Given the current low growth and low interest rate environment, most of the Asian region offers superior growth prospects than developed markets and better debt dynamics. The region is seeing an improving credit rating profile contrary to many of the movements in developed economies over the past few years. Asian credit fundamentals are stable and it is a growing asset class that offers attractive yields and diversification from developed markets. In addition, according to our analysis, detailed later in this paper, including an allocation to Asian fixed income alongside Australian fixed income can boost portfolio returns without increasing risk.

Asian debt markets continue to grow quickly

The Asia ex-Japan region comprises a diverse group of economies and bond markets at different stages of development. While the Asia ex-Japan bond market may represent only a fraction of developed world bond markets, it is growing rapidly, with about USD 8.7 trillion in outstanding bonds or 57% of the region’s GDP[1] (see chart 1).

Source: Bloomberg, IMF World Economic Database, AsianBondsOnline, SIFMA.org, HSBC, European Central Bank

In addition, the Asian region offers better growth prospects than developed markets. According to Standard Chartered Research[2], the forecast 2014-2030 annual GDP growth for China is 5.9%, India 6.7% and the rest of Asia ex-Japan 5.5%. Over the same time period, the average annual growth for the rest of the world is expected to be 3.0%, for the US 2.3% and for the European Union 2.0%. Led by China, Asia ex-Japan’s share of the global economy is rising, offering increasing opportunities for fixed income investors.

Asian local currency bonds grew significantly following the 1997 Asian financial crisis (see chart 2), with strong domestic support for the asset class as the economies expanded with high savings rates.

Foreign investor participation has also grown as Asian governments continue to reform their markets and improve foreign investor rules, making them more accessible and attractive. For example, as of December 2004, less than 5% of Indonesian, Korean, Thai and Malaysian bonds were held by offshore investors[3]. As of March 2014, offshore holdings had increased to 33.6% of Indonesian bonds, 10.5% of Korean bonds, 116.2% of Thai bonds and 30.8% of Malaysian bonds.

Asian economy fundamentals substantially improved

Since the Asian Financial Crisis, external debt in the region has fallen to more sustainable levels. Fiscal deficits in the region are now mostly below 4%, while some economies, such as Hong Kong and Singapore are in surplus. In addition, Asian economies have accumulated substantial foreign currency reserves, allowing governments the flexibility to manage currency volatilities, and their current accounts are largely in surplus.

As of mid-2014, most Asian sovereigns were rated as investment grade by Standard & Poor’s (S&P), Moody’s and Fitch. This is much higher quality than the broader emerging market countries, with Singapore and Hong Kong leading the pack with comparable ratings to the UK and US.

In the current environment, investors are on the hunt for yield. And yet many are overlooking the Asian market despite the fact that Asian bond yields are higher than developed markets. One of the most commonly used indices to represent the Asia local currency bond markets is the HSBC Asian Local Bond Index (ALBI), which tracks the total return performance of a portfolio consisting of local currency denominated, high quality and liquid bonds in Asia ex-Japan. The average return of the HSBC Asian Local Bond Index from 2002 to July 2014 was 7.27% pa.

In addition, from 2001-2013, the annual calendar returns of the HSBC ALBI have only been negative in one year – 2013. Even in 2008, at the height of the GFC, the index returned 1% (see chart 4).

Currency has contributed to the strong performance of Asian local currency bonds. However, as macro-economic fundamentals remain strong, with most countries’ current accounts in surplus, we still expect Asian currencies to appreciate in the long term.  Although there is a potential risk in a broad strengthening of the US dollar as the US Federal Reserve starts to remove its easy monetary policy, the Eurozone and Japan are expected to maintain their current easy monetary policy.  We believe that Asian currencies are in a better position relative to other regions with fewer geopolitical risks and volatility compared with other emerging countries.  India and Indonesia, two of the worst affected Asian countries during the ‘taper tantrum’ in 2013, have implemented policies to address current account deficits and with their new elected governments are viewed positively from a reform perspective. This should reduce their vulnerability when US rates start to rise.

Asian bonds also offer these relatively good historical returns with moderate volatility (see chart 4). Compared with the broader emerging markets, Asian credit and local currency bonds have demonstrated much lower volatility over the past 10 years.

Asian credit – attractive spreads with lower defaults than other EMs

Asian hard currency bonds (USD-denominated) have grown steadily as more issuers tap the offshore market and these are dominated by credit issuers (including corporate and quasi-sovereigns) at 85% of the market. The JP Morgan Asia Credit Index (JACI) tracks the total return performance of a portfolio consisting of USD-denominated bonds issued by Asia (ex Japan) sovereigns, quasi-sovereigns, banks, and corporate.The total market capitalisation of the JACI has increased from USD 143 billion in 2005 to USD 522 billion as of June 2014[4]. In terms of credit quality, investment-grade issues dominate at USD 400 billion, with USD 122 billion of high yield issuance.

Although investors may be worried about rating downgrade and default risk for Asian corporates, chart 5 below shows that this is lower than for other regions where default rates are higher. Although Asian high yield default rates are expected to inch up in 2014, we expect them to remain below the emerging market average.

Asian credit spreads are also more attractive than for US and European credits, now for high yield as well as investment-grade. As of 31 July 2014, the approximate spread pick up for an A rated Asian credit was 35 bps over US and European credits, while a BBB rated Asian credit saw a spread pick up of about 55 bps over US and 65 bps over European credits. In terms of high yield credits, as of the same date, the approximate pick up for a BB rated Asian credit was 80 bps over the US and 112 bps over Europe, while a B rated credit achieved about 235 bps over the US and 210 bps over Europe. In our view, spreads are at attractive levels that can offset impact of increasing risk-free rates.

Returns for the JACI Total Return Index have been largely positive over the past 12 years, with only two periods of negative return – in 2008 during the height of the GFC when credit globally suffered and in 2013 mainly due to the sharp rise US Treasury yields. Although JACI investment-grade credits suffered in 2013, JACI high yield actually offered a positive return (see chart 6). Higher bond yields were able to offset the impact of rising rates and wider spreads.

Including Asian fixed income in an Australian portfolio can boost returns without increasing risk

Asian fixed income doesn’t feature heavily in the average Australian investor’s portfolio. However, our analysis shows that including an allocation to Asian fixed income alongside Australian fixed income can boost returns without increasing risk.

We compared a range of Australian fixed income indices with Asian fixed income indices as part of our analysis. Chart 7 shows the risk/return for JACI, JACI high yield, JACI investment grade and JACI corporate compared with the risk/return for the UBS Australia Composite Bond Index, the UBS Australia Supranational/Sovereign Index and the UBS Australia Credit Index.

Although the JACI and its sub-indices offer high returns over the period, the volatility is also much higher. JACI high yield returned 11.79% over the period, but with 8.98% annualised volatility. Over the same period, the UBS Australia Composite Bond Index delivered a return of only 6.43% but with a much lower volatility of 3.29%.

Using our efficient frontier analysis, we studied various combinations of Australian and Asian fixed income indices in an example portfolio. Based on historical data, this analysis aims to create a set of optimal portfolios that would have offered the highest expected return for the given level of risk.

First we looked at the UBS Australian Credit Index, which offered a slightly higher return (6.85%) with lower volatility (2.24%) than the UBS Australia Composite Bond Index over the period studied. The analysis focused on the combinations that would have offered the highest return while maintaining the 2.24% risk level. The key is the amount of each allocation – for example, we included a much smaller proportion of JACI high yield to maintain the 2.24% risk level, although this combination still offered the highest return with an 84 bp pick up over the UBS Credit Index.

We also analysed what would happen if we combined Asian fixed income with the UBS Australia Composite Bond Index while maintaining its historical risk level over the period of 3.29%. A similar picture emerged, with the optimal portfolio combination of the UBS Index and the JACI Total Return Index offering a substantial 177 bp pick up over the return of the UBS Index on its own.

Obivously, to achieve these results would require perfect foresight to implement, but it does show the potential upside of combining Asian and Australian fixed income within a portfolio.

Asian fixed income offers diversification benefits

Another advantage of Asian fixed income is the diversification benefits that it offers. The correlation between Asian and Australian bond markets is fairly low, which could help manage overall portfolio risk and reduce volatility (see table below).

Sector diversification is another consideration, with the JACI offering Australian investors exposure to sectors that aren’t or aren’t well represented in the Australian markets (see chart 8).

Conclusion

Favourable macroeconomic conditions, higher growth trends, enhanced corporate transparency and improvements in sovereign credit ratings indicate that Asian economies are likely to continue to experience robust growth. In the current ‘lower for longer’ interest rate environment, strong capital inflows into Asian bond markets due to the hunt for yield should continue for some time. In our view, Australian investors are missing out on the opportunities that Asian fixed income offers, particularly the attractive yields and diversification from the Australian market.

By Bertram Sarmago, Investment Director – Fixed Income (Singapore), Nikko AM 

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[1] Source: Bloomberg, IMF World Economic Database, AsianBondsOnline, SIFMA.org, HSBC, Deutsche Bundesbank. Bond market size as of June 2014 except for Taiwan and India (mid-2013 estimate by HSBC), US (as of March 2014).

[2] Standard Chartered Research – The super-cycle lives: EM growth is key , 06 November 2013

[3] Source: AsianBondsOnline

[4] JP Morgan, as of 30 June 2014

Disclaimer: This material is issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (Nikko AM Australia). 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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Principal Global Perspectives

The global emerging markets landscape is changing rapidly, with the outstanding returns investors have seen in the past becoming increasingly difficult to secure.

According to Principal Global Investors, despite the volatility, emerging markets are a strategically important part of long-term investment portfolio and determining the right market exposure is more critical than ever.

The October issue of Principal Global Perspectives focusses on emerging markets, providing a compilation of articles from four of its boutique asset managers on what they see as the challenges and opportunities in this progressing asset class.

Key points:

• Waiting for growth no longer, emerging markets take action, by Milhail Dobrinov, Portfolio Manager, Principal Global Equities: “So how are emerging countries to prosper, and emerging stocks to regain their edge and outperformance in this new environment? The answer lies in applying a large dose of self-help; not just waiting for growth to happen along, but taking steps to create it. That means boosting productivity growth, reducing operating and capital costs, improving profitability, and returning more capital to shareholders. At the country level, this means structural reforms; at the firm level it requires prioritizing return on capital, rather than growth at any cost. These changes are necessary, but neither of them will be easy or popular, and some attempts will stumble.”

• Emerging markets forge ahead … on differing paths, by Ivailo Vesselinov, Economist, Finisterre Capital: “Emerging economies with large financing needs are likely to remain under the microscope as major central banks rein in global financial liquidity.”
• What to watch in emerging markets: aggregate ROI, by John Birkhold, Partner, Origin Asset Management: “What matters is not how fast a company is growing, per se, but the level of ROI that firms in aggregate have been able to achieve.”
• Emerging markets debt: as asset class evolves, by Nick Varcoe, Portfolio Manager, Principal Global Income: “Institutional buyers are likely to remain active in the emerging market corporate space, particularly as long as this attractive yield pickup over developed markets continues to exist.”

To read the full report, click here.

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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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Macquarie has added SMAs to Macquarie Wrap.

Macquarie has announced the launch of separately managed accounts (SMAs) as an investment option on its market-leading platform, Macquarie Wrap, enabling financial advisers to view and manage their clients’ assets on one streamlined and consolidated platform.

Justin Delaney, Head of Wealth Product, for Macquarie’s Banking and Financial Services Group, said Macquarie is committed to continually investing in and enhancing Macquarie Wrap to deliver efficiencies to advisers.

“The growing interest in managed accounts in Australia has become more apparent in recent years, with investors embracing the ability of SMAs to take the complexity out of managing an investment portfolio,” Mr Delaney said.

“The decision to add SMAs to the Macquarie Wrap platform was driven largely by client demand for more tailored investment solutions and a wider selection of assets. SMAs combine professional investment management with the transparency, flexibility and tax efficiency of direct ownership.

“We believe adding a discretionary portfolio like an SMA to Macquarie Wrap will provide significant opportunities for advice practices incorporating them into their businesses, as well as improved client experiences and investment outcomes for investors.”

Through Macquarie Wrap, financial advisers and their clients will have access to an extensive range of SMAs, managed by experienced investment managers and covering a range of asset classes, strategies and styles, allowing the construction of a unique portfolio tailored to a client’s needs.

“Investors can hold term deposits, managed funds, direct shares and SMAs on Macquarie Wrap, and receive a complete view of their total investments in one place, with one consolidated report,” Mr Delaney said.

“We have been providing managed accounts for over 15 years, giving us a depth of experience within the industry. We have a fully resourced team of investment professionals and analysts to help make informed decisions about clients’ investments.

“With our strong focus and commitment to providing the highest quality financial services products to our clients, we look forward to delivering the benefits of SMAs to financial advisers and investors.”

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Stockholm, Sweden

Few developed economies rebounded as quickly as Sweden did from the global financial crisis. After contracting 5% in 2009, Sweden’s economy expanded 6.6% a year later, swelled another 2.9% in 2011 and has grown since, even if at a lesser rate.[1]

The remedies that drove Sweden’s revival were the same cures that helped Australia avoid recession after the global financial crisis struck in 2008. Fiscal stimulus and aggressive cuts in interest rates by the central Sveriges Riksbank nurtured an economy that was in reasonable shape when Lehman Brothers folded in 2008. Sweden went into the crisis with a central budget surplus of 3.6% and low net government debt, at around 40% of GDP, having conservatively managed official finances and its banks since the country hosted a banking crisis in the early 1990s (just as Australia did).[2] Another boost was that the EU member has its own currency, the krona, because Swedish voters wisely decided against adopting the euro in a referendum in 2003 – which means, of course, that the country has its own monetary policy.

Having the ability to alter interest rates and other monetary tools to suit economic conditions, however, comes with no guarantee that this power will be used astutely. The Nordic country looks set for some harsh years ahead because its central bank has misjudged the economy. Sweden’s misfortune is that officials at the world’s oldest central bank used monetary policy to attack a frothy housing market, record household debt and largely imaginary inflation. It’s to be hoped that other central bankers (including those at Martin Place, Sydney) are studying the mistakes made at the Riksbank because many of their economies face the same challenges.

With housing in Sweden estimated to be 32% overvalued when judged against rents[3] and household debt at a troubling 175% of disposable income, the Riksbank under Governor Stefan Ingves raised its benchmark rate seven times from July 2010 to July 2011 and looks to have inflicted long-lasting damage on Sweden. In March this year, Sweden became the eighth EU country and the first in the north to record deflation over a 12-month period (over which time Swedish consumer prices fell 0.4%).[4] Five central-bank rate cuts from December 2011 to December 2013 don’t look like averting the counterproductive pain any time soon. The most self-inflicted damage is that deflation, among its many poisons, increases the real burden of household debt.

Sweden’s challenges aren’t just due to mistakes by a central bank founded in 1668, it must be pointed out. The country’s biggest market, the eurozone, is tottering, thus curbing export sales. The collapse of demand across Europe is a big source of the deflationary pressure swamping Sweden. The largest Nordic economy is still growing – it expanded 1.5% in 2013 – and there’s no sign that Sweden will enter a protracted recession any time soon, just years of puny growth. It’s not the central bank’s fault that Sweden’s welfare state discourages saving, thus encourages hyper borrowing, especially for housing. But the country is shaping as an example of the damage anti-inflation zealots can incur when they gain control of monetary policy and use it against a threat that doesn’t exist (inflation) and wield it to fight an asset bubble and rising household debt better controlled by other means.

Murdering a recovery

The Riksbank claims a colourful 350-year history that includes financing the wars during Sweden’s so-called Age of Liberty from 1718 to 1772 to even figuring in the assassination in 1792 of King Gustaf III, the autocratic regent who killed off parliamentary rule 20 years earlier.[5] Its more-mundane inflationphobia and anti-housing-bubble mindset probably traces to the more-recent financial, banking and housing crisis of the early 1990s. During this time, the Swedish central bank raised interest rates to 500% to defend its then fixed-exchange rate and struggled with a collapsing economy where household debt had soared to at least 130% of disposable income from only 95% in 1980.[6] One year after the krona was floated in 1992, the central bank was charged with keeping prices stable, a mandate the Riksbank interpreted as keeping consumer inflation close to, but under, 2%.

Inflation wasn’t a threat after Lehman collapsed in 2008 and the Riksbank was fervent in helping Sweden navigate the crisis. It cut the target repo rate, the level at which banks can deposit or borrow from the Riksbank for seven days, from 4.75% to 0.25% in seven cuts from October 2008 to July 2009. So accommodative was the Riksbank, it pioneered negative interest rates on overnight deposits held at the central bank. The Riksbank set this rate at minus 0.25% from July 2009 to September 2010, to encourage banks to lend rather than park reserves at the central bank. (Denmark cut to below zero in July 2012 while the European Central Bank did so this month.)

Then came the decisions from mid-2010 to raise rates in seven steps to 2%, verdicts that were never unanimous among central-bank board members. Lars Svensson, an influential academic who was deputy governor of the Riksbank from 2007 to 2013 and the advocate of negative rates, opposed tighter monetary policy and he has let the world know of his disapproval – Svensson has a website that hosts posts and other material slamming the Riksbank.[7] Svensson resisted rate cuts because he said inflation was too low (at 1.2% at the time of the first rate increase), unemployment was too high (at 8.8% in mid-2010) and because fighting housing bubbles with interest rates would prove counterproductive.

The Riksbank raised rates over 2010 and 2011 because it judged “a lower repo-rate path can contribute to increased indebtedness” among households and this in itself can lead to “an unfavourable scenario … in the form of a fall in housing prices,” the central bank said in its Monetary Policy Report of July 2013, the month of its last rate increase.[8]At this time, inflation in Sweden adjusted for the impact of rising mortgage costs was running at an annual rate of only 1.6% and unemployment stood at 7.9%.

The Riksbank’s actions showed the majority of its board were swayed by proponents of the strategy of “leaning against the wind” to control Sweden’s bubbling housing market. This is the tactic for central banks to tighten monetary policy more than necessary to suppress inflation to counter hasty credit growth and rising asset (housing) prices. Opponents of this stance (such as Svensson) say the temporary fall in inflation becomes permanent while the resulting drop in size in new mortgages is too insignificant to affect total nominal mortgage debt. In Svensson’s words: “That total nominal debt falls quite slowly means that movements in real debt and the debt-to-GDP ratios are dominated by faster movements in the price level and nominal GDP.”[9] In short, debt ratios worsen. The five rates cuts since December 2001 that have reduced the repo rate to 0.75% and the fact that the Riksbank forecasts household debt to reach 180% of disposable income by 2016,[10] double to where it fell in the mid-1990s after the banking crisis, would appear to vindicate Svensson’s claims. Perhaps even more damning, Sweden’s government is considering greater oversight of the country’s central bank.[11]

Many goals, many tools

The actions and failures of the Riksbank feed into the debate about whether central banks should extend their remit beyond price stability to financial sturdiness. For if the global financial crisis did anything, it has destroyed the notion that low inflation engenders economic stability. Large asset bubbles that led to a global recession made worse by erratic swings in global capital flows revealed the limpness of only targeting inflation with one instrument, interest rates.

The IMF, in another backpedal since 2008, now sympathises with those who call for central banks to concern themselves with financial stability as well as price stability. An IMF staff discussion released in April this year says that central banks could broaden their remit to financial and external stability (which means the exchange rate and capital flows) and sometime use the cash rate to achieve these goals. “Where possible, these (goals) should be targeted with new or rethought instruments (macro-prudential tools, capital-flow management, foreign-exchange intervention),” the paper says. “But should these prove insufficient, interest-rate policy might have a role to play.”[12]

Central banks have notched some success in heading off financial imbalances, though usually not with interest rates. The Swiss National (central) Bank has stood by its pledge of 2011 to keep the Swiss franc from falling below 1.20 euros (which means stop it rising) but that entails unlimited buying of the euro with Swiss francs and then mopping up excess francs through daily market operations. But there are many problems with a broader mandate for central banks. Financial stability is harder to judge than inflation. Bubbles are easier to spot in retrospect than when they are occurring – central banks may well smother healthy activity if they misdiagnose a spurt in asset prices. An expanded central-bank mandate would inject central bankers into political debates that could put at risk the perceived independence allowed central banks when they only worry about inflation. While judging interest rates entails a political choice between savers and borrowers, decisions on exchange rates and capital controls pit exporters against importers, restrict investors and hit different businesses in various ways, to name just some of the wider political decisions involved. Targeting financial stability could place central bankers in a situation whereby they enrage vested interests for raising interest rates when inflation is low. It’s hard for anyone to argue that a calamity that never occurred has been averted.

Another reason not to make financial stability as another target for monetary policy is that regulatory powers already exist to choke credit booms, controls that often sit within central banks. (The Reserve Bank of Australia lost these powers to the Australian Prudential Regulation Authority in 1998.) Bank regulators can easily suffocate credit frenzies by boosting bank reserve requirements, tightening rules around mortgage lending such as restricting low-deposit lending or capping the amount borrowed to a certain percentage of a person’s income. Regulators in Canada, New Zealand, Norway and Singapore have taken such steps recently. Politicians, as opposed to regulators, can stifle credit booms by altering fiscal policy. Lawmakers can raise stamp duties and other taxes on property or change (or even threaten to alter) tax laws to make housing a less-alluring investment. Sweden’s property boom is partly a result of lax regulation of bank mortgage lending, interest-only loans (no principal is repaid, which means home owners are essentially paying rent to their banks) and that fact that Swedes can claim tax deductions on a percentage of mortgage costs.

Even with all these shortcomings, central bankers, though, are bound to pay more attention to financial stability to avoid a repeat of 2008. The RBA appears to see financial stability as a long-term part of its mandate to keep inflation low and the economy at full employment. It’s “leaning” against Australia’s housing market (that the OECD judges is more overvalued than Sweden’s[13]) by warning about over-rapid price increases and by moving to a neutral stance with monetary policy. But, if you believe media reports, the government[14] is among those that are unhappy with the RBA’s efforts. The central bank, to its critics, is failing to stimulate a sluggish economy when inflation is tame (2.7% in the 12 months to March this year) and likely to slow, and is propping up the Australian dollar, at a cost to exporters and the government’s coffers. It is to be seen whether the RBA under Glenn Stevens is as successful as it was under Ian Macfarlane at calming a sizzling housing market or if, Riksbank-style, it causes a bigger mess.

by Michael Collins, Investment Commentator at Fidelity

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Jeremy Bendeich, Chief Investment Officer and Portfolio Manager of Avoca Investment Management, discusses the fundamentals of intrinsic investing.

The post Video: The principles of intrinsic value investing appeared first on AdviserVoice.

Chris Batchelor

Stock research application house, Skaffold, has said that the long-standing faith in stalwart shares may at last be on the wane with advisers.  According to analysis of the latest user data, financial advisers are no longer focusing mainly on traditional mining and banking stocks and are instead looking at service industries.

The research behavior of more than 100 advisers has been analysed over the past 11 months.  In April 2013, banks and resources formed the top seven out of the top ten researched stocks.  In March 2014, services formed the top four stocks and five of the top ten. Just one financial stock (ANZ) and one energy stock (Titan Energy Services) were included in the top ten most researched shares.

General Manager of Skaffold, Chris Batchelor, said Australian investors have relied upon these industries for growth.  However, this change in behavior with advisers signals that Australian investors are looking further afield, reflecting an increased level of sophistication.

“Banks and miners have been the core of Australians share portfolios for many years.  However, with many analysts now saying the mining boom is over and that banking growth is likely to be flat, it’s pleasing to see that advisers are getting more diversified in their stock research.

Highlights of the research include:

• 46% of stocks evaluated are in the Services sector
• 20% in the Technology sector
• 12% in healthcare
• 10% of views were CBA and ANZ

Mr Batchelor said none of the top 20 researched stocks by advisors were in the Basic Materials (resources) sector, whereas eleven months earlier Resources and Oil and Gas made up 20% of the top 20 most viewed stocks, with BHP the number one viewed stock by a considerable margin.

There were less changes evident among the advisers looking at international shares. In the US market Apple, which was previously the most viewed stock by Australian advisers on the US market dropped one place number two and Microsoft suffered a similar fate dropping one place from second most viewed to third most viewed. Resmed, the seep apnea specialist founded by Australian Peter Farrell was the most viewed US stock but technology stocks remain the largest represented sector in the US top 20.

Mr Batchelor said usage of Skaffold by advisers was also on the rise, with a 20% growth in adviser use.

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Background

Many empirical studies have shown that a value style approach to share investing has consistently outperformed growth investing – and with less risk. Other studies have shown that lower volatility portfolios, particularly lower beta portfolios, outperform higher beta portfolios.  Concentrated equity portfolios have also proven to outperform their more diversified counterparts.

If value, lower beta and concentrated portfolios have consistently outperformed in the past, then isn’t it only a matter of time before investors arbitrage this away? If this was true, then these ‘anomalies’ should have disappeared a very long time ago as they have been documented for many years. In fact, these so called ‘anomalies’ are a permanent feature of share markets.

This article looks at the first anomaly – value investing. 

Value has outperformed growth in the long term

There have been many studies on various equity markets which show that value has consistently outperformed growth. Typically, these studies defined value stocks as those with low ‘Price to Book’ ratios or in some cases low ‘Price to Historical Earnings’ ratios. It is also likely that this ‘anomaly’ will continue to persist in the future.

Among these empirical studies include Basu (1977), De Bondt & Thaler (1985) (1987), Lakonishok & Vishny (1994), Fama & French (1992), and Arshanapalli, Coggin & Doukas (1998).

Of course, this fact would come as no surprise to the many famous value investors, such as Warren Buffett and John Templeton, who have enjoyed enduring success with their share investments.

Australian market style indices produced by S&P/Citigroup, show that during the period October 1989 to January 2014, value investing in Australia has outperformed growth investing, as has been shown for the global share market.  (NB. This is the longest period we can obtain for Australian market style indices.)

During this period, value produced a return of 10.87% pa, while growth produced a return of 8.87% pa.  This means that value outperformed growth by 2.00% pa. In dollar terms, if $100 was invested in the S&P/Citigroup Value Index during this time period, it would have accumulated to $1,221 by January 2014, whereas for growth, the amount would have been materially lower at $786. Returns are before fees and taxes. Past performance is not an indicator of future performance.

Background

Chart 2 shows that during any 3-year time period, on most occasions, value has outperformed growth quite handsomely in Australia, as has been the case for global shares.   The key exception was during the unprecedented commodities and resources boom that fuelled economic growth in Australia for almost 10 years from 2003. This was driven by the rapid industrialisation of the most populated country in the world, China and in turn saw growth stocks outperform value stocks.

A cynic may argue that the only reason why value outperformed growth is because value shares are riskier than growth shares. Many value investors would totally disagree with this statement, and would argue that value investing is actually less risky than growth. 

Most value investors would argue that they pay 60 cents for something that is worth $1, and as such there is good margin of safety in the investments they undertake.

One measure of risk is the volatility of returns as measured by the standard deviation of returns.  As table 1 shows, value has been less volatile than growth with a standard deviation of 13.51% versus 14.27% for growth.

Another measure of risk is beta, which is essentially a measure of market risk and strips out the impact of stock-specific risk which can be diversified away. As table 1 shows, value has had less market risk than growth with a beta of 0.968 versus 1.028 for growth.

This analysis thus shows that not only has value outperformed growth by a significant margin, but it has done so with less risk.

Comparable numbers for global equities using the MSCI World Value/Growth Index, which co-incidentally has a longer history (January 1975 to January 2014), are provided in table 2. It should come as no surprise that the numbers for global equities tell a very similar story. Value has outperformed growth by 2.08% pa over the period and with lower risk with a standard deviation of 14.81% (versus 15.75% for growth) and a beta of 0.966 (versus 1.031 for growth).

How significant are these findings?

One way to measure the significance of a result, is to calculate a t-statistic.  In this case, we need to test how confident we can be that value will continue to outperform growth in the future. To do this, we need the historical outperformance of value over growth, the standard deviation of this outperformance, and the number of observations. Naturally, the greater the sample size, the more significant will be the result. The formula to calculate the t-statistic is provided below:

T-statistic = (outperformance/standard deviation of outperformance) x square-root (no. of observations)

As a general rule, a t-statistic of at least +1.0 is considered to be meaningful and +2.0 is considered be highly significant.  At +2.0, it implies at least a 98% probability that this ‘anomaly’ will persist in the future.

For Australia, the China-driven commodities boom has had a marked impact on the results, but despite this, we have a moderately meaningful result.  With a t-statistic of +1.4 (as shown in table 3), this implies a 92% probability that these performance and risk results will persist.

Can this anomaly continue? Overall we can be confident, at least from a statistical perspective that value will continue to outperform growth in both of these share markets.

Part 2 of this three-part series will focus on the second anomaly: lower beta portfolios outperform higher beta portfolios. It was also delve more into our reasons why we believe both of these anomalies will persist in the future.

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (TIML). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Share Concentrated Fund (TASCF) ARSN 143 598 556 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (TAML). Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest. Reference to individual stocks in this material neither promise that the stocks will be incorporated into TASCF nor constitute a recommendation to buy or sell. TIML and TAML are part of the Nikko AM Group.

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Australian venture capital firm, OneVentures, yesterday officially launched the OneVentures Innovation and Growth Fund II, seeking to raise $100 million from institutional investors and high net worth individuals over the next 12 months.

The fund will invest in a portfolio of emerging Australian companies with global ambitions across healthcare, education, mobile, media, cloud computing and data, security and privacy, machine learning, sensors and robotics, and food security.

The first OneVentures Innovation Fund, formed as an Early Stage Venture Capital Limited Partnership in 2010, raised $40 million and was supported by $20 million in funding from the Australian Government’s Innovation Investment Fund.

The fund was the first in Australia to tap into a growing trend in the Australian market for high net worth individuals and family offices to diversify their investments towards venture capital filling the gap vacated by institutional investors post-GFC. Since then, OneVentures has closed three co-investment funds securing $30m in additional funding for the portfolio.

“The quality of the portfolio OneVentures has assembled over the past four years is one of the best venture capital portfolios I have seen in Australia,” said Mark Nelson, Executive Chairman of Caledonia and an investor in OneVentures Innovation Fund.

The fund is trading at a premium after only four years and of its eight portfolio companies two are now operating out of Silicon Valley and one out of Boston, reflecting their successful growth into global markets. Smart Sparrow recently closed a $10m financing and Hatchtech over $12.5m for US expansion and US FDA phase three studies respectively.

“OneVentures is demonstrating a capability to do deals of global significance,” said Dr Michelle Deaker, Managing Partner at OneVentures. “Our investors value the technical experience of the partners as well as their proven entrepreneurial and business building experiences in the domestic and international arena. The partners also bring experience and networks of relationships to select highly attractive investment opportunities addressing large global markets, and to manage those investments through to the exit stage.”

Dr Deaker believes there has never been a better time for investors to turn their attention to venture capital. While traditional drivers of the economy such as mining and manufacturing are slowing or moving offshore, innovative technology-based companies hold the key to driving Australian economic growth and many are now succeeding on the global stage.

“While the innovation economy has been building, Australia continues to invest substantial capital in R&D and there has been substantial activity and investment in early stage angel syndicates and incubators. However, there is a dearth of capital available to propel those developing businesses forward with later stage development and expansion capital,” Dr Deaker said.

“This dynamic should create downward pressure on valuations and generate scope for superior returns. We see no reason why Australia’s entrepreneurs, with the assistance of experienced venture capital firms like OneVentures, cannot compete successfully in global markets. For investors, the fund provides an opportunity to truly diversify a portfolio and gives access to emerging businesses with true breakout potential.”

OneVentures today also announced that Dean Hawkins was joining the firm as a partner.

Mr Hawkins has led international businesses at the forefront of TV, media, broadband, apparel and sports industries for the past 18 years, working in UK, Germany, Holland and Switzerland, including 4 years as global CFO and board member of Adidas, based in Germany, during which time Adidas grew its market capitalisation from €1.5b to €8b. Since his return to Australia, he has served as chairman of International News Network Ltd (Hong Kong), and non-executive director Ten Network Holdings, Apparel Group, Leighton Contractors and I-Med Australia.  As chairman of compression garment company, Skins, he oversaw the expansion of the group sales into 30 countries world-wide including a joint venture in China.

Mr Hawkins commenced his career in investment banking with UBS and was chosen by Global Finance Magazine as one of its “Global Corporate Finance Superstars”. He has also led a number of media organisations, collecting Emmy and BAFTA awards along the way.

Commenting on the appointment, Dr Deaker said: “Mr Hawkins complements the skills of the partners and his experience in both high growth and established businesses will be invaluable for our portfolio companies.  Mr Hawkins brings a new dimension to our team with a strong finance, M&A background and international commercial and cross-border experience. The international experience of our team is showing a marked impact on our portfolio performance as they expand into global markets and prepare for exit.”

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The fund is a U.S. mutual fund and offers U.S. investors access to top hedge fund managers at substantially lower fees and account minimums than typical hedge fund investments. Non-U.S. investors, including Australian institutional investors, are able to access the strategy via Neuberger Berman’s Irish UCITS version of this fund (the “Fund”).

The Fund is managed by members of the Neuberger Berman Alternative Investment Management team, which has significant experience managing fund-of-hedge fund strategies. The team allocates fund assets to multiple hedge fund advisers that employ distinct alternative investment strategies. The Fund does not charge performance-based management fees, offers daily liquidity, and has lower investment minimums than typical hedge funds along with full transparency of portfolio holdings.

Paul O’Halloran, Managing Director of Neuberger Berman Australia says: “The alternatives sector has undergone significant change since the global financial crisis, and the industry has seen marked improvement in the areas of cost, liquidity, transparency and corporate governance.”

“Australian investors, like those in the U.S., are seeking diversification in their alternative investment allocation, while targeting a reasonable degree of liquidity and competitive pricing. Increasingly, investors are seeing the new breed of alternative investments as a key source of alpha,” Mr. O’Halloran says.

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