The latest edition of our fortnightly email newsletter was sent to subscribers on the 30th of September. 

The edition looked at the debt crisis, provided a summary of the bailout efforts of the US government as set out in the proposed Emergency Economic Stablization Act, provided a summary of the movements in markets over the past fortnight and looked at what to do in the current market conditions.  If you would like to be added to the mailing list please click the following link to be taken to the sign up page - The Financial Fortnight That Was Sign Up Page.

The following is the lead article for the newsletter:

Financial Topic Demystified - Emerging Markets

Today I have read an article in the Australian newspaper looking at the topic of whether financial planners should also be the investment managers for clients - Financial advisers can be fund managers.  The article refers to a US industry expert who suggests financial advisors should stick to technical strategic decisions and keep away from the tactical investment management.

The article provides a retort to this argument suggesting the new breed of Australian advisors are better-educated, some now holding undergraduate university degrees, and are just as capable as analysts employed by fund managers to help clients make investment decisions.  Another interesting discussion mentioned by the author is the 2.4% average client management expense ratios for using the services of financial planners associated with the major banks and the pressure being placed on these fees thanks to not only industry super funds but also boutique financial advisors who want to cut costs for clients.  (This 2.4% includes adviser, fund manager and administration service or wrap fees.)

So where do we sit on these points?

Firstly we believe that advisors with the proper academic qualifications are quite capable of providing the best strategic and investment advice.  I hold a Masters degree in Financial Planning along with a Bachelor of Commerce while my business partner Scott Francis holds a Masters in Financial Planning, a Masters in Business Administration (MBA) and is now studying towards a doctorate (Phd) in the area of investment markets.  We believe a committment to the education process is essential putting ourselves in a good position to deal with both strategic and investment decisions for clients.

On the issue of fees, we are definitely in the camp of trying to force fees down.  Paying 2.4% is way too much.  Our fee on a $50,000 balanced investment portfolio is 1.6% (GST inclusive).  This quickly falls away to 1.28% on a $100,000 portfolio and 0.9% on a million dollar balanced portfolio.

We think these fees are pretty competitive but we also acknowledge that we would like to get them lower and are currently in the process of reviewing our cost base to see how we can reduce costs and pass this reduction on to clients in the form of lower fees.  More on this point in the near future.

In conclusion, we think that a well educated financial advisor can provide both excellent strategic planning advice along with excellent investment advice.  So when looking for a planner carefully check out their qualifications and also check out their fee structure.  Their educational background does not afford them the right to charge exorbitant fees.

Regards,

Scott Keefer

In the latest edition of the Sound Investing podcast, published by FundAdvice.com, Paul Merriman, Tom Cock and Don McDonald discuss whether your portfolio is built for the amount of risk you can handle, whether a well diversified portfolio only needs 20 stocks, the outrage if you choose to sell down growth assets now and a discussion of how today's global financial crisis happened and what to do about it.

One warning, the radio show is 51 minutes in length and will use up 23MB of download.

If these constraints are not a problem, I recommend you take a look at the latest podcast - Sound Investing - September 26, 2008

For those who have limited time and/or limited download capability the following is a brief summary of the more relevant material that was covered:

Riding out the storm, how is your portfolio doing?

Paul Merriman comments that being a successful investor is not only about the rate of return you need but what risk you are willing to take and make sure your portfolio is built that way.

Don McDonald commented that your emotions are your biggest enemy.  He also reflected that we never refer to markets as turbulent when they go up only when they are going down.  The reality is that this has occurred in years past.  In 1982, unemployment at 10%, interest rates at 20%, the market was down about the same as now.  On August 12^th the market turned around and was up by 40% at year end.

Back to the Basics

What is the worse thing that can happen to your portfolio.  Answer - let your emotions take control.  It leads to buying high and selling low.

Myth or Reality: When the news is bad, get out; When the news is good get in

Paul refers to these type of investors as the Dalbar Dummies - referring to the Dalbar study, going back 20 years showing investors receiving less than 50% of the index return because of the behaviour of selling at lows and buying at highs.

You need to learn how to invest mechanically.

Does the government intervention in markets affect the passive investing story?

Markets are never solid nor stable one day at a time. You need to decide whether you have confidence in the long term success of the global economy.  If you have that belief in capitalism and that it will survive and grow and go through cleansing periods like now, which is normal, then every person should have a certain amount of fixed income and you stay within your personal risk tolerance and avoid the question are you doing the right thing.

They referred to the question what if the stock market has a period like the Japanese market through the 90s.  The response was that if you were in Japan during that period and invested internationally as long as investing in Japan you would have had a much better performance than by investing solely in the Japanese market.  The key, having an internationally diversified portfolio.

Paul's Outrage: Why Fidelity's .750 batting average might strike you out

Paul looks at a full page advertisement taken out by Fidelity to try to calm investor nerves in the US.  Paul agrees with most of the content.

Westpac and the Association of Superannuation Funds of Australia (ASFA) have released their latest national Retirement Standard - Westpac-ASFA Retirement Standard.  The report shows that petrol, health and food prices are driving up the costs in retirement.  The details are presented in the table below with the figures assuming retirees own their own home.

Budgets for various households and living standards

The conclusions set out in the media release were:

Over the year to the end of June 2008, Food costs were up 3.9%. Living the good life in retirement became more expensive, with the cost of take away food increasing by 6.5%, restaurant meals by 4.5%, milk by 12.1%, cakes and biscuits by 8.2%, snacks and confectionery by 5.3%, cheese by 14.2%, bread by 6.8% and poultry by 11.0%. As well, alcohol and tobacco prices were up 4.8%, health costs rose 4.8% and transportation costs were up 6.9%. Over the year the average price of unleaded petrol increased from around $1.25 per litre to around $1.60 per litre.

Over the last four years the costs of a comfortable retirement have increased in total by 11.9% and for a modest standard of living in retirement by a total of 13.1%. Basic budget items tended to have the largest cost increases.

The increases are confronting and show the importance of not just holding financial assets as cash and/or fixed interest as the returns from these style of investments may mean that your financial assets do not keep pace with the rise in expenditure.

I also find that the report helps those preparing for retirement determine the level of assets they will need to live comfortably.  Our rule of thumb is that retirees should be able to draw down on their financial assets at a rate of 5% in retirement.  For a couple who want to afford a comfortable lifestyle this would mean that they need approximately $1 million in financial assets (in today's dollars).  Of course retirement needs are different from one person to the next but the ASFA Retirement Standard is a useful starting point.

Regards,
Scott Keefer

 This morning I have listed to a podcast from FundAdvice.com providing their response to the current crisis - Coping with the Wall Street Crisis.  The podcast is 30 minutes in length and 15Mb in download size in case you wanted to listen to it yourself.

Some of the topics were not totally relevant to the Australian context but I wanted to pull out a few points that were.

These events are not unprecedented

Paul Merriman pointed out that we need to put the current situation into perspective:

• Remember the high interest rates of the early 80s
• Between 2000-2002 the US market was down twice as much as it is now
• In the 70s the US market dropped over 50% in response to the oil embargo problems

This is not to say that this is not a very serious situation but it is a situation we have to go through.  This point goes back to the whole question of risk and return.  Returns from share markets over time are greater than returns from cash and fixed interest securities because they are riskier investments.  As a trade-off for that risk, investors expect to be rewarded.  If they were not riskier and experience volatility in prices, returns should be more consistent to returns for other investments like cash deposits.

Emotions are your worst enemy

Your emotions can lead to making unwise financial decisions.  A quote from Paul Merriman:

"Your emotions are absolutely your worst enemy when it comes to dealing with money. People get way too excited when times are good. People get far too frightened when they are bad. In both cases, you will react irrationally based on some really bad information that is coming from within you. And the media is making money by driving those fears right now."

Be careful listening and watching the news media

The news media despise putting the current situation into perspective, they want to sensationalise the issue by using terms such as worst, or worse than to get attention to their story and by doing so sell more advertisements or subscriptions.

Importance of Asset Allocation based on scientific research

Mark Metcalfe, a financial advisor from Merriman, Berkmann & Next - the firm behind FundAdvice.com, suggested that he is just as convinced of the benefit of asset allocation & diversification which is underpinned by peer reviewed white papers - academic research - which is based on long run historical investment data.

What to do now?

The key is have a disciplined approach and stick to it.  This means doing nothing or even adding more growth assets to your portfolio but definitely not make wholesale changes.

Paul Merriman also suggested that investors should understand where they are now and what their portfolio needs to provide for their future.  A financial advisor should be working with clients to do this and help make sure portfolios have built in an appropriate amount of risk for each client.

Don't pretend to know which way the market will go

One presenter paraphrased a quote from William Bernstein, the author of the Intelligent Asset Allocator.  There are three basic groups:

1. Those who don't know which way the market is going
2. Those who know they don't know which way the market is going
3. Those who know they don't know which way the market is going but pretend to know to justify their livelihood

Characteristics of Good Advisors

• offer an initial fee consultation,
• prepare people for the bad times
• advisors work together to service clients
• have an approach to investment based on the fundamentals of asset allocation based on academic research
• they don't pretend to know which way the market will go
• are a fee only advisory service, fees are separate from products
• they are available
• they have back up support
• advisors share their opinions on a client's situation with another advisor
• provide the right direction and give clients the best service

Some food for thought in what is a difficult time on investment markets.

Regards,

Scott Keefer

It would be a gross understatement to suggest that the current investment market conditions are very difficult.  (Some of my more colourful friends would add a few different adjectives in front of difficult.)  In my reading over the week I have come across an article coming out of the USA which I thought was worth sharing to try to add some perspective as to what investors should do.

The article comes from FundAdvice.com - Don't Dump Those Dogs.  It looks at the temptation to dump all the poor performing asset allocations and transfer into better performing assets.  The author of the article is an advisor for Merriman Berkmann Next which uses a very similar approach to our firm.  They recommend that their clients invest in U.S. large-cap, U.S. value, U.S. small-cap, U.S. small-cap value, U.S. real estate, international large-cap, international value, international small-cap, international small-cap value, international real estate and emerging markets stocks.

The article suggests that in any given week, month, year or decade some asset classes will shine and some will lag.  One of the problems for investors at present is that all growth asset classes have struggled over the past 12 months.  Does this mean that we should dump all growth assets and move to cash and fixed interest?

The author, Jim Whipps, suggests not:

"Market declines are a normal part of long-term investing. Fortunately, they don't last forever. It's tempting to think that a falling market will keep going down indefinitely (or that a rising market will keep going up indefinitely) and as a result of that to make emotionally based transactions (usually at precisely the wrong time). History has one piece of advice about that: Don't do it."

"If you get out of the market now, at some point you will want to get back in. That is tougher than you might think. If you wait until it is comfortable to re-commit, you will almost certainly have missed a big rally - possibly even the majority of the market's next upswing."

Jim goes on to look at some recent historical examples where jumping out of asset class dogs turned into missing out some significant rises in returns from these allocations.

These statements are easy to say but when you are in the middle (hopefully nearer the end) of one of the most significant downturns in investment markets the psychology of investing plays a much greater role.  In a recent blog I suggested that if the turbulence has been too great it may be worth reconsidering your risk profile and as cash comes into your portfolio from your investments not to automatically reinvest this cash but strategically consider what you want your asset allocation to be going forward and then structure any future investments to get you to that point.

All this being said, there are some positive signals out there with the USA bail out moves, organised activity on the part of central banks around the world including our RBA and as I write news is coming through that Warren Buffett is investing $5 billion into Goldman Sachs with the option of investing another $5 billion, one of the investment banks at the centre of the financial crisis.

I am definitely not suggesting we have reached the turning point.  All I am saying is that we can't be sure and after sustaining the 20% or more falls over the past 9 months I for one, sure do not want to miss a rebound when it comes.

Regards,

Scott Keefer

Last Wednesday the Sydney Morning Herald published an article looking at fixed interest investments - To have or to hold

Fixed interest investments are rarely high on the agenda of the media or backyard BBQ discussions but it is times like now that highlight the need for more focus on fixed interest investments.  For us, fixed interest investments are about reducing the volatility in portfolios and smoothing out returns in portfolios.  They are mostly boring, consistent performing investments but in times like these the value of fixed interest investments can not be overstated.  The average monthly investment returns from the main indices since the beginning of 2008 to the end of August are outlined below:

Annual returns to the end of August were:

On both time periods we can see that cash and fixed interest have well and truly out performed the growth asset classes.  But not all fixed interest offerings are the same.

Unfortunately some investors don't just use cash and fixed interest securities to reduce portfolio volatility, they use these investments to chase returns.  The Sydney Morning Herald article highlighted some distressing returns with the article suggesting fixed-interest funds have lost about 8%.  These styles of funds are not the boring but safe fixed-interest investments most peoples associate with.  They are aggressive funds that use names such as "high-yield", "diversified credit" and "multi-strategy income" and invest in such things as collateralised debt obligations, asset-backed securities and mortgage-backed securities, as well as emerging market debt and non-investment grade corporate debt.

It is now well publicised that these investments have been at the centre of the crisis on financial markets.  Some well know funds which have come unstuck include Absolute Capital, Basis Capital and City Pacific.  Investors were encouraged to invest because these funds promised share-like returns with supposedly less risk.

Our approach to fixed interest is worlds apart from this aggressive approach.  We focus on high quality securities that produce reliable consistent returns over time.  Our preferred investment in the fixed interest area of portfolios is the Dimensional 5 Year Diversified Fixed Interest Trust.  The Trust uses a variable maturity approach which involves no interest rate forecasting.  This approach seeks to identify the countries and maturity ranges with the highest expected returns and generally increases country allocation or extends maturities when the expected returns are significantly higher for a country or for longer term securities. It invests in A1+ short term securities and AA or higher rated long term securities.  Take a look at Dimensional's quarterly update for more information.  The one year return after fees has been 7.46% to the end of August (0.35% above the relevant index.)

Another fund that we do not currently use but worth a look is the Vanguard International Credit Securities Fund (Hedged) mentioned in the Sydney Morning Herald article.  It is invested in over 8,500 securities issued by government owned entities, government guaranteed entities and investment grade corporations.  The one year return has been 6.99% after fees for the wholesale version.

To summarise, fixed interest securities are about smoothing out returns in portfolios, especially crucial in times like now.  It is important to have a well diversified exposure in high quality offerings.  Take a look at our Building Portfolios page for more details about how we incorporate fixed interest securities into our recommended portfolios.

Regards,

Scott Keefer

This morning I have read what I feel is a very useful piece on Vanguard's website - Just when you thought it was safe to go back in the water.

The article gives a brief summary of current happennings on the markets and concludes by asking what action, if any, should investors be taking?

It suggets the following courses of action (directly taken from the article):

There is no surprise that I fully concur with the thoughts pointed out by Vanguard.  I particularly like the last point.  Now is the time to be reconsidering your risk profile.  Risk profiling is a difficult task.  When you are asked the question how would you feel if your investments fell by 10,20,30,40% it is difficult to provide an accurate response if you have never experienced such falls.  After 9 months (or more for listed property investors) of really tough conditions the question to be asking yourself is how have you gone handling not only the 25% or more falls on equity markets but also the significant turbulence (volatility)?

If your answer is that you are finding it extremely uncomfortable it may make sense to ease back on your growth asset allocation.  Most likely this will have occurred automatically as growth investment values have fallen and defensive assets remained steady but produced income.  However a decision will need to made when rebalancing your portfolio whether to set your growth assets back at the original percentage level. 

If your portfolio still has too great an exposure to growth assets it may have to be a gradual process to rebalance to a more defensive position as ideally you do not want to be realising losses and then see the market turn back up sharply.  One way would be to make sure you don't reinvest income and dividends as they come into portfolios, rather set these aside in cash and fixed interest security investments and by doing so rebalance your portfolio towards a more defensive setting.

Please get in touch if you wanted to discuss any of these points in more detail.

Regards,
Scott Keefer

The latest edition of our fortnightly email newsletter was sent to subscribers on the 16th of September.

In this edition we take a look at the problem with investing using managed funds, provide a summary of the movements in markets over the past fortnight and look at whether you are able to time your entry into and out of risk premiums.

We have included our fascinating financial fact for the fortnight that was included in the newsletter.

If you would like to be added to the mailing list please click the following link to be taken to the sign up page - The Financial Fortnight That Was Sign Up Page.

Fascinating Financial Fact

In August the Association of the Super Funds of Australia published a paper looking at the returns for the past financial year in context of historical returns - Super Returns - putting them into perspective.  The paper looked at balanced portfolio financial year returns over the past 15 years using data from Super Ratings.  (They also provided a table with the past 40 year data.)  The 2007/08 financial year returns have been by far the worst over that period - down 6.8%.  The next worse year was 2001/2002 with a negative 3.5% average return and then 2002/03 with only a 0.1% positive return.  The 2000/2001 year with an average return of 5.6% was the only other year in the 15 year period where returns failed to beat inflation (CPI).

When we look at these one year returns it seems to make sense to question the appropriateness of investing in growth assets such as Australian shares, international shares and property which have been the cause of these years of poor performance.  However, taking a wider view of time periods provides quite a different perspective.  The paper proceeded to look at 5, 10, 15 and 20 year periods putting this issue into wider periods of perspective.

Over the 5 year period leading up to the 30^th of June of each year, the data showed:

-          only in the period 1974 - 1978 did the average returns from balanced investments under-perform inflation.  For those who experienced this time, it was a very difficult time economically with high levels of inflation and poor share market returns

-          in the periods ending 2003, 2004 & 2005 returns went close but still out-performed inflation

Over the 10 year period leading up to the 30^th of June each year, the data showed:

-          the ten year period leading up to 1979 and 1982 saw average balance returns underperforming inflation

-          all other periods provided above inflation returns with most well above

Over the 15 year period leading up to the 30^th of June, the data showed:

-          all periods out-performed inflation

Over the 20 year period leading up to the 30^th of June, the data showed:

-          all periods out-performed inflation

The issue that stood out to me in the data is that we need to be careful assuming that growth returns will be better than inflation over a 5, 7 or even 10 year period, as not until we get to 15 year and 20 year periods do balance returns out-perform.

For those with over 15 years until reaching 60 this should provide some comfort in investing in growth assets in superannuation.

For those approaching closer to retirement more care needs to be taken to properly structure investments so that a period of poor performance in growth asset classes does not provide a significantly detrimental result or even cause you to delay retirement.  Our approach is to be very closely looking at income planning, making sure clients have at least 5 to 7 years of income requirements in retirement held in defensive assets such as cash and fixed interest securities.  This means that you should not need to sell down growth assets in times of depressed prices in order to sustain their cost of living.  (Unless you sell growth assets at depressed prices you do not realise losses and history tells us that growth asset prices will rebound.)

A point to note here is that investing in a diversified superannuation fund or investment that does not segregate the account into distinct defensive and growth assets does not protect an investor from having to realise falls in growth asset prices.  When it comes to the time to retire, investors in non-segregated funds would need to sell down a certain number of units in order to get the income that they need.  In a balance account (40/60 split) this would require redeeming both defensive assets (40% of each unit) and growth assets (60% of each unit). Thus you would be forced to realise the poor prices for growth assets.

In a nutshell, our take on this is that in the 15 years leading up to your preferred retirement date, we think you should start to focus on income planning.  In doing so you are building towards having the necessary amount of assets set aside in cash and fixed interest so that you are not forced to redeem growth investments at the wrong time and/or not having your retirement date dictated to you by investment markets.

Regards,

Scott Keefer

In his latest article written for Alan Kohler's Eureka Report, Scott looks at how to determine a fair valuation for the price of Wesfarmer shares.

He applies the dividend discount model which suggests that if Wesfarmers can produce an ongoing 4.5% annual growth in dividends, the current valuation of approximately $31 is reasonable.  However there are a number of other key issues in play such as economic growth and inflation, the way managers deploy capital, management of debt and the strategy for and market power of Coles.

Click on the following link to read Scott's analysis - What price Wesfarmers?.

I had the pleasure of joining a presentation from Mr Inmoo Lee (Ph.D.) a Vice President from Dimensional Fund Advisors in the United States.  Inmoo along with two other colleagues from Dimensional has conducted research into the relationship between risk premiums and business cycles looking at whether there are systematic patterns and if so whether investors can effectively access better returns utilising these patterns.  (The following is my own summary of the presentation and not that of the researchers.)

Before getting to the results let's first step back and define a couple of key concepts.  For those who have followed our website and our underlying investment philosophy you will be aware that we subscribe to the academic research behind the three factor model as identified by Fama & French.  Fama & French found that there are areas of investment markets where risk premiums exist over the long term.  In particular, small and value companies, taken as a group, hold higher levels of risk for investors and therefore investors expect compensation for taking on that risk. i.e. higher risk leads to higher return in the long run.  (Take a look at our Investment Philosophy and Our Research Based Approach pages for more details)

However, these risk premiums are not present all the time and over short run periods, small and or value companies may under-perform the index.  Currently the Global Value fund that we use in portfolios has underperformed the Large Company fund year to date but has out-performed over 5 years.

Therefore, based on these presumptions which are supported by academic research, the question to ask is can you time your entry and exposure to the risk premiums so that you make the most of periods when the risk premiums are being realised and minimise the exposure when the risk premiums are not being realised and the index (and growth stocks) are performing better.

What Inmoo and his colleagues have done is to look at business cycles as a source of prediction.  Let's stop here and break off for a brief economics lesson first.  The business cycle basically tracks the periods of expansion (growth) and contraction (recession) in an economy.  Throughout history economies move through this cycle moving from periods of expansion, reaching a peak and then contracting, reaching a trough from whence the economy starts to expand again.

Intuitively we should expect that the risk premiums (expected future returns) are greatest at the bottom of contractionary periods (troughs) and worst at the top of expansionary periods (peaks).  The theory being that at the bottom of the market cycles, riskier investments such as small companies and out of favour companies (value) will be sold off the furthest.  Therefore the expected future return is the greatest as these investments are at relatively low prices.

So theoretically, the best time to be buying into risk premiums is at the bottom of the business cycle and selling out at the top of the business cycle.  Inmoo's research actually found that some relationship did indeed exist with small and value areas of the US market out-performing the market going forward from the bottom of the business cycle and under-performing after the cycle reached the peak.

Everyone should be getting excited now as there seems to be an opportunity to trade in and out of the premiums and thus achieve greater returns.  Unfortunately there is a big BUT.  A major problem is that it is very difficult to identify exactly when the business cycle reaches its peak and trough.  The National Bureau of Economic Research in the US has the task of doing just that.  They identified the last peak as being reached in March 2001.  Unfortunately they were only able to make this determination in November of that same year. i.e. 8 months later.  Similarly they identified that the last trough in the business cycle was November 2001 and this was determined in July 2003, some 20 months later.

If an organisation which has this task as its primary focus takes so long after the fact to make a determination, what hope to make the determination beforehand.  This is the key problem.

Now some might say well what does it matter if you miss the peak or trough by a month or two you should still end up with a better outcome.  Inmoo and his colleagues took this very consideration into account.  They found that if you missed your timing either coming in or going out the benefit of the timing decision was statistically non-existent.  Basically the conclusion was that you had to be lucky twice with your timing decisions.  You would have to pick the precise month going in to the risk premium and then precisely time the month when to get out of that area of the market.

Yet again it seems the probability of greater performance is stacked against the "market timers".  A much better approach is to determine your ideal portfolio exposure to risk factors i.e. the market, small companies and value companies, and hold this exposure through time.

If you would like more information about our approach to structuring investment portfolios please take a look at our Building Portfolios page.

Regards,

Scott Keefer

Back on the 26th of July Scott Francis joined Warren Boland on his "Weekends with Warren" segment on ABC radio.  We have eventually caught up and posted Scott's notes from this segment on our website.

In the segment, Scott looked at the topic investing for income.  He commented that "In really volatile times like these, investors often don't think about the income that their investments are paying to them.  Whether it be property, shares, cash of fixed interest, they often focus too much on the price of the investments.  However income can be a great investment benefit, and is actually more important in some ways to investors."

Scott went on to look at the strategy of focusing on income when planning a portfolio.  Click on the following link to be taken to a summary of the segment - Investing for Income - ABC radio segment.

Our page on The Reality of How Investment Marks Work has been updated to reflect more current data up to the end of June 2008. 

This page provides a concise summary of some points that investors should be considering particularly in the difficult investment market conditions we are experiencing at present.  It is well worth a read.

Regards,
Scott Keefer