With Australia having the second worst returns amongst the above-mentioned OECD countries this clearly shows the benefits of having a portfolio that was diversified globally during 2008. Even in the USA, the originator of the global financial crisis had better returns than in Australia.
Whilst the following statement from Paul Krugman is taken from a debate on how to deal with the global financial crisis and is quite a few weeks old. It still applies and is an excellent description of the current state of the Global Financial Crisis and why interest rates should stay relatively low despite massive budget deficitis from governments around the world…
Let’s think about what is actually happening to the global economy right now. On the one side there has been an abrupt realization by many people that they have too much debt, that they are not as rich as they thought. US households have seen their net worth decline abruptly by $13 trillion, and there are similar blows occurring around the world. So the people, individual households, want to save again. The United States has gone from approximately a zero savings rate two years ago up to about 4 percent right now, which is still below historical norms; but suddenly saving is occurring.
That saving ought to be translated into investment, but the investment demand is not there. Housing is flat on its back because it was overbuilt; housing bubbles collapsed not only in the United States, but across much of Europe. Many businesses cannot get access to capital because of the breakdown of the financial system. But even those that do have access to capital don’t want to invest because consumer demand is not there. Between the housing bust and the sudden decision of consumers to save, after all, we have a world with lots of excess capacity. The GDP report that just came out says that business-fixed investment, non-residential fixed investment, essentially business investment, is falling at a 40 percent annual rate.
This causes a problem. There are lots of people who want to save, creating a vast increase in savings, not only in the US but around the world, combined with a sharp decline in the amount that the private sector is willing to invest, even at a zero interest rate, or rather even at a zero interest rate for US government debt, which is what the Federal Reserve has the most direct impact on.
One way to think about the global crisis is a vast excess of desired savings over willing investment. We have a global savings glut. Another way to say it is we have a global shortage of demand. Those are equivalent ways of saying the same thing. So we have this global savings glut, which is why there is, in fact, no upward pressure on interest rates. There are more savings than we know what to do with. If we ask the question “Where will the savings come from to finance the large US government deficits?,” the answer is “From ourselves.” The Chinese are not contributing at all.
Those extra savings are, in effect, the savings that America has wanted to make anyway, but that US business is not willing to invest under current conditions. That is the way Keynesian policy works in the short run. It takes excess desired savings and translates them into some kind of spending. If the private sector won’t do it, the government will. There is actually no contradiction between the Federal Reserve’s actions and the actions of the US government with a fiscal stimulus. It’s very much necessary to do both. By buying a lot of private securities, the Federal Reserve is essentially going out there and playing the role that the private banking system is no longer playing properly; by engaging in investment, the federal government is playing the role that businesses are not now willing to play. All that debt-financed spending on infrastructure by the Obama administration is basically filling the hole left by the collapse in business investment in the United States. There is not an excess demand for savings that is going to drive up interest rates. The only thing that might drive up interest rates—and this is a real concern—is that people may grow dubious about the financial solvency of governments.
Now, the great concern I have is that although we understand these things fairly well, there are thirty-eight Republican senators who say that the answer for the crisis is another round of Bush-style tax cuts that will reduce revenues by $3 trillion over the next decade.
This crisis has been so large and the political process has been so sluggish that the difficulties have been greater than expected. And yes, there are some green shoots. Things are getting worse more slowly, but we have not managed to head off a crisis that could turn out to be self-reinforcing, and leave us in this trap for many, many years.
We are a little isolated in Australia and there’s little doubt we are positioned better than other countries around the world, but at the end of the day we are part of the global economy still in crisis so we should not be complacent and think all is well. For what its worth, in my opinion we have a long way to go yet. Markets have been responding sharply to the slightest bit of good news but whilst the crisis was created over many years, it will not be over in just a few months. Hang on for a rollercoaster ride.
Unfortunately there are numerous funds out there that have benchmarks that fail these key attributes and have benchmarks based on marketing or investor needs. For example, many hedge funds have had an annual positive return benchmark even though they are largely exposed to equity or credit markets.
This week I have seen global listed infrastructure funds that benchmark to CPI plus x% and this is also the case for numerous multi-manager investment funds and the benchmark of asset allocations set by the numerous asset consultants and research agencies.
What a ludicrous benchmark CPI plus or annual positive return benchmarks are for funds that are exposed to equity markets. High inflation is not good for equities and neither is deflation so the relationship is weak. If I want to beat CPI I can just invest in an inflation linked bonds.
Equity markets are so volatile that at any stage the equity markets will be outperforming a stated positive return so a positive return benchmark is surely just a way of increasing fees for the manager on the back of the belief in the equity premium.
Overall, if a fund’s benchmark does not reflect their investible universe and it cannot be replicated for investment then the fund will be dismissed by me. The role of an active manager is to outperform its benchmark after adjusting for risk (and fees). When a benchmark doesn’t reflect a fund’s actual risk then iits time to dismiss the fund as an investment consideration.
Over the past few months the global economy has seen the emergence of “green shoots”. As implied, there are indications that the global economy may be turning a corner. Like turning around a super tanker, turning around the global economy will take a long time and these signs aren’t so much an improvement but indicate a slowdown in the deterioration of the global economy. For example, in the US only 345,000 jobs were lost during May which is around half the average monthly decline of the previous six months. US Unemployment is still increasing but not at the rate it previously was.
Other positives include the gradual decline in the cost of credit (remember the Global Financial Crisis started as a credit crisis), stabilising financial markets, perceived future demand resulting in increasing commodity prices (Oil increased by 48% in USD terms over the past 3 months), and improving consumer confidence.
In Australia, our unemployment stands at 5.7% and the Australian Bureau of Statistics announced that we avoided a technical recession to the quarter ending March 2009 with positive real GDP Growth of 0.4% thanks to declining imports.
For the Australian sharemarket investor, returns for the 3 months ending May 2009 have been spectacular with the broad All Ordinaries Accumulation index increasing by a little more than 17%. Overseas sharemarkets also provided strong returns and the major sharemarket indices of the US, UK, and Japan increased by 25%, 15% and 25% respectively. With the Australian dollar appreciating over the same 3 months against the US Dollar, Pound, and Yen, by 25%, 11%, and 22% only the hedged international investor experienced the strong international gains as the strength of the Aussie dollar most of these returns.
The perceived improvement in the global economy combined with large budget deficits all around the world including here in Australia, government bond yields increased substantially. This means that investment returns for the bond investor were relatively weak (as high interest rates mean lower bond prices). The UBS Composite Bond index had a slightly negative return of -0.6% for the 3 months to May 31, and the global fixed interest index, JP Morgan Broad WGBI (AUD) Hedged Index, returned only 0.43%.
Whilst the short term sharemarket gains indicate positive signs for both the Global and Australian economy, there are still significant signs of weakness. Unemployment both here and overseas is still increasing which will continue to dampen demand and force households into increased savings instead of spending. Business investment is weak and companies continue to struggle, as evidenced with the recent collapse of General Motors and Chrysler in the US, and two of the largest agribusiness companies in Australia, Timbercorp and Great Southern. The last few months have shown the risks of being out of the sharemarket when everything appears to be at their worst. For investors, sticking to a portfolio with the risk profile designed to help achieve financial goals is essential.
I’m typically a little nervous about interviews with journalists because you never know how they may use your comments and its not always 100% clear as to specifically what they’re writing about.
Lucky me had my photo and was quoted in today’s Financial Review article on inflation linked bonds written by Brendon Lau (page 42 if you’re interested). Unfortunately the article suggetsed that I am “convinced that if retirement investors had access to a deeper and richer inflaiton-linked bond market, their retirement savings would not been as badly devastated by the global financial crisis”.
I don’t recall saying anything of the sort and nor do I believe it. Maybe if retirement investors were more conservative and invested in AAA rated government bonds whether inflation-linked or not insted of equities and property then their retirement savings would not have been devastated. But that is a question of risk profile…not as to whether there was a deeper and richer inflation-linked bond market.
An incredible steepening of the yield curve has occurred throughout 2009. As can be seen the latest 10 year bond yield isn’t too far from where it was in the middle of 2008. This yield curve tells us several things about the state of current markets and economy…
Overall this is a good looking positive yield curve despite global economic news continuing to be mixed. We are still in the ‘green shoots’ phase of a global economic recovery so this steep yield curve looks to be a relatively attractive buying opportunity to me.
I have just read an article by Zvi Bodie, who has authroed a few university investment texts, and he reminds us of a simple but unfortunately forgotten or ignored concept…
“Matching is the safest investment strategy for achieving a specific goal. To eliminate the risk of falling short of an investment goal at a specific future date, the investor needs to match the maturity of his investments to the date of his goal, with target dated, inflation protected investments” like inflation linked bonds.
Government Inflation linked bonds is the only true risk free investment…does anyone actually realise this fact???
Index funds were born out of modern portfolio theory which suggested that the highest risk-adjusted return should come from purchasing the market portfolio. As it is impossible to purchase market as a whole, the index fund effectively replicates the market by purchasing a large proportion of the market with each stock’s weighting proportional to its market capitalisation. Around the world, this method has been replicated across all asset classes. In Australia, the available index funds are mostly limited to the major asset classes. Some geographic index funds, like BRIC, China, S&P500, etc are also available as well as specific sub asset classes like Global Credit index funds. There is little doubt index funds provide a low-cost way of providing investors exposure to specific markets without the active management risk of the ‘bad bet’.
The current bear market has resulted in many investors looking for simplicity, transparency, and low costs and index funds satisfy all criteria. Whilst many wealth and funds management companies have suffered during the Global Financial Crisis, index funds have thrived. Barclay’s have released a wide array of listed international index funds, Vanguard also released some exchange traded funds and only yesterday announced they are moving into larger premises and hiring an additional 8 sales professionals. And now, in Australia the index fund has another variety with the introduction of Research Associates’ Fundamental Index (RAFI) and various investment products linked to this index approach.
In recent weeks I have received more queries regarding this new index method than anything else (except the ubiquitous structured product). It is marketed as an alternative to traditional index funds and its difference is that it doesn’t use a company’s market capitalisation as the weighting determinant but uses measures such as sales, profits, dividends, amongst others. The founders of RAFI believe traditional indices overweight overpriced stocks and underweight underpriced stocks and they believe this new method overcomes this flaw. Despite the strong support the fundamental index has received locally and overseas, there have been many critics.
The main criticisms of the Fundamental index method are that it resembles an ‘active value strategy in disguise’ requiring numerous subjective decisions around stock selection. As a result of this, many believe the fundamental index is not efficient when compared to multi-factor quantitative strategies. Even if these arguments are true, at this point in time they are fruitless arguments in Australia because accessing passive strategies that are different but priced similarly to traditional index funds are few and far between (the one exception is DFA which is not necessarily easy to access as an adviser). At least the fundamental index investments are around 40bps cheaper than active equity managers and this is a significant cost saving over the long term. With this cost saving if its stated return premium is due to a value bias then as long as this bias/risk is understood there is nothing wrong with that. With the exception of the DFA funds, to achieve a value bias typically costs a lot more than the RAFI funds.
Back to the critics opinions…belief in the so-called efficiency of multi-factor quantitative strategies creates an opportunity in the Australian funds management industry. Globally, it is widely acknowledged that over the ‘long term’, equity portfolios biased towards…
• low price to book,
• small companies, and more recently,
• companies exhibiting performance momentum (i.e. performed well over the last 3 to 12 months)
…outperform traditional indices on a risk-adjusted basis. Accessing these style biases in low cost ways cannot easily be achieved in Australia for the retail investor. Perhaps this is the future of equity index investment in Australia.
For the active manager style biased index funds will be a significant threat. The active manager will have new truly investible benchmarks and they will have to prove their skill against low cost funds with similar style biases. This in turn could reduce costs due to increased competition and only the strong will remain. The active manager often hides behind their style bias when underperformance occurs, however, with style biased index funds in direct competition this will not be an excuse.
The introduction of the fundamental index products are an excellent addition to the Australian managed fund scene and moving forward I look forward to seeing more low cost, style biased index funds to provide more efficiency and choice for the retail investment portfolio.