Not even Marty McFly can avoid periods of drawdown

Short-term relative under-performance often receives excessive attention from investors and, whilst Zenith believes that it is important to understand the drivers of short-term performance, we also believe that it is important to look past this to achieve the best portfolio outcomes over the longer term.

8 Jul 2019

The following quote best summarises our thoughts:

“When an investor focuses on short-term investments, he or she is observing the variability of the portfolio, not the returns – in short, being fooled by randomness” – Nassim Nicholas Taleb

The 12 months to 31 March 2019 highlight the short-term performance difficulties of Zenith’s rated long/short managers. Our rated funds returned an average of 5.2% versus 11.7% for the S&P/ASX 300 Accumulation Index, representing significant under-performance of 6.5%.

What caused the recent under-performance?

During 2018, Zenith observed a large dislocation of company valuations within the Australian equity market. Using the price-to-earnings ratio as a proxy for valuations, we have tracked the aggregate valuations of the most and least expensive quartiles of stocks in the S&P/ASX 200 Index over the past 10 years to 31 March 2019, in the chart below:

Source: Reuters, Zenith Investment Partners

Typically, Australian long/short funds are long cheaper stocks (blue line) and short expensive stocks (orange line).

In 2018, the spread between the cheapest and most expensive stocks (as represented by the grey line) reached record highs and, even after the fourth quarter correction last year, remained at elevated levels.
As we can observe from the chart above, the cheaper segment of the market continued to become even cheaper throughout 2018. We note that the subsequent rebound in the first quarter of 2019 corresponded with stronger performance from our rated long/short funds.

In relation to the expensive segment of the market, the sharp rise in early to mid-2018 forced several managers to reduce or exit meaningful short exposures. As such, losses were absorbed and the funds were not in a position to benefit from the subsequent valuation contraction experienced in late 2018.

Whilst we are disappointed with the shorter-term outcomes of our rated long/short funds, we retain confidence that they will produce strong relative and absolute performance over the longer term. However, in the below analysis, we illustrate the difficulty of producing superior investment outcomes without some short-term performance issues.

The portfolio Marty McFly built

Those who are movie buffs would be familiar with the time-travelling adventures of Marty McFly (played by Michael J. Fox) in the Back to the Future movies. If Marty McFly was an Australian equities portfolio manager and he travelled back in time to 31 March 2014, which stocks would he pick long and short to hold for the following five years?

For the purpose of this exercise, McFly is required to select 10 stocks long and 10 stocks short from the S&P/ASX 200 Index.

As at 31 March 2014, McFly selects the top 10 performing stocks for his long portfolio and the bottom 10 performing stocks for his short portfolio, based on their share price performance over the five year period to 31 March 2019.

To implement McFly’s portfolio in a typical active extension framework, he was given $130 to invest equally across 10 stocks in the long portfolio and $30 to invest equally across 10 stocks in the short portfolio. In our simulation, McFly’s portfolio was rebalanced on a monthly basis to ensure the exposures remained constant.

The results of the simulation are shown in the chart below:

Source: Reuters, Zenith Investment Partners

As expected, the results are astounding. McFly’s portfolio generated a whopping return of 51.6% p.a. over the five-year period compared to 7.4% p.a. for the S&P/ASX 200 Accumulation Index.
Even Marty McFly’s portfolio could not avoid a drawdown!

Despite having a time-travelling DeLorean to pick the best and worst stocks possible over the five-year period, McFly’s portfolio still experienced a maximum drawdown of 13%.

The chart below compares the drawdown profile of McFly’s portfolio to that of the Index.

Source: Reuters, Zenith Investment Partners

Notwithstanding his perfect foresight and out-performance of the Index, McFly’s portfolio experienced several drawdowns that were more severe than the Index. Zenith notes that the drawdowns occurred over relatively brief periods and the subsequent recoveries were prompt.

Why is this relevant to our Australian equity long/short managers?

Uncharacteristically, most of our rated Australian equity long/short funds have materially lagged the benchmark over the past year. We believe there are some similarities between the performance of our funds and that of a portfolio built with perfect foresight. That is, whilst we expect that our rated funds will produce highly attractive returns over the long term (although not to the astronomical extent of McFly’s portfolio!), there will be short periods where they will under-perform. As such, we emphasise our belief that investors must take a long-term view when investing in actively managed funds.

By Jacob Smart, Investment Analyst.

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