Fureyous

With the ASX last week announcing that it is allowing bond ETFs to trade on the market, financial planners have the last basic building block in place to recommend portfolios that are completely listed covering all major asset classes. Previously listed portfolios were limited to equities (local and global of varying strategies) and commodities. With the inclusion of bond ETFs on the ASX that may result in many financial advisers abandoning master trust and wrap platforms, whereby they used managed funds for their fixed interest exposure, to the more transparent and lower cost listed portfolios.

With the movement to fee-for-service by the financial planning industry, thanks to the Future of Financial Advice (FOFA) reforms that kick off in July, ETFs are bound to be a very popular investment vehicle by financial planners so we will undoubtedly see further cost cutting by the platforms and further consolidation as the smaller platforms struggle to stay profitable.

This change of rules by the ASX is way overdue and whilst this initial move into bond ETFs is a small step…underlying bonds must come from only two Australian bond indices (UBS Composite or S&P Australian Fixed Interest)…its bound to start a significant change in behaviour in the financial planning and investment platform industries.

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Sorry about this article but i have to express my disgust at an article I’ve just read on a former Storm Financial adviser in today’s Sydney Morning Herald…I reluctantly place the link here but I don’t want to give any more publicity to this adviser. Overall the article, by Stuart Washington, is quite fair and appropriately cynical in parts but nevertheless I’d rather it wasn’t written at all.

As the article demonstrates, the one-trick pony that Storm Financial influenced their clients with was a double gearing strategy whereby clients, would borrow against their home and then use these funds to further gear with a margin loan into sharemarket investments. Storm apparently charged fees that would typically amount to around 7% of the invested amount…i.e. appallingly very high. This strategy made millions of dollars for Storm and lost $3billion of investor funds over 2008/09. On this system the financial adviser is of the opinion (in her book) that, “Academically, it was the perfect wealth system – use someone else’s money to make money, buy low and sell high”

On this, I just have a few comments to make…

• This adviser clearly has no idea what academics think of this ticking time bomb strategy…there’s nothing academically rigorous about it
• Clearly, this adviser has no understanding of the volatility and return history of sharemarkets
• It was only the perfect wealth system for the financial advisers who collected disgustingly high fees for this massively risky strategy
• Avoid any adviser who flippantly uses the term, “buy low, sell high

I’m disappointed that somehow this ignorance hasn’t stopped this financial adviser gaining publicity  by appearing on various television shows including, Sunrise (Kochie should know better), The Circle, and The Project (usually the best current affairs show and run by comedians…go figure).

Finally, I cannot believe that her current passion is Financial Literacy and “lifting the sorry state of financial education in this country”…given the earlier quoted statement on the Storm system, this financial adviser should start educating herself and do this industry a favour and consider an exit…Yep, I am Fureyous that many of the best financial planners are not given the publicity that this person has undeservedly received.

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Page 31 of the Australian Financial Review (AFR) today has an article suggesting “that the traditional buy-hold approach to owning shares is dead”…full text, with subscription can be found here. The article’s stated reason for buy-hold is that “in the long run, markets always go up and will provide investors with a good return on their investment as well as tax benefits, despite any volatility”.

Unfortunately, financial planners are placed in a dim light as usual, with ignorant comments like, “The buy-hold strategy is often sold by financial planners because it requires less management work – helpful for those with a large client base – as stocks selected are held for many years”.

Whilst there is a little bit if truth in each of the above statements, unfortunately the main reason behind the buy-hold strategy is ignored altogether. That is, that timing markets is very very hard and after transaction costs and potentially other costs are taken into account, there is more evidence to suggest that buy-hold is a far more successful method of achieving sharemarket returns than active management. This belief has the foundation in numerous academic articles, most notably Brinson, Beebower and Hood’s “Determinant of Portfolio Performance”, and the consistent failure of active managers to outperform benchmarks (see recent SPIVA results).

Unfortunately the AFR article suggests that in order to be successful at beating the buy-hold approach,  signals such as momentum, timing markets (good luck!) and the ability to pick ‘high-quality’ companies using certain factors is all you have to do. If only it was that easy.

For the individual investor, picking stocks is largely a mug’s game…sure you might beat the market but I can pretty much garantee it will typically be more through good luck than any demonstration of skill and any outperformance will probably come from taking on more roisk (even unknowingly).

Personally, I like the idea of being dynamic with regards to investment portfolio. My approach is a little different and is based around designing portfolios to accept or not accept various macro risks…the likelihood of underperformane must be accepted and outperformance will never be guaranteed like some of these fund managers market but rarely live up to.

Bottom line…there is no silver bullet but the most efficient way to receive sharemarket returns will be via a very cheap index fund…and that is a buy-hold strategy and a very popular strategy of financial planners and for good reason.

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Firstly I think its appropriate to suggest that I intend to make no return predictions for this year as I do believe its pretty much impossible with litte upside for me. However, what I would like to do is simply point out a few facts, rules, and current issues that need to be considered when building or reviewing the investment portfolio.

• The big issue this year will once again be the Euro-sovereign crisis. This shold result in significant volatility for equity markets from time to time and daily movements exceeding 2% up or down will be relatively frequent. This type of volatility is the current norm for markets but whether those markets move up or down through to the end of 2012 is anyone’s guess.
• Now whilst equity markets appear historically cheap on a PE basis, this is not necessarily a buy signal as PE ratios should be low in the face of high risk and lower than usual earnings growth, so be very very careful. Despite this warning, cash and bonds are hardly attractive on their own simple value metric, yield to maturity.
• If you think you can pick stocks better than the professionals, I’m afraid you cannot. Even the professionals, backed by massive amounts of resources and always very very intelligent people, frequently fail to beat the market so if you are looking to accept any equity-like risk make sure you are very well diversified and use an index manager or an active manager who is not taking on too many risky bets (remember, noone really knows at this point in time how this European situation will ultimately impact markets)…just because your only stock Telstra outperformed the market this year does not mean you are a good investor…it actually suggests the opposite
• The only free lunch in investing is diversification…this means don’t just invest in Australian equities (or Telstra), spread your investments across other investments such as Global equities, local and foreign fixed interest, local and global property, commodoties and if possible other alternative investments…but make sure the risk you accept is within your comfort zone
• The sharemarket performance  of specific countries has very little to do with those countries economic growth. Two of the worst sharemarket performers this year were China, yes China, and India!!! Sharemarkets go up if information is more positive than expected and vice versa…this has nothing to do with economic growth…its expectations so if you can predict the future you’re looking good if you can’t, you’re possibly in trouble (unless you diversify)
• If you are retired and want your money to last for the rest of your life…you can do this by either buying an annuity (lifetime or term certain which very long) or invest in a diversified portfolio of share, property, bonds, cash and don’t draw out too much each year (for example 5% or more linked to inflation). The financial services industry has talked many retirees into investing a very high proportion of their investment portfolio into shares (e.g. greater than 50%) and sold the concept of “over time the sharemarket outperforms”…whilst this is often the case in savings mode, it unfortunately doesn’t apply in drawdown (or pension) phase…you’ run a very big chance of running out of money before you know it!!!
• You cannot get 10%pa return on your money without taking on a lot of investment risk. Cash and Bond interest rates paid by the Australian government are at most 4.25% (and that’s the cash rate)…so if you need to earn more than 4.25% you must take on more investment risk than the Australian government…so that will mean shares if you need to earn a lot more than 4.25% or may mean bank term deposits of you only need a little more than 4.25%.
• Australian houses have dropped in price over the past 12 months…this is not an argument to suggest they are cheap. Interest rates may be reasonable but compared to our average household income we still have the most expensive housing in the world ( and don’t listen to what the banks say…they’re behind on their home loan budgets and need new business)
• The best investment for anyone’s money will always be to pay off your non-tax deductible debt…so that includes your home loan, personal loan, and perhaps that loan that was taken out to contribute to superannuation (I know quite a few people did this in 2007 and they need to pay out those loans asap…but I’m sure they know that already). Non-deductible debt is a risk-free high return that compares to no other investment…if you don’t have non-deductible debt, fantastic and half your luck … and I’m happy for you to pay off my home loan!

I’m sure there’s many other little tidbits but I’m sure that’s more than enough to read for now and if I think of anything I’ll obviously let you know!

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I just did some simple analysis of balanced fund returns and on a time weighted basis (excluding tax), balanced funds returned on average a compound monthly return of 0.38% in the ten years to the end of August 2011. This is equivalent of a compound annual growth rate of approximately 4.7%.

I then assumed the annual household income was around $70,000 and assumed the 9% superannuation contribution was added to a starting balance of $10,000 growing at around 3.6%pa across the same 10 year period. Low and behold it turns out the compound monthly return ended up being 0.33% which is the equivalent of approximately 4.06%pa.

So in this second scenario the average return dropped around 0.64%pa. This is because the worst returns over the last 10 years were in the latter half. So when they are applied to a larger balance the impact is far greater. Therefore, the risk your portfolio  takes as retirement approaches is critical as a nasty return shock when your balance is highest can be quite damaging to your retirement health.

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Around a year ago I was involved in a project looking at life cycle investing and I flippantly said that we should differentiate in the market place by offering the younger investors, say 25 years of age,  150% geared investment that reduces down to 30-40% risky assets at age 65. Older investors could lend to the younger investors, at say 7%pa, and it was win-win….that is, the older investor would receive above-market yields for their fixed interest investment and the younger investors had cheap borrowing.

Of course, I’m sure you are all thinking that I was being a little stupid naive in that I wasn’t considering what happens in case of a market crash…obviously, the younger investors would be in default and the older investors had a fixed interest investment that has failed. A terrible strategy? Do you think?

Here’s an oversimplified scenario. If my 25 y/o has a balance of $10,000 and borrows $15,000 (i.e. 150% gearing), and this total of $25,000 is invested in a diversified equities portfolio which crashes, say worse than 2008, and loses 50%…the outcome is that the portfolio is now worth $12,500 with a loan of $16,050 ($15,000 + 1 year’s interest @7%)…hence the value is negative $3,550…obviously a negative balance isn’t that good. But you know what, if the 25 y/o is earning $25,000, then in a little more than 18 months that negatiev balance will be paid off by SG contributions of 9% and the 27 y/o is back to square one with another 38 years to save for retirement. Whilst the result is not good…it is far from recoverable in terms of providing for retirement.

What we have today, is an enormous number of pre-retirees invested in balanced funds that have around 70% of risky assets. If a pre-retiree, say age 64, had saved $500,000 to the end of 2007, and was ready to retire at the end of 2008, they would have started retirement with a balance of $400,000 at best. Recovering $100,000 in retirement is impossible and it takes an incredible massive income to save $100,000 over a few years…now this situation is a disaster.

What these two examples demonstrate is the power of asset weighted returns. The financial services industry is so caught up in a “time-weighted” returns, i.e. looking at average returns over the last 5, 10, 30 years that it does not consider the impact returns have on the ‘size’ of one’s assets.

So whilst everyone thought my 150% gearing was outlandish, is it really as outlandish as the appalling practice we see today where an enormous number of pre-retirees are investing in “balanced funds”? No where near it…my 25 year old can easily recover but the pre-retiree with the so-called ‘lower’ risk strategy cannot.

Professor Michael Drew of Griffith University and QIC has been talking about asset weighted returns for some time now…I can only hope the financial services industry starts to listen and adjusts accordingly.

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Believe it or not it comes from Lifetime Annuities…the obvious catch is that you need to survive beyond your life expectancy. In Australia, this product type has been totally out of favour since the government reduced social security benefits associated with them a few years back but perhaps this is an overreaction and their true value has been forgotten.

I’ll quote an extreme example from the Canadian academic, Moshe Milevsky.

Lets suppose five 95 year olds place $100 each into a term deposit, paying 6%, and after 1 year the $530 ($500 + 6% interest) is split between the survivors. Now apparently the probability of a 95 year old surviving one year is 80% which means we expect there to be four survivors splitting $530 between them or $132.50 each. That is a return of 32.5% comprising of 6% interest plus 26.5% in mortality credits.

Now a lifetime annuity does not actually allow you to cash out at the end of 1 year or any term for that matter. But, the above example still shows you how a return can be enhanced by a long life thanks to others invested int he product dying earlier. For those who live a long long time it is highly unlikely the returns on any sharemarket portfolio will outperform the lifetime annuity. So, for the retired with excellent health and a family history of long life, perhaps the lifetime annuity should be a serious consideration for part of the retirement investment portfolio.

Please note…my remuneration has absolutely no connection with the sale of lifetime annuities. In fact my employer would probably hate this article!!!

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I just had a meeting with Charlie Lanchester, who manages half of Perpetual’s massive Industrial Share Fund, and his views on the Australian economy were far more dire than many commentators are saying. Like many, he believes that commodity prices are very high and showing signs of faultering (doesn’t mean they going to crash just beware) and also like many, the Australian residential housing prices are in some trouble (once again not that they’ll crash but that there’s cause for concern). Now whilst, many commentators (including me) agree with these views, Charlie (like me) is of the belief that the Reserve bank is not likely to (or should not) increase interest rates in the short term and that there is a reasonable probability that interest rates could be lower in 12 months time, such is the weakness in the underlying Australian economy. If the Reserve Bank increases rates Charlie believes this could be potentially disastrous for the Australian housing market and we can all extrapolate on the potential effects of that.

It is amazing that economists of the bigger banks are suggesting rate hikes, particularly given they are more likely to suffer the consequences of a housing market decline. Either way, Charlie believes that the real sufferers of a housing market decline are likely to be companies in the consumer discretionary sector and as we’ve seen in recent days, some of the bigger players in property securities, like Westfield, Mirvac and Co.

As mentioned in earlier posts, Australian investors are facing some big risks…

• very very high commodity prices (for when they crash they really crash)
• record high residential property prices (that have effectively propped up this ecoomy through the GFC)
• China needing to slow and contain inflation
• a Euro Sovereign crisis that could always overflow into global financial markets
• record high AUD that is contributing to our two speed economy and preventing foreign investment

Our markets are mostly financial services and commodities (plus a fair share of property) so when investing ensure these risks are considered in full.

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Source: www.macrobusiness.com.au

Found the above chart on the brilliant Australian blog, www.macrobusiness.com.au, and its quite a frightening picture indeed. As the headline says, “at no time in the last 200 yeasr have commodity prices risen as fast and as high as in the last decade without a sharp decline”. When you throw in the fact that Australia residential property prices are amongst the highest in the world, there is little doubt there is significant downside risk to the Australian economy. Unlike the US adnmuch of Europe during the GFC and Japan over the last 20 years, our banks have held strong thanks largely thanks to our property prices holding up. If our property prices crash, and some sources (Economist) say they are overvalued by 50%+, and commodity prices bust, then our amazing run of economic growth will probably crash like never before.

Of course, hopefully that won’t happen, just sayin’.

For me the key message in these two key risks in our economy is that we shouldn’t be complacent, we should consider diversifying our portfolios more than we do (we have way too much Australian equities exposure), and we should educate our clients on what true risks we face in this country…we are a lucky country, and lets hope that luck doesn’t run out.

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A change in adviser remuneration structure is causing a structural shift in asset allocation away from active products towards more passive products such as exchange traded funds (ETFs) and passive funds, according to Fidelity Investment Managers.

The above paragraph, taken from Money Management’s daily,  isn’t quite true. Whilst I believe adviser remuneration restructure has some impact on the move towards passive products, the big move to passive management really accelerated after investors and advisers saw that many active managers (including hedge funds) didn’t quite deliver their marketing hype during the negative return periods of the GFC. These large negative market returns frightened investors who demanded increased transparency, simplicity, and definitely at a reasonable cost…passively managed strategies tick all of these boxes and whilst some Morningstar and Mercer performance tables show a comeback of the active manager the damage was done and the psychology has changed from chasing return to reducing risk. 

I have a belief that, in general, investors and advisers felt their payments for alpha (active) risk would somehow reduce a portfolio’s beta (market) risk…alpha and beta risks are independent or uncorrelated so if the market goes down a lot then every long only fund goes down a lot…the impact of active management for the long only portfolio has a relatively small impact in big market downturns. So advisers and investors have simply decided to de-risk their portfolio by removing their portfolio’s only reducible risk…the alpha risk….and they just happen to save fees at the same time which is always an easier sell for an adviser. In fact, the reality is that the retail investor not only reduced their exposure to alpha risk but also beta risk as the proportion of cash or term deposits held by investors has possibly never been higher.

The GFC has changed the way everyone looks at risk and we are all a little more conservative and wary today.

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