+ About Russel Chesler
An actuary with over 20 years’ experience in financial services, Russel is responsible for managing Van Eck Global’s Australian ETFs.
Prior to joining Van Eck Global, Russel was a partner at boutique consulting firm Sunstone Partners, specialising in Asset and Wealth Management.
Previously Russel worked for Perpetual Limited as General Manager of Protected Investments and Lending. Russel has also held positions at Grange Securities, Alexander Forbes and Liberty Life.
Russel has a Bachelor of Science (Honours) from the University of Witwatersrand, Johannesburg. Russel is a Fellow of the Institute of Actuaries (United Kingdom) and a member of the Actuaries Institute Australia
Wednesday, December 02, 2015
We have had quantitative easing one, two and three, Abenomics, taper tantrums, debt crises, China crashes and Fed uncertainty. During all these, investors have been concerned about the economic influence and the impact on investments. While economic uncertainty continues, the process for choosing quality investments has not.
Investors, more than ever, are looking for investments that outperform throughout the economic cycle. By analysing more than 40 years’ data, it can be shown that companies which outperform over the long term have identifiable characteristics.
A quick refresh
There are four basic stages of the economic cycle. These are distinguished by economic growth and inflation.
A slow-down is a period of slow growth and falling inflation (or deflation).
A recovery is typified by rising growth and falling inflation.
A heating-up economy is one which is characterised by rising growth and rising inflation.
Stagflation is a period of slow growth and high inflation.
Different types of companies tend to perform better than others during the different stages of the economic cycle.
Investment professionals try to identify companies that will outperform over the long term. Some classify quality companies as those that have been consistently profitable and have increased their earnings throughout all stages of the economic cycle. MSCI defines quality companies as those that have demonstrated historically high return on equity, stable annual earnings growth, and low financial leverage. The MSCI World ex Australia Quality Index only includes the highest scoring 300 companies based on these three factors. Investors can access these companies through the Market Vectors Market Vectors MSCI World ex Australia Quality ETF (QUAL).
We have been able to illustrate that the MSCI World ex Australia Quality Index outperforms the standard benchmark, MSCI World ex Australia Index, over the long term. See chart below.
Economic cycle: Where the global economy is now
Many commentators believe that the global economy is entering the slow-down stage of the economic cycle (slow growth and falling inflation). This is evidenced by:
- Sustained low interest rates and the continued need for central bank intervention. The most recent European QE and long term bond yields are signs of low growth;
- Slowing demand and falling commodity prices;
- Falling demand and structural change in China further dampening growth prospects;
- Falling consumer price levels in many countries; and
- The steady increase in the proportion of countries with deflation.
Performance of MSCI Quality
MSCI analysed more than 40 years’ data to provide insight into the best periods of outperformance of its Quality factor.
MSCI, by comparing the performance of its World Quality Index, its World Index and its World Sector Indices in economic periods characterised by rising and falling growth and inflation, MSCI demonstrates that its Quality factor consistently outperforms in three out of the four stages of the economic cycle. A summary of the analysis is below.
MSCI Quality traditionally has its strongest relative performance during economic downturns.
Quality may hedge the risk of decreasing growth
MSCI’s Quality factor has historically been an effective hedge in periods of decreasing growth, generally outperforming more cyclical investments. Quality can be considered defensive. It has tended to only underperform, on a relative basis, during stronger economic times.
Historically, MSCI research shows quality has outperformed in periods that had the characteristics of current global markets.
Thursday, November 26, 2015
The Fox and the Cat in Aesop’s fable had different philosophies. However, only the Cat survived the attacking Hounds because the Cat’s escape plan focused on the most important aspect of escape. The same sharp focus is needed when investing.
The Fox and the Cat is an Aesop fable in which the Fox boasts to the Cat how clever he is at escaping threats. He has formulated hundreds of ways to escape the enemy. The Cat, on the other hand, has just one escape plan. A pack of Hounds attack and the Fox, confused by the many plans in his head, soon meets his demise. The Cat survives because she has focused on the one thing that would ensure her survival – getting out of reach of the Hounds.
If the Cat were an investor she would not be worried about stock picking within asset classes. She would focus on the one thing that ensures her portfolio would have the greatest chance of success – asset allocation.
In the 1986 article, the Determinants of Portfolio Performance, Brinson et al, demonstrated that the asset allocation decision was responsible for 93.6% of a diversified portfolio’s return pattern over time. Subsequent studies have confirmed this. The asset allocation decision is responsible for around 90% of portfolios movements, while the remaining 10% comes from security selection and market-timing.
If we, like the Cat, concentrate our efforts on getting asset allocation correct, our portfolio has the greatest chance of success.
Likewise, the costs we incur when investing should be reflective of where there is most portfolio movement. Unfortunately, the fee structures of many active managers who are focusing on stock selection and market timing to extract the most from the 10% of portfolio movement cause fees to be misallocated.
A sound investment portfolio for individuals, superannuation funds and institutions should begin with investment goals and objectives within acceptable levels of risk and appropriate asset allocation. It is here that most time and money should be spent.
While Brinson et al acknowledge active managers, in particular bond and cash managers, achieve positive contributions to overall portfolio performance “it seemed to be harder for managers to outperform equity benchmarks”. They concluded “extra returns seemed to be unrelated to the level of active management”.
Exchange-traded funds (ETF)s are ideal trading tools for investors who have worked hard on the key 90%, like the Cat, by using their investment goals, objectives and risk tolerances to determine the most appropriate asset allocation. ETFs allow you to access professionally managed portfolios covering a wide range of asset classes via a single trade on the ASX. Rebalancing and monitoring is simple as ETFs are easy to trade in and out of and are fully transparent. The varied range of ETFs allows investors to easily diversify between sectors to reduce exposure to the risks associated with a particular company, sector or region.
ETFs are also cost effective.
Additionally, ETFs that track strategic beta indices are giving investors the potential to outperform traditional market capitalisation ‘beta’ within a low-cost, passive structure.
The Cat must also regularly review her investments in light of her changing goals and risk appetite and must execute effectively to maintain the success of her portfolio. A portfolio of ETFs makes this easy.
Monday, December 01, 2014
When Charles Dow first published the Dow Jones Industrial Average in 1896 he allocated weightings to the top 12 stocks based on their prices. Over time index allocation based on market capitalisation was developed by Henry Varnum Poor and the Standard Statistics Co, resulting in the 1926 predecessor of the United States’ S&P 500 Index.
Investing evolved and tracking a market capitalisation stock market index became conventional investment strategy.
It’s time to break convention.
Equal weight investing is particularly suited to Australian investors as Australia has one of the most concentrated equity markets in the world. The top 10 companies make up more than 55% of the top 200 listed securities by market capitalisation.
Stock market indices, such as the All Ordinaries or the S&P/ASX 200 Accumulation Index were designed to be economic barometers of a market; something the media could quote in the news. Many ETFs and managed funds track the returns of these stock market indices.
By doing so they assume that the biggest companies are the best companies to invest in. This is not always correct. An ETF tracks an index by investing in the companies that make up the index in the same proportion as the index.
An ETF which tracks a market capitalisation stock market index allocates more to bigger companies than smaller companies. So when the market overvalues a stock, a fund tracking that index buys too much of the overpriced stock. Conversely, when the market undervalues a stock, the fund sells too much of the underpriced stock. This does not deliver the best performance outcome for investors. There is mounting research that concludes market capitalisation weighting is not the best method for portfolio construction.
Further, the research indicates that equally weighting a portfolio delivers the best outcome for investors. CSIRO together with the Monash Superannuation Research Cluster concluded in November 2013 that equal weighting is the “highest performing” index method. This conclusion supports research from London’s Cass Business School released in March last year which demonstrates the inefficiency of market capitalisation stock market indices.
Market Vectors Index Solutions has also published a white paper on the subject, which found that hypothetically, a $10,000 investment made in January 2003 in a fund which tracks the Market Vectors Australia Equal Weight Index would have been worth $30,304 in January 2013. The same amount invested in a fund tracking the S&P/ASX 200 Index would have been worth $27,910 over the same 10-year period.
Friday, November 21, 2014
Q: How would a scientist build an investment portfolio?
The CSIRO is Australia’s national science agency and is one of the largest and most diverse research agencies in the world. So diverse that it is now directing resources to investment portfolio construction.
The CSIRO-Monash Superannuation Research Cluster is researching many aspects of our superannuation system, including investment practices. A recent paper concluded that equal weighting is the “highest performing” structure for a portfolio, better than market capitalisation and better than alternatives such as RAFI’s ‘fundamental indexation’.
Put simply, an equally weighted index aims to allocate the same amount to each company within the index regardless of size. An equally weighted Australian index, for example, would have as much CBA in it, as it did Harvey Norman.
The paper tests US data for the years 1962 to 2009. US data is used because this is the largest reliable data set available.
The results are that investing $1 in 1962 would grow to:
- $100.86 in an equally weighted portfolio;
- $87.28 in a fundamental indexation portfolio; and only
- $59.04 in a market capitalisation portfolio.
Sophisticated models developed by such finance luminaries as Nobel Prize winning economist Eugene Fama and Robert Merton were used to determine the source of this outperformance.
The conclusion is that equally weighting a portfolio outperforms market capitalisation because of three factors:
- higher exposure to smaller stocks rather than bigger stocks;
- higher exposure to so-called ‘value stocks’, meaning those stocks with a high book-to-market ratio;
- and better market timing.
What the paper means by market timing is that equal weighting extracts more return when markets are rising and loses less when markets are falling.
Equal weighting was found to outperform fundamental indexation because of the better market timing. This is contrary to the claims made by the proponents of fundamental indexing.
Fundamental indexing is promoted as being superior to market capitalisation on the basis that it uses better measures of the size of a company. Market capitalisation is based on traded prices so is distorted when the market misprices. Fundamental indexing uses data such as book value, revenue, cash flow, dividends, sales and employee numbers to get a less market-distorted quantifiable size-based weighting.
The resulting index is said therefore said to be less susceptible to market sentiment and extreme market phases such as bubbles. The CSIRO have shown equal weighting achieves this but that fundamental indexation does not.
In non-scientific terms, the problem with investing more in bigger companies and less in smaller companies is twofold. When the market overvalues a stock, you buy too much of the overpriced stock. When the market undervalues a stock, you sell too much of the underpriced stock.
Tuesday, October 07, 2014
By Russel Chesler
Goldilocks is a woman who knows what she wants. She complained when the bed was too hard and she complained when it was too soft. She complained when the chair was too big and she complained when it was too small. Then there was that incident with the porridge. They call her ‘high maintenance’ – but when it comes to investing her attitude pays off.
When Goldilocks buys shares in companies, she insists that the company not be too big and not be too small – the so-called ‘midcaps’. The ‘mighty midcaps’ are the sweet spot in the investment universe combining the attractive attributes of large and small companies.
Some midcaps can be former small caps that have grown up. They balance spirit and safety. They have experienced management teams, established brands and client bases, infrastructure already built, and access to capital markets – advantages that small caps may lack. At the same time, they can grow more quickly than their large-cap counterparts, benefiting from flatter management structures, entrepreneurial drive and quick decision-making.
Midcaps are established businesses generating revenue with solid financial structures that can raise capital at a reasonable cost when they need to. These aren’t highly speculative small caps still burning capital hoping to make it one day, before crashing in a fiery heap.
Nor are they the business giants with huge market share that is impossible to grow more than a few per cent. Midcaps still have room to capture market share, offer new products, enter new markets, gain economies of scale or obtain intellectual property quickly. They also have a much greater potential to be taken over than the large caps have.
Large caps are covered in such depth by every analyst in the market that there are no hidden gems to find. Large caps give you straightforward equity returns but you are never going to get a spectacular above-market return. Midcaps have greater potential upside.
The S&P/ASX Index Series defines midcaps to be the stocks ranking from 51 to 100 by market capitalisation.
So, if you would like to be a savvy investor like Goldilocks you now know where to look for midcap stocks. However, picking the best performing midcap stocks is difficult. As with any investment strategy, diversification reduces the risk without, according to modern portfolio theory, giving up too much of the return.
One approach is to increase your exposure to midcaps by investing in Market Vectors Australian Equal Weight ETF (ASX code: MVW).
MVW weights the securities in the portfolio based on the purpose built Market Vectors Australia Equal Weight Index. MVW offers true diversification across securities and market sectors reducing concentration risk. It invests in the most liquid ASX-listed companies across both large caps and midcaps, with a greater exposure to midcaps than you would get from a market capitalisation index.