Rethinking Risk
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Rethinking Risk

Post-GFC uncertainty and volatility saw investors flocking to low-growth, 'safe' assets. but as the Australian economy strengthens, is it time to give asset allocation a rethink?

INVESTORS REMAINED quite conservative about allocations going into 2013 and are still hesitant to divest out of their overweight cash and fixed income assets. A majority are still considered underweight in equities, and even property, but the market has also seen a ramp-up in the search for yield.

Instead of using the traditional model for portfolio construction using a conservative, balanced approach, we are now seeing advisers shift to an objective-based approach.

“[They are] moving away from the risk profile-based asset allocations for clients and focusing on objectives for clients, overlayed with a risk tolerance,” MyAdviser’s managing director, Philippa Sheehan, tells ifa.

“So you’re seeing income-based model portfolios, cash-enhanced model portfolios, which are trying to achieve a better cash rate for the client. [This is] a change we saw towards late last year but certainly a trend we think will gain more momentum this year.”

Historically, retail and institutional investors have been afraid to get back into growth markets for fear of risk, but most advisers urge that in order to overcome the fear factor, investors need to understand their risk tolerance.

“I think it’s fine to educate people to understand what they should do, but we’re experts and hopefully we’ll design product capabilities which allow people to invest with confidence,” Principal Global Investors’ chief executive Grant Forster tells ifa.

Some asset allocations in the past have been ‘knee jerk’ reactions, he explains. When investors sat weighted in the bond market in 2008, the market fell, so financial planners had the task of explaining to clients their returns were plummeting.

“I think we’re coming back to a more traditional asset allocation approach,” Forster says.

“Institutional investors are much more aware of risk than they were five years ago; they are thinking about risk buckets more and more. I think that’s sensible – it’s fine to be aware of your risk in your asset allocation, but you’ve got to understand what risks you should take with a five-, 10- or 20-year view.”
Tyndall Asset Management (Tyndall AM) said the market shift caused by the aftermath of the global financial crisis (GFC) has made reassessing asset allocation to tactically manage risk increasingly important for Australian investors.
Tyndall AM’s head of multi-manager, Ken Ostergaard, said the firm has become much more active in tactical asset allocation in the way it manages portfolios, particularly in the multi-manager portfolios with Australian and global equities.

“If you look at the way asset allocation was done ‘old school’, it was for investors to look in the rear-view mirror, back in history over several economic cycles and decades. [In] the last five years, that has more or less been turned upside down,” Ostergaard tells ifa.

“You have more or less had zero equity return, on average, from when the GFC started to today. Volatility is twice the level as what we have seen in history. That clearly means that the way you traditionally did asset allocation has been completely thrown out of the window in the last few years,” he says.

Traditionally, investors have chased any investments that look remotely ‘safe’ and as a result the trend was to invest in stocks for the wrong reasons.
High-dividend yielding stocks have become relatively expensive, markets have become increasingly volatile and money is being invested for reasons of safety and certainty rather than based on a longer-term, forward-looking view on where the world might be going.

“We take one long-term view with strategic allocation and we favour things like emerging markets over developed markets in equities,” Ostergaard says. “But we also have short-term mechanisms in place to quickly move in and out of almost anything using financial instruments such as derivatives and exchange traded funds (ETFs) to manage short-term risk and volatility.
“It is definitely time to review asset allocation and be wary of volatility. Returns in equities are here to stay for a while. We have had a number of recessions in a number of economies and that will persist into the future.”
But although there is plenty of chatter about asset allocation, it is unclear whether any meaningful action is being taken.

Morningstar’s co-head of fund research, Tim Murphy, notes that yield-focused ETFs have been the market’s strongest asset gatherers. Then, more broadly, the yield-focused sectors like the banks were the best performers while some of the lesser yielding sectors lagged.
“Clearly that shows there has been a preference from all sectors of the market for yield and income, and I certainly don’t anticipate that’s a theme that is going to go away,” Murphy says.
“There is lots of chatter about the role of fixed income within asset allocation these days and everyone [is] talking about how low government bond yields are and fixed interest bond funds, which have traditionally played the income-generating part of most people’s portfolios. They’re certainly thinking [about] what other ways or asset classes can play that role in their asset allocation.”
Where there has been a bit more action is in the area of new products coming to market although, as with any new concept, the jury is still out regarding their potential.
A majority of investors are overweight in Australian equities but they could benefit from broadening their investments overseas to global equities, particularly on an unhedged basis.

“In a world of increasing low cash returns, fixed interest is looking questionable in many areas; government bonds and the Australian dollar are arguably overvalued. We believe unhedged global equities are a reasonable place to be at the current time and many fund managers out there are having similar thoughts,” Murphy says.

According to recent Morningstar data, Australian fixed interest and cash make up the bulk of a multi-sector ‘moderate’ portfolio, with 28 per cent and 22 per cent respectively. Australian and international equities take up a much smaller chunk, with only 14.60 per cent and 9.29 per cent respectively.
In comparison, a multi-sector ‘aggressive’ portfolio is more skewed towards growth, sitting with Australian fixed interest and cash at only 3.01 per cent and 3.40 per cent respectively. Instead an aggressive portfolio is heavily concentrated on international and Australian equities which hold 36.95 per cent and 36.76 per cent respectively.

Asset allocation advice
Advisers’ key role in this area is to assist clients in rethinking their approach to allocating their assets so as to benefit from higher growth and returns.

Instead of investing large slabs of money back into the market, advisers should help investors find a portfolio that reflects their objectives and use the dollar cost average approach each week, fortnight or month as appropriate.

“You know, who cares if it’s $250 per week,” Sheehan says. “It’s about putting toes back in the water and getting comfortable with the fact that we have an objective that needs to be achieved. We’re not going to do that sitting in cash and fixed interest.”
The financial planning industry is evolving, with a change in attitude among advisers that realigns their focus to a client’s key objectives. As a result, advisers need to educate them, demonstrating that sitting on cash in this environment means they are unlikely to achieve some of their long- or mid-term objectives.

“They don’t need to take all the longer-term risks right now, they can gradually start to put their toes back in the pool and it’ll be ok. It’s about [taking on] that coaching, training and mentoring process that will get them to that point,” she says.
“The pre-GFC days of saying, ‘come to us and we’ll get you a return of 14 per cent or over’ [have gone], so advisers have had to evolve to a point where they say, ‘we’ll help you achieve your objectives with a strategy, and we’ll look for portfolios that do that’.”

The market, however, acknowledges it will still be a tough time for advisers, following the poor run on equities seen over several periods of time. Investors have been sitting in cash and during the GFC days, that was the right thing to do.

But an attitude shift now needs to occur to make investments sustainable.

“For the last year, all these guys in cash have got it wrong,” Forster says. “So the advisers have now got a little more pressure. But obviously on a five-, seven- or 10-year view it has been a poor time for equities. In Australia [advisers] have to get investors out of cash and into asset classes which are going to generate returns for them to live on into their retirement.

“I think advisers should be changing their client’s portfolios from now – at least at some level. Advisers should be having investors take a more aggressive stance than they did 12 months ago.

“It will still be a difficult discussion with investors because they are still nervous. Despite all the data, your average person is still nervous about their job because they haven’t seen any price rises in a long  time so convincing them to take more risk when they’re still feeling that there is more risk to come is a tough job. But if you’re an adviser, that is your job.”
Ultimately, advisers should ensure their clients have adequate diversification across asset classes and a balance between assets with high-growth potential that reflects individual risk tolerances.

“Tactical flexibility is also a plus, either through the use of actively managed multi-asset funds or through a satellite and core approach, with specialist funds added to a more static mix of investments,” Fidelity head of asset allocation and portfolio manager Trevor Greetham tells ifa.
Currently, the Australian dollar is also deemed relatively expensive and overvalued, making international assets particularly attractive.

“An Australian investor should probably review his or her asset allocation in terms of finding great long-term investment opportunities outside of Australia,” Ostergaard says.

“It is definitely not a bad time to use this strong Australia dollar and use this to reason with asset class performance and to seriously review the asset allocation and diversify a bit more outside of Australia.

“Despite short-term uncertainty and risk, it is not a bad time – if you have overweight Australian equities, for example – to shift your weight a bit more in favour of overseas equities.”

The road ahead
Huge changes in the market or a significant shift in the way investors approach asset allocation is not expected in the next 12 months, but the message is still starting to get through.
“I don’t know about wholesale change; you’re probably likely to see continued growth in terms of assets coming to those sorts of products and maybe other managers bringing out a similar style of products,” Murphy says.
Meanwhile, Sheehan agrees the market is likely to remain similar to last year, with no huge change in volatility.

“I think clients will be prepared to put a little bit more money back into the market this year. However, we are not going to see the significant sums that perhaps fund managers and the market would like to see. It is going to be done very conservatively and very gradually over this coming 12 months,” she says.

Clients who want to generate money for retirement will need to be in risk assets but that requires a change in mindset, which will take time.

“I think it will happen,” Forster says. “Maybe another year and a half and people will come on board [with equities]. But by then, unfortunately, they just won’t get out of it what they should.”

Most expect an upturn in the overall market to happen eventually. Greetham explains that Fidelity adjusts the asset mix of its multi-asset funds continuously as expectations for global growth and inflation evolve.

The firm has added considerably to equity exposure in the last few months, in anticipation of a global economic upswing.

“Experience has taught us to keep an eye out for policy mistakes that might trigger another slump in activity,” he says. “We hope this is not another short cycle, but we stand ready to lock in gains if that’s the way things turn out.

“More likely things to watch out for in 2013 are a pick-up in commodity prices early on as even Europe’s economies start to grow. If global growth really gets going we could see a sell-off in bonds and a strong US dollar. Japanese equities could do best in that environment but safe-haven gold would rapidly lose its shine.”
Ostergaard, however, takes a more positive view. He says he would not be surprised if there were changes in the market over the next 12 months, given the fluctuations experienced over the past four to five years.
“It is definitely time to review asset allocation and be wary of volatility,” he says. “Returns in equities are here to stay for a while. We have had a number of recessions in a number of economies and that will persist into the future.
“You might have to be a little bit more aggressive, take just that little bit more risk longer-term, making sure you achieve the returns that will see you have a reasonable retirement.

“You will also need to view your asset allocation a little bit more frequently than you have done in the past.”

The hunt for yield
Investors’ chasing yield has driven a majority of shifts in asset allocation over the past six months, with the strongest overall trend being a move towards growth assets.
UBS Global Asset Management Asia Pacific’s head of fixed income, Anne Anderson, says there is movement in credit and increasing yield, with a passive increase in fixed income allocations allowing them to drift higher while not dynamically rebalancing away from other asset allocations.

“The fall in bold yields, the narrowing of credit spreads and re-raiding of the equity market has happened, so for investors now, it’s the harder yards that begin – stock rotation, choosing the right securities and the right industries, and being on the look out for beta trades,” Anderson says.
“Components of fixed income remain important for Australian superannuation funds. Credit remains the highest priority – seeking out yields in various forms – and notwithstanding that, we’ve already seen very strong returns. That’s being acknowledged, but there’s still some value there.”
Fidelity Worldwide Investment’s head of asset allocation and portfolio manager, Trevor Greetham, agreed that high yielding assets have been very popular since the GFC drop in global government bond yields, which deprived investors of a safe source of income.

“The single most popular asset class remains global high-yield, but multi-asset funds have seen consistently strong inflows in recent years and we expect this to continue,” Greetham tells ifa. “Investors have long memories and, for many, the logical first step back into risky assets is via a diversified fund with a balance between equities, commodities and safe-haven asset classes like bonds and cash.”
According to RBS Australia, Australian investors should continue to skew their asset allocations in search of yield, a strategy supported by the last two or three interest rate cuts, which caused a market inflection point and drove investors towards yield.

“We think as people move from term deposits with the cash rate coming down – [and] even though [they are] moving into growth products and equities – they’re still looking at the yield component. People are still chasing yield and people are still chasing those franking-credit style income products,” RBS Australia global banking and markets director Elizabeth Tian told ifa.

“What is going into equities is still really all about the yield stocks and all about the defensive stocks. I think this trend is only going to continue with cash rates coming down.”

The company also expects increased interest in international equities, supported by the weakening Australian dollar and US market.
“Large broking firms have now branched out to not only local equities advice but also to international equities advice. So we’ve seen a pick-up in that and [to absorb that demand] we’ve got the products where you can trade international shares on the Australian Securities Exchange,” Tian says.
Principal Real Estate Investors said inflows to real estate investment trusts (REITs) property are also expected to pick up as retail investors begin to recognise the attractiveness of the sector in their search for yield.

Poor markets and falling cash rates mean investors are looking for strong yield prospects elsewhere.

“I think that if you’re interested in investing in this space, I would take a dollar cost averaging approach,” Principal Real Estate Investors’ real estate executive director Pat Halter told ifa. “Start to make some investments in this marketplace, then build on those investments over time. [This] allows you diversification in terms of the timeframe you’re investing in.”
Principal Global Investors’ chief executive Grant Forster adds that investment into the global REIT sector allows investors in Australia to have diversification offshore that they aren’t able to obtain elsewhere.

“At the same time, a lot of advisers are saying ‘this is a great cornerstone for the superannuation-type client’. So if there is a general belief to increase that exposure, getting global offshore just makes sense. It’s very difficult for Australians to go and get a meaningly diversified offshore property holding. This is a liquid and very easy way to do it,” he says.
However, Tyndall Asset Management (Tyndall AM) warned that blindly chasing good returns can lead investors into a trap. More time should instead be spent looking at the underlying health of a company rather than chasing high-yielding stock.

“The dividend yield is a function of the stock’s dividend and its price, and a high dividend yield could simply indicate that the stock is cheap – and cheap for a reason,” Tyndall AM’s head of Australian equities, Bob Van Munster, says. “For instance, deteriorating businesses can often have a high dividend yield that proves to be an illusion.”

Tyndall AM recommends investors look beyond headline dividend yield and instead focus on sustainable yields, earnings growth and capital appreciation. Some sectors with high-yielding companies may be facing structural challenges that can affect investor returns.

“The strength of a company’s balance sheet (particularly gearing levels), as well as franking levels, pay-out ratios, potential for share buy-backs and special dividends, are all keys to assessing the sustainability of a company’s dividend,” Van Munster says.

“Therefore, picking the highest yielding stocks without conducting thorough due diligence can lead to substantial underperformance.”

The global economic perspective
UBS Global Asset Management’s head of fixed income, Asia Pacific, Anne Anderson, says one of the overriding themes of 2012 was investors’ seeking yield and switching into credit and assets that will benefit from an improving economy and outlook in Europe.

“So, we are seeing greater risk appetite, driven by European and US policymaking and a general removal of uncertainty. There’s still a question mark over the US debt ceiling and economy, but largely the acute uncertainty we saw six months ago has diminished,” she says.

While fixed and relative income assets remain attractive in a climate of falling cash rates, Anderson adds, investors should prepare for likely changes to nominal income in the economy.
“While it’s expected that cash rates will be cut, indicating that you shouldn’t quit fixed income yet and go back to cash, I think there’s a bit of a shock to the level of nominal income in the economy ahead,” she says.

“Service-side inflation is likely to abate as wages remain stagnant and there’ll be a bit more slack coming from the fading of the resources boom. We’ve already seen jobs being pruned and attrition in industries such as manufacturing and tourism, but whether that’s enough to see a severe re-rating of the equities market – like we saw in the US at the end of last year – remains to be seen.”

Principal Global Investors chief executive Grant Forster agrees there are global factors that will continue to affect the way investors allocate their assets. Global deleveraging and good demographics in the United States are likely to drag up fresh investment opportunities.
“Global deleveraging continues, both at the household and sovereign level, apart from in Germany. Everyone else is in that phase. Why is that important? Because interest rates aren’t going anywhere up in a hurry,” he tells ifa.
“The US businesses have delivered and are in fantastic shape. They still have big debt but they have started. We think the US will be the fastest growing developed market. All the stories about the fiscal cliff and now they’re talking about the debt ceiling again,” he said.

Each asset class has done well since the crisis low in March 2009, helped by aggressive money printing by the world’s central banks. But short-term business cycles have created significant volatility, with different investments grouping into ‘risk on’ and ‘risk off’ buckets.

“We think the form the early rounds of quantitative easing (QE) took exacerbated this phenomenon,” Fidelity Worldwide Investment head of asset allocation and portfolio manager Trevor Greetham says. “QE was administered in a massive dose, spread over a fixed number of months like a course of antibiotics. The intention was to shock the markets out of a panic. However, once each program came to its pre-scheduled end, confidence and the global economy sagged.”

“The latest round of Fed QE is much more carefully constructed. It is open-ended with the aim of restoring the US unemployment rate to a low level, even if this means an overshoot in inflation.
“Other countries are also realising it is no bad thing to have inflation in the mix when you are dealing with debt. The Bank of Japan has adopted an increased inflation target and the British Chancellor hired in Canada’s dovish central bank chief Mark Carney to take the helm at the Bank of England.”

Rethinking Risk
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