Balancing risk and opportunity through asset allocation - Australian ...

Balancing risk and opportunity
through asset allocation
AIA Conference
Sydney 2 Sept 2011
Doug Turek
Managing Director

Today let’s try to answer …
Why asset allocation is your most important investment decision
What are the most commonly used Asset Allocations (AA)
What should guide determining yours
What assets belong in your allocation
PW AGSM 0405
-1-

About this presentation
About Doug Turek
PW AGSM 0405
This is general information … not advice
I don’t know you and by law I can’t give you
advice until I do …
… and only in writing and not via a lectern
Please do your own research, or speak to a
licensed financial advisor, before making
any investment decisions
This is © Professional Wealth –contact us
for permission to reuse
-2-
MD Professional Wealth
- Independently owned wealth
advisory and money management firm
Passionate about financial literacy via…
(ABC, Eureka, AIA, Wealth benchmarks)
Former industry consultant with The
Boston Consulting Group
Australian by birth despite accent

What drives your investment experience and results more?
Choosing between …
BHP vs. RIO
CBA vs. ANZ vs. WBC vs. NAB
WOW vs. WES
DJS vs. MYR
Ubank vs. ING Direct vs. Rabobank
Unit 11 with a garden vs. Unit 31 w/ a view
or
Shares vs. cash
Australian vs. International shares
• Hedged vs. unhedged currency
• Developed vs. Emerging markets
Cash vs. TDs vs. Bonds vs. Hybrids
• Fixed vs. floating vs. Inflation-linked
Listed vs Unlisted vs Direct Property
• Residential vs. Commercial
Index vs. active management
Core vs. satellite exposures
Commodities? Collectables? Gold? …
PW AGSM 0405
-3-

Some say allocation drives 90% of performance
Determinants of Portfolio Variance
Asset Class
Selection
94.0%
Market
Timing
2.0%
Security
Selection
4.0%
Source: Brinson, Hood, Beebower 1986 study of 91 pension fund returns over one decade
PW AGSM 0405
-4-

Asset allocation is the architecture of your portfolio
whereas “ Investment selection ” is the interior design
PW AGSM 0405
-5-

Wrong Asset Allocation is the #1 of 7 deadly sins of wealth management
1. Have wrong asset allocation (incl. too little of … and too much of …, none of …)
2. Not optimally structured (eg. super incl. pensions, income splitting, debt structure)
3. Inefficient investment style (incl. tax, fees, risk/reward , too active …)
4. Poor investment “process” management (eg. monitoring, rebalancing, time-averaging)
5. Un- or under-insured (incl. newly retired’s young adult children)
6. Incomplete Wealth Succession and “Investment Dementia” planning
7. Infected with “Affluenza”
Source: Professional Wealth
PW AGSM 0405
-6-

Fancy knowing how others invest (earn, have in super …) ?
PW AGSM 0405
-7-

Wealth benchmarks average asset allocation
Include the home?
Exclude home
Shares
Property
Cash
Property
© Wealth benchmarks
PW AGSM 0405
-8-

But averages can be deceiving … % break down of AA by investor
Group of
investors
all in cash
Group of
investors all
in property*
© Wealth benchmarks % equity-like
Group of
investors all
in shares
Diversified
investor
group
PW AGSM 0405
* Out of total 40% who invest in direct property
-9-

Common portfolio types and asset allocation biases
DIY
The brokered
The Planned
& Industrialised
Bricks/ Mortar
Cash/TD*
Top 10
shares**
*23% on avg at 20110630
**ASX top 11 ex-Telstra
(from Multiport SMSF study)
Australian Shares!
Int’l LICS
REITs
Hybrids
(all ASX listed,
+++ equities)
Managed Funds
(Retail Planner)
+ incl. 30% illiquid
(Industry fund)
Rental properties
Mostly residential
Drivers: Investor need or supplier business model? Behaviour/philosophy, …
PW AGSM 0405
-10-

Australia investors are 3 rd biggest equity (%) investors in the world …
and lowest investors in bonds
PW AGSM 0405
-11-

10,000,000.0
1,000,000.0
Australian investment returns 1880-2010
Annualised Return (%)
Price Yield Total
Shares
100,000.0
10,000.0
Company shares 6 5 11
Residential property 4 3 7
Government bonds - 5 5
Cash 90 day deposit - 4 4
Inflation (cpi) 3 - 3
© Professional Wealth
Property
1,000.0
Bonds
100.0
Cash
10.0
Inflation
1.0
1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
PW AGSM 0405
0.1
-12-

Equities AND bonds can work together
$2,000,000
100%B
$1,800,000
50%E/50%B
100%E
$1,600,000
$1,400,000
50:50 rebalanced mix
All Australian shares*
All Australian bonds
$1,200,000
$1,000,000
$800,000
31-Dec-04 31-Dec-05 31-Dec-06 31-Dec-07 30-Dec-08 30-Dec-09
*incl. dividends
PW AGSM 0405
-13-

What is the right balance for you?
Defensive
PW AGSM 0405
-14-

Factors driving your overall “equity-bond” mix (I)
Your pain threshold
• emotional risk-tolerance, equity-flight risk
Risks you need to take or don’t
• Need to fund lifestyle choice, or don’t need to if have enough
Risk you can afford to take (“risk budget”)
• If funding a pension, if only just have enough
Other assets you have/will
• Earned income? Other DB pension? Business? Inheritance?
“Intra-entity tax optimisation”
PW AGSM 0405
-15-

Historic trade-offs between return and volatility-risk
Investment Return
(% pa)
For portfolios with increasing % of equities (defensive>aggressive)
0% 20% 40% 50% 60% 70% 80% 100%
Average annual (% pa) 6.9 7.9 8.6 9.0 9.3 9.7 10.0 10.3
1 Year
Worst
Best
2.4
15.7
-2.7
18.2
-12.1
23.3
-17.2
27.5
-21.8
31.8
-26.2
37.1
-32.1
42.1
-39.6
52.1
5 Years
Worst
Best
5.3
9.4
5.4
10.8
4.6
12.3
4.0
13.1
3.4
14.5
3.3
16.4
2.8
18.1
1.0
21.1
10 Years
Worst
Best
5.5
7.9
6.1
9.4
6.0
10.7
5.9
11.3
5.7
12.1
5.8
13.0
5.7
13.5
4.8
15.1
Frequency of negative
year returns (1 in # yrs)
~ 20 10 8 7 6 5 4-5
Based on monthly returns for 20 years to 20100830 including through GFC
PW AGSM 0405
-16-

Factors driving your overall “equity-bond” mix (II)
Your pain threshold
• emotional risk-tolerance, equity-flight risk
Risks you need to take or don’t
• Need to fund lifestyle choice, or don’t need to if have enough
Risk you can afford to take (“risk budget”)
• If funding a pension, if only just have enough
Other assets you have/will
• Earned income? Other DB pension? Business? Inheritance?
“Intra-entity tax optimisation”
PW AGSM 0405
-17-

Most pension funds can’t afford volatility/risk
Return (%)
Fund / Portfolio / Series Steady Volatile
Year 1 9 -10
Year 2 9 30
Year 3 9 -10
Year 4 9 30
Year 5 9 -10
Year 6 9 30
Year 7 9 -10
Year 8 9 30
Year 9 9 -10
Year 10 9 30
Average Annual Return (%) 9.0 10.0
Standard Deviation (%) 0.0 20.0
Growth of $100,000 $ 236,736 $ 219,245
Compound Annual Return (%) 9.0 8.2
Balance of $1m after $100k pa pension $ 711,334 $ 459,891
PW AGSM 0405
-18-

Life stage / lifecycle investing – “have your age in bonds”
PW AGSM 0405
-19-

Factors driving your overall “equity-bond” mix (III)
Your pain threshold
• emotional risk-tolerance, equity-flight risk
Risks you need to take or don’t
• Need to fund lifestyle choice, or don’t need to if have enough
Risk you can afford to take (“risk budget”)
• If funding a pension, if only just have enough
Other assets you (will) have
• Other DB pension? Business sale? Inheritance? Earned income?
“Intra-entity tax optimisation”
PW AGSM 0405
-20-

Work & Wealth
also inter-relate
Contracting Part-time
Overseas
Directorships Consulting
?
Teaching
Venturing
+ $
Charitable
Family
Leisure
-$
Earn ?
Pay = expenses
Lets investments
compound,
postpone drawing
Invest
Retirement
has been retired
PW AGSM 0405
-21-

Equity / bond mix
Australian vs. International equity (hedged vs. unhedged) ?
Small companies vs. large?
Growth vs. value?
Industry Sectors? Income? …
Property trusts or direct?
Listed vs. unlisted?
Commercial vs. residential? Developmental vs. passive? …
Cash vs. TDs vs. hybrids vs. bonds vs. mortgage trusts vs. ……..
PW AGSM 0405
Alternatives ….
-22-

International diversification and currency protection
Markets by Sectors
Top 10 Companies and % of market
2.9%
4.3%
6.2%
10.6%
Australia
43.1%
4.8%
9.9%
The World
12.0%
4.1%
0.5%
21.0%
8.5%
Australia top 10 stocks and size % World top 10 stocks and size %
BHP Billiton Ltd 14.1% Exxon Mobil Corp 1.2%
Commonwealth Bank of Australia 8.6% Apple Inc 1.0%
Westpac Banking Corp 7.5% Microsoft Corp 0.8%
Australia & NZ Banking Group 6.5% Procter & Gamble Co 0.7%
National Australia Bank Ltd 5.8% Nestle SA Reg 0.7%
Woolworths Ltd 3.9% HSBC Holdings Plc 0.6%
Rio Tinto ltd 3.6% Intl Business Machine Corp 0.6%
8.8%
9.5%
Wesfarmers Ltd 3.6% Chevron Corp 0.6%
Newcrest Mining Ltd 3.3% AT & T Inc 0.6%
27.2%
10.4%
10.7%
Westfield Group 2.9% General Electric Co 0.6%
Total Australian Top 10 59.7% Total MSCI Top 10 7.4%
Source: iShares MSCI Australia and ACWI index at 30 September 2010
Australian market is 2/3rds
banks & resources
Top 10 Australian stocks = 60% of market
vs. 7% for top 10 Int’l companies
PW AGSM 0405
-23-

Small and value stocks sometimes outperform
Long-term low priced large-company returns vs. large, high priced vs. small companies:
(% pa)
Source: Dimensional Fund Advisors
PW AGSM 0405
-24-

Outlook for property?
Prior to latest run up property
prices rose at inflation +0-1%
Recent
Australian
boom and … ?
US boom
and bust
PW AGSM 0405
-25-

Shares and Property (not or)
Shares
Property
Interest in a company
Interest in land and a building
Value tied to profits (dividends)
Value tied to rental income and also
… and also expected future profits
… appreciating land and depreciating bldg
Tax benefits (imputation, CG, gearing) Tax benefits (dep’n, CG, gearing)
No holding costs
Holding costs (taxes, maintenance)
Divisible
“Lumpy”
Liquid and low transaction costs
Illiquid and high t/x costs
… volatile pricing (+39%, -43%, …) … stable pricing (~ 5%pa or ???)
… leverage able 50-75% … leverage to 90+ %
Intangible
Tangible
PW AGSM 0405
-26-

Can you have too much cash?
Average silver content of 10 European countries’ coins (grams)
Do you suspect there is still a pound of silver in a GB £ Pound Sterling?
Source: Reinhart and Rogoff
PW AGSM 0405
-27-

Australian inflation experience – time for a change?
Negative
High
Low
High
Low
(on gold
standard )
Inflation persists, over long periods (doesn’t mean revert)
Likely to encounter inflation over 30 year long retirement periods
Recent 20 year absence long enough for it to surprise again
PW AGSM 0405
-28-

Inflation can be unkind to retirement portfolios
$2,500,000
$2,000,000
$1,500,000
$1,000,000
$500,000
Actual retirements
from 1875 – 2008
Early failures were
during high inflation
periods (eg. 1970s)
and not from
retiring through
poor investment
eras (eg. 1930s)
$0
© Professional Wealth
0 5 10 15 20 25 30 35 40
1970 start 1930 start
PW AGSM 0405
Projection of $1m retirement balance invested earning actual year-year returns before 1.5% pa taxes/fee, not averages, for 60/40 Australian
equity/bond portfolio for retirements beginning in 1875 and every 2 nd and 5 th year thereafter. Initial 6% drawdown adjusted by actual inflation for
subsequent years.
-29-

Inflation linked bonds might strengthen your defense
Cash
Nominal
bonds
Inflation
linked
bonds
Interest rate linked
CPI linked
PW AGSM 0405
-30-

How different cash/bond components might work together
Inflation linked
Long term inflation protection
Higher yield from longer
bonds (safer than if from
nominal bonds)
Match real liability
DIY annuity?
Short-term FI,
cash,
floating
notes?
Long (or
medium)
term fixed
nominal
FI
Or add ….
and
High Yield?
PW AGSM 0405
Capital protection, short-term
inflation hedge, liquidity for
income and rebalancing,
overall portfolio volatility
reduction
De/dis-inflation protection
(Capital gain if i-rates drop)
Volatility reduction from –ve
correlation with equities
Lock in higher income
-31-
+ Higher return from credit
risk from non-investment
grade bonds? Use equities
instead?

Fancy something alternative?
Gold and other precious metals
Other hard commodities and oil
Soft commodities (eg. agriculture)
Infrastructure
Private equity
Hedge funds
Art and other collectables
…
ETFs and indexing
Core-satellite constructions
Portfolio protection
PW AGSM 0405
-32-

Example portfolio mixes from defensive to aggressive
Truth in labeling? “balanced growth”, “assertive” , “alternative defensive”, …
Source: Morningstar
PW AGSM 0405
-33-

Investment portfolios like a garden need occasional pruning
PW AGSM 0405
-34-

Rebalancing controls risk & may reward - example equity/bond mix
+10 %
Target
-10 %
PW AGSM 0405
-35-

PW AGSM 0405
-36-

An unmanaged property portfolio?
PW AGSM 0405
-37-

Know more about your investment performance than your car’s!
PW AGSM 0405
-38-

Dr Douglas Turek
Managing Director
Professional Wealth Pty Ltd
AFSL No. 369453
13/350 Collins Street
GPO Box 4975
Melbourne VIC 3001
Australia
p 61 3 9605 0600
e dturek@professionalwealth.com.au
w www.professionalwealth.com.au
PW AGSM 0405
-39-