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September Quarter 2008 Update – Future Directions Funds

What occurred in investment markets in September to have such a profound impact on investment returns?

September 2008 turned out to be the worst month for financial markets and corporate credit in recent history. The month saw the bail-out of Fannie Mae, Freddie Mac, AIG, and others.  At the same time it witnessed the demise of Lehman Brothers and Washington Mutual, signifying two of the largest defaults in history. In addition, European governments implemented policies for the rescue of financial institutions through nationalisation and we witnessed the continued US Federal Reserve liquidity injections. We also saw the introduction of restrictions on short selling in many Western markets.

These events and general weakness in global economic data have created uncertainty around the stability of the banking system and heightened risks of a global recession. Equity, credit and some listed markets have been negatively impacted by this uncertainty. Markets have also been particularly impacted by the market-wide de-leveraging that is occurring as a result of portfolio redemptions.

As a result of this de-leveraging, the selling has been indiscriminate, with quality stocks also being caught up (in many cases, the better quality securities are sold to a greater degree because they tend to be more liquid). In this environment, fundamental valuations are ignored.

As experienced fund managers, we acknowledge that markets can move away from fundamental valuations at certain points in time. However, on a short-term basis, we believe the recent market activity is unprecedented and having a major impact on managers’ ability to deliver on their target returns.

We do not believe that current trading conditions will continue for long, however markets are likely to remain extremely volatile in the short term. In the meantime, we are interacting with the underlying managers on a frequent basis.


How have the Future Directions Funds performed in this environment?

Overall, the Future Directions diversified funds have underperformed their performance benchmarks by the end of September. Diversified funds – which gain exposure to a number of underlying sector funds such as shares, bonds and property, have been exposed to the downturn experienced across all of these asset classes.

In the mainstream diversified fund, the Future Directions Balanced Fund, the underperformance was spread across a number of asset classes, largely from exposure to the Total Return Fund (TRF) and the Future Directions International Share Fund. Within the Future Directions Conservative Fund, the underperformance came from exposure to international bonds as well as TRF and international shares.

On a positive note, the Future Directions Australian Share Fund outperformed the benchmark due to the lower allocation to Australian materials and energy stocks. The Future Directions Extended Markets International Share Fund also outperformed its benchmark over the month.

How have the Future Directions Funds performed against competitors over this period?

The September quarter was a poor performance period for the Future Directions Funds and a disappointing result versus our competitors. Anecdotal evidence would suggest third quartile performance versus our competitors.

Part of the underperformance can be explained by the lower exposure of the Future Directions Funds to direct assets such as infrastructure and direct property. Correspondingly, the relatively higher allocation to listed assets has meant that the Future Directions Funds have been more exposed to the market downturn. It is our view that listed markets have priced in expected weakness in the global economy. However, we believe that direct assets are yet to see the valuation adjustment that we believe is inevitable.

Nonetheless, we regonise and acknowledge this underperformance. One of our key objectives is to outperform the median multi-manager in the surveys and we remain incentivised to do this. However, performance versus competitors needs to be assessed over the longer term.

The recent decision to increase the allocation to alternative assets is expected to better diversify the returns of the fund against this type of event, and place the funds in a better position to manage downside risk versus our competitors going forward.
 

Has the Future Directions team made any changes to the portfolio over this period?

The Future Directions team, along with our research consultants, have been interacting closely with our invested managers over the course of this financial crisis. It is critical that we maintain a constant dialogue with the managers to ensure our investments are managed to the highest standard.

Typically, our focus will be on the managers’ exposures to various companies or sectors within their portfolios. It is important that we have a clear understanding of the overall exposure of the portfolio to sector risks (eg resources or financials), counterparty risk (eg Lehman Brothers) or geographic risk (eg US or European stocks).

We aggregate the underlying investments across all of the managers to ensure that we are comfortable with the various risks that the aggregate data identifies.

In this type of environment, it is important that we do not make any decisions based on short-term performance as volatility has reached extreme levels. We constantly assess the reasons and rationale which drove the decision to invest with the manager in the first place. Provided nothing has fundamentally changed, we would not discard a manager on short-term performance reasons alone.
 

What about the fall in the Australian dollar?

The sharp fall in the Australian dollar should be viewed as an extreme and abnormal event, the type of which has not been seen since the floating of the dollar in the early 1980’s. The fall in the dollar is a function of investors fleeing higher yielding currencies (where interest rates are higher), slowing Australian economic growth and the perception that Australian companies will be dealt a harsh blow as global growth falls.

Whilst these may be valid concerns for investors, the fact is that Australia is expected to still produce positive growth (albeit slowing) relative to many other Western nations. From a valuation point of view, the Australian dollar is now undervalued on a number of economic measures.
 

How has the fall in the dollar impacted upon returns?

A falling Australian dollar will benefit an unhedged portfolio as the assets are typically owned in currencies such as the US dollar or the Euro. For example, a 1% fall in the Australian dollar means that international assets will be worth 1% more.

The international shares component of the Future Directions diversified funds typically holds a 50% currency hedge. This means that 50% of the Future Directions International Share Fund is exposed to the fluctuations in the Australian dollar. This unhedged portion is of benefit to the Fund when the Australian dollar falls but acts as a detractor when the currency rises.

Some may ask why we did not remove the 50% hedge when the Australian dollar was close to US 98 cents. The reason is that we do not aim to time currency movements. As we have just witnessed, currencies can move erratically in a very short period of time.

We aim to capture currency movements through underlying managers who trade currency on a tactical basis. In this type of environment, these managers can add value to overall portfolio returns.
 

How confident can investors be that investment returns will turn positive?

With the falls in investment returns and many asset classes showing high levels of undervaluation, many investors remain cautious, particularly given the uncertain outlook in the global financial system. Investors are also looking to company reports as a guide to the depth of the economic downturn.

Against this uncertain backdrop, it is unlikely that we will see a return to more normal trading conditions for the remainder of 2008 and possibly into 2009.

In saying this, we expect that the extreme market volatility will begin to normalise as investors gather more facts on the state of the economy rather than trade on the fear and speculation that we witnessed over the September quarter and into October. As we have seen historically, markets tend to outperform before the official end of the economic downturn.

For more information on the outlook for the Future Directions Funds, please see our regular performance reports.

Important links

  Future Directions Funds Strategic Asset Allocation (SAA) review

Future Directions Funds overview flyer
Brief overview of what the Future Directions Funds are, the reasons to invest and what each fund’s investment approach is.
http://www.ampcapital.com.au/_pdf/futuredirections/overview/FDFOverview.pdf

Panel of managers
Access the manager listing for each of the funds.  A downloadable PDF document of the panel of managers can be also accessed on this page as well as detailed profiles on each of the FDF managers.
http://www.ampcapital.com.au/ampfp/futuredirectionsfunds/panelofmanagers.asp

Manager profiles
Detailed profiles on each of the FDF managers
http://ampcapital.com.au/_pdf/ampfp/fdf/FDFManagerProfile.pdf

Target manager allocations

Education booklet
An educational guide to:

 

 

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