At Perennial Value, we believe it makes sense to embed risk management in the form of simple insurance style instruments into the equity portfolio itself. The aim is to manage some of the risk of equity market downturns automatically, without the investor having to make a conscious decision to change asset allocations. Using equity derivatives, managing risk in equity portfolios can be more efficient and cost effective, while leaving the upside in markets available to the investor.

Consider a portfolio with a beta approaching 1 on the upside but less than 1 on the downside. As the market rallies, the portfolio also enjoys that rally. As the market falls, the portfolio becomes increasingly weighted towards cash.

Unlike some strategies that give away the upside, we feel managing a portfolio of simple option strategies can achieve the best of both worlds. More importantly managing the downside that is closer to the current level of the share market can give us a better outcome.

We focus on the most likely loss range of a portfolio. To determine the most likely loss range, in the chart below we show six monthly Australian equity returns over a 20 year period. Approximately two thirds of the time, returns are positive and almost one third of the time, returns are negative. Importantly, of these negative returns, 90% of the falls are between zero and -20%.

It makes sense to focus on the capital losses that are most likely to occur. This type of dynamic protection differs significantly in its approach versus many other protected products. Traditional protected products tend to preserve the portion of the portfolio down to zero after the initial fall, sometimes at a very high cost. If you think about this in practical terms, this is the portion least at risk. For example, it is hard to imagine that 100% of the shares in the S&P/ASX200 suddenly all become worthless overnight. As shown in the chart below, dynamic protection focuses on the portion of the portfolio most susceptible to loss, typically in the -5% to -20% range. As markets fall, we adjust the dynamic protection strategies and/or increase cash to protect investor capital.

The other limitation with traditional protected products is that they can end up cashing out in a major market correction, and inevitably when the market does recover, the investor does not get to participate in the upside. We need to avoid this outcome and reset the clock each day, making sure today’s portfolio can meet the needs of the investor.

We buy insurance on our biggest asset, our house, our valuables and car. We even buy insurance on our lives and earnings. But one of our biggest assets, our superannuation, is rarely insured. Why not? Access to option markets can be complex and expensive. This process needs to be managed in an ongoing and professional manner. Option markets provide insurance to the investor. Managing option portfolios historically has been the domain of the investment banking community who design, structure and sell products to do this for us. They can be extremely good investments but they can be complicated, expensive and inflexible for the average investor. The role of the professional investment manager is to navigate this environment such that the portfolio owns the most efficient insurance at any time, maintaining a highly flexible approach compared to most other common strategies.

Derivative instruments can be complex and risky. Intuitively selling insurance is a risky business. Receive a nominal amount and risk an event that could be 20, 30 times more damaging than what you have received. While a derivative portfolio can sell options there is one simple rule to live by: be the net buyer of insurance. i.e. make sure that you own more insurance than you sell. In derivative speak this is called being long ‘vega’.

There are various option strategies that can be used to protect against significant losses. Some of the strategies used include:

Put option – buy put options at a specific strike price to protect the portfolio against falling markets below the strike level.

Put spread – buy put options at a specific strike price while also selling the same number of puts at a lower strike price. A put spread protects the portfolio in falling markets, but to a more limited degree compared to a buying a put option alone, and therefore costs less.

Put spread collar – purchase a put spread while simultaneously selling (writing) an out of the money call option. A put spread collar allows for some upside potential, with less downside risk when there is a decline in the market, for relatively little cost.

Put time spread – buy a put with a shorter-term expiration and simultaneously sell a put with a longer-term expiration. A put time spread allows the portfolio to gain if there is a fall in the market. It is also one of the lowest cost protection strategies used within the dynamic protection portfolio.

The table below shows some examples of the most commonly used protection strategies, what they can achieve on both the downside and upside, and how they compare to each other on a relative cost basis.

By maintaining market participation, and having in place protection strategies that will provide a pay off if the market falls by a specified percentage, capital can be better preserved in the long run.

Dynamic protection can provide peace of mind. If you can limit the downside, investors can feel empowered to stay invested in equities even if markets get choppy, when they might otherwise just panic and exit the market, quite possibly at the wrong time. Limiting capital losses in a market downturn is equally, and possibly even more important, than maximising outperformance in rising markets, due to the effects of compounding. By reducing the impact of a fall in the market on your equity investments, you should have a higher level from which your capital can grow, all thanks to the effects of compounding. Compounding works best if you stay invested. By maintaining market participation, and having protection strategies in place, capital can be better preserved in the long run across varying market conditions.

At Perennial Value, we believe we have moved the goalposts by combining a mainstream long-only Australian equities capability with dynamic protection strategies in the Perennial Value Wealth Defender Australian Shares Trust. By doing this, we have created an investment capability that seeks to limit the drawdown in equity markets while retaining the ability to capture the full upside that equity markets generate over time. In other words, the best of both worlds for those investors who are seeking to protect their equities portfolio from significant capital losses.

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Disclaimer: Issued by the Investment Manager, Perennial Value Management Limited, ABN 22 090 879 904, AFSL: 247293. Responsible Entity: IOOF Investment Management Limited ABN 53 006 695 021, AFSL: 230524. This promotional statement is provided for information purposes only. Accordingly, reliance should not be placed on this promotional statement as the basis for making an investment, financial or other decision. This promotional statement does not take into account your investment objectives, particular needs or financial situation. While every effort has been made to ensure the information in this promotional statement is accurate; its accuracy, reliability or completeness is not guaranteed. Past performance is not a reliable indicator of future performance. Investments in the Perennial Value Wealth Defender Australian Shares Trust must be accompanied by an application form attached to the product disclosure statement. The current relevant product disclosure statement and application form can be found on Perennial’s website www.perennial.net.au.

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Daniel Gara

Authorised representatives who take part in training for their AdviserLogic software will be eligible for up to four Financial Planning Association (FPA) Continuing Professional Development (CPD) points as of 27 October 2014.

Head of Product Development, Daniel Gara, says the CPD accreditation is another demonstration of AdviserLogic’s commitment to help advisers to perform at their best. “Our goal is to help advisers develop and maintain high-performing, compliant and client-centric practices,” he says. “Providing CPD points is one way we can help them to achieve this.

The FPA-accredited AdviserLogic training sessions are offered in webinar format, hosted by AdviserLogic Product Specialists. Introductory and intermediate sessions are aimed at new users while cashflow and workflow sessions are for both new users and existing users who have upgraded their software package. “One CPD point will be given for each module completed from the AdviserLogic introductory session, intermediate session, cashflow session and workflow session,” Mr Gara says.

For ASIC competency purposes, the points all fall within ‘Skills’.  For FPA Professional Dimensions, 0.5 point applies for Capability, and 0.5 point for Attributes and Performance.

The CPD points will be applied to training completed after 27 October 2014.

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Background

Australia’s demographic shift is having a significant impact on Australia’s financial markets. The search for income in a low interest rate environment has seen investors, particularly the rapidly growing self managed superannuation funds, develop a love affair with high-yielding stocks.

With bond yields expected to stay at relatively low levels, the demand for high-yielding equity strategies is likely to continue. Investing in just a handful of traditional high-yielding blue chip stocks and holding onto them, may however expose investors to greater volatility than they are prepared for. An actively managed portfolio, comprising a diversified selection of traditional and non-traditional high-yielding stocks that are continually assessed for value, can help reduce this volatility.

How has Australia’s population changed?

Over the past 100 years or so, Australia’s population structure has changed markedly. In 1911, it was a typical pyramid shape – bottom heavy with the population skewed to younger age groups. By 1961, the pyramid had widened reflecting the growth in Australia’s population, particularly in the 0-14 age bracket, reflecting the birth of the baby boomers post World War 2.

By 2004, the pyramid had changed shape altogether, particularly around the middle, with the baby boomers now aged in their 40s and 50s. By 2051, the Australian Bureau of Statistics (ABS) is projecting Australia’s population structure to be more top heavy, with people aged 80 plus representing a significant percentage of the population – more than those being born (ie 0-4 years of age).

What’s causing the change in shape?

In addition to the ageing of the baby boomers, increasing life expectancy is another contributing factor causing the shift in Australia’s demographic structure. According to the ABS, the average life expectancy for females born between 2010 and 2012 is 84.3 years of age, up from 58.8 for those born just over 100 years ago in 1910. The average life expectancy for men is 79.9, up from 55.2.

A lower fertility rate is also playing an important role. Australia’s fertility rate has fallen sharply since the early 1960s. A fertility rate of 2.0 (ie two children) is considered to be the replacement rate for the population – two children replaces two parents. Australia’s fertility rate has been below 2 since the mid-1970s.

Should we be concerned?

While the 65 plus age group as a percentage of the total population is expected to increase to 27% of the population by 2050 (from 15% currently), of greater economic significance is the forecast decline in Australia’s ‘inverse dependency ratio’. The ratio of the working age population to dependents (defined as those aged less than 15 years of age and 65 plus) is expected to fall from around current levels of 2 to 1.5 by 2060.

A shrinking working age population has significant implications for the Australian economy and the share market.  An ageing population places a financial burden on the economy through higher demands on public healthcare costs and social security from retirees; while tax revenue and consumer spending is dampened due to the lower proportion of the working age population.

Japan has experienced the demographic shift already and in a more pronounced manner due to negligible immigration, persistently low fertility rates and rising life expectancy. Currently, Japan has 25% of its population aged 65 plus. Over the last several years Japanese investors have been seeking high-yielding investments around the world due to low interest rates and an ageing population seeking higher income than what is available in their own country. The Australian equity market has been a beneficiary of this demand.

What impact are SMSFs having?

The rise in grey power is impacting the Australian share market quite significantly via the growth in self managed superannuation funds (SMSFs). According to the Australian Tax Office and Credit Suisse, SMSFs received an average of around $15 billion per financial year in net inflows over the nine-year period from 2003-04 to 2011-12.

What’s concerning, is that SMSFs appear to have a distorted asset allocation with a significant bias to direct domestic equities and property.

Anecdotal evidence suggests that the direct equity exposure is limited to the big four banks and a handful of blue chip high-yielding stocks. What’s more, SMSFs are continuing to buy these stocks, regardless of value or where we are in the market cycle.

The boards of companies are becoming increasingly aware of the growth and influence of SMSFs and their increasing demand for higher dividends.

As noted above, the demographic shift will potentially lead to lower economic growth. This, together with the increasing demand for higher dividends by SMSFs could exacerbate this problem as companies feel pressured to meet their demands – at the expense of investing in their businesses.

Does this mean dividend yield strategies will continue to outperform?

This demand for high-yielding equities has obvious implications for yield-driven strategies. Over the past 12 or so years, dividend yield strategies have outperformed the broader share market by a comfortable margin.

There is a strong correlation between the change in the number of retirees and the performance of dividend yield strategies. The yellow line in the chart below shows the percentage change in retirees (with the green line representing the forecast change) and the outperformance of dividend yield strategies (blue line).  As the number of retirees has increased, dividend yield strategies have outperformed.

Sustained demand for high-yielding equities for at least the next two to three decades as the percentage change in the number of retirees continues to increase, suggests that dividend yield strategies will continue to outperform for quite some time yet.

An active, value-driven approach can help to navigate through the volatility

We would however caution against simply investing directly in a handful of well known high-yielding stocks and locking them in the bottom drawer. This is not an ideal way to invest, due to the risk that pockets of yield stocks may become more vulnerable to shocks as their valuations become stretched.

This risk is exacerbated by SMSFs, which tend to hold stocks directly in a relatively passive ‘buy and hold’ manner as well as invest in index funds and Exchange Traded Funds (ETFs).

To minimise the potential of a portfolio of yield stocks being prone to such vulnerabilities requires active analysis and continual valuation of stocks.  Well-resourced active managers, such as Nikko AM Australia, who have yield strategies but with a focus on value, is one way for investors to help navigate through this potential volatile and uncertain period. It may come as a surprise to many investors but a large portion of outperformance in our high-yield strategies has actually been derived from ‘other’ non-traditional high-yielding areas where opportunities have arisen in specific stocks, rather than the traditional high-yielding stocks.

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Disclaimer: This material was prepared and issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (Nikko AM Australia). Nikko AM Australia is part of the Nikko AM Group. The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

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It begs the question: in today’s highly regulated world post FoFA, how well do you really know your fund manager? Do you fully understand risk as it pertains to doing business with any particular funds management outfit? Should you even care?

Alex Wise from specialist fund manager Select Asset Management continues his second of a four part CPD mini-series with an insider’s account to better understand what goes on to determine the key (non-investment) risks in funds management. (Click here to read the first article in this CPD series).

Business Risk Due Diligence is an important part of any allocation decision.  The main drivers are always likely to be forward looking views of strategy and manager performance, however since a number of high profile investor frauds such as Trio in Australia and the Bernie Madoff affair in the United States, greater scrutiny has been placed on operational and business due diligence globally. It should be made clear that whilst thorough Business Risk Due Diligence should assist in uncovering concerns and inconsistencies, it is not a fool proof method of uncovering any highly sophisticated fraud.   However, several ‘red flags’ – common to the Trio case and the Madoff fraud should have put investors on notice.

A thorough Business Risk Due Diligence review will consider the risk of a catastrophic event or, in crude terms a “blow up”. Effective due diligence provides a much broader insight into the overall quality of each manager’s business, including the firm’s culture and operational philosophy. Indeed, “business risk” due diligence is probably a more helpful description than a more limited “operational” due diligence framework.

It is important to consider both Business Risk Due Diligence and investment research, when making an investment.  Whilst it is important to differentiate between these disciplines there are clearly multiple points of overlap that exist.

The Manager

Many investors believe that larger managers rank lower on the operational risk scale and are thus relative ‘safe havens’.  Whilst it widely believed that smaller boutique managers tend to be exposed to greater operational risk it is also true that larger managers often have complicated business models and may exhibit significant operational risks.  Larger investors may have “deep pockets” and resources but many investors believe the outperformance or ‘alpha’ is higher in smaller, more nimble managers.  Operational processes do vary within the asset management industry and investors need to do their homework on a particular manager and fund before investing.

Investors should consider whether there has been appropriate investment in people, systems and other infrastructure. After analysis, investors have a good indicator of whether the manager is investing in infrastructure for the long haul or treating the management vehicle as a “cash cow”.

Business Risk Due Diligence should include a review of the manager’s personnel.  The manager’s team of people is important not only in implementing investment strategy but also in supporting that implementation through operations.  Some fundamental questions that should be asked include:

• are the managers significantly experienced to run the strategy?
•  are business support staff appropriately qualified in accounting or law?  (A good test is to review the qualifications of the key staff and where possible take references.  I have seen some underwhelming qualified people acting as “Chief Compliance Officers” and even an electrician sitting on an offshore fund board!

Segregation of duties is important and high level Business Risk Due Diligence should uncover the roles of the portfolio manager and the COO or back office manager.

Technology is increasingly available and affordable, and as such any review should include some review of the manager’s technology platform.  In my experience technology and business continuity plans of fund managers in Australia often exhibit weaknesses for example in appropriate server security or untested business continuity plans.

We have noted far deeper adaptation of cloud based technologies in overseas fund managers and expect this trend to continue into Australia.  Users of the cloud should have significant redundancy in internet connectivity in place with multiple ultra-fast internet connections.

The back office functions are clearly important in any fund manager but often overlooked or treated as mundane.  Trade reconciliation, settlement monitoring and valuation are hugely important areas.  Failed trades represent a risk not only to the manager but also to the fund and its investors.  Furthermore valuation errors can have a significant impact on net asset values or “NAV”s.

In respect of compliance, investors are looking for a compliance culture.  This doesn’t mean a business has to be bogged down in red tape: in fact an easily applicable set of rules is more appropriate for a smaller manager than a 200 page document that nobody reads.  In terms of personnel a seasoned compliance officer and an experienced, independent compliance committee provide a solid base from which a compliance culture can grow.

The Fund

Most investments are carried out through fund structures.  In Australia these are unit trusts and elsewhere these are typically companies or partnerships.  No matter what the structure funds are legal entities and governed by a set of constitutional rules and offering documents.  Whilst these documents contain powers, discretions and authorities they are low on practical content.  A Product Disclosure Statement for example contains limited practical information other than perhaps the fees (unless they are hidden through swaps) or timeframes for redemptions and subscriptions.

A PDS does not typically include some important information, for example who calculates the fund’s unit price or the identity of the custodian and auditor..  These are material issues and investors should ask questions to ensure sufficiently qualified and rated counterparties are involved. I have seen examples where affiliates of the manager are used in various roles without adequate disclosure. Additionally we would prefer accounting firms with dedicated financial services practises to be carrying out the audit.   There are still many managers who prefer to hire lesser known auditors effectively “doing things on the cheap”.

Practical investment terms of redemption and subscription should be carefully reviewed.  It is also important to match the redemption terms of the fund with the liquidity of the underlying investments.  For example, if a fund holding illiquid credit or property offers daily liquidity investors should consider what will happen if unitholders stampede for the door in significant numbers?    Investors should understand the ‘gating’ powers.   During the GFC investors were left holding illiquid investments for significant periods of time – often with managers and “responsible” entities charging substantial fees during those periods.

The fund structure offers significant opportunity for managers to align their interest with investors.  Investors should want to know the answer to one simple question “how much money does the portfolio manager have invested in the fund?” Few diners eat at a restaurant where the chef refuses to eat his own cooking.  In our experience this is a question that largely goes unasked and unanswered by many investors and researchers.  We have also seen many examples (particularly in Australia) of high earning portfolio managers with insignificant amounts invested in the fund.  Investors can make up their own mind as to whether they think the manager has sufficient alignment with investors.

Another area for alignment is performance fees.  In essence if the manager performs he gets paid.  However it is not quite as simple as that and investors should look at high watermarks, benchmarks and equalisation. Some performance fees allow a manager to collect performance fees even where the fund’s performance is down for the year, investors can make their own judgements on whether that is fair.  Equalisation is uncommon in Australia but it effectively means an investor pays an individual performance fee from the time they invest.  Due to the fact that few fund administrators in Australia have purchased systems that allow equalisation; investors can lose out in paying performance fees when the fund performance is below the level at which they invested.

To recap

Many investors and advisers are constrained by their resources but governed by a best interest duty.  Investing with a poorly organised manager with inequitable fund terms, liquidity mismatch and a weak auditor are unlikely to be in the client’s best interest.  Investors should also have some method of concentrating resources only on the highest risk managers.

Business Risk Due Diligence should capture the operational and wider business risks; in particular what can go wrong.  Experienced investors weigh the risks of what can go wrong against the ability of the manager to make money.  Only in doing this can investors truly satisfy the best interest test.

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

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Claire Wivell Plater

As the start of the Future of Financial Advice (FoFA) reforms races towards us at headlong speed, there is an upswing in the number of advisers working on changes to their systems and processes to accommodate their new obligations, according to Claire Wivell Plater, Managing Director of The Fold.

“We’re seeing a real willingness to embrace the changes and get on with business,” said Ms Wivell Plater. “It’s very encouraging.”

That said, Ms Wivell Plater said advisers do need to be careful that what they are doing is technically accurate and therefore should not be relying on word of mouth interpretations of the new requirements.

“Unfortunately, while there is lots of information about the reforms out in the market place, there’s also a lot of non technical opinion and interpretation,” Ms Wivell Plater said. “Advisers need to be sure that the changes they are making actually comply with the letter of the law.

” To meet this need, The Fold has transformed its popular FoFA White Papers into online courses which cover off each component of the reforms. Each course carries continuing professional development (CPD) points and can be accessed via desktop computers and mobile devices such as iPad and iPhone.

“The courses are written in the engaging style for which The Fold is renowned and cover every element of the reform,” Ms Wivell Plater said. “They contain lots of real life scenarios and are liberally sprinkled with plenty of humour to help advisers understand how the reforms apply to their activities.”

Participants can also download a copy of the related Everything They Need to Know White Papers which succinctly summarise the requirements and provide an indispensable implementation guide.

First cab off the rank is Fee Disclosure, Opt In and Client Engagement. After completing this course, advisers and their staff will be able to properly:

• Explain what an ongoing fee arrangement is
• Understand to whom the Fee Disclosure and Opt-in requirements apply
• Know what must be included in a Fee Disclosure Statement
• Manage the timing and provision of Fee Disclosure Statements
• Understand the implications of not complying with the Fee Disclosure and Opt-in requirements
• Understand the importance of Engagement Letters and the role they play in helping you comply with the Fee Disclosure and Opt In requirements

The Fold will launch their online Conflicted Remuneration course and Best Interests Duty courses shortly.

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