The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Wednesday, May 25, 2011

The Aussie shares sham...

I have two puzzles for you to consider.

The first is why retail investors are locked out of the low risk, direct fixed-income markets. To invest in a corporate bond, the regulator has deemed that the minimum commitment you can make is $500,000. This effectively destroys retail demand. And yet any Joe on the street can gamble $10,000 on vastly riskier shares.

This is truly bizarre: after all, debt is, by definition, safer than equity. Debt gives you a predetermined rate of return, and sits above equity in the corporate capital structure. It is also easier to value. Equity has vastly higher probabilities of loss (ie, risk), offers an unknown rate of return, and is more complex to value. It is much safer investing in senior bank debt than in bank shares. So why do mums and dads only do the latter? I will offer an answer.

The second puzzle is this conversation I had with an Australian shares portfolio manager overseeing over $1 billion at a big fund. I asked him, “What’s your performance been like?” He responded happily, “Oh, really great.” So I said, “What returns have you delivered?” He hesitated, and then answered, “I’ve beaten my benchmark by a wide margin.” Confused, I persisted, “But what have been your actual returns?” Remarkably, he said he did not know, and only focused on his benchmark. Okay, I thought, “What has your benchmark delivered over the last year?” He did not know this either. Gobsmacked, I thought I’d ask the simplest possible question: what returns has the fund you work for produced? He had no idea. This exchange casts into sharp relief some of the dysfunctions that lie at the heart of our wealth management system.

For years now I have highlighted the hazards of shares compared with safer fixed-income alternatives. I’ve been especially critical of super fund asset-allocations, which typically commit around 60-70 per cent of all their money to highly correlated Australian and global shares, and then throw another 10 per cent into private equity and hedge funds.

Rismark’s analysis suggests that the idealised portfolio weight to all forms of ‘equities’ is only around 30 per cent for folks seeking inflation plus 3-5 per cent per annum. Interestingly, the Future Fund targets 35 per cent. Yet this would require most super funds to halve their current allocations.

During the GFC we discovered that many private equity and hedge fund managers that purported to be ‘uncorrelated’ with shares had, in fact, embedded substantial listed equity ‘beta’, or sharemarket risk, into their portfolios. They therefore proved to be poor diversifiers at precisely the time they were supposed to protect their customers.

As a matter of empirical record, 10 year Australian government bonds have outperformed global equities over the last 30 or so years (see table). On a risk-adjusted basis, government bonds and cash have smashed both Australian and global equities. More specifically, Australian shares (accumulation) have thrown off annual volatility of 19.7 per cent over the last three decades. This contrasts with cash and government bond volatility of 1.3 per cent and 8.7 per cent per annum, respectively. Global equities have not been much better, thumping investors with annual volatility of 14.7 per cent.

The risk of putting all your money into Australian shares has been evident in the sharp and very striking losses that occur every so often. In 1987 you would have lost 44 per cent of all your money. Over 2002-03 you would have lost 15 per cent. (If you had global shares, you lost another circa 50 per cent during the 2001 ‘tech wreck’.) And then you were down 48 per cent over 2007-08. These enormous draw-downs mean that if you get your timing wrong with shares, you can earn nothing for years.

What about the fund managers who are paid to beat the market? By diving into ratings house Morningstar’s database, one can lift the lid on their recent track-record. The table below shows the post-fee returns delivered by Australian fixed-income funds and actively-managed, large-cap Australian share funds. Over the last five years you would have earned nearly three times as much by sticking with fixed-income.

And this came with less than half the risk. According to Morningstar’s Phillip Gray, “Over the past five years…the average volatility from the share funds of 16.81 percent per annum was meaningfully greater than the equivalent for…[fixed] income funds of 6.73 percent per annum.”

Renowned pension advisor, Ibbotsen, believe that Aussie equities will deliver no returns at all for the next seven years. Ibbotsen’s Australian boss, Daniel Needhman, thinks Aussie shares are 40-60 per cent overpriced, with fair value for the S&200 being around 3176 points. He argues: “[ASX} earnings are above long-term trend and look unsustainable, leading us to view [Aussie equities] as overvalued and in the long-term bubble camp...Investors should consider reducing their exposure.”

As Australia’s population ages, our risk-aversion will rise. This means we want more certainty over our financial futures. That is, we’d like to avoid losing half of all our wealth in a short space of time! This then begs the question as to what kinds of fixed-income investments one should make. Here it is useful to go back to basics.

First, what is ‘fixed-income’? The name itself is actually misleading, since these investments may have fixed or variable rates of return.

Companies, like banks, raise external money through two sources: debt and equity. When you invest in an ASX-listed company, you are providing them with equity finance. The debt capital is less visible.

While it is not normally understood this way, when you put your savings with the bank you are actually lending to them, just like they do to you. In return, the bank offers to pay you a fixed (term deposit) or variable (at-call) rate of return on your loan (savings). They also promise to repay this money when you want it back.

Alternatively, very wealth individuals can invest directly in the bonds of these companies. These too may be variable (ie, ‘floating’) or fixed-rate. In this manner, they are also lending them debt capital.

Oddly, mums and dads cannot tap this market because ASIC has mandated that the minimum direct investment in corporate credit is $500,000 despite this being inherently simpler and safer than listed shares.

Fixed-income researcher Dr Stephen Nash and others believe that is a result of lobbying by the banking system to restrict retail investors from the debt capital markets for fear of this threatening their captive business lending activities. Dr Nash opines, “Banks...have lobbied hard to make sure that small issuers cannot escape them. Regulation has effectively supported this approach, with the...$500k minimum investment eliminating a whole direct ownership, fixed-income market. Consequently, small issuers have less diversity of funding than they need, and small investors, especially SMSFs, have less bonds they need.”

The fundamental advantage of debt over equity is that debt ‘ranks ahead’ of equity when companies get into trouble. When profits fall, shares typically decline in value. Investors in debt, however, are normally paid their returns irrespective of a company’s trading conditions (unless it defaults).

Think about what happens when you buy a home: you contribute equity, which is your cash investment, and you raise debt by borrowing from the bank. If things go badly and you have to sell your home, the bank’s debt gets repaid before you recover your investment.

Fixed-income investments have three main sources of risk. The first is credit risk, which is like a worst-case profitability scenario. This is the same as the risk of defaulting on your home loan.

The second is interest rate risk. If you invest in variable-rate debts, such as a floating-rate bond issued by one of the banks, or a simple variable-rate deposit account, your returns move up or down with the RBA’s cash rate.

If you think interest rates are going to be edging up, cash is a good place to be. This is especially true once monetary policy heads into ‘restrictive’ territory since other asset-classes, likes shares and property, will tend to underperform as the RBA squeezes activity. On the other hand, cash may yield lower returns if the RBA cuts rates.

Debt securities with fixed rates of return can remove this interest rate risk, since you are guaranteed a regular payment for the term of the investment. But they also introduce a third source of risk: pricing.

If interest rates rise above the return you have been promised on your fixed-rate investment, you suffer opportunity cost. You could, for instance, put your money into a variable cash account and get a better pay-off.

Rising interest rates tend to result in a fall in the capital value of bonds. If interest rates fall, your opportunity cost is less, and so your bond investment is usually worth more. This is why the price of a fixed-rate bond rises (falls) as interest rates fall (rise).

If you invest in a floating-rate bond, you don’t have this risk. Another way to obviate the problem is by putting your money into short-term, fixed-rate investments, such as 180 day bank bills, or a one year term deposit, which you can hold until maturity, and then get your capital back.

The sensitivity of the value of fixed-income investments to changes in interest rates is known as ‘duration’. Fund managers like taking on duration when they think rates are going to fall in the future, since the value of their bonds will rise. The flip-side of this coin also applies: people seek to avoid long-term fixed-rate bonds when they think rates are heading up. Duration can thus be an important diversifier depending on your views on the economy.

Investing in shares exposes you to the risk of enormous losses. Cash and fixed-income are easier to understand and afford superior certainty and security. Those approaching retirement should make sure their portfolios have appropriate weights to these asset-classes.