Can we do this differently?

21 January 2010

In an industry that's sometimes criticised for being overly homogenised, an Australian equities ex-20 strategy can offer a unique opportunity for investors to add value. Paul Cuddy, CEO of Bennelong Australian Equity Partners, discusses.

Exploring current portfolio outcomes for clients
Australia has amongst the highest per capita share ownership in the world. This has evolved due to a number of reasons including the willingness of governments to float public assets, high levels of financial literacy and the integrity of the Australian market. According to an ASX report in 2008, more than 41% of the adult population own direct shares and if you then include indirect share ownership within super, it may well be higher.

The Australian share index as measured by the S&P/ASX 300 has some interesting characteristics that are worth exploring when trying to construct a portfolio. This benchmark has some biases in that its top 20 stocks represent 65% of the index. As a product of this large proportional representation, most Australian investors have the majority of their shareholding within a concentrated few stocks which may not represent the best investment opportunities the Australian market has to offer. The following paper will attempt to tackle several related challenges such as:
  • blending may not be as effective as desired: advisers blend groups of managers but find the resulting portfolio can result in the unintended outcome of generating passive returns at a high cost (i.e. active fees) for the privilege;
  • the client has existing holdings: advisers often have the situation where they need to build a portfolio for a client taking into consideration that the client has historical positions (potentially direct equity holdings). These may have large unrealised capital gains or perhaps hold some other attraction to the client that restricts selling; and
  • clients are looking for direct exposure: as levels of financial literacy amongst Australians increases, individuals see the benefit of holding direct shares for increased control over tax and exposure outcomes.
We will look at the underlying benchmark of the Australian market and suggest some strategies that may offer clients a solution to some of the more common challenges with constructing a portfolio.

Complementing the current benchmark
The Australian equity market is characterised by the dominance of the ‘mega cap' stocks. This structural anomaly distorts the weighting that the top 20 stocks represent in the S&P/ASX 300 Index. The pie chart below presents a very powerful example of that dominance.

Source: Standard and Poors Nov 09

Close enough to two-thirds of the index is accounted for by just 20 stocks. This disproportionate representation creates a number of problems for investment professionals which can lead to known sub-optimal outcomes. Firstly, most large cap Australian equity portfolios have investment constraints that don't allow for individual positions to stray away from the stock's benchmark weight. Typically, this means that most managers will need to hold a position in a stock (ie BHP) whether they like it or not. The stock guidelines only allow for a fluctuation of 6-10% from an individual stock's benchmark weight.

Further to this is that one of the more common measures of risk for portfolios, rightly or wrongly, is the tracking error. The tracking error quantifies the degree to which a strategy differs from a given benchmark as measured by standard deviation. A manager that chooses not to hold this dominant stock can expect a large tracking error which, although not necessarily a bad thing in its own right, may have other repercussions. It is most probable that even the most benchmark unaware Australian equity manager will have 50% or more of a portfolio in the S&P/ASX 20 due to stock limits, sector limits, tracking error or a combination of all of them.  

Investigating different benchmarks
A complementary benchmark which can be used alongside an investment in the broader benchmark is the S&P/ASX ex-20 benchmark. This benchmark simply excludes the top 20 stocks of the broader index. One of the benefits of the ex-20 benchmark is that it is not dominated by a handful of stocks as is the case with the S&P/ASX 300. The chart below shows a comparison of the top 20 stocks in the standard benchmark versus the ex-20 benchmark.

Source: Standard & Poors

Traditionally, portfolios have been constructed using a blend of three to four Australian equity managers and one to two smaller cap managers. This has been a simplistic rule of thumb that has not necessarily thwarted the dominance of the top 20 stocks in the S&P/ASX 300; the argument being that limited exposure to the ex-100 market is wiser given the dramatic fall in market cap and liquidity. This argument has proven to be a good rule of thumb but has nevertheless meant that portfolios have an under representation in the larger cap stocks outside of the top 20; those that have strong brands with robust business models and don't suffer as much from illiquidity issues.

At the time of writing, Santos is the 21st stock in S&P/ASX 300. Its market cap is over $12bn and its turnover is over $60m per day. This is not an illiquid stock. Other names that appear in the list from 21st-50th in the index include Newscorp, Leightons and Worley Parsons. Entry into this market is not an entry into the small caps space.

Source: Iress, BAEP Jan 2010

The ex-20 benchmark has the added advantage of not compromising on the underlying fundamentals of the market. More specifically, the ex-20 index provides greater growth opportunities than the S&P/ASX 300 whilst maintaining other fundamentals such as price and yield. As the table below demonstrates, the fundamentals of the S&P/ASX ex-20 benchmark exhibit strong growth opportunities whilst still maintaining a yield of close to 4% on a one-year forward basis.

Source: Bennelong Australian Equity Partners

Practical strategies utilising the ex-20 index
The following refers to utilisation of the ex-20 benchmark or product to provide a solution for the challenges that were presented earlier in this paper:
  • blending may not work: most financial planners' models focus on understanding the style analysis of blended portfolios, which typically involves managing a compatible mix of styles (eg. core, quantitative, growth, value). The assumption here is that different style portfolios will have different (or in some cases the same) active bets, that when combined deliver superior price/factor diversification attractive to clients across different markets. Although the theory is solid, the outcomes often aren't.

    One way of addressing this situation is to use a mixture of large cap active managers that attempt to outperform at the large cap end of the market, or seek passive exposure in the ASX 20. These products are available via platforms and SMA's and lower the overall cost to the client. Alpha is then sought by the use of a specific allocation to a manager benchmarked, versus the ex-20 benchmark where a less researched universe may offer greater opportunity to outperform;
  • client already has direct holdings: in this situation the majority of clients holdings will be in the ASX 20 due to the large exposure to banks, resources and/or other well known blue chip names. Although this won't always be the case, it will be in many instances. If the client has embedded capital gains, the planner may not be in the position where they can readily divest without creating a large tax liability. In this situation, an exposure to the ex-20 benchmark will in many cases ensure no duplication of current positions, added diversification and hopefully alpha; and
  • client looks for direct exposure: SMA products have been part of the Australian investment market for a number of years. They allow investors to access stocks directly which attaches certain control and tax benefits. Arguably the most popular investment product (as measured by flows) is a passive S&P/ASX top 20 product. This product seeks to gain exposure to the largest part of the market by weighting stocks either equally or by market cap and limiting the turnover by re-weighting quarterly. Alternatively, the adviser may be able to provide a portfolio of top 20 stocks outside of an SMA or platform. This would allow the adviser to in turn use a professional manager to add value outside of the top 20.
An ex-20 Australian equities strategy presents a compelling proposition for investors and not surprisingly, is attracting a growing investor audience. With structural anomalies suggesting that many portfolios are over exposed to the market's top 20 stocks, an ex-20 strategy offers a complementary alternative to the more traditional funds to harnessing the investment potential that lies within the ASX300 but outside of the top 20.



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