The worst December on Wall Street since 1931 had slashed the index return to 1.4 per cent expressed in Australian dollars. Without being able to go short, Magellan’s downside protection strategy kicked in and did exactly what it was supposed to.
Here’s how they did it.
Douglass was worried that the US Federal Reserve would end up ‘behind the curve’ if there was an inflation break-out, forcing it to increase the pace of rate-rises, which would hurt stocks.
He decided to get more defensive and raise the portfolio’s cash weighting to the most since 2009. By the end of the year he was 19 per cent in US dollar cash and this contributed 2.2 percentage points of the 9.8 per cent annual return, but he was already 18 per cent cash in July.
In fact the third quarter was pretty friendly: three big positions – hospital operator HCA, Apple and Lowe’s – each gained more than 20 per cent in that period. Ratcheting up the defensiveness could cost the manager if the bull market was sustained, but Douglass justified this by saying “only conservative investors sleep well”.
He couldn’t believe anyone would want to be in emerging markets given the US dollar risk.
Everything changed between the third and fourth quarter.
Trade war casualties
US companies started warning about the impact of the trade war. The Federal Reserve was tone deaf in its policy intentions, and long term bond rates even short term rates were cranked higher – a sign of mounting recessionary risk. Developed markets didn’t look overly expensive but that disguised the fact growth stocks were really expensive and value stocks were really cheap.
It had been a long time since the market experienced as bad a drawdown as it did between September and December. The data shows it was a 95-day event, the longest since the Greek crisis of 2011. That means it had been a long time since the Magellan portfolio was tested under such extreme conditions.
“We run two different portfolios, we run a very defensive and a growth portfolio inside the same strategy, so our growth part of the book has been knocking the ball out of the park but we offset that with very defensive things as well – because we’ve got this downside protection in what we’re trying to do,” Douglass reflected at the time.
The June 30, 2018 league tables showed Magellan was not even close to the top 10. According to Mercer, the top-ranked global manager Baillie Gifford did 44 per cent, before fees, in 2017-18 and the median manager did 15.6 per cent. (Douglass’ strategy returned 16.9 per cent after fees).
As Douglass decided to add some cash, other positions had to be trimmed. The US hardware store Lowe’s was one of them – the investment team didn’t believe the market was adequately pricing recessionary risk into the Lowe’s share price. Wells Fargo was another fortuitous reduction given how badly financials perform when economic conditions deteriorate.
They also exited Costco. but mostly because it became fully valued.
So in the fourth quarter, when Apple fell 30 per cent and Facebook 20 per cent, the reliable earners HCA, Starbucks and Yum! Brands behaved entirely reliably by doing almost nothing.
As for Tencent, Douglass was never convinced the owner of WeChat and the backer of runaway video game hit Fortnite, was indeed valuable money spinner.
“Tencent’s a gaming business. It’s an okay business. I’d own it at the right price, but it trades on a crazy price for a gaming business,” he said earlier this year.
By the end of the year Tencent had slid by 23 per cent, punishing the funds that held overweight positions.
Highs and lows
In portfolio construction terms, it comes down to high and low beta stocks. High beta stocks win by more and lose by more than the market, and low beta stocks do the opposite. HCA, Starbucks and Yum! are low beta.
Magellan Global Fund’s drawdown capture ratio since inception is 0.5, meaning it never wears more than 50 per cent of the market’s losses in a falling market based on actual performance since July 2007. An index fund, in theory, has a drawdown capture of 1.
In a brutal year for stock markets, many ‘active’ fund managers failed to deliver for their investors.
They either underperformed the benchmark indices they are paid to beat, or lost capital when they were hired to protect it. Magellan were an exception along with hedge funds such as Bronte Capital and VGI Partners that delivered 20 per cent and 17 per cent returns respectively.
Others, such as Charlie Aitken’s AIM, and Melbourne boutique L1 Capital suffered 20 per cent-plus declines.
This was a year when, the bearish, cautious and conservative managers finally came good.
For managers that are focused on downside protection, it’s obviously been a tough period for them over recent years until the past few months,” said Steven Carew, of investment consulting firm
“You need a lot of patience and a lot of resilience to stick to your knitting for that length of time.”
Carew, who is the head of investment outcomes at JANA says fund managers that manage capital from institutions tend to be more “relative focused” and tied to the index benchmarks.
“There’s a limit to how aggressive or how defensive they might be.”
But “many managers targeting retail investors are more focused on absolute returns and they’re more inclined to have a greater focus on downside protection.”
An odd year
The year 2018 was an “odd year” in which the cyclical resources sector and defensive sectors such as REITs and consumer staples, outperformed.
“If there was takeaway, he said it was about fund manager’s “confidence in future earnings,” Carew said.
“Investors favoured sectors such as health care and IT for the stronger earnings outlook, but later in the year it was the companies that had a more stable earnings profile, such as Staples, Utilities and REITs, strongly outperformed.”
While Douglass considers himself a disciple of celebrated value-investor Warren Buffett, his strong numbers have defied the generally lacklustre performance of value funds, which focus on ‘cheap’ companies that trade at low prices relative to earnings or their accounting book values.
Douglass was worried last year that the problems facing deep value stocks were in fact intensifying.
“Value as a style has under-performed again, and that has been the case for most of the past decade,” said Morningstar’s Tim Murphy who researches, analyses and monitors managed funds.
“Most large cap managers have an element of value discipline in their process and the stronger that has been, the worse they are likely to have performed – that is true both globally and domestically.”
The year was a tough one for Magellan’s peers, including rival home grown manager Platinum Asset Management.
“The place not to be was emerging markets and China. So the notable poster child was Platinum as their exposure to these regions led them to have a poor year,” Murphy said.
Magellan is the “flipside” given its heavy exposure to US markets and the quality factor. Murphy points out however that 2017 was the “absolute reverse” where Platinum had a particularly strong year as emerging markets traded well.
The year of divergent fortunes among global fund managers is an important lesson.
“The most important thing is, when constructing a portfolio, is not to have concentrated exposure to any one manager, style or approach,” the Morningstar analyst says.
“There is no such thing as an investment approach that works in any time, in any market condition, as much as fund managers try to make you believe otherwise.”
The poor performance of so-called value managers was most profound in Australia with famed value investing shops such as Maple Brown Abbott and Perpetual sinking towards the bottom quartile of the rankings.
Research firm Lonsec said that out of 100 large cap funds it recommends in Australia, only 15 were able to outperform their benchmark.
“Those that outperformed tended to have broader mandates – they could hold more cash, invest globally, or were quite simply, growth managers,” said Lonsec co-head of manager research, Deanne Baker.
She says the dispersion between growth and value managers in the Australian market was incredibly large – with an index of growth stocks delivering a 2.8 per cent gain while value stocks fell 7.4 per cent.
While value investors were given a reprieve in the fourth quarter as value stocks fell 5.6 per cent versus a 9.2 per cent decline in growth stocks, returns were “still negative and not enough to close that gap,” Ms Baker said.
“The growth story just keeps powering while it has been hard to find value.
L1 Capital, for instance, cited a spread between growth and value stocks that had reached a two decade extreme to explain why their long-short fund had suffered losses.
“We also saw many large cap managers that couldn’t find ‘alpha’ head down the market cap spectrum – which was initially beneficial but when volatility returned that was the part of the market that got punished the most,” Ms Baker said.