Why I’ve changed my mind on CGF, and some thoughts on sell discipline, page-6

The last couple of reports for CGF have came after pretty average gains on both the aus and usa markets, only for both markets to have terrific runs at the end of the year. Do you think that CGF report in feb might be better than previous due to the amazing runs markets have had which in turn allows challenger to essentially increase returns on investments for the past 6 months?

@adamdouglas555666

If we look at the FY18 and FY19 Australian financial years in their entirety, the performance of CGF’s Equity portfolio (expressed as a percentage of Average Assets) compared with the main Australian and US market indexes as follows:

As the table shows, while the ASX200 and the S&P500 had pretty healthy gains over both financial years (especially the S&P500, when expressed in A$ equivalents), the return of CGF’s Life Equity Portfolio was not just sub-par, but also negative in absolute terms.

It is worth pointing out that the above returns are relative to capital growth only, i.e. before the impact of dividends. CGF’s Dividend Income, as it appears in their Cash Flow Statement, refers to the aggregate of the Life Equity and Infrastructure Portfolios, so it is not possible to isolate the contribution from Equity. At any rate, the aggregate dividend yield on Average Equity and Infrastructure Assets was 3.7% for FY19 and 4.3% for FY18, i.e. not far from the corresponding yield for the ASX200 and the S&P500.

The bottom line in the table (highlighted in green) shows that (before dividends) CGF’s Life Equity Portfolio would have underperformed a 50%*ASX200+50%*S&P500 basket (currency-unhedged) by an average of -14.5% pa over the two year period.

If we now look at the appreciation of the Australian and US equity indexes between July 1st and December 31st 2019 (i.e. during the period the next set of results will refer to), it was only +1.0% for the ASX200 and +9.8% for the S&P500 (in A$); therefore, while it is indeed possible that CGF’s 1H20 Investment Experience will benefit from broad equity market performance, I would not necessarily jump to the conclusion that the corresponding impact will be material.

Let me also remind you that, since the end of 1H19, Challenger have been using an Equity Collar hedging strategy on ~30% of their Life Equity Portfolio, to reduce the impact of market volatility. What that means is that they have been buying index put options and selling a similar amount of index call options (presumably in a zero-net-premium fashion).

While the purchase of put options limits the downside in the event of a broad market sell-off, the sale of call options limits the upside when the market rallies. Because the broader market did indeed rally in 1H20, the net payout of this hedging package is likely to have been negative for the period (especially if the call options were written on US indexes), which will be detrimental to the overall Investment Experience.

Cheers