Why hedge funds aren't to blame for the decline in Australian banking stocks

Dr Evil from the Austin Powers. Photo: YouTube Screenshot

It’s been a roller coaster ride for Australian bank investors so far in 2016. From the beginning of the year to the end of February, the ASX 200 bank index slumped by close to 18%. Like clockwork, and unsurprisingly near the lows, the cries that the selloff was being driven by “evil short sellers” was being echoed my many prominent commentators.

Buy-and-hold investors (as they’re called) tend to become most parochial when the market is moving against them, looking to blame others for why their investment strategy isn’t working.

According to David Pain, a London-based hedge fund portfolio manager, there’s a simple explanation why hedge funds are targeted for special attention whenever Australian banking stocks fall: the investment community has come to adore the sector given the strong returns seen since the global financial crisis.

“Buying the Australian banks has been a trade that has worked for over a decade for every Australian fund manager,” says Pain in a research note released in conjunction with the VFS Group on Monday.

“Australian institutions have never had an easier trade nor have they made so much money so easily. As such they have understandably developed a certain bias towards those companies that have been so good to them.”

The chart below, supplied by Thomson Reuters, shows the ASX 200 banks index going back to the start of the 2002 bull market. Clearly, even with the recent pullback, it’s been a stellar run for investors.

Source: Thomson Reuters Eikon

Pain suggests that “the first phase of any major change in markets is always met with resistance”, adding that whenever bank stocks suffer a sharp decline “investors feel threatened and have as such created a bogeyman that they can attack”.

That bogeyman, in this instance, is the hedge fund industry.

Unperturbed by that view, Pain suggests that there’s a simply reason why hedge funds are betting against a further rally in bank stocks: the potential for reduced profitability, and as a consequence dividend payouts.

He cites three factors — declining net interest margins, regulatory risk and increased competition within the sector — as three factors that bolster this view.

Here are a few snippets from the VFS Group report in which Pain explains his concerns, starting with net interest margins.

A bank’s NIM is determined very simply by its cost of capital (i.e. at what rate it borrows money) vs the rate at which it lends money. This creates a spread which they then leverage up. When a banks cost of funding rises this creates a squeeze on their NIM. Because banks lever this ratio so much even a small change in a banks cost of funding (and a subsequent decrease in their NIM) means their profitability declines rapidly. Over the past year the cost of funding for the Big Four has jumped quite dramatically.

On regulatory risk, Pain also suggests that the risks are multifaceted, ranging from increased capital requirements, greater regulatory oversight to the possibility of a royal commission.

Firstly APRA has already indicated they are looking to increase the amount of equity the Big Four hold against their loan book. Having to hold more cash against their lending book increases a bank’s “safety net” but also reduces its leverage ratio which in turn means less profitability. Secondly, the Big Four are continuing to be rocked with various misdeeds over the past five years. This ranges from rigging interest rates to defrauding insurance claimants. The results of which inevitably leads to fines and again means lower profitability. The final regulatory risk for the banks is the growing demand for a banking Royal Commission.

Finally, Pain notes that APRA, Australia’s financial regulator, has now begun the process of allowing smaller players into the market, something that he believes has the potential to further erode margins at the big four, hence profitability.

“This process will take some time to play out but it will inevitably lead to lower margins in a number of sectors which again will lead to lower profitability,” he says. “Look at the increased competition in the mortgage re­financing market over the last decade and transpose that to the rest of the banking industry.”

Given those concerns, not only expressed by Pain but other investors, he suggests that some hedge funds have “come to the conclusion that the profitability of the big four is under threat and thus they should be re­valued to a level more in line with their global peers.

He also dismisses the view that hedge funds are “evil horde” taking on local Australian investors, calling the idea that have taken some kind of personal vendetta against the Aussie banks as “ridiculous”.

“Anyone who has ever worked with hedge funds will know they are anything but personal. No one lasts long in that space making things personal,” he says.

“They are merely looking at the same factors we have pointed out and drawing the appropriate conclusion that the big four are facing structural decline.”

It all comes down to perceived value. It is, after all, a two-way market, requiring both buyers and sellers.

An asset that some may deem to be undervalued or fair value might been seen as expensive by another investor. Just because they are taking an alternate investment view, or are called a “hedge fund”, does not make them “evil” or carrying a “vendetta”.

NOW WATCH: Money & Markets videos

Want to read a more in-depth view on the trends influencing Australian business and the global economy? BI / Research is designed to help executives and industry leaders understand the major challenges and opportunities for industry, technology, strategy and the economy in the future. Sign up for free at research.businessinsider.com.au.