Following a big week in global markets where US tax cuts are on the tip of everyones’ tongue, David Walker and John Abernethy sit down to discuss the important topic of asset allocation. When seeking long-term returns from your portfolio, asset allocation is arguably the most important decision you will make, with 80% of returns coming from here. They weigh up the current pros and cons of fixed interest, Australian and international equities, property and cash, and layout a set of broad guidelines for investing at different stages of your life.
DW: Hello again everyone I’m David Walker from StocksInValue. With me is John Abernethy, managing director of Clime Investment Management, our parent company. We come together once a month to record these video versions of The View about macro trends and topics, and general investing themes. Starting this week we have our Investment Forums in Melbourne, Sydney, Brisbane, Perth, Hobart and Adelaide, so I brought John along today to ask him about some of the asset allocation themes he’ll be talking about at the forums. Starting today John, as we’re recording on Monday, we’ve got a risk-on rally, a relief rally, in markets after the French election outcome of the weekend. What else are you seeing as we head into these important forums this week?
JA: The forums are about asset allocation, but it’s a pretty important week for the world. Apart from the French election, which is a couple weeks away, the big issue in America is these tax cuts. We’ll see later this week what Trump’s proposing and whether he can actually fund it, because the biggest issue there is having tax cuts and not blowing out the budget. It’s got to have a zero consequence for the budget, so there’s got to be something on the other side. So the markets will be excited but I think it’ll be more rhetoric than fact. So that’s the big over overpowering issue. In Australia we’ve got inflation reports this week and around the world GDP reporting. Arguably we shouldn’t get too excited about GDP as the March quarter, particularly in the northern hemisphere, is usually disappointing because of the weather and in particular America. I’ve seen year after year March quarter’s GDP is general disappointing. I’m not really worried about that and I think it’s steady as we go, frankly, around the world.
DW: OK thank you. Stepping back and looking at longer-term trends in asset classes, as we were talking about is this morning before we recorded. Tell us about some of the longer-term rates of return on the various asset classes and what we’ve seen on the ASX over the last ten years in particular, where most of our investors are invested.
JA: Yes look, it’s an interesting decade we’re looking back on because the two big asset classes – fixed interest bonds like against equities growth. The fixed interest markets have outperformed the equity market for a decade. There has been patches where equities have rallied back but have given it up and bonds have consistently been strong (probably now in the last six months they’ve tempered that). That’s a quite a unique period for markets and the problem is looking forward we’ve got a very low bond yield to start with and it’s very hard to see sustainable returns coming out of fixed interest or good returns to justify the risk of being there. Now when you take that asset class out of the play in a balanced portfolio, you’re not left with much other than going to towards property. In Australia, if you look at the equity market, we do have listed property, which has been a strong performer over last five years, not so good over ten years because of the GFC. Arguably now direct property is probably a little bit highly because it is trading off yield and the unit prices of most property funds are trading at a premium to equity. So that drives you logically into direct property and then when you go direct property you want to find well-managed portfolio of assets. You can’t just buy and hope. You’ve got to have active management in the property market, so that’s something we’ll certainly be talking about. The equity market, as we were discussing this morning and you’ll probably writing about this, the market’s not greatly over-priced. It’s not great value, it’s just sort of sitting there. Australia today reflects the same index as it did ten years ago, which is a bit of a worry. The total returns from the Australian market are excessively dividend and obviously enhanced by franking but growth outlook is pretty much the same as it has been for the last five or six years. There’s not much growth in the equity market. From an asset allocation perspective, you’ve got to think broader than equities, but you are driven back to equities because the fixed interest market yields are so poor at present.
DW: Ok then, so if the long-term returns on equity indices in Australia have been so mediocre, what does that say about the traditional investing approach being index relative and trying to outperform the benchmark and the kind of concentrated, dull portfolio that resulted?
JA: I touched on this last week in The View, so hopefully people can read that. Exchange Traded Funds have a place, particularly the funds and the fund managers who have different techniques or ways of managing money. Indexes really short-term plays and really a self-managed super fund or self-directed retiree should just use an index fund if he/she is for some reason bullish on the equity market. Now today being bullish on the equity market where bonds are so low on yield, you’d have to struggle to work out why you are so bullish. So I think Exchange Traded Funds away from index is a way to go if you want to play that. But then you’ve got to work out whether you want to be bullish or bearish, if you want to be industrial or resources, financials or retailers or Telco’s. You’ve got to segment the ETF market and come up with conclusions why you want to be there. What we say is, you’re better off stock picking and picking good value stocks as a way to play the equity market and that’s not always easy. Whilst we think the equity market is giving better value for value investors now because momentum is out of the way, given the bonds have rallied too hard, we come back to value investing – selectively rifle shooting, occasionally putting an ETF on if you can find a reason to buy a segment of the market, but it’s very hard to segment the stocks. I go back to my initial point. Self-managed retirees take bonds out of it, take fixed interest out of it, you’re left with segments of international and Australian equities where you’re looking at a bit of income coming out of the share market (so you can slant the portfolio), and direct property, are the areas we think are the most interesting. In terms of long-term returns, there are a lot of financial announcers saying that asset allocation is more important than stock selection. So getting the asset allocation right, in terms of contribution to returns, can be about 80% of the returns – getting the assets right as opposed to getting stocks or bonds right.
DW: Would you like to provide some broad guidelines or suggestions? If someone has just retired, they have their SMSF and have to live off income for the rest of their lives. What asset allocation would you say for the average retiree?
JA: Look, there are several phases – pre retirement, early retirement, mature retirement and very late retirement. Very late retirement you’re obviously going for capital maintenance as the call. Focused on yield, you’re not chasing a 7 or 8% return from a balanced fund; you’re probably looking at 5 or 6 with capital stability. That takes you out of international equities, takes you slightly into a very low allocation of equities, a low allocation in direct property and big allocation to yield and probably floating rate yield. In the middle pension markets (so you’re sort of around that seventy year old age), you’re probably balanced between direct property, floating income, Australian equities and international equities. If you’re in an accumulation phase, you’re probably less on chasing yield and more pursuing growth. You’re in international equities and probably direct property and Australian equities is where you are you focused on and leaving yield. Yield is downplayed a bit at that point.
DW: Just a comment I’d like to make on direct equity investing in Australia. Over five years, regardless of style – value, growth or so on – managed funds that benchmark themselves against the index, their performance converges. People end up with too much in banks, too much in resources, regardless. So, do you think the more purposeful approach of focusing portfolios on the retirees’ actual life objectives is more valuable than the traditional index-relative approach?
JA: The issues you’ve got are – you’ve got to beat inflation to maintain the value of your capital. And the legislation says you’re going to take a certain amount of money, depending on your age, out of the pension fund. That gives you an idea of what your target should be. You should be well above inflation and you should be at least matching your retirement payouts. Your younger retirees obviously want to exceed their retirement payouts so they get some compounding of growth. But, as I said, when you get towards that eighty to ninety year old bracket, they’ve got to take out that 7% plus in pension, so to get 7% returns is going to take on too much risk to justify it. They’ve got to look at a drawing down on their capital – it’s not a game anymore. There’s no magic box that says you’ve got to maintain your capital when you’re ninety years old. And guess what, if you do make it into aged care, you’ll be taking a lot of capital out anyway for that final part of your life. So the targets are very much set – exceed inflation and don’t take on too much risk, but certainly try to exceed your pension payouts. Those pension payouts, only time will tell whether the government changes them – it’s an interesting period in our lives as governments grapple with those policy settings. But at this stage the rule of thumb is 7% is your target rate of return.
DW: Great, thank you very much John, very insightful. Comments there from somebody who would know. Thank you for watching. If you have any macro questions about investing – that’s the big picture of economies, the markets interest rates, policy and so on, please post them in the comments section below this video. We hope to see you at our Investment Forums starting this week, there are full details on the Clime website. Thanks very much for watching and we’ll see you next time.