and so forth. Note that for smaller funds, the total brokerage paid will still be less than a small fraction of that of the largest institutions; and that, while the tenth or twentieth broker may have little marginal value, the third or fourth probably will.

Options market constraints

The options market is used in varying degrees by investors, with major constraints being as follows: • limited market liquidity • tax considerations • administrative complexities • possible mandate and/or legal restrictions.

Passive equity management

The task of a passive (or index) manager is to replicate the returns of a selected index (e.g. the All Ordinaries) at the lowest cost. The practice is more involved than might be expected. The sheer number of stocks in the index and changes in the composition of the index bring their own problems. Firstly, for passive management of Australian (and overseas share) portfolios, it is normally not cost-effective to try to replicate the entire index. Full replication would be expensive in terms of transaction costs unless the sum of money is enormous. Most passive managers will replicate the larger, more liquid stocks that account for most of the index, and will use sampling techniques to cover the smaller, less liquid stocks.

Transaction costs (including capital gains tax)

The transaction cost differential will, of course, vary according to the level of turnover within the actively managed portfolio under consideration. For Australian share portfolios, turnover rates (measured as the lower of purchases and sales divided by the average asset value) will vary between about 25% p.a. for low turnover managers and about 120% p.a. or more for high turnover managers. The average for active managers would be around 50% to 80% p.a. as opposed to around 8% for passive managers. Transaction costs (including the impact of transactions on market price, but excluding the capital gains tax impact) would average out at about 0.4% to 0.9% of turnover (assuming brokerage of 0.4% on a round trip basis, plus an allowance of up to 0.5% for the impact of the trade on the market price of the shares 'market impact'). This equates to a 'drag' of between 0.2% and 0.5% for the average active Australian share manager relative to the average passive Australian share manager. Share portfolio turnover also results in a bringing forward of the liability to pay tax on unrealised capital gains as they now become realised capital gains. Investments that are held fo

Value vs growth manager style

The two most common styles are value and growth. Relative value and growth strategies tend to have a negative correlation, (i.e. when value outperforms, growth underperforms and vice versa). For example, the tech boom year of 1999 was a terrible year for value investors, yet was a great year for growth investors. This was followed by several years of value outperformance during the so-called 'tech wreck' years from 2000 to 2004. The mining boom then led to several years of strong growth outperformance in the second half of the decade, 2006 to 2010. More recently during the global financial crisis value underperformed significantly as many global equity fund managers saw the valuations of financials (banks) drop significantly and fundamentally concluded they offered good value. Their large investments in financials led to significant underperformance as the fundamentals of the banks continued to significantly deteriorate as the Global Financial Crisis ('GFC') persisted. This occurred initially in the US and then in Europe — Greek, Spanish and Italian banks, for example, had particularly high levels of bad debts, poor balance sheet ratios (including solvency). Similarly in the 2010s, value investors piled into Energy and Material stocks which had fallen significantly in price. With the continued dramatic falls in key oil (energy) and commodity prices (materials) up until December 2015 this has also negatively impacted their performance. Thus the underperformance of value as an investment style relative to growth has continued since the GFC into the mid-2010s. This has led to one of the longest periods of underperformance (now over 7 years) and has seen investors question whether they have the very long time horizon that could be required to harvest the benefit of 'value investing'.

Factor investing

The value and benefits of diversification are long held investing principles. The mix of asset classes in a portfolio balances the risks and rewards of investing, with the equity allocation providing real returns. The bond and cash allocations role is to reduce volatility and provide a measure of capital protection to a portfolio. The entire concept is based on the idea that stock and bond prices generally move in opposite directions (i.e., that the correlation is negative). This strategy was at the heart of portfolio construction since the 1950s however the GFC led a number of investors to question the logic of the above allocation. The financial crisis that began in 2008 and the recovery period (fostered by central bank efforts to maintain low interest rates) both have in common that asset prices for stocks and bonds moved in the same direction during both periods. Even 'alternative investments', like hedge funds, moved largely in the same direction although the drawdowns were in many cases less than the asset class in which they were operating. Clearly, diversification and traditional portfolio construction weren't working in the traditional and expected manner due to the fact that correlations moved toward 1. The problem is that as correlations increase investors experience extreme movements in the value of their portfolios. Extreme downside movements can result in the need for individual investors to delay a planned retirement and/or the inability to make key purchases while for institutional investors, it can result in pension funding shortfalls. Factor investing seeks to identify and mitigate risk factors to build a truly diversified portfolio. MSCI has conducted significant research into factors that drive equity returns as well as factor investing. They have also developed MSCI Factor Indices, which have assisted in factor research as well as stimulating development of factor investing as an alternative to the current two major approaches to investing (namely passive and active investing).

Theme-based (thematic) investors

Top-down investors are also described as theme-based investors. Top-down or theme-based processes are more often employed within the context of growth investing. In contrast, the only source of decision-making for a pure value investor is a fundamental assessment of the worth of a company relative to the current stock price (a bottom-up approach). Thematic investors can, for example, focus on global/macro-economic trends, innovation, political themes and/or demographic trends. Sometimes these are very long-term (decade-long) trends or stories. For example in 2015 some of these themes or trends included: • a number of technology related innovation themes, for instance 'the Internet of Everything', digital disruption and 'big data' • the rise of genome technology and genetic testing within Healthcare. • aging societies/demographics and the rise of the emerging markets middle class consumer. Top-down investing in equities is much rarer than bottom-up stock picking. It is important to note that the investment process is essentially the reverse of stock picking. The approach starts with identifying the big picture or overall themes and then populating these themes with individual stocks that are expected to benefit from these themes (i.e. stock picking).

Fundamental indices

Traditional indices are generally based on a basket of 'like' securities, which are either equally-weighted or cap-weighted (e.g. weighted based on company size, bond issue size etc.). A growing branch of equity index investing looks to weight securities based upon different metrics or factors. These fundamental or factor-based indices are meant to give more weight to an index in companies whose economic fundamentals are in better shape. In their paper on factor investing, MSCI (2013) highlight the following systematic factors: • value • low size (small cap) • momentum • low volatility • high yield • quality. Fundamental or factor-based indices look to overcome some of the main disadvantage of traditional passive investing (using a cap-weighted index). This can be done by potentially overweighting to overvalued stocks (and underweighting to undervalued stocks).

Value investing

Value investing involves selecting stocks that the market has under-priced relative to their estimated fundamental/intrinsic value/fair value, however, it should be noted that different investors will have different estimates of intrinsic value. Value investors emphasise a high level of current/forecast earnings or asset values relative to the current market price in their stock selection process. Value investing typically refers to the purchase of shares in companies that have the following pricing characteristics: • low price-to-earnings ratios • a high level of asset backing (low price: book ratio) • high dividend yields • price to cash earnings/cash flow, or • a mixture of some (or all) of these. The use of price to cash earnings/cash flow has increased in popularity in recent years as it less prone to accounting manipulation of earnings/accounting profits based measures. A key issue with this approach is that a manager attempts to identify stocks that are temporarily cheap (over-sold) and expects the price to revert and correct upwards over time. Often these companies are experiencing short term difficulties. However sometimes with hindsight the short term difficulties turn out to be much longer, more protracted or more challenging difficulties and the stock price corrects sharply further. Such stocks are called 'value traps'. They initially seemed good value but turn out to be a trap. In 2015 a good example of such a stock was mining company Glencore.

Performance of the Australian share manager

Why then has the median Australian share manager been able to outperform the All Ordinaries Index/S&P/ASX 200? Part of the explanation lies in technical issues relating to the way that the index is constructed. For example, newly listed companies are not included in the index until at least six weeks after listing. On average, new floats tend to outperform the index over this six-week period. One simple way to beat the index is therefore to invest in new floats. There is an entire category of managers called 'enhanced passive managers' who aim to produce an outcome slightly better than pure passive managers could achieve by taking advantage of easily exploitable opportunities such as this one. A Mercer survey for enhanced index managers shows that over the five years to June 2018, the average enhanced index manager beat the index by 0.8%, implying that this subgroup of managers was not far behind the fully active peer group. A further explanation lies in the mix of participants involved in the Australian share market. For example, the Australian share managers in the Mercer database are not the only players in the game. It can be expected that those whose performance is recorded over even a five-year period are only those who have been in existence during that entire period — it is possible to overlook the performance of any who have 'dropped off the vine'. This selection problem in correctly assessing the performance of managers versus the index is known as 'survivorship bias'. Put very simply, funds or managers that were unsuccessful in the past are less likely to be in today's survey. This means that the data which is reported is likely to be only for the more successful fund managers and could overstate reality by excluding the less successful ones that did not survive. There are also other players: these include international institutions (whose main aim is to add value against their own benchmarks rather than against the All Ordinaries or S&P/ASX 200), retail 'mums and dads' investors, and companies buying shares in each other for strategic business reasons. These other players in the game are often motivated by objectives other than beating the All Ordinaries. They may also be handicapped by the lack of research resources that they commit to the task of analysing Australian shares relative to resources available to the average Australian institutional share manager. Both of these factors provide scope for the average institutional Australian share manager included in the surveys to outperform the index, at the expense of the other market participants.

After-tax management

Within the Australian market, institutional managers have traditionally mostly ignored the tax consequences of their actions and instead focused on beating the (pre-tax) benchmark return. Only in high net worth private client management has much attention been given to after-tax returns. In recent years, some large superannuation funds have started to award after-tax mandates to institutional managers or have started to include references to tax in their investment management agreements with wholesale managers. However, even today the practice is not widespread, due to the considerable practical as well as conceptual difficulties associated with assessing manager performance on an after-tax basis. These complexities are highly technical in nature. This is covered in more detail later in this subject.

Australian stocks

n the Australian market, the most commonly used performance benchmarks within investment management mandates are the S&P/ASX 200 index (composed of the top 200 stocks) and the S&P/ASX 300 index (composed of the top 300 stocks which includes a greater number of smaller stocks). The most recognised index, and the one with the longest history, is the All Ordinaries Index, which now comprises about 500 stocks. However, this index is no longer used by the institutional investment community. It is worth emphasising that the performance of the index reflects only the aggregate of many individually — and very divergent — stock returns. It is sobering to reflect on the post-1987 performance of some of the leading 'entrepreneurial' stocks included in the All Ordinaries Index before the stock market correction of 1987 (e.g. Adelaide Steamship Company, Bond Corp and Quintex). More recently companies such as One.Tel, HIH, Pasminco, Allco, ABC Learning Centres and Babcock & Brown were all, at various times, members of the S&P/ASX 100 index of the largest 100 listed companies — and all have been

Passive vs active: Performance

• The major finding is that active fund managers, as a group, have underperformed their stated benchmarks across most of the fund categories and time periods considered (1, 3, 5, 10 and 15 years). To take one example, 60% of Australian large-cap equity funds underperformed their benchmarks over the ten years ended 31 December 2016. The case for indexing has been strong over shorter horizons, too, although shorter sample periods have tended to produce slightly more erratic results. There is also a strong case for indexing over longer horizons (such as 15 years). • Vanguard attempted to account for survivorship bias in Figure 7 (see page 10 of the paper) by identifying those funds that were 'alive' at the start of each period but dropped out of the database at some point along the way. In the case of Australian large-cap equity funds, at the ten-year horizon, the adjustment for survivorship bias increases the proportion underperforming from 65% to 74%. Indeed, after accounting for this survivorship bias, the degree of underperformance increased across all categories.