The global managed funds industry

Relatively resilient in extraordinary times

The ongoing credit crisis over the past weeks has become, without a doubt, the defining general news story of 2008. Its causes, sequence of events and implications are discussed at length elsewhere in this issue of Corospondent. But it is not only a story about the macroeconomic outlook, fiscal policy and deleveraging – it is also about how incredibly widespread the impact of market events and capitalism has become.

You may wonder what more than 300 million people across the world, including 80 million Americans, 120 million Chinese and 3 million South Africans have in common. All have a direct stake in the health of the financial markets as investors in collective investment schemes (unit trusts). And all of them have in some way been affected by recent market events.

Some of the implications of the market crisis for funds and their investors were discussed at a recent international industry conference*, and are highlighted below.

The scope of the crisis is truly global

Share prices and currency exchange rates were impacted everywhere, regardless of the fundamentals of the local economy or the strength of the domestic banking system. Whether you live in Shanghai, San Diego, Stockholm, Seoul, Sydney or Sandton, your share market lost more than 30% of last year’s peak values (and in some cases more than 60%). Global market declines of the past weeks have largely been caused by, in particular, US investors reducing risk in their portfolios. The impact of this risk aversion is so significant due to the sheer size of the US: Since 2003, nearly US$500 billion net new investments were made into foreign markets through regulated mutual funds alone. As much of these assets have been repatriated at speed in late September and early October, asset prices everywhere have come under pressure.

It may be the worst financial crisis since the Great Depression, but it doesn’t mean that its long-term implications will be as severe

Most observers confirm that the response from global governments has been unprecedented in terms of speed, size, breadth and resilience. Policy makers around the world have shown that they are willing to do whatever it takes to get the financial system back to normal. While the market has not yet sent clear signals that the worst is over, it is possible that confidence in the banking system may be restored relatively quickly.

Investors are still prepared to wait for the long-term recovery… for now

Investor behaviour through the current crisis appears to be more long-term focused, with less withdrawals from growth funds recorded than in previous market crises. This may partly be the result of an increased use of balanced and flexible funds, where the fund manager explicitly aims to meet specific investor-oriented objectives. If this behaviour persists, it may reduce the impact of the crisis on household wealth significantly.

Studies show that investors are more likely to ‘convert’ the full market return over time if they do not attempt to time their allocations to different assets or managers. The results of one study conducted by Morningstar provide support for this position, see below:

Source: Morningstar, Investment returns in US Mutual Funds, 2003–2007.

Note that the investor return can also be defined as the time-weighted return of the funds, while the fund return refers to the money-weighted return.

Note that the average investor in a balanced fund, following a buy-and-hold strategy, performed significantly better than the average investor in equity sector funds, following a market-timing strategy. The impact of ongoing uncertainty and current double-digit negative returns from moderate risk funds, experienced for the first time in a decade, may however pose a severe test of investor resolve. It will also be interesting to watch whether the relentless global march to convert the retirement system to market-linked defined-contribution schemes continues post the crisis.

Money market funds survived with their integrity largely intact

Regulated money market funds are the lowest risk investment options offered by fund managers. Because these funds can only invest in the highest rated short-term debt instruments, regulators allow managers to price these funds at a stable one rand price, implying capital stability.

With the exception of a few isolated problems in the US and Europe, affecting only five out of approximately 10 000 portfolios, money market funds across the world survived the turmoil of the last few weeks without suffering capital losses. Given the severity of the crisis, the limited impact confirms their safe haven status. Since the introduction of local money market funds a decade ago, no South African investors have suffered capital losses and none are expected at present.

Not all income funds were created equal

Investors were, until recently, happy to take on significant additional risk in exchange for marginal additional benefit. This led to the proliferation of enhanced cash and managed income funds globally. Many of these funds invested in increasingly exotic instruments in an attempt to improve yields and as a result suffered losses when the markets turned. As investors became more risk averse over the past months, these funds experienced massive withdrawals. This again highlights the significant amount of due diligence work that should be performed before deciding that a certain risk profile is acceptable. The old adage still holds true: If you do not understand it, you should not buy it.

Beware perceived safe havens and weak guarantees

Many investors suffered big losses after investing in ‘guaranteed’ products that proved to be less than secure. During September, Asian investors lost more than US$10 billion in this way, after buying structured products sold and backed by Lehman Brothers. Remember that a guarantee is only as good as the name behind it, and that unregulated or ‘over the counter’ investments introduce additional (non-market) risks.

The valuation of assets is also of key concern at the moment. Listed assets respond immediately to market sentiment. In a time of crisis, when fear is the dominant emotion, volatility can be extreme. In this environment, it is best to remember Benjamin Graham’s advice: ‘The market is a voting machine, not a weighing machine.’ It tells you how popular certain investments are, rather than what they’re worth. Unlisted assets with similar characteristics to their listed counterparts may appear to provide a smoother return, but this is arguably only due to the availability of less information. A classic example of perceived difference in volatility is found in property investments, with reported returns for listed real estate appearing to be more volatile than for physical property, despite the same fundamentals driving the outlook for both.

Stewardship trumps salesmanship

Investors and their advisors are increasingly emphasising integrity as a key buying criterion. The culture, compensation and incentive structures, governance policies and customer-focus of investment managers will in the post-crisis world become an even bigger driver in manager selection processes. Investors will progressively seek the combination of competence and credibility in a trust-starved world.

While writing about current events which are still in the process of unfolding is a little like identifying the man of the match before half-time, it appears that the investment fund model remains the most resilient, best governed, most transparent and operationally robust vehicle to provide broad-based access to the financial markets.

* Excerpts from presentations and discussions at the 22nd annual conference of the International Investment Funds Association (IIFA), held in early October in Montreal, Canada. The IIFA represents the global investment management industry. Thirty six industry associations from every continent, collectively responsible for more than US$24 trillion investment fund assets participate in its activities.

Pieter Koekemoer
Head of personal investments