“The markets haven’t been very good lately,” the investor said with some concern. “Should we be doing something?”

Markets were off their highs. Trump was being Trump. August had been one of those months. Off nearly 5% in a week. Sideways for the next three. A slight upward burst at the end, but the media had been salivating at the prospect of more losses. The wind had stopped blowing and the seas had calmed. The investor was still thinking about those storm warnings.

“Well the ASX All Ords is up about 19% until the end of August,” the adviser said, bringing up a returns chart.

“That’s strange, I could have sworn we’d been doing pretty badly this year,” returned the confused investor. “Interesting.”

August, and its last day, is an interesting study on why that might be.

Earlier in the month these are some of the headlines leading broadcasts, gracing newspaper front pages and taking the top left on news websites throughout August:

Bloodbath for share markets: Here’s how it affects you

ASX drops 128 points in worst loss of 2019

Trade war wipes $38b off ASX

Aussies’ super smashed as USA-China trade war hits ASX

Australian stock market slumps after US-China trade war prompts Wall Street plunge

Investors told to brace for more volatility as ASX sells off

Yes, it could be recency bias. The tendency to let the most recent events weigh heavily in one’s mind, but that’s only able to occur if a person is confronted by all information.

Below are the homepages of four well known Australian newspapers on that last day in August. The ASX All Ords finished up 93 points that day or 1.4%. It was up over 100 points when these screenshots were taken. You’d think such a great day would have warranted some interest by the media; telling us how many billions had been ‘wiped on the ASX’, what the gain ‘meant for us’ and how important it was for ‘our super’.

After all, those top left corners are usually reserved for important stories reminding us how much we’ve lost on the down days.

Nary a mention.

The day’s gains were buried much further down the page. Positive market news relegated to the business & finance section. Flicking through the nightly news it was a similar story.

Media bias by omission is why investing is so hard. It explains why some people are scared of the sharemarket. It also explains why sharemarket investors regularly think they’re doing worse than they are.  If we use months as our guide, 63% of the time the ASX is heading upward. It’s 72% of the time if we’re using years.

The likelihood of a 100-plus point down day leading the news? We can only guess, but we’re assuming it’s very high.

The likelihood of a 100 point-plus up day leading the news?

Looks like zero.

_{This represents general information only. Before making any financial or investment decisions, we recommend you consult a financial planner to take into account your personal investment objectives, financial situation and individual needs.}

June 6, 2019

Neil Woodford has a neck thick like a rugby player and a head shaped like it was chiselled out of granite, it could be mounted somewhere on Easter Island. Imposing is an appropriate word to describe his appearance. Woodford is a man screaming conviction.

Charlie Aitken is almost the opposite, but no less memorable. His features are sharp, he’s thin. Hair slicked back, often wearing a smug smirk; he appears supremely confident, giving the impression you should be listening to him. Aitken is a man screaming conviction.

While Woodford looks like he could be cracking heads outside a nightclub and Aitken cracking jokes on a late-night talk show, they’re both in the same business. They both manage money and lately it hasn’t been going so well.

Woodford was known as a star stock picker during his time at UK investment manager Invesco, so in 2013 it was time to set up his own fund. He started off strongly.

In his first full year on his own, Woodford’s flagship fund returned 16 per cent, beating all 50 of its peers tracked by Bloomberg. That has all changed, with the fund down 7 per cent this year through May 31 and down 18 per cent in the past 12 months.

And those falls have caused panic with Woodford’s investors.

Neil Woodford’s problems are a fund-management version of that old-fashioned bank run. Investors in the Woodford Equity Income fund have been asking for their money back at a rapid rate – about £10m a week. Unlike a bank, the fund has all the money – but it is invested in a series of companies.

To come up with the cash at once, the fund would be forced into a fire sale, with the result that investors would almost certainly get back less – much less – than they put in.

To stop the rot, this week Woodford suspended trading in his flagship fund in the UK.

Back in Australia, Aitken was one of Australia’s better-known stockbrokers before he made the leap to start his own fund in 2015. He attracted high profile investors such as billionaire Kerry Stokes and was said to have $300 million in funds under management. The fees were 1.5% and 15% of any outperformance over the fund’s benchmark.

Aitken’s Global High Conviction Fund started off promisingly enough. It outperformed its benchmark, the MSCI World Index, until 2018 when the fund fell almost non-stop throughout the year.

Aitken Investment Management’s Global High Conviction Fund suffered a 23.8 per cent loss in 2018 after being defeated by macro conditions that undermined the strategy’s pro-Asia bets.

This year it has lost further ground as the MSCI World’s recovery has been much stronger than that of Aitken’s fund. With that stinker of a return fresh in the memory, things are also happening at Aitken’s fund. The biggest investors apparently want change.

Rather than expand the stock picking team, we’ve heard the telegenic Aitken — we gather after some nudging by Stokes and Rankin — is going to recreate the business as a branded global index fund, with some high-conviction calls on the side.

Sounds like a fund available for 0.3% from a regular fund manager. Unless the pencil is sharpened on fees, any investor will pay Aitken an extra 1.2% for a little speculative indulgence. Hardly seems warranted.

Both Woodford and Aitken are known as conviction investors, but there is a problem with convictions. When you have convictions, investors expect your convictions to be right and they don’t give a damn about your convictions when they’re wrong. They have zero patience for theories on why something should have happened and yet didn’t.

They don’t want to accept a financial crisis type return in a year when there’s no financial crisis just because something happened in Asia or Europe that you didn’t foresee.

One of the more famous conviction stories is that of Michael Burry. It was memorably featured in the film The Big Short. Burry (played by Christian Bale) bought credit default swaps on subprime mortgage bonds. Doing this ensured Burry’s hedge fund performance was terrible for a considerable period of time due to the cost of holdings the swaps.

His investors were frustrated at the returns and apoplectic when Burry suspended redemptions and froze his investors’ capital until he believed the CDS market was acting as it should. If you’ve seen the film, Burry continually writes the percentage decline of his fund on a whiteboard.

In the end the payoff was spectacular. The number Burry finally wrote on his whiteboard was a two fingered salute to anyone who doubted him.

Michael Burry’s final return.

While it’s a great story, it’s not particularly helpful for everyday investors. In the film the audience is meant to sympathise, and cheer Burry on. In real life, the audience would be the investors screaming at Burry demanding their money back.

And for every Michael Burry who survived, recovered and delivered a monster pay off, there are an array of funds that have been shuttered after abysmal performance, the managers slinking off into the night. If an investor is down 20%+ in a fund based on a manager’s convictions, you can be assured they’re losing their convictions in the manager’s abilities.

Neil Woodford has been great in the past. Charlie Aitken has been great in the past. As we see time and again when it comes to investment returns, reputations mean nothing. Investors banking on previous conviction success won’t know the manager they’re investing with is right or wrong until after the fact.

Not that it stops the media giving them endless free publicity. Both Woodford and Aitken have been media darlings in their respective counties. In many investors’ minds media exposure equals skill and legitimacy when it’s only an indicator of the past and a willingness to provide a colourful quote.

But here’s a more important quote from some investors in Neil Woodford’s fund, “we trusted Neil Woodford with our money”.

Investors can trust a person, or they can trust capital markets and the factors that are known to drive returns. There are no guarantees, but in the past markets have been able to price in bad news and eventually keep providing returns.

The same can’t be said for every star manager’s fund.

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Neil Woodford explains to his investors.

_{This represents general information only. Before making any financial or investment decisions, we recommend you consult a financial planner to take into account your personal investment objectives, financial situation and individual needs.}

Economic Overview

I watched this film again recently and it made me think about the similarities with our investment philosophy.  In case you missed it, Moneyball was a 2003 book by Michael Lewis (later a 2011 film starring Brad Pitt) following the Oakland Athletics baseball team.  The team had the third lowest player payroll in US baseball, but general manager Billy Beane attempted to overcome this through using analytics and evidence based strategies to find undervalued players and compete with larger teams.

Despite losing star players, Oakland’s 2002 season was famous for besting their previous season, going on a 20 game winning streak and having the second best winning percentage in the league. A winning percentage only bettered by the New York Yankees who spent three times more on player salaries than Oakland.

How does this relate to investing?  The concept of finding players who are undervalued by the market isn’t so different to tilting a portfolio to incorporate value companies that are out of favour with the market for some reason.  The end goal is a better return through increasing risk, but using historically compensated risk, to achieve that better return.

There are three givens when it comes to compensated risk factors.  These givens are all based on academic research.

First, the market itself. Shares are riskier than bonds so they offer higher expected returns.

Second, small companies have higher expected returns than large companies because they are more of an unknown quantity.  Think an established star player vs a first year player.  Superstars tend to perform according to their pay packed so there may not be much upside.  For the first year player, expectations are low, so the pay is low, but they may provide a significant upside.

Finally, value companies offer higher expected returns than large and successful companies because they are out of favour with the market for some reason. In this instance you might think of a player recovering from a long term injury, maybe one with offield issues or just misused by a previous team. For value companies, they may have been poorly managed, missed guidance or have been going through a restructure meaning their shareprice has been dented, but their potential remains.

In Oakland’s case, GM Billy Beane found certain important statistics were underutilised in baseball and the players who ranked highly in those statistics were often undervalued and not well regarded in the league. This meant Beane could build a high performing, albeit unfashionable team, within Oakland’s salary constraints.

On the back of the book and the film, Billy Beane became a much more widely known figure and his and his team’s methods attracted a lot more scrutiny. Oakland hasn’t performed as well since, so some assumed it was a fad and a flash in the pan. Not the case. Essentially Oakland was pulled back to the pack because many other teams began incorporating the same statistical analysis into their team building.

So long term in baseball it becomes harder to find value and outperform the market. In contrast when investing, the outperformance from value generally appears over the longer term – if an investor maintains discipline.

As the following chart shows with Australian and Global value returns vs their respective benchmarks since 2000. To note, the red lines represent Australian and Global value funds while the blue lines represent their respective Australian and Global market benchmarks.

Now you don’t build your whole portfolio on value funds because value premiums are not always available.  Sometimes yearly returns will fall behind market returns and value funds also come with higher volatility. However, as part of a diversified portfolio a tilt to value can help increase overall return.

In baseball the increasing use of statistics and research has meant a change from scouting and recruiting players based on intuition by scouts and managers.  Much as statistical analysis has contributed to less guess work when investing.

As Billy Beane notes when comparing baseball’s changes to the investment industry, “thirty years ago, stockbrokers used to buy stock strictly by feel. Let’s put it this way: Anyone in the game with a 401(k) has a choice. They can choose a fund manager who manages their retirement by gut instinct, or one who chooses by research and analysis. I know which way I’d choose.”

Wise words.

_{This represents general information only. Before making any financial or investment decisions, we recommend you consult a financial planner to take into account your personal investment objectives, financial situation and individual needs.}

Economic Overview

Global economic data remained encouraging during Q1, though after a long period of relative calm and upward movement volatility again reared its head in equity markets. While towards the end of the quarter the potential for trade wars heated up.

In the US, economic data continued to be supportive. US business confidence reached a multi-decade high in March. GDP for Q4 2017 was revised upwards to show growth of 2.9%, and while industrial activity slowed – as measured by the ISM manufacturing index – it continued to indicate expansion.

The US Federal Reserve raised rates by 25 basis points in March, from 1.5% to 1.75%. It did not, however, alter its overall rate projection of three hikes for 2018. This announcement quelled some concerns, but escalating US-China trade sanctions precipitated a renewed bout of turbulence in March.

In the eurozone, GDP growth for Q4 2017 was confirmed at 0.6% quarter-on-quarter and unemployment stable at 8.6% in January 2018. However, forward-looking surveys painted a picture of slower growth. The composite purchasing managers’ index (PMI) hit a 14-month low in March and annual inflation was 1.1% in February, below the European Central Bank’s (ECB) target. ECB chairman Mario Draghi noted interest rates would not rise until the end of the quantitative easing program.

While UK economic growth remained sluggish, in its February inflation report the Bank of England nudged up its growth forecast for 2018, from 1.7% to 1.8%. There was further progress with Brexit negotiations, with an initial agreement struck on the terms of a transition period for after the UK formally exits the EU.

The Japanese economy experienced a soft patch in Q1 2018 with many indicators of production and consumption slightly slipping. The most pervasive influence came from the switch in US policy towards increased protectionism. Investors were also taken by surprise by a sudden change in stance of players engaged in discussions on North Korea’s nuclear ambitions.

In Australia, the Reserve Bank left its own benchmark cash rate unchanged for a record equalling 18th consecutive meeting at 1.5%, pointing to strengthening economic growth alongside continued low inflation.

The Bloomberg Commodities index turned negative in Q1. Weakness came from industrial metals amid global trade tensions. While copper was particularly weak, down 8.3%, energy again recorded solid gains. Brent crude continued to rally amid confidence OPEC would maintain production cuts throughout 2018.

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Market Overview

Asset Class Returns

The following outlines the returns across the various asset classes to the 31^th March 2018.

It was a mixed first quarter for global equity markets in 2018, with an upsurge in volatility from the very low levels of 2017 a major talking point.

US equities began 2018 strongly, buoyed by ongoing strength in economic data, robust earnings and the confirmation of a major tax reform package. However, the latter part of the quarter saw a marked increase in volatility. Investors first digested the destabilising potential of an elevated US inflation reading and the possibility that the Federal Reserve (Fed) may need to become more proactive in raising interest rates in order to keep upward price pressures under control.

Eurozone equities delivered negative returns in the first quarter, with the bulk of the declines coming in March. Markets began the year on a firmer footing but worries about the path of US interest rates and the outlook for global trade led to declines for the period overall. Sentiment towards UK equities was poor as the FTSE All-Share fell 6.9%. Overseas buyers shunned the market amid ongoing political uncertainty and a weak outlook for economic growth.

After a strong start to the year, Japanese equities followed a similar pattern to other global markets and ended the quarter 4.7% lower. The heightened uncertainty resulted in a stronger yen against major currencies. Corporate results to December 2017 showed very positive trends.

Emerging markets equities registered a positive return in the first quarter, despite a rise in market volatility stemming from tensions over global trade. The MSCI Emerging Markets Index recorded a positive return and outperformed the MSCI World and although Chinese equities were volatile towards the end of the quarter, given rising trade tensions with the US, the market recorded a positive return and outperformed.

Australia was dragged down by its heavyweight banking sector as the potential impact of the Banking Royal Commission began to weigh. In sectoral terms, the other big losers on the Australian market were telecommunications stocks, utilities, REITs and energy.

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The China Hustle

If there’s one constant about money, it’s that someone is always wanting to take it from you. As disheartening as that statement is, the quicker investors learn it, and understand who they can and can’t trust, the more secure their financial prospects will become.

Bringing us to the latest financial fraud documentary, The China Hustle.

In the aftermath of the 2008 financial crisis a lot of investors in the US were looking to quickly recoup their losses. At the same time, many Chinese companies were looking to trade on US stock markets, but couldn’t do so directly. Some lower tier US investment banks got involved to help facilitate Chinese companies to list in the US through a backdoor using dormant companies that still had a stock market listing.

Hundreds of Chinese companies found their way onto US markets this way and some big money was being made as share prices surged. Until one US businessman, working in China, decided to investigate a Chinese paper company on behalf of his father who wanted to invest in it.

Orient Paper claimed to be doing $100 million in annual revenue. When the businessman arrived at their factory, he found a run-down operation completely incapable of doing the kind of revenues suggested, nor supporting the company’s market valuation.

It was a complete fraud and many of these Chinese backdoor listings were complete frauds.

And in a story as old as time, the only protection investors had, was the belief in their head that regulators exist to protect them – so no protection at all. The investment banks doing the backdoor listings were also putting buy recommendations on the companies and the unsophisticated individual investor, seduced by potentially high returns, were left holding the bag when the frauds were uncovered.

As one interviewee said, “you’re buying lottery tickets”. And when it comes to individual stocks, Chinese or not, that’s often the case.

In Australia 26 Chinese based companies currently trade on the ASX, only 5 are currently trading above their initial listing price. The ASX has rejected another 21 Chinese companies from listing on the ASX over the past two years.

The China Hustle is available on Netflix.

 

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With thanks to DFA Australia for charts.

This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.