Is the Aussie equity market efficient? 

The Australian equity market has become a stock picker’s paradise over the past few years, helping a number of Australian fund managers deliver significant alpha to clients. We think one of the reasons for these increased opportunities is that the broad Australian equity market is becoming less efficient. This may sound counter intuitive in this increasingly socially connected world, but our data suggests two underlying causes.

The first is a decline in research coverage of Australian companies and the second is an increasing flow of capital towards indexing. Both trends have created tailwinds for active managers.

Inefficiencies in equity markets

Theory suggests that the more information that is analysed, published and reviewed by market participants, the more efficient markets will become, as all ‘relevant information’ is incorporated into a share price. In general, therefore, a manager investing in a universe with poor research coverage is likely to have a greater opportunity to add more alpha than a fund manager operating in a highly researched stock universe. Mercer data (below) illustrates the point by comparing alpha between Australian large and small cap investment managers. Active managers in the under-researched small cap market have delivered significant excess returns over the last 10 years.

Median Australian large and small cap managers*

Median Australian large and small cap managers

Source: Mercerinsight.com *10 years to 31 August 2016 according to Mercerinsight.com. Benchmarks Large cap: S&P/ASX200 Accumulation, Small Caps: S&P/ASX Small Ordinaries Accumulation. Median manager based on the managers included by Mercer in the Large Cap and Small Cap universes.

The decline of published company research

Since the Global Financial Crisis, sell side research firms have encountered declining profits driven by lower revenues. As low cost competition, driven by technological advances and algorithms have eroded sell side research firm’s pricing power. Over time, we have observed sell side research firms have reacted to declining profits by:

  1. Employing fewer analysts – our data, captured over the past 10 years shows a 14% decline in number of sell side analysts publishing earnings estimates.
  2. Increasing stocks per analyst – giving each sell side analyst more stocks to cover which decreases the depth and understanding of each company. Over the past decade, sell side analysts have increased their stocks under coverage.
  3. Hiring more junior researchers – as senior analysts leave, firms tend to replace them with junior analysts that cost less to employ, but are far less experienced.

The charts below highlight the effects of this phenomenon over the last decade. More companies are being covered by fewer analysts, resulting in a 40% increase in stocks covered by individual sell side analysts. This has led to the time spent by each analyst on individual company research declining.

The decline of published company research charts

Source: Macquarie

Capital flows into indexing

The second trend and one we are witnessing both globally and at home in Australia, is that investors are increasing their allocation to passive strategies.

The trend of asset allocation towards indexing offers increased opportunity for active managers. In general it means there is relatively less money chasing mispriced securities, as investors choose passive approaches to their investment decisions. Importantly, the trend toward passive management is also taking place in the institutional investment market – both domestically and globally.

Summary

The decline in research coverage of Australian companies and the increasing flow of capital towards indexing has resulted in the Australian equity market becoming a stock picker’s paradise. We expect these tailwinds to continue for the foreseeable future and in our view, the best way to take advantage of these trends is through active management. For us, it’s a good time to be an active investment manager in Australia.