In his latest article written for Alan Kohler's Eureka Report, Scott looks at whether index funds are suitable investments in a volatile market.

Scott looks at the relatively high proce of index funds in Australia compared to the USA as well as some of the diversification difficulties faced by index funds in a relatively small market like Australia.  However, he also provides evidence that stock pickers do not appear to out-perform in volatile market conditions and concludes that index funds are a relatively low-cost, tax-effective and well-diversified tool within an investment portfolio.

Click on the following link to read Scott's article - What price index funds?.

In his latest article written for Alan Kohler's Eureka Report, Scott looks at the upcoming float of the Brisbane Airport tollway.

Scott looks at how the offer works, that distributions are not related to earnings, the underwriting fees involved with the offer and the performance of a similar offering - the Rivercity Motorway.  He concludes that it is a difficult offering to evaluate.

Click on the following link to read Scott's article - Tollway float not hazard-free.

The latest edition of our fortnightly email newsletter was sent to subscribers on the 15th of July.  This edition looked at whether borrowing to invest is worthy of consideration, provided a summary of the movements in markets over the past fortnight and looked at the failure of forecasts over the past financial year.  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.

The latest edition also contained the following Market Update:

ASX P/E Ratio and Dividend Yields
From this edition we will be reporting on changes in the Price / Earnings ratio and Dividend Yields as reported by ASX Research.  The P/E ratio is a common broad indicator of the price of shares.  It is a calculation of the price of shares compared to expected earnings.   A higher ratio indicates that share prices are more expensive.  The historical P/E ratio for the ASX has been between 14 & 15.

As of July 8^th the P/E ratio for the S&P/ASX 200 was 10.92.  The dividend yield is 4.73%.

Market Indices

Since our previous edition, Australian and global sharemarkets along with listed property have continued to experience negative movements.  The S&P ASX200 Index has fallen 4.91% from the 27^th of June to the 11^th of July.  It is now down 21.27% from the same time last year and down 21.45% for the calendar year (2008) so far.  The MSCI World - ex Australia, a measure of the global market, has fallen 3.89% over the same period.  The index is down 21.33% from the same time last year and down 17.50% for the calendar year so far.

Emerging markets have also experienced negative movement with the MSCI Emerging Markets Index falling 4.79% since the 27^th of June.  It is down 9.42% from the same time last year and down 17.49% for the calendar year so far.

Property trusts have seen the greatest falls since the 27^th of June with the S&P ASX 200 A-Reit Index falling by 14.31%.  The index is down 46.76% from the same time last year and also down 40.81% for the calendar year so far.  The S&P/Citigroup Global Real Estate Investment Trust (REIT) Index, a measure of the global property market, has fallen 6.33% over the same period.  It is down 27.75% from the same time last year and down 18.10% for the calendar year so far.

Exchange Rates

As of 4pm the 11^th of July, the value of the Australian dollar has been relatively flat against major benchmarks for the fortnight.  It has risen slightly against the US Dollar by 0.02% at .9602.   It is up 11.56% from the same time last year and up 8.92% for the calendar year so far.  Since June 27^th the Aussie has fallen slightly, -0.41%, against the Trade Weighted Index now at 73.1.  This puts it up by 5.71% since the same time last year and up 6.40% for the calendar year so far.  (The Trade Weighted Index measures The Australian dollar against a basket of foreign currencies.)

General News

Since our last edition the Australian Bureau of Statistics has released the latest employment data with the official unemployment rate falling slightly to 4.2% as of the end of June.  The participation rate has risen slightly to 65.3% with employment levels rising by 29,800 jobs.

The Reserve Bank of Australia board also met on the 1^st of July and decided to keep the official interest rate target steady at 7.25%.  The statement published with the decision indicated that the RBA believes that there are tentative signs that inflationary pressures are easing slightly.  Since then, effective mortgage rates have actually risen due to increases passed on by individual banks in the system.

Today I came across a two minute video on You Tube which looked that the question - Can newsletters help you beat the market?  The presenter was Tom Cock who is also involved with the Sound Investing podcasts of which we are big fans.  (This topic is the latest of a series of 15 videos under the banner SoundInvesting on YouTube)

In Australia, these type of newsletters include the Intelligent Investor, Huntleys, Fat Prophet and the Rivkin Report to name a few examples.  They provide recommendations for subscribers as to what individual shares should be bought, held or sold.

In this video Tom looks at American research into whether if you followed the recommendations of investment newsletters you could beat the average market return.  The research was conducted by Hulbert Financial Digest.  (Its main business is producing a newsletter which provides a guide to all the US investment newsletters.)

Hulbert found that since 1980 there has been a high attrition rate amongst these newsletters with 100s going out of business.  Of the ones that had survived, only 4 have managed to beat the average market return.  Interestingly, the conclusion of the report states that most will do better buying and holding an index fund.

On a similar note, an academic study conducted by Graham and Harvey from Duke University in the USA found some uninspiring results for investment newsletters - "Market Timing Ability and Volatility Implied in Investment Newsletters' Asset Allocation Recommendations".  They looked at the advice provided by a sample of 237 over the 1980-1992 period and found that only a small number appeared to have higher average returns than passive portfolios.  They also tested the timing abilities of newsletters by looking at how often newsletters correctly change there asset allocation weights.  Their findings were that the newsletters offered unimpressive advice.

We are not aware of any similar research in the Australian context, but there is a good chance that the same results would be replicated here.

In our opinion you would be much better served putting the subscription fee towards investing more units in a passively invested portfolio based on index funds.

Regards,

Scott Keefer

Last week I wrote a blog identifying some less than impressive stock picking for the 2007-08 financial year.  This week I have come across another example of how stock picking just does not work.

A Daily Telegraph article published December 15^th 2007 provided what they phrased the "hottest" stocks for 2008 according to six leading analysts - Craig James (Commsec), Rick Klusman (Aequs Securities), an analyst from Merrill Lynch, Peter Switzer (Switzer Financial Services), an analyst from Fat Prophets & an analyst from Credit Suisse.  (The hot stocks of 2008)  Each analyst chose between 4 & 5 stocks. 

The returns (including dividends) from the close of trade on the 14^th of December to the close of trade on Friday (11^th July) are set out below.  The ASX200 returned negative -23.29% for the same period (not including dividends).

The performances of these picks are less than appealing with every picker's average performance below the ASX200 index.  The average under performance for all 29 shares was 13.03%.  If you had started with $100,000 you would now be left with $63,685 not including transaction costs.  (Keep in mind that the ASX200 result does not include dividends over the period.  This makes the actual result even worse.)

Now of course it has only been 7 months since the picks were made.  Some of these picks may turn into extremely good investments in the long term.  (Our preferred approach is to buy and hold for the long term.)  However, given the brief given to the pickers to identify the hot stocks for 2008, not the long term, the record speaks for itself.

So what is the alternative to stock picking?

The approach to building investment portfolios taken at A Clear Direction Financial Planning is based on scientific research around the realities of how market works.  We use index funds as the core of the growth component of a portfolio and then tilt portfolios towards the higher risk, higher expected return sectors of equity markets - namely small and value companies as well as emerging markets in the international context.

Take a look at our Building Portfolios and Research based Approach pages on our website for more details.

Regards,

Scott Keefer

In the latest edition of the Sound Investing podcast, published by FundAdvice.com, Paul Merriman, Tom Cock and Don McDonald share their insights into the last six months of poor share market returns, the outlook for the future, the returns from residential property in the US and comment on how to judge the quality of the advice you are being given.

One warning, the radio show is 51 minutes in length and will suck up 23MB of download.

If these constraints are not a problem, I recommend you take a look at the latest podcast - Sound Investing - July 11, 2008

For those who have limited time and/or limited download capability the following is a brief summary of the more relevant material that was covered:

Investment Returns for the last 6 months

Tom Cock provided a run down of the recent market returns with some interesting low-lights for the past 6 months - particularly the Chinese stock market being down 43% and India's SENSEX down 29%.

However, earnings growth is expected to be 8.1% in the US over the 2nd quarter of 2008, up from 7% last year.

The presenters conclude by suggesting that young investors are benefitted by the strong falls in markets as they are temporary set backs and younger investors have the advantage of picking up these cheap stocks - "The Ultimate Sale".

What worked in the first 6 months of 2008?

Investing in commodities was the stand out performer over this period.  For those invested in index funds you were exposed to these gains without having to take a speculative "bet" on commodities.

How to judge the quality of financial advice

The key conclusion from the discussion was not to base your judgment on the current market environment.  Rather, what were advisers recommending in the past and do they have a strong conviction as to what to recommend rather than jumping on to band wagons once the bull has bolted e.g. now recommending that investors buy into energy stocks when they weren't doing this a year or so ago.

Regards,

Scott Keefer

This Saturday, 12th July, Scott Francis joined Warren Boland's "Weekends with Warren" program on 612 ABC Brisbane.  The major topic covered was 5 things you should know about your superannuation member statement.  The following is a brief summary of the content covered in the segment:

1/ Make sure your Tax File Number is quoted: Rules changed on the 1st of July last year, that all members of superannuation funds had to quote their tax file number or parts of the fund may be taxed at a higher rate. Most member superannuation statements will tell you whether the tax file number has been received or not - if not you should get in touch with your fund and find out how to pass this detail on to them.

2/ Fees: Fees matter in investing, and all superannuation funds charge some fees of usually starting from 0.7%. There will usually be a statement of the fees for the year on the member statement, and members should assess whether these are reasonable. Obviously you have to pay some fees for a service - you don't want to pay too many. (It is neither wise to pay too much nor too little in fees). Fees often have a number of layers: Administation; Investment Manager; Adviser Fees and sometimes even things like 'trustee fees'. People with Self Managed Super Funds have other fees associated with their fund, being accountant and administrator fees - the important thing is to find out exactly all the fees coming from your portfolio.  I have come across a $10,000 superannuation account with fees of $500. That is a 5% fee! That person simply cannot have a successful investment experience paying fees of that level! If the long term return of a balanced fund is 8%, you are giving away 65% of the long term return in fees.

3/ Insurance: Superannuation can be a good place for you to have relatively low cost life insurance. However, you should understand what the insurance is for: how much is the benefit? what does it cost? In the case of income protection - how long is the benefit paid for? Superannuation funds will often have an insurance outline - you should read and understand this, so that you know what you are paying for.

4/ Contributions: It is suprising how many people don't follow up whether their actual contributions are being received into a fund - plus other things that they are entitled to such as the government co-contribution. You should receive around 9% of of your income into superannuation - less 15% tax on the way in. If you are being paid $50,000 this is a contribution of $4,500 less about $675 in tax. You should check that this much in contributions have actually been received. After all - it is your superannuation money; not anyone else's.

5/ Asset Allocation and Performance: These two are related. You should understand the mix of assets in your fund. If you have a balanced fund, what does that include? The Q Super Balanced fund for example has a mix of 75% growth assets (higher return but volatile assets); such as Australian and global shares and property assets and 25% in cash and fixed interest returns (low return but safe and reliable assets). This is a really important part of investing - studies show that it accounts for more than 90% of the variation in investment returns.

A Fascinating Finance Fact:

The Sunday Mail last week looked at the stockmarket tips made 12 months ago by 4 experts in the article 'Redemption Time - Stock Experts Shrug off a Painful Year of Investing.' The article found that of the 16 stocks chosen by the experts, only 2 beat the average market return (the index).

Each of the 4 experts (2 stockbrokers; 1 software that picked outperforming stocks, 1 portfolio manager), picked 5 stocks. The average price movement of the market over the period was (negative)-16.54% for the year. The average return on the 4 portfolios of the experts were -22.59%: an underperformance of 6% a year. Individual portfolio returns were -3.6%; -19.32%; -25.68%; -41.76%.

Users of our website, through our User Voice feedback forum, have requested that we regularly update the graphs outlining the performance of the Dimensional trusts that we use in building portfolios for clients.  In response to this feedback we have updated these graphs to reflect performance up to the end of June 2008.

The graphs show negative returns in the Australian and international markets over June.

Overall, the graphs continue to clearly show the existence of the risk premiums (small, value and emerging markets) that the research tells us should exist.  Please click on the following link to be taken to the graphs - Dimensional Fund Performance Graphs.

For anyone new to our website, it is important to point out that we build investment portfolios for clients based on the best available academic research.  Take a look at our Building Portfolios and Our Research Based Approach pages for more details.  In our view, this research compels us to use the three factor model developed by Fama and French.  In Australia, the most effective method of investing using this model is through trusts implemented by Dimensional Fund Advisors (www.dimensional.com.au).  We do not receive any form of commission or payment from Dimensional for using their trusts.  We use them because they provide the returns clients are entitled to from share markets.

However, academic theory is nothing if it can not be implemented and provide the returns that are promised by the research.  Therefore, we like to provide the historical returns of the funds that we use to build investment portfolios.

Please let us know if you have any feedback regarding these graphs by using the Request for More Information form to the right or via our User Voice feedback forum.

Regards,
Scott Keefer

In today's podcast, Scott Keefer looks at the fundamental consideration behind the decision - will the investment provide returns above the effective cost of loaning the money.

Please click the following link to be taken to this podcast - Is it time to be considering borrowing to invest?

In his latest article written for Alan Kohler's Eureka Report, Scott looks at a bearish forecast by Gerard Minack from Morgan Stanley that the ASX 200 will fall to 3500 in 2010.

Scott provides three reasons why he thinks the forecast is unlikely to eventuate.  However, he then proceeds to look at the opportunities that would be created based on the forecasts and outlook provided by Gerard Minack.

Click on the following link to read Scott's article - Bearing Up.

The first 6 months of 2008 have provided some "interesting times" for "margin loaners".  The sharp fall in the Australian share market through the first quarter and now again in June has led to surges in margin calls by lenders.  Monday's Fin Review suggested that margin calls rose 10-fold on Thursday last week.  Margin calls in the first quarter of the year jumped to 3.85 per 1000 investors up from between 0.25 and 1.04 in 2007.

There have also been a few notable collapses of firms encouraging their clients into such loans - Opes Prime and Lift capital the better known of these.

At the same time interest rates have risen.  The Reserve Bank set the official cash rate target at 4.25% in December 2001.  This rate has been raised with the latest rate rise in March leaving the official rate at 7.25%.  Cannex and RateCity.com.au, two organisations that list the latest interest rates in the market, have the best margin loan rates at the moment sitting at 10.25%.

Given these observations, taking out a margin loan under the present conditions looks hazardous at best.

However, investing is about looking forward.  If you consider some of the fundamentals in the market there may be some good buying to be had.  The Fin Review on Saturday had the ASX200 Price Earnings ratio at 11.37, well below the historical averages of around 14.  This is basically telling us that shares are cheap at the moment.  Dividend yields for the same index are at 4.54% with many "Value" companies like the major financials on much higher yields as well as being fully franked.  Let me put on record that our firm does not attempt to predict short term market movements, however we do look at the long term realities of markets to suggest that sometime in the future there will be a significant upswing in markets.  Knowing when this will happen is the difficult part.

So what is our approach to considering borrowing to invest in the current climate?

Our firm is quite conservative by nature.  We would never be suggesting that investors heavily gear up, especially in terms of margin loans.  Rather we would take a measured approach considering the fundamentals.  The key consideration is that if you choose to borrow to invest you must have an expectation that the returns from the investments, on which you used borrowed money to purchase, will be greater than the cost of the loan.

Let's first look at determining the cost of the loan.  For simplicity, let's assume you want to borrow $100,000 at the best margin loan interest rate of 10.25%.  The interest payments for the year will be $10,250.  You can deduct these payments from your income for the year to reduce your tax so the after tax consequences are as follows:

This effectively means that your after tax returns from your investments would need to be better than this effective rate.

What this clearly shows is that borrowing money to invest in cash or highly rated fixed interest securities does not make sense.  Let's assume you invest the $100,000 in an online savings account earning 8% ($8,000 of interest for the year).  The after tax returns would be:

This shows that by having any of the loan invested in cash you would be going backwards.  Therefore you would need to invest in assets like Australian shares, international shares and listed property in order to beat the cost of the loan.

Let's consider Australian shares, with a dividend yield of 4.54% for the ASX 200.  The average franking credit level on the ASX200 is approximately 80%, which would provide franking credits equal to 1.14% providing a grossed up return of 5.68% ($5,680).  After tax this would leave you with:

To warrant borrowing to invest you then need to expect that the capital growth on your investment (growth in share price) will be greater than the difference between the after tax dividend return and the effective rate of the loan after tax.  In our example you will need to get the following capital gains assuming a buy and hold strategy (i.e. applying the 50% discount rate to all of the capital gains)

The average before tax capital gain of the Australian share market through history is somewhere between 6 & 7%.  On these numbers the borrowing to invest strategy seems to make sense.

That being said, if you had geared up in late October, early November the strategy would have resulted in a less than rosy return up to now.

Some other considerations to weigh up

Some other factors need to be considered before deciding either way.

• What is going to happen to interest rates?
• Falling interest rates would improve the scenario whilst increasing rates make it more difficult.

• Can you access a home equity loan?
• If you can, the interest rate could be as much as 1% lower than the best margin loan rate.  I won't do the maths on that here but it would definitely improve the chances of beating the effective loan rate
  
• What if I am an active style investor?
• Firstly we would consel you against such an approach, but if you could not be persuaded, you would need to factor in some extra capital gains tax pushing the needed before tax capital gains a touch higher than those mentioned above.

Final Thoughts

The maths looks promising especially for those on higher marginal tax rates however there is a huge elephant in the room - what is going to happen to shares in the next year?

Some experts predict the ASX200 could call a further 30%, down to 3,500 from the curent level of 5,000, whilst others suggest it could get back to historical highs in the new year - 6,800 or a 36% rise.

This is the key question and unfortunately one we do not have the answer for.  What we do know is that taking on more debt adds risk to your situation.  Increased risk levels can lead to increased returns over the long term but can also have a devastating impact.  This risk needs to be weighed up by each individual investor according to their own personal circumstances and preferences before even contemplating borrowing to invest.

Now that the investment books for the 2007-08 financial year are closed it is worth having a look at some of the forecasts and predictions made at the beginning of the financial year to see how they turned out.  The Sunday Mail ran a piece over the weekend - "Redemption time - Stock experts shrug off a painful year of investing".

The article looked at the 5 stock picks made by four experts at the beginning of the 2007-08 year:

To put these results in context, the ASX200 Index returned -16.54% over the year.  The average performance across the 4 experts was -22.59% or 6.05% below the ASX200.  Well done to Tony Dennis for beating the market but based on pure chance you would expect two of the four to have out-performed and two to have underperformed so basically the group as a whole did worse than pure chance.

An index fund would have to have had fees and costs of 6.05% to have matched the performance.  (Vanguard's Australian Share Index Fund has a fee of 0.75% on the first $50,000 or 0.34% for wholesale investors)

I know where I would have preferred to have my hard earned money invested.

Regards,

Scott Keefer

In his latest article written for Alan Kohler's Eureka Report, Scott looks at the Timbercorp bond (TIMHB) which has been trading for some time.

He looks at the current income yield, the conditions on maturity, the corporate rating of the issue and the trading liquidity.  He concludes that the bond has an attractive yield if held to maturity but comes with some high risks.

Click on the following link to read Scott's article - Timbercorp return comes with risk.

A friend asked us during the week where he could "park" some cash while he was tossing up possible renovation plans for his home.  A similar situation might be faced by those saving for a home deposit or who already have a deposit and are waiting for home prices to fall before jumping in to buy.

The first suggestion that comes to mind would be to focus on removing volatility from any possible investment (and in doing so reducing risk).  In particular, a serious look at investing for income is definitely warranted.  So what is investing for income?

--------------------

How do we apply this?

The latest edition of our fortnightly email newsletter was sent to subscribers on the 1st of July.  This edition looked at investing for income, provided a summary of the movements in markets over the past fortnight and looked at getting the right price for financial advice.  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.

The latest edition also contained the following Market Update:

Market Indices

Since our previous edition, Australian and global sharemarkets along with listed property have continued to experience negative movements.  The S&P ASX200 Index has fallen 2.62% from the 13^th to the 27^th of June.  It is now down 15.32% from the same time last year and down 17.40% for the calendar year (2008) so far.  The MSCI World - ex Australia, a measure of the global market, has fallen 5.49% over the same period.  The index is down 17.10% from the same time last year and down 14.17% for the calendar year so far.

Emerging markets have also experienced negative movement with the MSCI Emerging Markets Index falling 3.87% since the 13^th of June.  It is up 0.26% from the same time last year but down 13.34% for the calendar year so far.

Property trusts have also fallen since the 13^th of June with the S&P ASX 200 A-Reit Index falling by 3.29%.  The index is down 37.92% from the same time last year and also down 30.93% for the calendar year so far..  The S&P/Citigroup Global Real Estate Investment Trust (REIT) Index, a measure of the global property market, has fallen 6.74% over the same period.  It is down 23.28% from the same time last year and down 12.57% for the calendar year so far.

Exchange Rates

As of 4pm the 27^th of June, the value of the Australian dollar has risen against major benchmarks for the fortnight.  It has risen against the US Dollar by 2.11% at .96.   It is up 14.12% from the same time last year and up 8.89% for the calendar year so far.  Since June 13^th the Aussie has also risen 1.52% against the Trade Weighted Index now at 73.4.  This puts it up by 7.31% since the same time last year and up 6.84% for the calendar year so far.  (The Trade Weighted Index measures The Australian dollar against a basket of foreign currencies.)