In coming weeks Clime will conduct, in each capital city, investment forums where our speakers will delve into the asset classes which self-directed investors can and should be considering. The aim is to educate investors to help them understand the different risk profiles and the likely returns of different asset classes – Australian equities, international equities, Australian listed yield securities and direct property assets.
Today, investors generally and retirees specifically, are confronted by the very real prospect of lower returns from both bonds and equities than that which have been historically observable.
This outlook results from two key factors:
- First, the sustained period of low inflation which we have traversed has crunched yield and interest rates; and
- Second, the continued interference in bond markets by international central banks has pulled yields even lower.
It is the manipulated low or negative “real” yields of the bond market, along the maturity curve (5 to 10 years), which is acting to collapse the returns of all asset classes. Particularly those whose prices have been inflated by sustained low interest rates.
Therefore we perceive that balanced portfolio returns (i.e. spread across asset classes) may average about 5% per annum for the next few years with returns particularly dragged down by bond or fixed income returns.
This background draws us to consider the weighting of equities in a balanced portfolio. While we expect better returns from equities than bonds in the next few years, it seems that the equity market has its own unique issues. Poor earnings growth, measured by eps, is one factor but there is another insidious issue which is less obvious.
Of immediate concern are the pedestrian returns of the Australian equity indices over the last decade. Today the Australian equity market price index is still 15% below the 2007 high that was reached a full 12 months before the height of the GFC. Recently, financial commentators have crowed about the market reaching “2 year highs” rather than noting the alternative but less exciting observation that the market is at the same level it was 2 years ago.
This period of underperformance by the Australian equity market should not be glossed over. Equities have historically generated superior risk-adjusted returns and have been critical in contributing to the total returns of long-term investment funds in Australia. However, ten year equity returns have now fallen to well below long-term norms and shorter periods, inflicted by price volatility, have exhibited spasmodic results. Without the benefit of franking, the Australian share market indexes have returned about 5% per annum below their long-term averages over the last decade.
Apart from poor eps growth, the other issue that needs investigation is the haphazard allocation of funds into the equity market through entrenched market practices. It is the poor and undisciplined allocation of capital, without the demand for adequate returns, which is fuelling the problem. We can understand this issue more clearly when we see how the ownership of the equity market has developed over the last twenty years.
In a recent publication, US based fund manager “Marathon Asset Management” succinctly described the common make-up of publicly listed company registers in the US. Arguably the same descriptions can be applied to the shareholders, traders and investors that occupy the share registries of Australian listed companies.
The shareholder types, their focus and investment time horizon were described by Marathon as follows:
|High Frequency Trader||Next price tick||8 milliseconds|
|Hedge Fund||Quarterly earnings, “catalysts”||Up to one quarter|
|Passive ETF investor||Nothing||47 days average holding period|
|Management options/shares||Wealth and reputation||1 to 36 months|
|Value investor||Return on capital, cash flow||5 to 8 years|
|Average worker||A happy retirement||30 years|
From the table, it is easy to see the disconnection between the investment needs of the majority of investors (the average worker through his/her long-term pension plans), the focus of many equity managers and the design of their equity products. It is our view that this disconnect infects index returns by creating excessive volatility. Excessive speculation and volatility clouds the measurement of true equity market performance – particularly over short periods.
The short-term focus affects both individual stock prices and the market as a whole. The Australian share indexes are battered by trading which reacts to rumour, arbitrage and speculation. Importantly this appears to have little relevance to long-term wealth creation or the requirement to meet long-term pensioner needs. The table inherently implies that excessive speculation and trading is mixed with complacency by investors (passive ETF investment). It is this toxic mix with its direct and indirect linkages that has played a part in causing Australian share indices to underperform.
It is our view that the intentions and time horizons of the managers at the top end of the table (HFT and hedge funds) are rarely the same as those at the bottom end, who are the providers of patient capital (the average worker). The focus of both of the HFT and hedge fund manager is to generate returns for themselves. This arrangement is commonly constructed through incentive schemes which do not appropriately reward the risk capital of their investors. Inventive performance fees based on merely exceeding low or inconsistent hurdles such as zero returns, cash returns or short-term index returns are not for the long-term benefit of their investors. They are designed to reward the manager for mediocrity and this is magnified when the portfolio is leveraged with debt. It is hardly inaccurate to suggest that such performance fee arrangements are designed to help the managers retire early rather than their investors.
The average person unwittingly supports hedge funds and HFT activity
How does the superannuation or pension capital of the average worker find its way into funds managed by HFT and hedge fund managers? The answer sits in the middle of the above table, where passive Exchange Traded Funds (ETFs) predominantly invest in indexes. From their passive portfolios, managers dispassionately lend out the underlying securities from their portfolios to earn a few basis points and offset fees. Further, passive index investing is supported by large pension asset advisors that are being swamped with too much capital to invest. Dis-economies of scale work against large investment funds and to combat this effect, the asset consultant must break up their funds into smaller allocations across both asset classes and managers. As funds grow, the allocations to passive index type managers increase.
The capital support by the average worker for HFT therefore occurs through a complex web of investment flows. Pension savings flow through large funds (confronted by dis-economies) into index funds that include ETFs – which lend stock to hedge funds that use HFT computerised trading. This indirect linkage is also supported through direct investment by large asset managers that direct capital into hedge funds as part of their attempt to generate returns.
The circuitry of the investment flows is not closed allowing smart, active and unconstrained investors to utilise the ETF market to their advantage. They can directly access active fund managers when they perceive returns can be generated by the stated investment strategy of the manager. At various times, active investors may have a view on the market that is complemented by ETFs offering bear funds, bull funds or balanced fund products.
The short-term focus dominates markets
While the bulk of investment capital (i.e. superannuation assets) is long-term focused, it seems clear that an increasing amount of these funds is being managed with a short-term focus. Indeed this appears most pronounced in the equity asset class because it lends itself to short-term trading. The liquidity of the market has been extended by stock lending and leverage. While a small amount of actual stock trades, it does so endlessly giving the impression of massive turnover when really there is not.
The equity asset class is confronted by developments (such as the proliferation of HFT, hedge funds and passive equity funds) that are acting against proper capital formation and therefore affecting the returns of the equity market. If they remain unchecked and we suspect that they will, then the returns from the Australian equity market (in particular, the indexes) will remain sub-optimal. Passive ETF index investing simply does not work in Australia.
As noted earlier, the Australian equity market accumulation indexes have generated a return of just 3% compound over the last ten years. This index return has been generated from dividends with capital gains negative. The return required an owner to reinvest all of their dividends fully to achieve the accumulation return of about 40%. The good returns of a small number of companies have been swamped by the negative returns of many.
Observing the problem is one thing, but designing a solution is more important. We believe there are a number of things that self-directed investors should do:
1. Use index funds periodically and only when there is a good reason to do so. An investor must have a purpose for buying the index and not use it as a default;
2. Similarly, identify the focus of an ETF and again use them occasionally when there is a sound reason to do so. Identify the focus of the manager to consider whether that style will be effective in the current environment;
3. Select stocks based on a logical valuation metric. So long as the chosen companies are growing earnings and their intrinsic value is increasing, then investors should not be swayed by short-term price moves – except when the price moves dramatically away from value;
4. Acknowledge that income dominates the return from the Australian equity market, and balance your portfolio to seek out companies that can reinvest in their business to grow;
5. Diversify assets and consider international equities and direct property as essential ingredients of a balanced portfolio; and
6. Stay informed and treat share prices with scepticism. The excessively short-term focus in the equity market is to be noted, observed and ignored when investing for long-term results.