Last Wednesday the Sydney Morning Herald published an article looking at fixed interest investments - To have or to hold

Fixed interest investments are rarely high on the agenda of the media or backyard BBQ discussions but it is times like now that highlight the need for more focus on fixed interest investments.  For us, fixed interest investments are about reducing the volatility in portfolios and smoothing out returns in portfolios.  They are mostly boring, consistent performing investments but in times like these the value of fixed interest investments can not be overstated.  The average monthly investment returns from the main indices since the beginning of 2008 to the end of August are outlined below:

Annual returns to the end of August were:

On both time periods we can see that cash and fixed interest have well and truly out performed the growth asset classes.  But not all fixed interest offerings are the same.

Unfortunately some investors don't just use cash and fixed interest securities to reduce portfolio volatility, they use these investments to chase returns.  The Sydney Morning Herald article highlighted some distressing returns with the article suggesting fixed-interest funds have lost about 8%.  These styles of funds are not the boring but safe fixed-interest investments most peoples associate with.  They are aggressive funds that use names such as "high-yield", "diversified credit" and "multi-strategy income" and invest in such things as collateralised debt obligations, asset-backed securities and mortgage-backed securities, as well as emerging market debt and non-investment grade corporate debt.

It is now well publicised that these investments have been at the centre of the crisis on financial markets.  Some well know funds which have come unstuck include Absolute Capital, Basis Capital and City Pacific.  Investors were encouraged to invest because these funds promised share-like returns with supposedly less risk.

Our approach to fixed interest is worlds apart from this aggressive approach.  We focus on high quality securities that produce reliable consistent returns over time.  Our preferred investment in the fixed interest area of portfolios is the Dimensional 5 Year Diversified Fixed Interest Trust.  The Trust uses a variable maturity approach which involves no interest rate forecasting.  This approach seeks to identify the countries and maturity ranges with the highest expected returns and generally increases country allocation or extends maturities when the expected returns are significantly higher for a country or for longer term securities. It invests in A1+ short term securities and AA or higher rated long term securities.  Take a look at Dimensional's quarterly update for more information.  The one year return after fees has been 7.46% to the end of August (0.35% above the relevant index.)

Another fund that we do not currently use but worth a look is the Vanguard International Credit Securities Fund (Hedged) mentioned in the Sydney Morning Herald article.  It is invested in over 8,500 securities issued by government owned entities, government guaranteed entities and investment grade corporations.  The one year return has been 6.99% after fees for the wholesale version.

To summarise, fixed interest securities are about smoothing out returns in portfolios, especially crucial in times like now.  It is important to have a well diversified exposure in high quality offerings.  Take a look at our Building Portfolios page for more details about how we incorporate fixed interest securities into our recommended portfolios.

Regards,

Scott Keefer

This morning I have read what I feel is a very useful piece on Vanguard's website - Just when you thought it was safe to go back in the water.

The article gives a brief summary of current happennings on the markets and concludes by asking what action, if any, should investors be taking?

It suggets the following courses of action (directly taken from the article):

There is no surprise that I fully concur with the thoughts pointed out by Vanguard.  I particularly like the last point.  Now is the time to be reconsidering your risk profile.  Risk profiling is a difficult task.  When you are asked the question how would you feel if your investments fell by 10,20,30,40% it is difficult to provide an accurate response if you have never experienced such falls.  After 9 months (or more for listed property investors) of really tough conditions the question to be asking yourself is how have you gone handling not only the 25% or more falls on equity markets but also the significant turbulence (volatility)?

If your answer is that you are finding it extremely uncomfortable it may make sense to ease back on your growth asset allocation.  Most likely this will have occurred automatically as growth investment values have fallen and defensive assets remained steady but produced income.  However a decision will need to made when rebalancing your portfolio whether to set your growth assets back at the original percentage level. 

If your portfolio still has too great an exposure to growth assets it may have to be a gradual process to rebalance to a more defensive position as ideally you do not want to be realising losses and then see the market turn back up sharply.  One way would be to make sure you don't reinvest income and dividends as they come into portfolios, rather set these aside in cash and fixed interest security investments and by doing so rebalance your portfolio towards a more defensive setting.

Please get in touch if you wanted to discuss any of these points in more detail.

Regards,
Scott Keefer

The latest edition of our fortnightly email newsletter was sent to subscribers on the 16th of September.

In this edition we take a look at the problem with investing using managed funds, provide a summary of the movements in markets over the past fortnight and look at whether you are able to time your entry into and out of risk premiums.

We have included our fascinating financial fact for the fortnight that was included in the newsletter.

If you would like to be added to the mailing list please click the following link to be taken to the sign up page - The Financial Fortnight That Was Sign Up Page.

Fascinating Financial Fact

In August the Association of the Super Funds of Australia published a paper looking at the returns for the past financial year in context of historical returns - Super Returns - putting them into perspective.  The paper looked at balanced portfolio financial year returns over the past 15 years using data from Super Ratings.  (They also provided a table with the past 40 year data.)  The 2007/08 financial year returns have been by far the worst over that period - down 6.8%.  The next worse year was 2001/2002 with a negative 3.5% average return and then 2002/03 with only a 0.1% positive return.  The 2000/2001 year with an average return of 5.6% was the only other year in the 15 year period where returns failed to beat inflation (CPI).

When we look at these one year returns it seems to make sense to question the appropriateness of investing in growth assets such as Australian shares, international shares and property which have been the cause of these years of poor performance.  However, taking a wider view of time periods provides quite a different perspective.  The paper proceeded to look at 5, 10, 15 and 20 year periods putting this issue into wider periods of perspective.

Over the 5 year period leading up to the 30^th of June of each year, the data showed:

-          only in the period 1974 - 1978 did the average returns from balanced investments under-perform inflation.  For those who experienced this time, it was a very difficult time economically with high levels of inflation and poor share market returns

-          in the periods ending 2003, 2004 & 2005 returns went close but still out-performed inflation

Over the 10 year period leading up to the 30^th of June each year, the data showed:

-          the ten year period leading up to 1979 and 1982 saw average balance returns underperforming inflation

-          all other periods provided above inflation returns with most well above

Over the 15 year period leading up to the 30^th of June, the data showed:

-          all periods out-performed inflation

Over the 20 year period leading up to the 30^th of June, the data showed:

-          all periods out-performed inflation

The issue that stood out to me in the data is that we need to be careful assuming that growth returns will be better than inflation over a 5, 7 or even 10 year period, as not until we get to 15 year and 20 year periods do balance returns out-perform.

For those with over 15 years until reaching 60 this should provide some comfort in investing in growth assets in superannuation.

For those approaching closer to retirement more care needs to be taken to properly structure investments so that a period of poor performance in growth asset classes does not provide a significantly detrimental result or even cause you to delay retirement.  Our approach is to be very closely looking at income planning, making sure clients have at least 5 to 7 years of income requirements in retirement held in defensive assets such as cash and fixed interest securities.  This means that you should not need to sell down growth assets in times of depressed prices in order to sustain their cost of living.  (Unless you sell growth assets at depressed prices you do not realise losses and history tells us that growth asset prices will rebound.)

A point to note here is that investing in a diversified superannuation fund or investment that does not segregate the account into distinct defensive and growth assets does not protect an investor from having to realise falls in growth asset prices.  When it comes to the time to retire, investors in non-segregated funds would need to sell down a certain number of units in order to get the income that they need.  In a balance account (40/60 split) this would require redeeming both defensive assets (40% of each unit) and growth assets (60% of each unit). Thus you would be forced to realise the poor prices for growth assets.

In a nutshell, our take on this is that in the 15 years leading up to your preferred retirement date, we think you should start to focus on income planning.  In doing so you are building towards having the necessary amount of assets set aside in cash and fixed interest so that you are not forced to redeem growth investments at the wrong time and/or not having your retirement date dictated to you by investment markets.

Regards,

Scott Keefer

In his latest article written for Alan Kohler's Eureka Report, Scott looks at how to determine a fair valuation for the price of Wesfarmer shares.

He applies the dividend discount model which suggests that if Wesfarmers can produce an ongoing 4.5% annual growth in dividends, the current valuation of approximately $31 is reasonable.  However there are a number of other key issues in play such as economic growth and inflation, the way managers deploy capital, management of debt and the strategy for and market power of Coles.

Click on the following link to read Scott's analysis - What price Wesfarmers?.

I had the pleasure of joining a presentation from Mr Inmoo Lee (Ph.D.) a Vice President from Dimensional Fund Advisors in the United States.  Inmoo along with two other colleagues from Dimensional has conducted research into the relationship between risk premiums and business cycles looking at whether there are systematic patterns and if so whether investors can effectively access better returns utilising these patterns.  (The following is my own summary of the presentation and not that of the researchers.)

Before getting to the results let's first step back and define a couple of key concepts.  For those who have followed our website and our underlying investment philosophy you will be aware that we subscribe to the academic research behind the three factor model as identified by Fama & French.  Fama & French found that there are areas of investment markets where risk premiums exist over the long term.  In particular, small and value companies, taken as a group, hold higher levels of risk for investors and therefore investors expect compensation for taking on that risk. i.e. higher risk leads to higher return in the long run.  (Take a look at our Investment Philosophy and Our Research Based Approach pages for more details)

However, these risk premiums are not present all the time and over short run periods, small and or value companies may under-perform the index.  Currently the Global Value fund that we use in portfolios has underperformed the Large Company fund year to date but has out-performed over 5 years.

Therefore, based on these presumptions which are supported by academic research, the question to ask is can you time your entry and exposure to the risk premiums so that you make the most of periods when the risk premiums are being realised and minimise the exposure when the risk premiums are not being realised and the index (and growth stocks) are performing better.

What Inmoo and his colleagues have done is to look at business cycles as a source of prediction.  Let's stop here and break off for a brief economics lesson first.  The business cycle basically tracks the periods of expansion (growth) and contraction (recession) in an economy.  Throughout history economies move through this cycle moving from periods of expansion, reaching a peak and then contracting, reaching a trough from whence the economy starts to expand again.

Intuitively we should expect that the risk premiums (expected future returns) are greatest at the bottom of contractionary periods (troughs) and worst at the top of expansionary periods (peaks).  The theory being that at the bottom of the market cycles, riskier investments such as small companies and out of favour companies (value) will be sold off the furthest.  Therefore the expected future return is the greatest as these investments are at relatively low prices.

So theoretically, the best time to be buying into risk premiums is at the bottom of the business cycle and selling out at the top of the business cycle.  Inmoo's research actually found that some relationship did indeed exist with small and value areas of the US market out-performing the market going forward from the bottom of the business cycle and under-performing after the cycle reached the peak.

Everyone should be getting excited now as there seems to be an opportunity to trade in and out of the premiums and thus achieve greater returns.  Unfortunately there is a big BUT.  A major problem is that it is very difficult to identify exactly when the business cycle reaches its peak and trough.  The National Bureau of Economic Research in the US has the task of doing just that.  They identified the last peak as being reached in March 2001.  Unfortunately they were only able to make this determination in November of that same year. i.e. 8 months later.  Similarly they identified that the last trough in the business cycle was November 2001 and this was determined in July 2003, some 20 months later.

If an organisation which has this task as its primary focus takes so long after the fact to make a determination, what hope to make the determination beforehand.  This is the key problem.

Now some might say well what does it matter if you miss the peak or trough by a month or two you should still end up with a better outcome.  Inmoo and his colleagues took this very consideration into account.  They found that if you missed your timing either coming in or going out the benefit of the timing decision was statistically non-existent.  Basically the conclusion was that you had to be lucky twice with your timing decisions.  You would have to pick the precise month going in to the risk premium and then precisely time the month when to get out of that area of the market.

Yet again it seems the probability of greater performance is stacked against the "market timers".  A much better approach is to determine your ideal portfolio exposure to risk factors i.e. the market, small companies and value companies, and hold this exposure through time.

If you would like more information about our approach to structuring investment portfolios please take a look at our Building Portfolios page.

Regards,

Scott Keefer