Future Directions Funds quarterly update

In light of the recent market volatility, how have the Future Directions Funds performed over the last quarter?

Depending on the asset allocation of the fund in question, the typical balanced fund will show negative returns for the one-year period to 30 June 2008. The typical default balanced funds (70:30) tend to have a higher allocation to growth assets such as shares and property, and are therefore more exposed to a share market downturn than more conservative fund options.

The Future Directions Diversified Funds have outperformed their benchmarks over the June quarter (to see performance figures since inception, please click on the funds's links. Past performance is not a reliable indicator of future performance). Stronger performance from the Future Directions International Share Fund, Future Directions Property Fund and the AMP Capital Total Return Fund was diluted by negative performance in the Future Directions International Bond Fund and the Future Directions Australian Share Fund.

For the year end to 30 June, the funds have performed relatively well versus peers, particularly in the Balanced, Growth and High Growth options. 

For details of the performance of each of the individual funds, please see the relevant performance report on the AMP Capital website, http://www.ampcapital.com.au/ampfp/factsheets.asp

Which Future Direction Sector funds have performed well relative to benchmark/ peers?

The Future Directions Funds have not been immune to the recent volatility experienced in global investment markets, given their exposure to shares, listed property and international bonds. However, there are examples where some of the funds delivered strong excess returns above index. The standout performer was the AMP Capital Total Return Fund, which out-performed its benchmark for the June quarter by 12% and 18% for one year. The Fund (given its absolute return focus) has benefited largely as a result of its overweight position in high conviction strategies such as distressed debt, discretionary trading and commodities. These strategies have been the beneficiaries of higher energy and commodity prices and the move away from financials. This Fund continues to show a low correlation with mainstream asset classes such as shares and bonds.

We have also seen significant improvement in the Future Directions Extended Markets International Share Fund. This Fund has benefited from the performance of the global small company managers (which represent about two thirds of the total fund).

Are there any signs of an end to the credit crisis?

We continue to take a cautious stance with our asset allocation decisions. It is our overall view that the worst of the liquidity crisis has been seen, however we believe that there will be continued asset impairment as the global economy enters a period of cyclical slowdown. This may see a second phase of further write-downs in asset values as the banking sector continues to repair, lending conditions remain tight and funding expensive, and a slowdown in economic conditions causes additional stress on corporations.

The chart below shows some of the historical market downturns and the impact on credit spreads (or the extra interest rate the market requires as compensation to take on the relevant default risks). The higher the lines on the chart, the more bearish investors have become about that particular corporate sector. The grey area shows where this coincided with an economic recession.

 Source: GSAM, BNP Paribas

It is our view that we are likely to see continued weakness in risky asset classes such as shares and property, as companies in this sector revise their estimates in earnings and company balance sheets are adjusted for higher funding costs. This could continue for the remainder of 2008 and into early 2009, although the market has already begun to factor in future earnings weakness in current prices. This may provide some level of floor in the equity markets going forward. Obviously, the impact of the global oil price will continue to be the X-factor driving investment markets over the short term.

Why has the Future Directions International Bond Fund underperformed its benchmark over the past year and what is being done to improve performance going forward?

The Future Directions International Bond Fund (IBF) has been impacted by the credit-related problems that we have seen over the past year. Initially the sub-prime crisis evolved into a liquidity crisis, which affected all corners of the credit spectrum, as forced selling by leveraged players caused a widespread re-pricing of risk. As investment banks and the general financial institutions were caught in the eye of the storm, securitisation markets ceased to operate, banking funding rates rose, and de-leveraging began to occur as assets were bought back on balance sheets and the need for bank re-capitalisation grew.

Paradoxically, the poor performance of the IBF has not resulted from direct holdings in sub-prime mortgage positions or large holdings in sub-investment grade securities. Rather, this liquidity crisis has led to a widespread sell-off of many higher-grade positions as leveraged market participants had to unwind parts of their portfolio and risk aversion grew. This liquidation has directly impacted the managers in the IBF, as quality positions were marked down in their books as the whole credit market suffered. Some managers in the IBF have also been impacted by benchmark mismatches. Benchmarks that have traditionally moved in tandem (for example US Agency and Non-Agency Mortgage Indices) have begun to trade differently, partly a reflection of the liquidity issues in the marketplace.

Volatility is likely to continue given the unprecedented nature of this financial crisis. However, the IBF is designed to benefit from a medium to longer-term improvement in the pricing of high quality securities. There is a good degree of diversification within the portfolio and the average credit rating is A+, with security specific default risk in the portfolio still very low. We are confident that the underlying managers are positioning themselves in segments where they have expertise and where they see considerable value. For example, holding cheap securities where the fundamentals are good and where high running yield and potential capital gains will add to performance.

While an eventual recovery in spreads for high quality securities underpins a confident outlook for active returns, in the meantime the portfolio will benefit from a running yield that is well above its benchmark, as these volatile markets continue to play out the crisis. While we are optimistic on the return potential, timing is the real question. The speed at which the markets return to some ‘fundamental pricing’ is unknown and may be a drawn out experience.

How are the Future Directions Funds positioned if the volatility in markets continues?  

Unfortunately, market volatility is something that all investors have to come to terms with for the foreseeable future. The recent downturn in financial assets was largely an unwinding of the excess financial leverage in the system. This tends to happen when asset prices and cashflows are inflated due to high levels of debt borrowings.

This underlines the importance of maintaining diversity in investments. Diversification is one of the best ways investors can reduce risk in their portfolio. Unfortunately, this often comes with a trade-off in return potential or the length of time investors need to invest. Therefore, the balancing act is to maintain a mix of assets that have the potential to maintain returns while reducing overall portfolio risk.

While the Future Directions Diversified Funds have strategic (long-term) allocations to growth and defensive asset classes, we continue to look for new value opportunities within each of the funds. Our recent strategic review of the funds has identified a number of new areas of investment that we believe will improve the overall risk and return profile of the funds over the longer-term. You will be hearing more about these investments over the next few months.

What is your view of the high exposure to direct assets in competitor funds?

Many competitors have increased their exposure to direct assets such as opportunistic property and infrastructure over the past three to five years. Many of these assets are valued at longer-dated intervals such as annually. Some of these assets are priced at book value rather than market value, meaning that any fall in asset valuation may not be reflected in the fund’s returns, or the fall in values will only be reflected in lower fund returns at some point in the future. The other challenge with these assets is that they are illiquid in nature, meaning that they generally are extremely difficult to sell over a short period.

This places some pressure on the manager of the fund if liquid assets have fallen in price – which unbalances the asset allocation of the portfolio, meaning the manager may be breaching compliance targets. 

While we see a number of benefits that come from the addition of direct assets to a diversified portfolio, we believe that the illiquidity and valuation risks are not fully reflected in historical risk statistics. Therefore, we remain cautious on allocations toward this space, as it is our view that the rate of asset impairment will continue over the next 12 to 18 months.

Have you added any new managers to the Funds in the last quarter? Why have these changes occurred?

Changes have been made during the quarter in both the Future Direction Australian Share Fund (ASF) and the AMP Capital Total Return Fund (TRF).

We have removed MIR Investment Management as an underlying manager in the ASF as we felt that our exposure to quantitative value-based managers was well represented through other managers in the portfolio. In the TRF, we have added two volatility-based managers. These managers are able to benefit from inefficient pricing in options markets, as well as volatile market swings both up and down.

What changes to the funds can I expect going forward?

We have recently completed our annual strategic review of the Future Directions Diversified Funds product range. Out of this we have proposed a number of changes which we believe will improve the returns of the fund over the longer-term. We are also currently undertaking some changes to the mix of managers in the Future Directions Extended Markets International Share Fund, Future Directions Enhanced Index International Equities and Future Directions Australian Small Companies Funds.

We will be providing more information on these changes over forthcoming months.

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