Morningstar's annual investment conference came at a particularly exciting time this year, with a new UK government finally agreed mid-conference, the EU and IMF having agreed just days previously to a near-$1 trillion rescue package for Greece and other indebted European economies, and global stock markets on a daily rollercoaster, our broad range of investment luminaries addressed all these hot topics and more.
To keep you in the know, I kept a live blog throughout the conference, updating you on our fourth annual event, and reporting on the key messages and insights from all the presentations.
Below you will find coverage of the second day of the 2010 conference. For coverage of the Day 1, please click here.
Day 2 - Wednesday May 12
The Credit Crisis: Life Beyond? Paul Lambert, Director – Macro Strategies, Polar Capital
Paul Lambert kicks off the second day of our annual conference by sharing his thoughts on the decisions made by policymakers over the last two years and, having spent the early part of his career at the Bank of England, he's in a good position to provide insights.
Paul highlights that the crash wasn't all about the banks--there was a lot of leverage on individual balance sheets through house purchases, which was a rational move in an environment of falling interest rates. The wheels fell off, however, when there was an unprecendented fall in consumption, he says, adding that consumption almost never falls even in a recession.
Paul applauds a book written by Bernanke some time ago, in which the first chapter highlights the need to reduce interest rates to near-zero as soon as possible if such a situation as we have experienced occurs.
Regarding the quantitative easing programme in the UK, Paul says the Bank of England policymakers didn't know how much QE or what type of QE (i.e. what sort of bonds) to provide, so they had to make it up--trying a certain amount, gauging its impact, trying a bit more, etc. A move that took "an incredible amount of bravery," he says, adding "I think it's astonishing what they did, in the time they did it."
Most policymakers would agree with Gordon Brown's comment that he helped save the world, Paul says.
Going forward, he doesn't believe we're not going to have a decade of booming growth going forward, we're more likely to have sustained growth, with the highly indebted countries experiencing slow growth. The debt means that the outlook is for disappointing growth.
We need a productivity miracle, and need that high level of productivity in emerging markets but still we're likely to have slow growth as a global economy, Paul says. Where are we going to find returns? Equities have had a good preiod of returns recently and Paul sees scope for another. Potential for macros funds to provide returns too, and even cash in this type of environment. "The Japanese storing cash under their mattresses in the early 1990s might not seem so irrational to us now," Paul says.
Asked about the financial package agreed over the weekend by the EU and IMF, Paul says he thinks it was in everybody's interest to seal such a deal and he suspects that members such as Germany realised that there were two choices, they could either lend Greece money so that they can continue to sell them products that Greeks can't afford to buy, or they can not lend them the money, Greece will stop buying and the (German) producers will have to stop making.
A Journey Through the Emerging Markets Jonathan Asante, Joint Deputy Head of Global Emerging Markets, First State Investments
Jonathan kicks off with insights into potential opportunities ahead in global emerging markets. "The hard men are usually a disaster..." states Jonathan's first slide, which is littered with photos of Mao Zedong, Hugo Chavez, Fidel Castro, General Soeharto, among others; the second slide continues: "...which some realise is not sustainable" accompanied by images of Nelson Mandela, Mikhail Gorbachev and Deng Xiaoping.
In explaining how his company goes about investing in emerging markets and how they approach risk, Jonathan highlights some of the positives and negatives of companies operating in developing nations.
Development creates social risk:
'Better' economic policies do work:
In response to a question about China, Jonathan says he doesn't agree that investing in emerging markets provides diversification--it did a decade or so ago but not so much now.
The BRIC area in particular is too expensive at present, Jonathan says, so that's the region within GEM that they're most overly bearish at the moment. South Africa has some very good companies with good records at present.
Don't believe people when they tell you that emerging markets' banking systems were unaffected by the credit crisis--this idea that GEM did much better than the developed world in the credit crisis is not true, he says.
Any markets that you think are beyond the pail? asks a delegate. Jonathan says he'll go almost anywhere if he thinks there's potential but there are some countries he thinks are extremely difficult to invest in, among them are the Ukraine, Central Asia and Kazakhstan, and certain parts of Africa.
Jonathan highlighted areas of investment in GEM that he's particularly excited about in a Morningstar video interview, click here to watch.
Risks in Short Selling and Option Writing James Clunie, Investment Director - UK Equities, Scottish Widows Investment Partnership
James Clunie starts by highlighting that not all UCITS III funds have the same risk profiles and it's important to understand the distribution of returns. The distribution of returns has differed from that of a more traditional product, namely: small return, small return, small return and then an occasional large loss. There are challenges in the assessment of risk-adjusted performance of UCITS III funds, James points out, as short-telling and the possibility to use options introduces a number of risks 'along other dimensions', in particular: recall risk, manipulative short squeezes, crowded exits, potentially unlimited losses, risks of changes in margin or collateral requirements.
James uses Punch Taverns as an example of a crowded position. A crowded exits arises in stocks where short-sellers hold large positions relative to normal trading volume. A catalyst (e.g. results statements, director buying, take-over rumours) prompts short-sellers to cover their positions rapidly and simultaneously. Losses for short-sellers can be severe, as poor liquidity relative to short-covering demand drives the stock price higher.
Crowded exits typically affect a small number of stocks at any time, James says. They generally occur in smaller, less liquid stocks and are associated with losses to short-sellers that are economically as well as statistically significant. In extreme cases they can have a catastrophic impact on short-sellers (he found positive abnormal returns of up to 27% over a period of 60 days, in a three year study of UK stocks). New, long-only investors would generally struggle to exploit this finding by buying into crowded exits, as by definition these are illiquid positions. However, incumbent short-sellers, unable to readily cover their positions, suffer losses, he points out.
Practical steps to mitigate crowded exit risk: quantitatively screen for crowded positions and crowded exits, short-sellers should be risk-aware when short-selling less liquid stocks with high ‘days-to-cover’ ratios, and short-sellers should cover their short positions immediately upon observing exceptional levels of covering by other shorts-sellers in crowded positions. So, short sellers need to be studious, risk aware, and "quick panickers"--"if you're going to panic, panic quickly," James says--yes, you'll lose money but you'll save yourself more severe losses later on.
There are lots of unusual risks if you're going to invest in funds that involve short selling, as there are with option writing.
The use of options can profoundly influence the distribution of returns from a portfolio, which could make them a good diversifier, but it's paramount you understand what the risks are and why they occur, JAmes says. ‘Out of the money’ option buying generally leads to frequent small losses punctuated by occasional gains, it can also lead to a ‘Taleb distribution’ of fund returns. The fund manager appears to be very smart--i.e. small gain, small gain, small gain--until they're shown to be not so smart--i.e. huge 'one-off' fall. If performance measurement simply measures the fund’s returns, then risk-adjusted performance measurement must take account of the skewness introduced by the use of options.
"I quite like short extension funds," comments James. Their tracking error appears a reasonable measure of benchmark relative risk.
When using option writing in funds, James says short-term performance as a guide to calculating performance fees or manager bonuses could fail to capture problems with skewed distributions of returns. The bonus system can be ‘gamed’ by fund managers, e.g. think of Taleb distributions with annual bonuses and no 'maluses!' In a similar fashion, clients need to be careful of the structure of performance fees--he presents an argument for building symmetry into performance fees, i.e. outperformance leads to a performance fees, underperformance leads to a performance penalty, or else long-term ‘claw-back’ mechanisms.
An IFA in the audience comments that he will be leaving the conference more bewildered than he was when he arrived. James responds that this is one of his key messages: that the investment world is confusing, the more research he's done over the years the more confused he's become as products become increasingly complex. Being aware, and sceptical, of this complexity is a good thing--investors or IFAs need to get into the "guts of the fund" to find out what the strategy is, if a fund manager is open with the client and explains their strategy and performance and fees, then you should be able to make an informed decision, but if the fund manager is evasive then alarm bells should start ringing as perhaps there are hidden risks. Being sceptical isn't a bad thing--investors should be cautious when investing in complex products, he repeats.
A Conversation with Charles Montanaro Charles Montanaro, Chief Executive and Chief Investment Officer, Montanaro Asset Management; Jackie Beard, Director of UK Investment Trust Research, Morningstar UK
Setting up a boutique from scratch is no easy task--Charles goes into the trials and tribulations of creating a specialist small-cap equity firm. "If you want to get rich, don't join us, join Goldman Sachs," Charles quips, noting that you'll be worked too hard to consider having a family or a life outside the office at Goldman. Montanaro Asset Management employs people who want to work hard, meet interesting people, businesses and investors and be part of a family--with a small company of 24 staff, it really does feel like a family, Charles says, and he would continue to do what he does even if he didn't get paid for it.
Setting up a boutique asset management firm is likely to get harder, Charles says, the FSA's financial regulation is going to get tougher and bigger institutions are getting bigger--meaning they're less likely to outsource to boutiques but there are still opportunities.
Looking back at his thirty-year career, Charles says if you are going to set up a boutique asset management firm, don't put your name above the door because if you name the company after yourself, as he does, every time the company is in the newspapers, it's your picture that appears and it becomes very personal.
Asked by Jackie whether he can defend his reputation as something of a control freak, Charles says he thinks being a control freak is probably not a bad thing in this business, though he concedes the question should probably be directed at his team!
"You can't be good at everything, you can probably do more than you think, be an optimist, and money isn't everything." Charles summarises his ethos.
What We Know About Funds, Might Know, and Don’t Know John Rekenthaler, CFA, Vice President of Research, Morningstar Inc
John kicks off his presentation: "Please don't look at the Powerpoint slides, or only look at them out of the corner of your eye, try to look at me: I'm a higher evolutionary force than the slides--I made them, I can take them away...and they could say the same about me."
In reply to those who say performance doesn't matter, it's expenses that investors should look at and under no circumstances should they buy based on past performance, John says research of US funds (where more extensive research has been carried out) shows that funds with Morningstar's five star ratings (a rating based on past performance) tended to perform better--or not as badly--as those with lower ratings. Note that this correlation is weaker during less strong market periods. However, expenses are clearly still important, but John just doens't want to throw past performance out of the window.
Looking at global funds, research shows that there is some persistence with 'winners' but more persistence with 'losers', i.e. dogs tend to remain dogs. For active funds, cost is the issue--a study of UK fund found that the funds that charged more outperformed before expenses and matched out after expenses. Globally the story appears to be, John says, noting that this is an oversimplification, that before expenses, funds are doing fine or better than indices, and after expenses, they're either matching or slightly behind the indices.
Something else we know about funds is that investors don't use funds very well. This is apparent in the US and John suspects is also the case elsewhere. The difference between 'investor return' and total return shows that investors--retail as well as institutional--tend to mis-time their transactions, buying after funds have risen and selling after they've fallen, by and large.
What else do we know? US investors have learned about fees but investors elsewhere haven't quite caught on yet. Research in the US has shown funds with fees in excess of 150 basis points have generally experienced fund inflows, while those with expense ratios less than 50 basis points (i.e. very cheap funds) had outflows on an annual basis--this trend changed in 2009, largely driven by the US adviser community. Note that these figures exclude ETFs.
Moving from what we do know to what we might know. Stewardship performance--stewardship is about items that are off the balance sheet: regulatory issues; manager incentives (short or long term, etc); fees; corporate culture (a fuzzy concept to measure but, still, something that Morningstar fund analysts look into). Two of these five items have been found to have statistically significant relationship to how funds perform in the future. Stewardship seems to predict fund survivorship, i.e. poor stewards, few survivors; the better the funds' stewardship, the more likely they are to survive.
Another thing we might know is that stock funds that are more actively managed outperform stock funds that are less actively managed. Managers that aremost indiosyncratic--that deviate most from the index--tend to outperform. A finding that's a little strange given the popularity of trackers and ETFs, etc. The implication is that if you're going to be a tracker, then do actually track the index as replicating it fairly closely won't lead to outperformance. We haven't proven that the most active managers add value, John says, but we haven't disproven is either.
What else might we know? Top stock managers own the stocks of other top managers, implying that fund managers who own stocks that have been owned by unsuccessful managers, might also underperform. This is something that could be useful when evaluatiing new funds, John points out.
Among the things we don't know are trading costs--market costs are unavailable, existing estimates of market impact vary wildly. Key questions include, at what point does a fund become too wieldy? Also don't know enough about: fund timing; quantitative versus qualitative research; boutique versus full service; what's wrong with hedge fund of funds?
In summary, the literature has settled on the key attributes for future long-term performance. In order, low cost, good past performance relative to funds following a similar investment strategy. Little aggregate difference between active and passive funds aside from fees (and possibly taxes). Most investors do not time their fund purchases particularly well. Global findings tend to echo US findings on: persistence of performance; existence of short-term momentum; importance of costs. Elsewhere, however, there's much work to be done!
In response to a delegate's question, in which he notes that without bad decisions, there wouldn't be a market and suggests passive investors get a free ride, John responds: "Yes. Passive investors are free riders. They don't seem to have a guilty conscience."
Another question: "Has Morningstar done any research into funds where the managers put their own money in, and how these perform compare to those that don't?" John's response: Yes, we have but then "I don't put my own money into my fund," isn't something that you hear very often at conferences--managers don't have to prove it. In the US, however, they do need to disclose this so Morningstar has looked into this and about 50% of managers seem to invest their own money but all the data is new so there is much more to do to conduct a proper study. We tend to suspect that managers who invest their own money in their funds will outperform those that don't but a lot more research is needed here.
John's video interview, in which he also answers my questions about the investor experience in the UK versus that in the US, can be viewed by clicking here.
Morningstar/OBSR Qualitative Research: One Year On Dan Lefkovitz, Director of Business & Operations, Pan European Research Team, Morningstar Europe; Christopher Traulsen, CFA, Director of Fund Research, Europe and Asia, Morningstar Europe; Richard Romer-Lee, Research Director, OBSR, a Morningstar company
The final presentation of Morningstar's Investment Conference 2010 and it turns out that our fund analysts have assigned qualitative ratings to 1,009 funds in total--463 of which are available for sale in the UK--across 104 categories. Of those 1,009, 436 have been rated Standard, 78 Elite, 396 Superior, 70 Inferior--i.e. we think there are structural defects that will lead these funds to underperfom, and 2 Impaired ("the lawyers are chasing us on those," Dan quips). 1 is deemed to be unratable and 17 are currently under review.
Morningstar has been independent since its inception in 1986, Dan points out, and the key principles of our qualitative research are: we don't charge for issuing analysis/ratings; we give both positive and negative assessments; our coverage is driven by serving invetors; "global knowledge, local expertise" and our call for more transparency and better investor education.
Chris takes over from Dan to discuss the five qualitative research pillars: People; Process; Parent; Performance; and Price. Chris highlights the role of the parent and the people--after all, when you buy into a managed fund, you're buying into the expertise and skill of the team--and who stable the parent company is, and their attitude towards management, incentives, etc als play a role in our research.
Having systematically reviewed each fund, a ratings committee goes through a robust process where the analyst(s) rating is scrutinised by peers. It's important to note that the fund manager or fund company is not given access to our report before it is published, Chris says, we're completely independent.
You can find a comprehensive report on how we assess funds and assign qualitative ratings here.
Richard, of Morningstar's most recent UK acquisition, OBSR, highlights the similarities in the methodologies of Morningstar and OBSR analysts. We have five Ps, as outlined above, while OBSR also look at Parent, People, Performance, but they have an R: Risk.
Thank you for following this blog, I have tried to include the key messages of each presentation and highlight particularly interesting insights. During the conference, we also filmed several videos with presenters in which they answered additional questions. Links to these videos have been published immediately following the above summary of their presentation, where applicable.
