2023-05-30 05:26:05 ET
Summary
- Despite its high expense ratio, the actively managed abrdn Australia Equity Fund continues to underperform.
- With persistent inflation also set to extend the monetary tightening cycle, equity valuations could come under pressure.
- At current valuations, IAF's large-cap portfolio isn't cheap either and will be vulnerable to an expectation reset.
The YTD pullback in commodities has weighed on Australian equities, as the promise of a post-reopening China rebound has fizzled out in recent months. Compounding the equity headwinds are emerging inflationary pressures amid a resurgence in asset prices and wage growth. To recap, owner-occupier housing finance approvals rebounded +5.5% in March (the biggest monthly increase since 2021), against expectations for further declines. Any wealth benefits for the household will, however, be outweighed by a more restrictive stance from the central bank (i.e., the Reserve Bank of Australia or the 'RBA'), given its focus on asset prices.
Also concerning is the accelerated pace of wage increases ( +3.7% YoY ex-bonuses per Australia's Wage Price Index) ahead of this week's Fair Work Commission decision on minimum wages. In addition to the negative margin implication for corporates, persistent wage pressure means the RBA may be forced into an extended tightening cycle, further weighing on equity performance. While banking, the largest allocation in the abrdn Australia Equity Fund ( IAF ) portfolio will benefit from higher rates, the rest of its holdings (~74%) will come under pressure. And at ~14x fwd earnings (vs. -3% consensus EPS growth in 2023), Australian large caps are not cheap. Even at the current ~12% NAV discount, I won't be rushing to add IAF to my portfolio.
Fund Overview – An Australian 'Closet Indexer' with High Expenses
The US-listed abrdn Australia Equity Fund, actively managed by the abrdn Australian equities team, seeks to outperform the market-capitalization weighted ASX 200 Index on an absolute return basis. Like other abrdn funds, the investment philosophy is based on a fundamental bottom-up stock selection approach, with the principal objective being long-term capital appreciation, followed by a secondary objective of income generation (via dividends and interest on fixed income instruments).
The ETF held $126m of net assets ($136m of managed assets) at the time of writing and charged a 1.67% gross expense ratio (1.55% net), placing it at the upper end of abrdn's actively managed funds. Per the latest factsheet , ~95bps of annual expenses went to management fees, with ~54bps allocated to other expenses and the remainder going to leverage costs. Yet, IAF maintains a 'closet indexer' profile despite the high fees, as evidenced by its relatively low active share (42.7) and portfolio turnover (23%). A summary of key facts about the ETF is listed in the graphic below:
The fund's sector allocation is heavily concentrated on Financials (26.4%) and Materials (23.0). Health Care (15.6%) is the only other sector with a >10% allocation. The remaining sector allocations have similarly large weightings, with Consumer Staples at 8.0%, Energy at 6.8%, and Consumer Discretionary at 6.7%. The fund's sector composition is largely in line with its benchmark ASX 200 Index; the most notable overweight and underweight are Consumer Staples and Industrials, respectively. On a cumulative basis, the top six sectors accounted for a combined 86.5% of the total portfolio.
The fund isn't that diversified from a single-stock standpoint either, and the overall composition doesn't deviate too far from its benchmark. The largest single-stock exposure is mining leader BHP Group ( BHP ) at 11.3%, followed by biotechnology company CSL Limited ( CSLLY ) at 8.4% and Commonwealth Bank of Australia ( CBAUF ) at 7.7%. Other notable holdings include National Australia Bank ( NAUBF ) at 5.4% and Australian petroleum exploration and production company Woodside Energy Group ( WDS ) at 5.0%. All in all, the top ten holdings accounted for ~57% of the overall portfolio, with the -4.4% cash allocation indicating the fund is slightly leveraged.
Fund Performance – Relative Underperformance Made Worse by the Persistent NAV Discount
On a YTD basis, the fund has declined by 3.9% in market price terms, underperforming the benchmark ASX 200 index and the passively managed iShares MSCI Australia ETF ( EWA ) following a strong start to the year. Over longer timelines, the fund has also underwhelmed on a relative basis – per its latest annual report , the fund has compounded at +1.5% in market price terms over the last decade vs. the ASX 200 at 3.3%. Over three and five-year timelines, the fund has similarly underperformed at +2.7% (vs. 2.0%) and +2.0% (+3.1%), respectively, hardly sufficient given the outsized expense ratio and the equity risks IAF investors are taking on.
Since the 2021 peak, the income portion of the fund's distribution has also dropped off. While last year's total distribution yield was still strong at ~13%, the income portion (excluding capital gains) was closer to ~4%. And with commodity prices extending their declines this year, the income yield could decline further. Given IAF's relative underperformance over the last decade and high expenses, the persistently wide NAV discount (now at ~12%) seems justified. Pending a meaningful performance-linked buyback program, I don't expect the discount to narrow anytime soon.
Persistent Inflationary Pressures Could Force the RBA's Hand
One of the biggest surprises coming out of Australia over the last month was the positive housing data. The +5.5% MoM rebound in owner-occupier housing finance approvals (the largest since 2021) was particularly noteworthy, given the relatively low expectations pre-release. Most of the upside was due to a +7.9% rise in volumes (ex-refinancing), though the +4.9% MoM increase in approval value (a first since rate hikes began) was also positive. With home values for the five capital cities (Sydney, Melbourne, Brisbane, Adelaide, and Perth) also on the rise for a second consecutive month in April, consensus estimates are now factoring in a housing recovery for this year. On the one hand, housing price tailwinds would benefit consumer spending. Yet, it could also push the RBA into an extended hiking cycle, given the central bank had singled out asset prices in its May policy meeting minutes as a key factor in taming inflation.
Also concerning is the sticky inflationary wage pressure - Australia's Wage Price Index (excluding bonuses) has shown no sign of slowing down (+0.8% QoQ; +3.7% YoY). The private sector has been the main driver, with hourly earnings accelerating to +4.3% (from +4.0% in Q4). While public sector wage growth has lagged at +3% (up from +2.8% in Q4), ongoing wage negotiations (cumulative 10.5% over three years) will add further upside risks to wage growth over the coming months. The upcoming Fair Work Commission decision (Annual Wage Review 2022-23 decision due on 2 June) poses a significant upside risk to minimum wages as well. With core inflation still running at an elevated ~7% pace (vs. the long-term 2-3% target) and the RBA showing a hawkish lean at its last policy meeting, these incremental price pressures signal further hikes ahead.
Conclusion
The IAF fund may be down YTD, but the bottom may not be in yet. Inflationary pressures remain alive and well in Australia, with the latest surprise being housing, where mortgage commitments have rebounded sharply in March despite a looming fixed rate 'cliff' (i.e., when >800k household mortgages are repriced at higher rates). While a turning point in house prices could have positive implications for the consumer, the RBA has been explicit about its focus on asset prices and wages (also rising), and thus, another round of cash rate hikes could be on the horizon. Heading into next month's policy meeting, key leading data points to monitor include this week's minimum wage review by the Fair Work Commission, along with April owner-occupier approvals. With large-caps also trading at a pricey ~14x fwd P/E (vs. consensus estimates for a low-single-digit % EPS decline this year) despite a weaker backdrop for commodities, IAF could be vulnerable to a big reset down the line.
For further details see:
IAF: Unfavorable Risk/Reward Under The Extended Australian Tightening Cycle