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My simple market beater - Eureka Report article

My simple market beater

By Scott Francis June 29, 2011

PORTFOLIO POINT: Easy, proven investment strategies once again outperform the clever manoeuvres of sophisticated investors.

Buy and hold is dead. Long live buy and hold! With the ASX 200 closing today at 4530, it’s been a frustrating 12 months for the equity market investor, now looking down the barrel of a 5% return before dividends for 2010-11, a bitter pill after the equally skinny 8.7% return of the year before.

But if anything the difficult investment environment has proved that some of the simplest and oldest strategies of investment theory, such as rebalancing, low-cost equity exposure, a good cash account and regular investing, are as relevant as ever.

It’s especially important now as investors are bombarded with all manner of products from hedge funds to gearing and derivatives.

Strategies that were once the domain of the “sophisticated investor” are now increasingly being flogged out to every Tom, Dick and Harry to increase revenues of a financial industry that is finding it increasingly difficult to generate a profit.

In fact, in a year when the margins of outperformance are likely to be exceedingly slim, stripping out a layer of management artifice and the fees that go with it is more important than ever.

As an example, I would like to offer up the performance of a very simple investment structure I devised back in March 2009 as part of my role as a personal finance commentator on ABC Radio.

The portfolio consisted only of two assets: a $5000 investment in a simple Australian shares index fund with a MER of 0.75%, and a $5000 investment in a high interest rate cash account.

Note that this is not a simulation; it is a genuine portfolio and, according to my most recent statements, is now worth $13,412 (as at June 28).

This simple, two-asset portfolio has provided an investment return of 15.2% a year over its first two-years and four months in existence – well above the long-run average return from Australian shares (generally measured as 11–13% a year over periods longer than 30 years). Of course, this is only part of the story .

If you had been bold enough to wade into the market and fully invest your capital at the low point for equities and put the entire $10,000 in an ASX 200 Index fund you would be sitting on $15,918. If you had been waiting in cash since that time, all you would have had was a comparatively paltry $11,500.

But the fact is that being fully invested in one asset is never a good idea and investors are ultimately trading the ability to sleep well with the ability to eat well or vice versa.

Over the past 12 months, a pure cash portfolio has returned 6% while a pure equity exposure to the ASX 200 has returned 9%. Compare this to my “simple” portfolio return of 8% and I’m sure you’ll agree that a good night’s sleep is worth a lot more than a measly 1%.

The reality, though, is that it is impossible to precisely pick the bottom of the market. At that time I launched the portfolio, fear was everywhere and it would have been a difficult decision to be greedy and throw all your money into shares.

But this is exactly why I chose that moment to begin my experiment. To show how a simple mix of growth assets and cash can navigate a safe yet profitable path between the boring and secure returns of cash and the higher but more volatile returns of equities.

So let’s run through the strategies I’ve employed to achieve this attractive balance and some others that might make sense for you depending on your personal situation.

Maintain your balance

Rebalancing is a simple strategy that helps keep investors focused on the ultimate investment goal – to buy low and sell high – because it is precisely when sharemarkets fall in value that an investor should be considering using a portion of their cash to “top up” their exposure and rebalance their portfolio.

In a previous article (click here) I showed how that regular rebalancing over the long term not only delivered marginal outperformance but also significantly reduced the volatility of returns. But in the case of my simple portfolio, it was the rebalancing that was the key contributor to its solid performance over the limited time frame we are studying today.

When the ASX 200 approached 5000 for the first time following the GFC in April 2010, I decided to rebalance the portfolio and sold $700 worth of units in the index fund. This has turned out to be a profitable decision, with the ASX easing in the aftermath while the rebalanced capital earned interest.

You could argue that I should have rebalanced back towards shares in July 2010 when it fell through 4300 and sold them off again at the peak of 4976 in April 2011; had I done this I would almost certainly have beaten the index by a considerable margin. But as we all know hindsight is a wonderful thing and if anything this strengthens not only my case but my resolve to “top up” my exposure to shares again at lower prices should the ASX 200 fall below 4400.

Create a cash cushion

One of the keys to being able to quickly and efficiently execute a rebalancing strategy is a simple cash account, and fierce competition among the banks means there is absolutely no excuse for not having readily available cash on hand earning a good rate of return.

Even if you already have one, you should check that the rates you are getting are still competitive. When I started my “risk weighted” portfolio, Suncorp had the most attractive offer on the market. Since then, I’ve moved the funds to NAB subsidiary UBank for an even better offer.

The latest innovations among the cash accounts are bonus rates of interest for making regular deposits. If you really want your money to work hard for you, these are well worth investigating to see if they suit your personal circumstances – but note that they are almost all capped.

As simple as cash is as an investment, it should never be overlooked as an important personal finance strategy.

Having a cash buffer helps people cope with unexpected circumstances such as losing a job, coping with an illness or needing short-term access to cash for lifestyle needs. For people in the retirement stage of their life, cash provides the liquidity in their portfolios to make pension payments without having to sell growth assets – a crucial asset allocation strategy when investments fall in value.

Alongside any discussion of the importance of cash in a portfolio should be a discussion of the income produced by the portfolio. In the first 12 months, the portfolio produced $513 of cash income with franking credits of $81. In the second 12 months, it produced $671 of income with $98 of franking credits.

Once again this doesn’t sound like much, but when you consider what sort of income a million-dollar portfolio invested in this manner would throw off ($51,300 in the first year with a further $8100 of franking credits and $67,100 of income in the second year with $9800 of franking credits) you can see that it is showing signs of producing a strong and growing income stream – an outcome most investors look for.

Simple equity exposure

Most Eureka Report readers will have acquired a portfolio of direct shares over time which, it must be said, gives them even greater flexibility when it comes to rebalancing by allowing the sale of specific stocks and sectors that have had a good run. But those investors just starting out might be better served with cheap equity exposure through index funds, ETFs or even listed investment companies (LICs).

There are pros and cons associated with each type of vehicle but the key point here is that they each offer diversified exposure to the Australian equity market for only a fraction of the cost of an actively managed fund and much less time than it would take you to assemble a direct portfolio of shares by yourself.

That said, the MER on the simple index fund, of 0.75%, is more than five times what investors in the US pay for a similar index investment. In this instance, my preference for an index fund over an LIC or ETF is the ability to buy and sell relatively small amounts without incurring transaction fees. In this instance I made a conscious decision to pay a slightly larger management fee for the privilege.

More importantly, I have avoided “active” managed funds, which generally have higher fees (up to 2% or more) with significant evidence that they struggle to produce satisfactory returns for investors. In a report that covered the five years to December 2010, Standard & Poor’s found that 71% of Australian funds failed to match the return from the ASX 200 accumulation index. This is a poor result for fund managers, made worse by this being based on pre-tax returns, with the active nature of many funds seeing them struggle to produce acceptable after-tax returns.

Invest early, invest often

The most basic of all investment strategies is what Albert Einstein called “the eighth wonder of the world”: compound interest. But another equally simple and devastatingly effective strategy is the simple power of investing regularly over time. The sophistication of this strategy lies in some interesting calculations.

Let’s assume that a person invests $1000 a month into an investment that has a unit price (or share price) of $10. In the second month the unit price falls to $5 and they invest a further $1000. The question is: What is the average price of their investment? Most people will say that the average price is $7.50. However, doing the sums shows that the average price falls all the way to $6.66 because the $1000 invested at $5 buys twice as many units.

This simple strategy of investing regularly over time has the inbuilt sophistication of buying more units when prices are low, and fewer when prices are high. Of course, this is the strategy that underpins many people's superannuation investments, a regular flow of investments made over time.

The opposite of investing regularly would be borrowing to invest – effectively a punt that one point in time will provide investors with a good enough return to justify an investment that uses borrowed money. In this article from 2006 (in those carefree pre-GFC days) I wrote of the structural bias that the financial planning industry had towards borrowing to invest. The article discussed the significant fees that could be generated by getting clients to borrow to invest, and how this was certainly not suitable for everyone. In the cold, hard light of the GFC, Storm Financial sadly demonstrated how risky it could be to invest large sums of someone else’s money in the sharemarket.

It’s obvious that a portfolio consisting of a simple index-style investment and a high-yielding cash account won’t be suitable for everyone. Indeed, I would find it difficult to limit myself to just two investments for my overall portfolio. But as I have shown, a good cash account and a simple, clean exposure to Australian equities will provide investors with a reasonable, and sometimes benchmark beating, return over long periods of time.

Doug Turek reminded us of the attractive long run average returns from shares (click here). Use an investment (in the case a simple index fund) that captures these returns in a cost-effective and tax-effective way, and add to these a high-quality cash account to provide access to money (liquidity), and a simple solution can be quite effective, and simple to monitor, report and provide tax details for.

Add the strategy of making regular contributions to the portfolio, with an eye on rebalancing, and you have a robust recipe for a simple effective solution that leaves plenty of time for fishing.