The resources boom has changed the beta of Australian shares in a way that may alarm those with a passive approach to asset allocation. The regional chief executive of Lazard Asset Management, ROB PRUGUE, here puts his value prejudices aside, and calls on investors to at least reconsider where the risks in their portfolios are coming from.
Dear friends and colleagues; It is often said that asset allocation is the single largest factor in delivering a diversified fund’s total return. Most large funds generally have between seven and nine asset classes, while holding between 20 and 30 investment strategies, that in turn tend to hold between 30 per cent and 100 per cent of the underlying securities from the asset class’ benchmark. Too much in the wrong asset class can have a much greater drag on the fund’s total risk/reward than bad stock selection from any one manager. But what if the benchmark in the single largest asset class is dominated by one name? What impact will this one name have on the diversification profile of most balanced funds? In such a case, can stock selection play a bigger role than previously envisaged?
Before we start, it is best to define diversified funds. What separates a ‘balanced’ fund from a ‘growth’ or even a ‘defensive’ diversified fund? The purist will answer from a risk/return trade off point of view whilst the pragmatist will usually answer with an asset allocation mix between shares and bonds. The pragmatist generally defines a balanced fund as 60/40 or 70/30 shares/bonds, whilst the purist defines it through an expected return target of CPI plus 4 per cent, or positive expected returns in six out of seven years. Of the two, however, the pragmatist usually prevails. Rarely are diversified funds actively rebalanced to maintain risk/return objectives as stated above. If they are, it’s usually done through the management of ongoing cashflows.
Take, for example, yesterday’s bifurcation between the ‘old’ and ‘new’ economies. Whatever the thesis driving this bifurcation of yesterday, its impact was felt well beyond most equity portfolios alone. For many North American defined benefit (DB) pension plans, its impact saw plans move into a 30 per cent plus funding surplus at the turn of the century, then back to a 30 per cent deficit by year end 2002. Although the majority of Australia’s pension liability is defined contribution (DC), to quote Keith Ambachtsheer, “At the end of the day, it’s still someone’s balance sheet we’re immunising”. DB and DC differ only in who ultimately immunises this pension liability.
Are we in Australia headed for similar lessons? Given Australia has just experienced one of the best real return periods since 1936, has this impacted risk/return parameters of the average diversified balanced fund? After all, asset allocation and balanced fund decisions are generally made off asset class assumptions, not off manager configuration.
Let’s digress for a moment by examining the recent return pattern within Australian equities. Courtesy of our broking friends at JPMorgan, we’ve compiled the rolling one-year nominal returns on each of the 200 names within the S&P/ASX 200 index, and then categorized each into one of 10 GICS sectors. Starting from month-end June 1996 through to May 2008, we ranked and sorted each share from best to worst performance. We then grouped into two broad categories: resources and everything else. Not too surprisingly, the current top performing 5 per cent of companies (10 names) have all come from this resource universe. In contrast, back at the peak of the new economy bubble, not one resource name was within this prestigious list.
What is interesting is that neither BHP nor Rio, the poster children of the resources run, made this list of top performing companies. During the bottom of the old economy cycle of 2000, there were only 26 resource names in the ASX 200 Index. As of June 19, 2008, there are now 50 resource companies within the ASX 200 index. The vast majority are recent entries into the large cap arena following three to five year returns of 1,000 to 3,000 per cent. Fortescue Metals Group (FMG), for one such example, now represents 1.2 per cent of the ASX 200 index. As of June 18, 2008, and at a share price of $10.92, FMG’s market cap now makes it Australia’s fifteenth largest company. Three years ago, FMG had a share price of $0.29 and $0.018 five years ago, or returns of 3,665 per cent and 60,566 per cent over three and five years respectively. FMG today has a larger representation within Australian share benchmarks than AMP, Suncorp-Metway, and Macquarie Group.
Before some of you say, “Rob, I know. But this time, it really is different. This Black Swan lays eggs made from copper, zinc, iron, and gold”. I get it. This time around, Australia has been the beneficiary of the China miracle. Our proximity, trade position, and abundance in the raw materials used to fuel the Asian economies have all contributed handsomely to the aforementioned results. We’re the lucky country. But the relative enormity of the resources boom, coupled with its duration, has altered the risk/reward parameters within the whole Australian equity market and even more broadly, the Australian equity market’s position from the global capital market’s standpoint.
Take for example the Australian share market representation within the MSCI Developed World Index. At the peak of the dot com bubble, Australian assets went both unloved and under-owned. The Australian dollar was near half current levels while Australian share representation was a miserly 1.2 per cent of the MSCI World. Today this representation has more than doubled. Australian assets are now both well-loved and well-covered by most global investors.
But as strong as the performance has been of Australian shares in general, these robust results were dwarfed by the even greater returns generated by the Australian mining and resource sector. At the peak of the dot com bubble of 2000, Australian resource shares represented around 15 per cent of the broad ASX 200. Today, resource shares represent near 35 per cent of the ASX 200. If it is correct to assume that resources are generally more cyclical, higher beta, and higher volatility assets, then their increase within the broader share market should increase the overall volatility of that asset class.
According to the Mercer asset allocation survey on Australian balanced funds for the month ended April 2008, the average asset weighted allocation towards Australian shares for balanced funds was 34.2 per cent. The minimum allocated to Australian equities was 25.3 per cent, whilst highest was 40.2 per cent. The second highest asset allocation was towards international shares, with the average balanced fund holding 25.8 per cent. In the latest available online APRA asset allocation survey of June 2007, Australian superannuation funds held a not too dissimilar allocation towards Australian shares at 31 per cent.
Regardless of the survey used, Australian shares are still the single largest exposure held by most diversified balanced funds.
Historical asset allocation analysis shows a not too dissimilar conclusion – Australian balanced funds have long held a bias towards Australian equities. While diversified funds’ objectives are defined by real return targets and by expected positive returns in years, asset allocation figures change little from year to year. Where there are shifts in asset allocations, much of the shift can be explained by market movements rather than active changes. Most funds prefer to set their strategic asset allocation and let them move with the market.
The extremely strong performance from Australian shares, coupled with the even stronger results from resource shares, has no doubt influenced the risk/reward metrics of balanced funds. As of month end May 2008, the GICS Resource sector weight in the ASX 200 index was 32.6 per cent, whilst BHP represented 13.0 per cent and Rio Tinto 3.5 per cent. Australian equities represents 2.8 per cent of the MSCI ACWI (combined World Developed and Emerging) index, compared to the larger markets of the US at 41.5 per cent, Continental Europe at 21.8 per cent, UK 9.2 per cent, Japan at 9.0 per cent, Asia ex Japan 10.1 per cent and China at 1.6 per cent.
As previously stated, balanced funds direct nearly 35 per cent of their total assets towards Australian shares. What is concerning, is what this means at a stock level. A current ASX 200 index weight of 14.0 per cent towards BHP would suggest that this one stock has a 4.6 per cent total allocation within the average diversified balanced fund. Compared to the larger and deeper international market, this would suggest that most Australian funds have almost as large an allocation to BHP as they do to a combined index weight in UK and Japanese equities. Holding an index weight in just two stocks, BHP and Rio, would match the total index weight held within the whole continental European equity market. Assuming an index weight in Fortescue Metals Group (FMG), this position would deliver a larger total allocation than held in ALL of China.
Whereas there are plenty of other examples of large cap bias and influences, what makes this interesting is that much of this bias stems from a near unprecedented five-year, triple-digit return from one sector – resources.
Why we raise this stems more from highlighting a potential mismatch in how we define balanced fund objectives from a CPI plus ‘x’ per cent or years of positive returns, versus a more static ‘let it ride’ 60/40 allocation. As an asset class’ constituency changes, would it not be equally correct to reconsider the risk/reward implications from the changed asset? As detailed above, there has been a complete role reversal in the past eight years as to the constituency within Australian equities, yet there have been modest shifts in allocations. So far, this inactivity has delivered net positive results – but is it reasonable to assume these benefits will continue indefinitely? And has the shift towards a more dominant exposure in what has historically been a volatile sector altered the risk/reward definitions for diversified funds?
Risk management is not about altering your decisions, but identifying where the bets are being taken and how this could potentially alter the return profile. Most diversified funds have more money in two stocks than they do in the whole continental European equity market. Most have more money allocated towards resources stocks than held in the whole US equity market. And assuming the Australian resource boom has a lot to thank China for, an index holding in Fortescue Mining Group equates to a larger total exposure than the whole of China, and off a free float of only 47 per cent!
A black swan perhaps, but at least be mindful of implications were this creature to turn out to be plain ole white under the spot light. The sting from a retracting pendulum hurts more than from the one that got away. North American balanced fund investors learned this painful lesson back in 2002.
Plus ca change, plus c’est la meme chose. (The more things change, the more they stay the same).