Andrea Slattery

Allegations that SMSFs don’t provide the same level of information about their asset allocation as the larger APRA-regulated funds are simply spurious, says Andrea Slattery, CEO of the SMSF Professionals’ Association of Australia (SPAA).

Slattery was responding to a submission to the Financial System Inquiry (FSI) that alleged there was a lack of information about the asset holdings of SMSFs and that this made it difficult to assess the extent of any risks in the system.

“This really is a case of the pot calling the kettle black – and is so far removed from the reality.

“Look at the annual returns required to be completed by SMSFs and APRA-regulated funds and it’s easy to see which sector provides the greatest level of detail. It’s all there in the Australian Taxation Office (ATO) files, SMSF by SMSF.

“ATO reports on SMSFs not only disclose the number of new funds, details about members, their ages and how much they are earning, but also disclose information about the fund’s investments split into 19 investment categories. By contrast, APRA-regulated funds report under the cover of broad aggregates that reveal nothing specific about their asset allocation

“Significantly, overseas superannuation funds that are much larger than their Australian counterparts currently provide significant and specific information as part of a continuous disclosure regime that enables their members to gain immediate access to fund investment allocations on a daily basis.

“Changes to reporting of investment allocations by APRA were highlighted in the last APRA quarterly report showing the aggregates all fund assets, as well as the number of entities with more than four members. This broad level of detail provides less insight into APRA-regulated funds than previously reported.

“Now this broad information will have to be reported annually, although this still lags the SMSF sector where significant levels of detail are reported quarterly and annually in a transparent and comprehensive way by the ATO.

“The fact is there has been huge resistance by the APRA-regulated funds, even after the current superannuation system has been operating for more than two decades, to disclose their investments.  This is something they will need to do, to some degree, in the future ­– but still not to the same extent as SMSFs,” she says.

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The search for the ultimate ‘system’ of efficient portfolio construction and ongoing management has led to some interesting innovations. Here, Select Asset Management’s Alex Wise looks at the evolution of the underlying product structure with an eye to the top-line investor benefit.

Efficiencies in portfolio management have long been a goal of savvy investors and their financial adviser. But today we are shackled with the onerous task of reporting compliance, Dreaded paperwork. The process of completing a Statement of Advice (SoA) for material changes or a Record of Advice (RoA) for minor changes each time a change in investment is required is a tedious and intensive process for all concerned.  Moreover, client investments may be put at risk when markets begin to gyrate. Advisers may not produce timely, written advice to be acted upon quickly enough in order to protect clients. Similarly, clients are often unable to take advantage of short-term mispricing opportunities.

Solution? Two investment structure approaches have evolved to provide a more responsive investment solution for clients. They are, firstly, the use of a multi-asset unit trust as a core portfolio tool and, secondly, the use of managed discretionary accounts (MDAs), while an increasing number of advisers are considering a hybrid solution as the best of both worlds.

Managed Discretionary Accounts

MDAs are provided by a financial planning, fund management or brokerage house – each working as an MDA operator (“Operator”).  Typically an Operator manages a portfolio of equities for a client on an individual or model basis, although solutions exist encompassing other non-equity assets.  A client gives the Operator discretionary authority to make and implement investment decisions on his or her behalf. Importantly, client approval is not required for each investment decision.  This also means that reporting requirements to clients can be simplified and the Financial Planner is not required to  to engage the client in advance each time an investment decision is made.

Certain MDAs can be tailored specifically to the requirements of each individual client. Bespoke MDAs, called individually managed accounts (IMA), require higher minimum investment amounts in order to be practical. More commonly the MDA operator will apply the same investment decisions to multiple client accounts according to a model portfolio i.e. a separately managed account (SMA). Importantly, from a legal perspective, the client holds a direct legal or beneficial interest in the underlying assets within the MDA. This is distinct from managed investment schemes where the underlying assets are held by a unit trust, and the client has a direct interest (a unit) in that trust.

For clients with larger balances, the MDA offers increased control, however, the expense associated with operating an MDA have made it impractical and commercially challenging for small to mid-size clients to get the benefits of a tailored MDA.  Clients with larger sums to invest are able to take more or less risk depending on their appetite or investment preferences – for example, financial securities could be excluded from a bespoke MDA account; perhaps not a bad thing given current valuations!

Some MDAs can offer portfolio protection via derivatives or options strategies.  However, these protections are not available to all clients as they depend on the Operator’s regulatory status and whether they can transact derivatives on behalf of their clients.  Many fund managers and financial planners acting as MDA operators don’t have the necessary licence to use derivatives or options.  This can leave clients exposed without portfolio protection in times of market volatility.  However, for those clients that benefit from an Operator with derivatives experience, market protection strategies can insulate portfolio returns from severe downturns in market values. All with the attendant risks, of course!

Importantly, the tax impacts of investment decisions remain specific to each client.  This means that the Operator ensures that the client’s tax consequences are insulated against the impact of other investors.  Unit trusts offer a similar outcome for all clients.

It is worth noting that many Operators have a lack of experience outside of equity securities.  This can leave clients facing low or non existent access to  bond and other markets (as well as derivatives outlined above).

One further criticism of MDAs is that they usually do not allow access to global investment markets and outcomes.  Whilst many investors are satisfied having 100% of their investment outcome linked to the ASX, many others are now seeking exposure to fixed income or Term Deposits. Global equity markets – including established markets like the US – or more exotic emerging market locations may be in favour.

Additionally, incentives for MDA operators have also been called into question by some observers.  The use of brokerage commission as a remuneration tool has been linked with an incentive to churn the portfolio, meaning that clients will participate in more trades to generate higher commission for the Operator or their affiliate.

Detractors of the MDA model also point to the lack of accessible performance data.  Unlike unit trusts which have audited track records, the performance of MDA operators on a risk-adjusted basis is less clear.

The universe of fund managers operating MDAs is relatively small except in the case of Australian Equity managers.

Many skilled fund managers generating market outperformance or alpha can be difficult or impossible to access via an MDA, particularly the universe of high quality offshore managers. As such, MDAs can also offer access into unit trusts to access these high quality managers. However, even access to these managers via a unit trust can be fraught with difficulty as many highly skilled managers have high entry levels precluding MDAs from rebalancing into these managers.

For the Financial Planning business considering operating an MDA the costs can be high. Australia’s regulatory authority, ASIC, is considering implementing higher minimum capital requirements for MDA operators which may deter many prospective Operators from offering MDA solutions.  Many Operators also suffer from internal costs associated with reporting. Clients who require customised portfolio reporting creates a business drag on the desired scale efficiencies in reporting, including performance and portfolio reporting. 

Multi-Asset Unit Trust

Many financial planners are also utilising or considering the use of a multi-asset unit trust to act as a core portfolio.  Like an MDA, the discretion to make investments is vested with an investment manager which can be the financial planning group or a third party manager.  This obviates the need to make ROAs and SOAs every time a change in investment is required.

The unit trust would then make investments into third party fund managers or direct assets that can be based in Australia or offshore. Groups that utilise the unit trust solution enjoy the ability to access any investment fund anywhere in the world.

Whilst this approach requires research, many unit trust sponsors will utilise an asset consultant or third party manager to implement research on these funds.

Endowment ‘likes’

Access to the global talent pool is important for investors who seek to diversify their returns from solely Australian equities or fixed income.  Many sophisticated investors are now looking for “endowment like” portfolios that deliver long term returns. These investors view the ASX as being increasingly volatile and the access to unique investment strategies offshore can reduce overall portfolio volatility over time.

Access to market protection is also a key selling point of a unit trust with a unit trust operator being able to hedge foreign exchange, interest rate and market exposure.  These traits are important for those seeking endowment like characteristics.

Responsible entities of unit trusts are subject to rigorous supervision from the ASIC.  Supervision visits and high regulatory capital requirements mean that responsible entities operating a unit trust are subject to higher regulatory standards than MDA operators.

Unit trust structures do come at a price however, and the fixed costs of operating a unit trust can preclude access from smaller groups with small amounts of funds under management.  Whilst providers such as Custodians and Auditors offer protection to investors, they charge additional costs which are typically recharged to unit holders.  Moreover, any third party responsible entities or asset consultants will need to receive fees for their services.

Additionally, ownership of the underlying assets is co-mingled and clients hold units in a trust rather than the underlying investments.  As such investors are subject to the redemption rules of the unit trust rather than having the ability to sell investments directly into the market.

Summary

Whilst MDAs and Unit Trusts deliver significant efficiencies to clients and advisers, both also bring  pros and cons which should be understood prior to embarking on either strategy.  The ability to access a global investment talent pool through a unit trust is tempered by the lack of direct ownership of investments and additional costs.

The MDA often lacks ability to enact portfolio protection from violent swings in foreign exchange rate, interest rate or market movements.  Additionally, the limited pool for accessing investment ideas through an MDA can be off-putting for some clients.  Many financial planning groups are proposing solutions that include a unit trust for a core portfolio but on an MDA platform for satellite investments so that benefits of both can be realised.

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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Asset allocation driving investment landscape for advisers investors: Blackrock.

Asset allocation is driving the investment landscape for advisers and sophisticated investors. Rather than debating which Aussie bank to own, the focus is moving to which countries should I be invested in and in what asset classes.

Continued pressure on the Australian dollar, combined with recovering Asian and European markets, give investors opportunities to gain upside through international exposure.

Jon Howie, iShares ETF specialist at BlackRock Australia, said investors who work with their advisers to diversify their international portfolios to specific countries and regions, including United States, Europe, China, and Japan, could take full advantage of the global opportunities.

He pointed out that it’s not just about improved performance. Diversification is also about reducing risk.

“United States equities funds have been good performers in 2013, particularly for Australian investors,” Mr Howie said. With the prospect of a weaker Australian dollar during 2014, it may be opportune to increase and diversify international exposure through investments in the United States, Europe, Japan and some Asian markets, where equity market performance has been strong.

Mr Howie said ETF diversification opportunities also extended to domestic equities and fixed income, something many advisers were using to full advantage for their clients.

“ETFs have experienced significant growth in Australia with Australian Stock Exchange (ASX) ETF assets sitting around $9.51bn. This equates to an annual growth rate of over 60% in the past 12 months. Total industry inflows this year have been around $1.99bn, the largest annual inflow level ever,” Mr Howie said.

“iShares have attracted just over 62% of these flows and is currently the largest Australian ETF issuer, with $3.4bn ASX-listed assets under management.

“In 2013 we have seen advisers and their clients being far more flexible and sophisticated in the ways they use ETFs. Advisers recognise the many and varied applications of ETFs in client portfolios. One of the most interesting developments of late is investors getting specific about their international allocations. This is supported by the notable increase in trading volumes in some of our single country or region funds. For example:

“ETFs are about much more than a passive exposure.

“They are about tailoring your exposure to different markets and different asset classes by using the flexibility offered by ETFs. iShares is the only ETF provider in the market that gives advisers and their clients the ability to make such specific decisions about their portfolios: what country they invest in and whether they invest in midcaps, mega-caps or small caps etc. And they are using ETFs to provide exposure to more asset classes. Advisers have always been aware that fixed income remains a cornerstone of a well-constructed portfolio,” Mr Howie said.

A large number of investors used ETFs for the first time during 2013 because they found they could use them in a very specific way and were able to narrow down their investment choices.

“As we move into 2014 it is clear that investors are getting much more specific about the countries and regions they are including in their portfolios.

“Working with your adviser to gain that level of insight is important. International markets have been strong in the past year, and we expect the global economy to continue on its slow path to recovery. However, that does not mean there won’t be setbacks along the way. Some countries and regions are likely to outperform in the year ahead, and being discerning about investing opportunities will be a critical factor in success.”

Mr Howie said Australian equities continue to recover, led by solid performance from the local banks, however most investors remain heavily exposed to the local market, and the momentum was currently with international equities.

He said iShares was the only ETF issuer that provided local investors exposure to China, Japan, Korea, Taiwan, Hong Kong and Europe. Their use has increased in the past year as too has that of the most popular iShares – iShares S&P 500 (IVV), iShares Global 100 (IOO) and iShares MSCI Emerging Markets (IEM).

“As investors look to more dynamic asset allocation in 2014, we expect the use of ETFs will continue to grow.”

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SMSF nest-eggs increase to $496B

Key points:

• SMSF assets grew to $496 billion in the year to March 2013 representing 32 per cent of the overall super industry.
• Asset allocation study highlights room for improvement with large skew towards direct share investment and cash neglecting potential cost and diversification issues.
• SMSF investors continue to drive growth in ETF investment.

Vanguard and Investment Trends released the results of the April 2013 Self Managed Super Fund Report, providing a comprehensive look under the bonnet of the largest superannuation sector in Australia.

The Self Managed Super Fund (SMSF) sector now represents 32 per cent of superannuation industry in Australia, growing to $496 billion in assets. One third of SMSFs are now valued at over $1 million, and together control 73 per cent of all SMSF assets.

Fieldwork for the report was conducted in March and April of 2013 and the research which represents a survey of almost 2000 SMSF trustees uncovers detailed analysis of how SMSF trustees are constructing their portfolios and who they are consulting for advice and assistance with administration.

Asset allocation

The findings report 35 per cent of SMSF investors made substantial asset allocation changes in the past year with 39 per cent of those looking to be more defensive, while 26 per cent did so to be more aggressive in their asset allocation.

Allocations to cash fell for the first time since 2010, comprising 26 per cent of total SMSF assets, down from 28 per cent last year. Allocations to direct shares increased by 5 per cent to now make up 45 per cent of investors’ portfolios. On average SMSFs hold 18 different direct shares in their portfolio, with 30 per cent trading shares at least once a month.

The total amount sitting in cash was $140 billion, of which $46 billion is classified as excess cash (or cash that would normally be invested in other investments but for recent market volatility). This excess cash figure has fallen by $4 billion since the previous study. 83 per cent of investors say that when they do decide to invest their excess cash, they will use some of it to invest in direct shares.

8 per cent of SMSFs now hold ETFs in their portfolio, making up about 1 per cent of total SMSF investments. The number of SMSF investors holding ETFs has increased by 28 per cent over the past 12 months (to April 2013). The study also shows a 54 per cent increase in the number of SMSFs intending to invest in ETFs in the coming year. The vast majority of SMSFs who invest in ETFs use broadly diversified Australian and international equity ETFs.

Only three in 10 SMSFs are currently invested or intend to invest in fixed income in the future.

Robin Bowerman, Head of Market Strategy and Communication said “SMSF investors are clearly demonstrating a strong preference for directly investing in shares and cash”

“While the focus on Australian shares is understandable, it points to investors focusing on specific shares and tax or income outcomes and not taking a strategic asset allocation view of their portfolio. That means SMSF investors may not fully appreciate the risks and the costs involved in holding a concentrated portfolio of direct shares.

“There is a stark difference between large institutional super funds and SMSFs in the way they construct portfolios. Professional institutional investors typically begin with the asset allocation decisions. It is a straightforward comparison to make and a way SMSF trustees can benchmark themselves not just on performance but also on risk.

“When it comes to risk, SMSFs shouldn’t discount the importance of fixed income as part of a strategic defensive investment – term deposits should be viewed as a short term savings vehicle rather than a long term defensive investment given they don’t offer the same negative correlation to equities.

“Fixed income may be out of favour as an asset class at the moment but for a long term investor it performs an important role which cash doesn’t provide, which is to offset the volatility of equity markets and provide a steady income”.

Use of advisers

The 2013 survey showed satisfaction with advisers has improved across every area measured, and 83 per cent now rate their main adviser as good or very good overall, up from 76 per cent in 2012. Most of the improvement is driven by the proportion who rate their adviser as “very good” (44 per cent, up from 29 per cent).

This study reconfirms the fact that SMSFs use financial advice to complement their investment decision making rather than delegating the full process.

218,000 SMSFs report that they have unmet advice needs, and are willing to spend an average of $2,000 p.a. each to meet these needs. Major advice gaps included inheritance & estate planning, borrowing within the SMSF and buying distressed or undervalued assets.

Over a third of SMSFs said they currently use an accountant only for tax advice but 45 per cent of these said they would consider also using them for investment advice if they offered it. This is significant given accountants’ expectations following recent licensing reforms.

“This points to the need for both accountants and advisers to have specialist skills and training to properly service these investors” said Mr Bowerman.

Next wave of SMSFs

The report this year also considered recent SMSF set ups and the next generation of SMSF investors looking at trends in reasons for establishing their fund.

Control, investing in property via super, saving fees, and the belief that they would make better decisions than their super fund were the top five reasons given for intending to switch into an SMSF in the next 12 months.

42 per cent of this next wave of SMSF investors say that they would consider staying with their existing super fund if fees were lower.

“These investors are clearly very cost conscious and unwilling to pay where they don’t see value. The message seems loud and clear to the industry, equally for professional managers, super funds and advisers. Having a very clear value proposition to justify costs charged is critically important to attracting SMSF investors” said Mr Bowerman.

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Advisers thriving in the SMSf space.

Key points:

• Advisers thriving in the SMSF sector say that their value proposition to SMSF investors, their relationships with accountants and their ability to do administration in-house are key success factors.
• Key challenges for SMSF advisers include concessional cap changes, dealing with unsuitable SMSF set ups and dealing with compliance aspects of SMSFs.
• Asset allocation decisions focused on generating income and franked dividends.

Vanguard and Investment Trends released the results of the April 2013 Self Managed Super Fund Planner Report yesterday, examining how Australian financial planners interact with Self Managed Super Fund (SMSF) investors.

The report, which surveys more than 400 advisers, reveals that some advisers are racing ahead of the pack in servicing SMSF investors, while others struggle to demonstrate their value. The report groups feedback from planners into two groups – SMSF specialists who service 20 or more SMSF clients and SMSF generalists who service fewer than 20 SMSF clients.

Planners in general have been struggling somewhat in the SMSF space over the last few years, unable meet the growth they have been anticipating for the past few years.

However, some planners have been more successful than others. There are now more planners who fall under the SMSF specialist category (25 per cent, up from 23 per cent last year), and these planners derive half (49 per cent) their practice revenue from SMSFs, up from 44 per cent in 2011.

In contrast, SMSF generalists have not found their place in this booming market yet, with their revenue from SMSF clients remaining steady at 19 per cent over the same period.

Advisers who said they are succeeding (find it easy to attract and retain SMSF clients) were more likely to say their value proposition resonates with SMSFs, they work closely with (or in) accounting firms and do the administration for SMSF investors in house.

Planners are charging on average 17 per cent more in upfront fees than last year for their service and 5 per cent more for ongoing fees.

When asked about their single biggest challenge to servicing the SMSF sector, specialists cite falls in concessional contribution caps and keeping fees competitive as their greatest hurdles. Meanwhile, SMSF generalists’ challenges relate to relationships with accounting firms and finding clients.

Commenting on the report, Michael Lovett, Vanguard’s Head of Adviser Distribution said:

“It’s clear from this report that there continues to be a large and growing opportunity for advisers servicing the SMSF space. Those advisers that are specialising their businesses, demonstrating clear value propositions for clients and working well with accountants and other SMSF influencers seem to be the clear contenders in this sector.

“There is a strong message for advisers who want to excel in this sector to safeguard their practice and add immense value to investors by spending more of their time looking at areas of unmet advice to their clients.

“Our studies show that for advisers, creating this point of difference in their practice value proposition can ensure they present a more enduring model, particularly in this new fee for service world which the Future of Financial Advice reforms have introduced”.

Asset allocation

SMSF planners estimate they influence $145 billion of SMSF assets.

There was a marked increase in the flow of money into investments other than cash following the rise of investor confidence at the start of 2013.

Asset allocation strategies differ between specialists and generalists, with specialists tending to allocate more to direct shares – 29 per cent of new SMSF investments versus 23 per cent by generalists, and less to active managed funds. Specialists project direct shares to grow to 32 per cent of new SMSF investments by 2016.

SMSF specialists also had a greater level of ETF usage than generalists (5 per cent versus 3 per cent).

Advisers said their top priority when selecting investments for SMSF clients was the availability of franked dividends. The lack of dividends and income from international shares investments was the biggest barrier to their allocation to international assets for SMSF clients.

Use of term deposits was similar between the two groups of planners, with specialists allocating 16 per cent versus generalists at 15 per cent, and both expecting to reduce this below 11 per cent by 2016.

Both groups say they currently allocate about 30 per cent to cash and fixed income assets, but expect this to fall by 2016.

More than 20 per cent of specialist SMSF advisers say they need a better range of annuities and longevity protection products than are currently available, while generalists said that they need lower cost platforms to better service this client group. Access to emerging markets and Asian countries was cited as a gap for planners in this market.

Unmet advice needs

218,000 SMSF investors still have unmet advice needs that they are willing to pay for, which represents an opportunity for all advisers. More than a third of SMSF investors who were willing to pay to fill the gaps in advice said that inheritance and estate planning was the biggest unmet area.

In addition, borrowing within the SMSF, buying distressed assets, buying investment property and tax planning were all significant areas of unmet advice needs.

Accountants versus financial planners

While some advisers have strong working relationships with accountants, two in five report having had some issues involving accountants where SMSFs were being established for clients inappropriately.

Nearly half (48 per cent) of advisers said that the regulatory reform on limited licensing for accountants will have a positive impact on their overall business income and 34 per cent expect it will increase their SMSF client base.

SMSF specialists were much more likely to work for an accountancy firm (27 per cent) and slightly more had several accountants referring work to them.

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Top down asset allocation in 2013

In Part 1 of his CPD paper on asset allocation modeling, Ray Griffin detailed a step-by-step process to deploying a top down approach to designing balanced client portfolios.

In Part 2, he now goes deeper into asset allocation and portfolio risk management but first he outlines stress testing as a means of understanding the impact on client portfolios if certain events were to occur.

It’s all well and good to methodically work through a top down asset allocation process but how can you, as the person recommending investments for clients, begin to understand how a portfolio might behave in the future?

This is not to suggest that the future can be known but, rather, to recommend that you carry out some scenario planning; some ‘What if?’ scenarios otherwise known as stress testing of portfolio models.

Stress testing
At every minute, of every day, investment portfolios are being ‘stressed’ through the forces at play in world economies and the reflection of those forces in markets.  Reward requires risk and demand is theoretically met by supply (and vice versa) all of which dictates that nothing is certain in asset allocation.

Stress testing of portfolio models can be readily achieved through relatively straightforward computer spread-sheeting.  In effect, stress testing is simply a ‘What if?’ examination of certain potential scenarios.  It attempts to understand the impact on portfolios of certain events such as large interest rate movements, share market declines, dividend reductions, inflation and so on.

• What if share markets declined by 20%?  What if they declined by 50% or numerous other declinations?
• What impact on portfolio income would a 300 basis points decline in interest rates have on overall portfolio income?
• What impact would deterioration in dividend payments have on overall income for clients?

The outcomes modeled from considering such scenarios and other stress tests will provide you with a much deeper insight into potential portfolio behavior. While the real world is always different to spreadsheet outcomes, stress testing nevertheless is a vital component of portfolio modeling.

Right now, do you have any insight into how your recommended portfolios might behave under future scenarios?  To what extent, approximately, might your clients’ portfolios decline under the above example scenarios? What will the impact be on portfolio income under interest rate decline scenarios?

And for all of these questions, what options do you have to ameliorate such impacts? What, if anything, might you change in your asset allocations?

So, a quick recap. To this point in this two-part CPD paper we have:

• Followed an analytical process to determine domestic versus international weightings in portfolios
• Moved to determine weightings domestic investment sectors
• Developed a framework through which to understand how portfolios might behave under future scenarios – stress testing of portfolios.

We’ll now move to look more closely at the selection of individual investments to build portfolios in line with the overall asset allocation models you develop.

1. Fund manager style and diversification
The very essence of diversification is that allocation across markets should not be consigned to a single funds management company.  Funds managers are rarely (if ever) investing successfully across all sectors be that domestically or internationally, so to entrust your clients’ entire portfolios to a worldview taken by a single company is a very big call.

As such, diversifying across funds manager ‘styles’ is a further step in managing portfolio risk.  For example, if a fund manager were a so-called ‘value’ investor, the complementary co-allocation would be to a bottom-up style fund manager(s). To pin your hopes on a single management style, e.g. value, might also be a big call regardless of how many such value managers the equities allocation is spread across.

2. The last step – investment selection
The final step in a ‘top down’ approach to asset allocation is the selection of individual investments. While this is an important step, it’s arguable that getting the broad sector allocation right will have a much greater impact on overall portfolio performance.

A portfolio can cope (subject to weightings) with an investment that underperforms its peers however a mis-allocation to sectors, such as being over/underweight sectors, can result in quite deleterious outcomes overall for portfolios, particular portfolios which are overly dependent upon the performance of a single sector.

In terms of managed funds, both qualitative and quantitative aspects must be considered in developing an Approved Products List.  Similarly, with direct assets such as listed securities, performance track records (quantitative) and company management, strategy, competitiveness, board performance and overall business direction (qualitative) influence decisions for APLs.

3. Research
The top down approach is finally finessed through use of either internal and/or external research that should aid in ‘filtering’ the number of investments that will appear on the Approved Products List for each licensee and its representatives.

Another risk management consideration
While not strictly an asset (sector) allocation issue, in managing the overall financial risk for clients, one step that is sometimes overlooked is the need to be mindful of legislative risk. In Australia, the constant risk that looms large is the prospect of changes to superannuation legislation.

Witness the recent rumors of changes to the tax-free status of pensions from superannuation accounts of $1 million or greater.

In addition to taxation risk within superannuation i.e. the risk that it loses some or all of its taxation advantages, there is also the possibility that, if the political will should ever prevail, access to lump sums of capital from superannuation could be withdrawn. Such a change would be made in order to enhance the potential for superannuation benefits to ‘go the distance’ through someone’s lifetime.

Having a portion of capital invested outside superannuation would assist in managing the risk which might emerge from future changes to the legislation.

Summary
The ‘top down’ asset allocation is founded on a deep understanding of the status and potential trend direction of international and domestic economies and markets.  The methodology is based on the following process:

1. Understanding the current world economic and investment market conditions
2. Developing initial, broad, allocations to domestic and international assets mindful of current conditions and in accordance with investors risk tolerance profiles
3. Determining overall allocations to each sector, again, mindful of investors risk profiles
4. Identifying individual assets/investments within those sectors.

While asset allocation is in itself a risk management process, in Australia, it needs to be complemented with managing the risk of changing investment legislation especially in regard to superannuation.

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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At any time asset allocation is centred on the two key themes of seeking a return on capital and investment risk management.  It’s a given that people recommending investments are being asked to do so on the presumption that they are able to identify suitable investments for clients; selections which are otherwise superior decisions to what the investor herself would make.

Simultaneously, the typical investor is seeking – no matter to what degree – a component of risk management within the overall recommendations. Regardless of how ‘risk averse’ an investor might claim to be, there’s nothing like a market rout to remind them that losing all their capital is very undesirable.

Broadly speaking there are two primary approaches to portfolio asset allocation – the top down (macroeconomic to microeconomic) method and the ‘bottom up’ allocation model.  The latter is generally predicated on the asset allocator’s view that, despite overall trends and conditions, investing in undervalued/mis-priced stocks will add alpha to portfolio returns.  This paper will not debate these methodologies but will address a process for developing a top down methodology for application in an adviser’s day-to-day practice.

No doubt you’re hearing a lot about asset allocation – in early 2013 everyone seems to have an opinion and not all will be correct. However, when all the random noise of multi-channel commentary is cleared away, under a top down approach, advisers are able to develop a view of the world and then begin a process to make appropriate recommendations for clients.  It’s never been easy but in 2013 it comes with such a complex array of conflicting indicators, that it really is a tough gig being an asset allocator.

Thousands of papers have been written and opinions proffered over very many years on asset allocation modeling; from Harry Markowitz’s much-cited Efficient Frontier thesis in his 1952 paper, Portfolio Selection, to the latest opinion from a media finance personality.  Arguably, there is no single methodology which is superior for each will have there moments to shine. Indeed, some studies suggest blended top down/bottom-up allocations strategies have merit.

However, for the purposes of this paper, discussion is restricted to top down asset allocation for a ‘balanced’ portfolio. Yes, balance is in the eye of the asset allocator but please bear with me – the key issue here is the process of making decisions around asset types and their weightings in portfolios.

This paper does not attempt to provide an in depth technical analysis of myriad asset allocation theses in academia; rather it aims to provide financial advice practitioners with an insight into a practical approach to building investment portfolios premised on top down asset allocation methodology.

The conflicting components of asset allocation in 2013
Consider these contemporary (at the time of writing) conditions and their impact on asset allocation:

Australia
Low inflation – low interest rates and trending lower(?)
Modest GDP – modest unemployment
Modest corporate debt to equity ratios
Modest sovereign debt to GDP
Falling business confidence – relatively stable consumer confidence

The rest of the world advanced economies
Low inflation – very low interest rates
Low GDP (recessions?) – high unemployment
Weak but graduated improvements in corporate debt to equity ratios
Very high sovereign debt to GDP
Low business and consumer confidence

The above aspects are the headline environments within which asset allocators are practicing in 2013.

1. ‘Begin at the beginning’
It is perhaps very tempting for practitioners to move straight to selecting individual shares or managed funds for portfolios. The so-called hunch, or hot tip, is what brings investors undone every day and yet I’ve seen enough evidence over the years to know that advisers are not necessarily immune from such temptation.  It fails a disciplined, considered, top down approach to investment selection.

In order to enhance the opportunity for top down asset allocation to lead to successful investment selection, advisers must have a deep understanding of world economic conditions; it is the beginning of a disciplined approach which applies whether advisers recommend managed funds or direct assets such as shares and property.  Looking beyond broad economic and market issues, there is also a need to be cognisant of fiscal and monetary policies at play around the world, especially those within the major economies.

An understanding of global conditions provides insight into how certain classes of assets might behave in the foreseeable future.  Granted that no one can foretell the future, a worldview is nevertheless the starting point.

Start with the RBA Chart Pack
In terms of gathering information about international economies and markets, one very sound starting point is to access the RBA’s ‘Chart Pack’ which is downloadable, at no cost, each month following the RBA Board meeting.  The macro information which is available with the pack is extremely helpful in understanding where economies and markets are at and where they might be trending. http://www.rba.gov.au/chart-pack/index.html

Then there are resources available through the central banks of other economics such as the Federal Reserve Bank in the United States which can provide additional information about world economic conditions.  While all such data is subject to interpretation, it nevertheless will provide asset allocators with the information from which to begin forming an opinion about global and domestic conditions.

2. Growth and income – where from?
The very essence of a balanced portfolio is to apply a spread of asset sectors within the portfolio in order to balance potential outcomes both on the upside and the downside.  Essentially and to state the seemingly obvious, the spread, or ‘balance’, is an outcome of how an asset allocator views the world.

So in 2013 and notwithstanding that the future is largely unknowable, with such a mixed bag of economic data across the globe, where will you find sustainable long-term growth and consistent, reliable income for portfolios?

3. Domestic versus international weightings
This leads directly to the initial question of what level of international exposure, if any, should a portfolio have in the present conditions?  While as is always the case, there will be exceptions to broad trends both in terms of individual economies and individual investments, the key issue is what outcome are you hoping to achieve versus the likelihood of that occurring in current conditions?

By default, once the proportion of the portfolio exposure to international assets has been determined, the remaining exposure is to domestic assets.

Some questions to ask?

• Is it likely that international exposure will provide growth in the foreseeable future?
• What income is likely to be derived from international exposure?
• What about currency movements?
• What might the trend for the AUD be and how might that impact on portfolios?
• Should the international allocation be hedged or part-hedged back into Australian Dollars?

4. Domestic macro conditions
With the remainder of the portfolio, allocated to Australian based assets, broadly the questions are:

• Interest rates
o Up? Down? Steady?

• Equities
o Priced for fair value?
o Overpriced?
o Undervalued?

• Listed/Managed Property
o Occupancy rates?
o Developments in the pipe-line and subsequent floor space
o Debt/equity ratios
o Fund geographic/ (city/country) exposure
o Business/Consumer confidence

• Fiscal and Monetary Policy

Looking more broadly, there is a range of macroeconomic issues that need to be considered including: consumer and business confidence, business investment, credit growth, construction, inflation and employment growth.

If looking to make recommendations for direct investments, an understanding of the macro data enables opinions to be formed on weightings to sectors within sectors.  Once a weighting to domestic equities has been determined, in then falls to asset allocators to decide which sectors to target and the weightings.  For example, consumer discretionary assets versus non-discretionary.

It then follows that decisions on equity sector weightings leads to the task of identifying the preferred companies within, for example, the banking sector.

Let’s just recap on the top down methodology:

Top down asset allocation

In effect, top down asset allocation could be described as a hierarchical process wherein the overriding determinant in portfolio outcomes is the allocation to market sectors.

In Part 2, we’ll look at the next steps in asset allocation along with stress testing of portfolios.

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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“Looking back on 2012, it would be fair to say that given the difficult macro backdrop and the many challenges facing the developed world, risk assets performed much better than many commentators had expected. Within equities, most markets gave comfortable double digit returns despite modestly weakening corporate profits, and negative revisions to GDP growth.

Within fixed income, credit and emerging market debt performed well, with returns positively correlated with the riskiness of the investment. Only core Government bond markets gave a disappointing return, but then given the starting yield that was always going to be the case.

As we have discussed many times, there were two key drivers to this outcome: In a low interest rate environment, income starved investors were forced to seek out alternative yielding assets and became increasingly more adventurous in the types of investments they considered. The central banks’ various QE policies both crowded out investors, exacerbating this trend, and provided a favourable liquidity backdrop to the market and saw all credit spreads narrow significantly.

The second driver was the very robust performance of corporate balance sheets. Companies are at a multiyear high in terms of their financial strength, with record profit margins and prodigious cash flow. As a result the risk of default or bankruptcy, despite the challenging macro backdrop, was deemed low. Investors therefore became increasingly confident of the safety of both their dividends and corporate bond coupons, and rerated asset classes accordingly.

This also acted as a catalyst to corporate treasurers to kick-start the bond issuance pipeline and take advantage of the falling cost of corporate debt, even if the cash was used for nothing more than share buy-backs (which in itself was value accretive).
 
This all begs the question as to how 2013 might turn out given how well markets have performed over the last 12 months. It is our view that we should still have a satisfactory year. The defining feature is still going to be the zero interest rate environment.

Developed world growth is still low by historic standards, western economies are over indebted and the financial system is undercapitalised: Interest rates aren’t going up any time soon. This will continue to force investors to seek out yielding assets and will provide markets with the support it provided last year.

However, in our view things are getting a little better: In China we have seen the leadership transition and the end of the accompanying uncertainty has been a boost for both growth and the Chinese stockmarket. In the US, it remains our view that, although it is not yet resolved, a compromise will be reached on the fiscal cliff and this too should provide a boost to growth. In any event, the US housing market continues to recover from very low levels which is supportive of the US banking sector and consumer sentiment.

In Europe (both UK and continental), while we are likely to be in mild recession this year, the situation does not appear to be getting any worse and it is probable that the worst of the problems of the banking system are behind us.
 
Against this backdrop, it is no surprise that markets have had such a positive start to the year, and it may well be that some profit-taking is in order. Nevertheless, we retain our overweight position to risk assets and expect equities in particular to make further positive progress in 2013.

On a number of metrics, valuations are still supportive, and at some stage the M&A cycle will pick up as companies put their cash to work constructively. Our stance is therefore predicated on a safe middle ground- some growth so that economies can continue to rebuild and repair the damage done by the global financial crisis, but not too much growth so that rates remain low. For now we appear on track, but we will clearly monitor developments very closely.”

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At the time it would have been popular with an audience that had picked up the habit of tracking the price of pretty much everything on a weekly basis but its bad timing was exquisite.  Published in 1981 it coincided with the election of Ronald Reagan who gave then Federal Reserve chairman Paul Volcker the platform to finally kill-off the inflationary curse that had beset the US and much of the developed world.  If Ruff had stuck to shopping tips the damage would have been limited but most of his advice centred on the merits of buying inflation hedges such as gold and silver.

Unfortunately for his followers, inflation was well and truly priced into the market and when it finally started falling gold fell and stocks and bonds took off. A decade later gold had gone backwards while stocks, which in his words “remained a guaranteed loser to long-term inflation”, were up some five-fold.  A further irony is that in real terms gold lost half its value over the next decade as inflation levels, although declining, remained significant.  Stocks were still up almost 300% in real terms over the same period. 

From where we stand now a book on surviving a Japanese-style deflationary spiral would most probably sell better than an update to Ruff’s book, which is exactly why now could be as good a time as any to start thinking seriously about the impact of future inflation on portfolios. 

Certainly there are many that believe that an extended regime of financial repression starting sometime in the not too distant future is the only feasible way for many governments to reduce debt to manageable levels. Very low or negative real interest rates mean that we are already there but inflation somewhere above 5% is seen by many as a necessary ingredient if the deleveraging process is to start in earnest.  This is just one scenario that might never happen but, with markets already pricing in deflation (much as they priced in inflation in 1981) it is one that we have to think about even more seriously.

Take the following simulations using our valuation-driven asset allocation model under different inflation scenarios. As fixed income investments are the most vulnerable to inflation we have shown the impact of higher inflation on a conservative portfolio over 3 years, given current market pricing.  

Functional markets

Even if inflation stays where it is and we see reasonably strong real GDP growth of 3% per annum there is a strong likelihood that a typical conservative portfolio is going to miss its objective of CPI plus 1% per annum over the next 3 years, given current market pricing.

Deflation

This is because fixed income markets are priced for deflation.  In simple terms this means that most conservative options will only provide satisfactory performance if we see a period of sustained price deflation and 3 years of negative GDP growth of -1.5%.  While this might happen, thankfully most people are still applying a low probability to this scenario – a good thing generally but not great news for conservative investors.

Inflation

In nominal terms, even 7.5% inflation with respectable 3% per annum real GDP growth means a flat return from the conservative portfolio.  However, this takes us into a regime that many of us have lost the habit of dealing with. After a sustained period of high inflation investors and consumers become highly adept at mentally discounting the impact of inflation but an unexpected inflation shock now would leave them vulnerable, especially older investors.  While a typical conservative portfolio might retain its value in nominal terms, in real terms the conservative investor would have lost 25% of their purchasing power in this scenario over three years.     

Stagflation

The situation gets worse in the stagflation scenario where inflation is elevated but real GDP growth is negative (-1.5% per annum). Interestingly though, this reduces returns only slightly compared to the high inflation/high nominal growth strategy. Even if the difference between recession and strong growth is hugely important for most people’s welfare and wealth generally, for their investments inflation will have a much greater impact, again, especially if they are a relatively vulnerable conservative investor.  

Even if the high inflation scenarios remain a distant possibility we believe that the stakes are high enough that it is worth doing some scenario analysis with clients, especially given how markets are currently pricing those scenarios. With that in mind we will soon be providing an update to our tactical asset allocation tool on iRate to let our subscribers examine the impact of inflation on their portfolio in real terms.  We will also be conducting an interactive session during our annual conference in March aimed at helping the audience analyse these issues with clients using our online tool.

The article first appeared in the January issue of The van Eyk View, which can be downloaded here.

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“We shouldn’t be surprised by this, but over the last few years the economic environment has been so extreme, we’ve become used to it dominating market returns and outcomes. Somewhat surprisingly therefore, risk assets have had a positive 2012.

“In sterling terms, equities have broadly speaking returned 10%, although the performance differential, particularly between large and mid/small cap in the UK has been more extreme than this. In credit, returns have been comfortably double digit, with the scale of the positive return being correlated with the riskiness of the credit rating. Similarly the returns for EM debt have been very strong, accompanied by very positive flows into the asset class.
 
“From a macro perspective the situation in Europe continues to worsen. The austerity measures insisted upon by Germany for the periphery have had the predictable outcome of undermining growth for the entire region. The reduction in Government spending has created an overwhelming headwind for Spain and Italy, and has reduced demand for Germany’s exports. The PMIs and other leading indicators indicate that Germany too will also be in recession imminently.
 
“In the US, following President Obama’s successful re-election, we are now in the eye of the storm of debate regarding the fiscal cliff. As has been well rehearsed, in the first quarter of next year a combination of automatic tax increases and spending cuts will reduce US GDP by about 4% unless agreement can be reached on moderating their impact.

“Our research on the ground continues to suggest that companies are using this uncertainty as a reason to defer investment spending, containing both economic and employment growth. In common with the market, we expect some form of agreement to be reached and this impact to be moderated by at least 50% but it is possible that the political deadlock takes the US economy over the cliff and into recession for 2013.
 
“Against this backdrop it may be surprising to hear that we are becoming increasingly more constructive towards equities and have gone moderately overweight, initially increasing our weighting in EM and Asia Pac. Indeed if the markets continue to be unsettled by the situation in the US we will use the market weakness to increase our equity exposure further. The key driver to our decision is valuation and what is currently discounted.

“Although the backdrop remains very challenging, it is not new news and in many respects we are closer to a resolution of the uncertainties. This is clearly true of the US, but also of Asia, where the regime change in China is now largely effected. In Europe, investors probably face crisis fatigue and an unexpected negative outcome is becoming increasingly unlikely.

“What is true is that against this backdrop, interest rates are going to stay close to zero for the medium term and high yielding equities are likely to remain well supported. Other valuation metrics remain attractive, and the robust balance sheet strength is another positive. Although not our central case, it is just possible that we get a positive growth surprise in the global economy in the second half of 2013. If that is the case, equities will start next year with significant positive momentum. Now that would be a turn up for the books!”

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