Discipline proves its mettle in down market

Many traditional value investment mandates had been severely beaten by the benchmarks in the last couple of years, but with the rapid downturn of the last three months, there are some signs that disciplined value mandates in particular are beginning to demonstrate that patience can pay off — if only moderately — in this type of market.

David O’Leary, manager of fund analysis for Morningstar Canada, says you cannot paint all value styles with the same brush, so investors need to look at managers on a case-by-case basis. He says there is some evidence that managers who have maintained a contrarian investment style, and stuck with it when the markets turned, may very well be seeing a bit of a pick-up in performance relative to the benchmarks.

“Some value funds outperform in a down market,” he says. “You really have to look at it on a manager-by-manager basis to determine if they are doing better or worse than their competitors. Value firms like AIC have gotten crushed as well as value managers like Rory Flynn and John Arnold at AGF — who also employ a value style — because of huge financial weights in their respective funds.”

It’s important to note that outperformance does not mean positive performance. Assessing the value of a manager in this market is more likely to be determined by comparing the manager’s performance to the benchmark or to other managers in that manager’s sector.

In this case, managers who employ a disciplined active management style, and avoided heavy weighting in the beaten up sectors like commodities and financials, should be showing returns above the benchmark.

According to a report released by Russell Investments earlier this week, active value managers have made a terrific comeback. The report states 93% of value managers in Canada beat the benchmark in the third quarter.

It should be noted that the Russell study doesn’t look at after-fee returns, so it’s not the best barometer of whether active is better than passive management in a down market. But it does highlight that active value management is certainly in a better position in this market than many other investment styles.

Firms that have applied a disciplined approach to their portfolio management still have a little bit of spring in their steps that you might not otherwise expect. For example, the management team that oversees the Trimark brand of funds for Invesco Trimark has been pleased with the relative performance of their funds of late.

At the firm’s recent roadshow stop in Oshawa, Ontario, chief investment officer Graham Anderson explained that this market seems to be showing there is definite value in active management.

He noted that, historically, his firm’s value funds underperform during the peaks of a bull market, and outperform during the troughs of a bear market. He stresses that the company’s disciplined investment style makes a point of not being correlated to the indexes.

He pointed out that many of the Trimark funds have moved to the first two quartiles of performance over the last quarter during the recent downturn. Some, like the Trimark Canadian Fund, have leapt from the fourth quartile YTD as of June 30, to the top quartile YTD as of September 30.

“On a relative basis, we are scraping by with negative returns, as with everyone else,” he said. “That’s obviously very difficult to have to go through. Over the last quarter or so, we’ve done very well on a relative basis.”

Anderson notes that the same discipline worked in the bear market that occurred between 2000 and 2002, in the wake of the technology bubble bursting.

“Leading up to the tech bubble, we underperformed; when that bubble burst and markets turned, our funds were well positioned at that point to benefit from the changed environment,” he says.

Institutions are taking a second look at these type of mandates, quite possibly because they are looking for value mandates that have not deviated from their style, but, given market conditions, would be trading at a substantial discount to where they were. Approximately 30% of Invesco Trimark’s funds business is now institutional.

Don Reed, president and CEO of Franklin Templeton Investments, says institutional interest has “picked up” in both the funds and customized institutional investment pools offered by the firm. He notes that while value mandates seem to be drawing particular interest, disciplined active styles of all stripes are being looked at in this type of market.

“Sir John Templeton said over the long term you cannot be the same as the index. Most bottom-up managers, when they put stocks together, the result is usually a well-diversified portfolio,” he says. “I would say active management does add value. We can’t confuse active management with activity.”

Reed says if their research and investment thesis hasn’t changed, then a disciplined manager will not deviate in these market conditions.

Some of the firm’s offerings have shown extraordinary resilience to the market conditions. For example, the Mutual Discovery Fund, a global deep-value mandate, is a top-quartile performer that has had a return of -7.63 over the past six months, but its benchmark index, the MCSI World Index, is down nearly 12%. The same goes for the Bissett Multinational Growth (US$) fund, another top quartile fund outperforming its benchmark by more than 3% over the last three months.

“Through any period, but particularly in this period, you’re looking at the portfolio on a stock-by-stock basis. Over time, you’re making changes as the investment thesis changes, based on the criteria you used to value a company,” Reed says.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(10/31/08)