The return of lifetime annuities!??!

I just read that the Henry Review is likely to suggest that superannuation can be exchanged for guaranteed lifetime income like lifetime annuities. Strangely, it can be done already by purchasing a lifetime annuity with superannuation money. The problem with the current situation is that there are no lifetime annuities left on the market....Comminsure and not much else.

Hopefully this initiative re-opens competition for this outstanding product, except, instead of the current situation, hopefully the new products are priced appropriately. Yields for lifetime and long term anunities have a long way to go to be attractive.

Economist Magazine says Australian housing overvalued by 50%!!!

I started reading this week's Economist mag yesterday and the lead article is about the asset bubbles that are appearing all around the world thanks to low interest rates. Article can be found here for subscribers.

In terms of housing the article suggested that the US is at fair value, whilst Britain is 30% overvalued, and Australia, Spain, and Hong Kong are 50% overvalued based on the current level of rental yields. Commodities were mentioed as being overvalued and as with my last post, so too are Emergin Markets.

"Today the prices of many assets are being held up by unsustainable fiscal and monetary stimulus. Something has to give"

I guess I'm off to a bearish start to the day today.

Why shouldn't I invest in China?

There's an excellent article in the 12 Jan Financial Times on investing in emerging markets...found here. The basic message is that there is no correlation between GDP Growth and stockmarket performance, in fact its slightly negative if anything, so be wary when investing in emerging markets.

According to Professor Jay Rittner of the University of Florida,

"Countries with high-growth potential do not offer good investment opportunities unless valuations are low"

Another interesting point made was that in fast growing economies, the companies that end up winning the race may not even be known yet.

"In the 1950s there were more than 100 motorbike companies. The market leader was driven out of business by the cut-throat pricing of a flaky upstart called Honda"

The conclusion in terms of value is that the biggest emerging economy of them all, China, is in a current bubble and valuations are far from low, in both equities and real estate, where valuation metrics are above what Japan was at its peak in 1990. What is frightening with regards to China's valuations, is that twenty years after Japan's peak, its equity market is still trading around 70% lower.

Bottom line, be careful of investing in Emerging Markets and secondly, don't forget Australia's current reliance on China as any bust could be catastrophic for both our economy and markets.

Current thoughts on some investing risks and themes

We have seen numerous investment trends come and sometimes go over the last X number of years whether it be technology, commerical property, Buffettology, CDOs, high yield, hedge funds, mortgage funds, etc, but at the end of the day a balance of the key investment risks wins through....i.e. the risks relating to equity, liquidity, interest rates, credit, currency, and inflation.

These are my current thoughts on these risks and some investment themes...

• Liquidity Risk - forgotten for many years (particularly by the MTAA Super fund, and mortgage investors...remember Estate Mortgage???) but it still exists...forget chasing returns and having liquidity at the same time!!! Know what liquidity you need and hold CASH...not the so-called liquid Asian High Yield securities Basis Capital used for liquidity or even Enhanced Cash funds...CASH in a bank or pure Cash Management Trust that get's it returns from 11am, government securities, and bank bills.
• Equity Risk...guess what? equity risk doesn't just turn up in...equities! It can also be found in corporate bonds, hybrids, hedge funds, property securities, and many others...it is essential to understand the true equity risk a portfolio has and don't push some of that risk into the more conservative asset classes like fixed interest. Equity risk can be scary, is required for growth, and shouldn't substitute for anything else...like...an inflation hedge!...investing in equities is often a poor hedge to inflation as the 1970s showed...high inflation is not good for equity performance at all
• Interest Rate Risk...too many have ignored this one...but it can work in your favour in a crisis and can provide some portfolio stability...stockbrokers should try them some day...the whole "everything correlates to one in a crisis" is absolute rubbish...during the global financial crisis, those who diversified their portfolio with pure interest rate risk (i.e. little to no credit risk) from boring government bonds or conservative bond funds received double digit returns from this risk. During a crisis, investors run to quality and boring government bonds are just that...why don't retail investors want to invest in quality???
• Credit risk...in times of crisis this is highly correlated with equty risk...as a result when building portfolios ensure your credit securities do not result in overweighting the exposure to equity risks. However, always keep in mind that credit securities have a negatively skewed return distribution...limited upside with massive downside...so why not just invest in equities instead and leave the fixed interest to boring governemnt bonds???
• Currency risks...what's the Australian dollar going to do? Answer...absolutely no idea. So what to do? Being unhedged was favourable during the GFC as Yen carry trades returned to Japan and the flight to safety went to the US (yep....good ol' Australian currency wasn't considered that safe!). So perhaps unhedged is the go...however, the reverse was true in the recovery...market timing is very very difficult so if you don't know, and I don't, perhaps 50% hedged, and 50% unhedged is the go for global share allocations. Its difficult to invest in international bonds without being hedged to the Australian dollar...I guess if you want ot investin bonds for their safety and income then currency risk removes the safety aspect and perhapd hedged is best.
• Inflation risks...this is my favourite...bonds are best during deflation but the only investment that (hopefully) guarantees strong performance during high inflation is INFLATION LINKED BONDS!!! Governments around the world, including Australia, are issuing more...woohoo!...let's get on board and reduce inflation risk from our portfolios. Life companies issue inflation linked annuities also...let's look at them as well.
• Commodities can also can be a good inflation hedge also but they certainly carry a few other risks but are worthy considerations as they provide diversification with other asset classes. The only thing with commodities is...they mostly supply and demand driven!...there's not really much added value there, so...good luck with picking supply and demand!!!
• Hedge Funds...these guys carry equity risk and/or credit risk...when markets crash...SO DO Hedge funds...the marketing myth of positive returns in any market has been exposed by the GFC and there's two other things...its very very difficult to get your money out and their fees are so big that they have to take on significant risk to get the return...but at the end of the day if you don't know how a fund invests you don't know the risks so...don't invest in hedge funds!
• Emerging Markets...all the rage because of their economic growth...guess what...there is no evidence that shows high returns from countries displaying high economic growth. If Emerging markets aren't in a bubble today...they probably will be tomorrow...so proceed with caution. 
• Mortgage funds...they're gone for a long time
• Australian economy...had an amazing run and is the leading economy in the developed world but keep this in mind...we're basically a hole in the ground and reliant upon commodities. If the emerging economies falter and decide to stop buying our commodities then look out Australia...things may not be so rosy...just keep it in mind...and stop being so complacent about the Australian economy...I know you are so stop it!
• Property...I think I need a new Post for this one! Stay tuned

Perhaps House Prices are a bit high in Austraila?

It appears there is a breakdown in the relationship between unemployment and house prices. I hazard a guess that its due to the low home loan interest rates we currently have (see my previous post) but given it appears the Reserve Bank looks like increasing rates further this year, for how long will this breakdown last?...probably not too long...my guess....house price growth is unlikely to be sustained and the property purchaser needs to be careful.

Low Interest Rates for some but not all

Source:RBA

The above chart shows the changes in interest rates since the start of 1997 for 3 different bank loans...

1. Credit Card Interest Rates
2. Personal Loan Variable Interest rates
3. Home Loan Standard variable interest rates

Now, over the past 18 months we have all heard about ow the banks have not been passing on all of the RBA interest rates cuts and passing on even more than the RBA's interest rate increases. This piece of information relates to the Standard Variable home loan rates which as the green line shows, as at the end of November, is at roughly the lowest levels since the beginning of the chart in 1997.

Unfortunately for those stuck in the debt trap of the personal loan or credit card, interest rates continue to be historically high...despite lower Reserve Bank rates, credit card and personal loan rates were lower just over 2 years ago and were never higher from the start of the chart in 1997!!! No wonder the rich get richer and the poor get poorer.

The last 12 months....Australian Government Bond Yields

Certainly an interesting 12 months has transpired in financial markets. The above chart shows the movement in the AUstralian Government Bond yield curve and this time last year the sever downward slope indicated the market was expecting the Reserve Bank to drop interest rates to below 3% during 2009. Clearly that didn't happen but there was a rapid decline down to 3% which was maintained until the last few months.

The yield curve was incredibly steep at 22 Jun 09 indicating an expected strong economic bounceback, however over the last six months the longer term yields have dropped suggesting the economic outlook has subdued a little. What we are left with is still a strong upward looking curve which is a good sign for economic prospects and the market appears to expect continued interest rate rises by the Reserve Bank. However, with a one year government bond yield of approximately 4.25% the expectations of the level of interest rate increases appears to have diminished a little so there's no guarantee of a rate rise in February but a good chance of a 25bps increase in March or April.

A Simple 2009 Review and Outlook piece for clients

The year 2009 has turned out to be a significant turnaround year for the global economy and sharemarkets. At the start of the year, the word depression was mentioned often as many economists, investment professionals and politicians thought entering the world’s second great depression was a potential reality. Thankfully, around March 2009, “green shoots” of the global economy started to appear and whilst they haven’t blossomed into anything too beautiful, we have at least witnessed the emergence of many other “green shoots” that have improved conditions in credit markets, share markets, and in the US some positive signs in their housing market.

Sharemarkets bounce...
For investors in sharemarkets, the year 2008 was one they would rather forget and this continued into the first quarter of 2009 where the S&P/ASX200 index bottomed at the start of March. This was the lowest level for the sharemarket since 2003 but despite a lot of paper talk of the market potentially going lower, as is often the case, when the news out of the sharemarket is at its worst prices start to rise. Although the news continued to be bad it wasn’t as bad as expected and between March and October the S&P/ASX200 increased by almost 60%...an astonishing rebound.

The same was true for global shares despite the US, Japan, and Europe’s economic woes that continue today. For the global share investor, returns were also strong double digits. Unfortunately, for the unhedged investor, which is most of us, the strength of the Australian dollar reduced investors global sharemarket gains and many may well see negative performance for the 2009 calendar year.

Bonds subdued...
The economic “green shoots” that contributed to the increase in sharemarkets from March of this year also contributed to increases in interest rates. Unfortunately for the bond investor, an increase in interest rates results in the decline in the value of bonds. For the local bond investor the strength of the Australian economy resulted in some of the strongest interest rate rises in the world and overall returns for Australian bond investors may well be flat. Global bond investors have fared a little better as the overseas economies have struggled significantly more than in Australia and interest rate movement has been minimal to negative. As a result global bond investors may see annual returns between five and ten percent.

Economic Landscape...
The Australian economy has certainly fared very well compared to the US, Europe, and Japan and this is largely due to three main factors:

1. Strength of our banking system which is significantly more conservative than some of the largest banks in the world
2. Strength in our commodity export sector and geographci position close to Asia. This has provided the ability to leverage from the significant growth in China
3. Strength of our government’s balance sheet who in the good times had budget surpluses allowing these savings to be used for the tough times that turned out to be the global financial crisis

Looking forward it is near impossible to know how investment markets will perform but indications are that overall the global economy will be slow as global households continue to reduce debt and high levels of unemployment (which are expected to still rise) provide a drag on consumer spending. Whilst the global economy is improving there remain significant risks as evidenced by the default in its debt payments by Dubai World. Credit markets are far from normal and this is a strong indication that full recovery is a long way off yet.

In Australia, markets have priced in further increases in interest rates by the Reserve Bank with another 0.5% of rises expected by March or April 2010. Rising interest rates is a sign of strong economic conditions so with a bit of luck if there are no further economic shocks there is a stronger sharemarket into the first half of 2010. Given the volatility of sharemarkets this is far from a sure thing but on the positive side, we are coming from the worst global economic conditions since the Great Depression and we are still a long way off our sharemarket highs which were reached in November 2007.

Australia's unemployment creeps back to 5.8%

With the government downgrading its June 2010 unemployment expectation to 6.75% it appears we will be creeping there slowly given we have been around 5.8% for much of the last 6 months. This is largely thanks to a drift from full time to part time employment and of course the downside is that on average we are working much less and therefore earning less.

The number of unemployed persons in Australia is now 669,000 (increasing by 34.3% over the last 12 months) and this is the highest since late 2001. From an Australian perspective, we must be thankful thta we are no where near the horrific unemployment levels of the US at 10.2%...things must be very tough there with small signs of recovery but most economists believe that US recovery will exclude employment growth.

Economic Growth does not mean High Equity Returns

One of the more frequent queries I receive is from planners who want to invest their client's funds into high economic growth countries of India, China, and emerging markets. My response is fairly standard in that I wonder why they believe that would provide their clients and the response is typically along the lines of "their growth potential is greater than the rest of the world".

Last week, one of my favourite bloggers, Buttonwood (The Economist), provided commentary on this phenomenon, titled "The Growth Illusion". I know I'm doubling up and perhaps you can read it yourself but in essence, "the faster an economy grows does not mean the faster corporate profits grow and therefore the investor receives higher returns". A study performed performed by Dimson, Marsh and Staunton (they're a few academics involved in the production of Credit Suisse's Global Investment Returns Yearbook this year), showed that there was in fact a "negative correlation between investment returns and growth in GDP per capita, the best measure of how rich people are getting"...so no go there.

A second study showed that the better returns from 1990 to 2005 did not come from the highest growth economies. And a third study showed "no statistical link between one year GDP growth rate and the next year's investment returns".

Another study by Paul Marson of Lombard Odier, showed there is no correlation between GDP Growth and Stockmarket returns of Emerging Markets.

The most likely reasons for all of this rests with a few reasons stated in the Buttonwood blog...

• the potential is already recognised and factored into prices so that they are bid up to very high levels
• the stock market does not represent a country's economy and vice versa
• "growth is siphoned off by insiders at the risk of shareholders"

The best recent example I can think of is China. It may have had one of the best growth rates in 2008 but the sharemarket still crashed by 70%. With all of this good news flowing through for the month of August China's stockmarket was still down 20% (albeit up by 70% beforehand). Maybe investing in a growth economy will produce the good or maybe it won't, but as the first point above alludes to...everyone knows this so why wouldn't it already be priced in?

Bond Fund Correlations

The above chart shows the 6 month daily correlation between Hedged Global Shares and four Australian bond funds...

• Tyndall Australian Bond
• UBS International Bond
• Macquarie Diversified Fixed Interest
• Principal Global Strategic Income Fund

Each fund is different. Tyndall is invested in high grade Australian bonds, UBS International in high grade global bonds, Macquarie is 60% Australian bonds, 40% global and also takes on some investment grade credit risks, and Principal's fund invests in high yielding securities including hybrids, asset backed securities, junk bonds, as well as some conservative bonds. All global exposures are hedged to Australian dollars.

What this chart demonstrates is the increasing correlation between Principal and hedged international shares from mid 2007, the start of the credit crunch. Basically, diversification benefits did not really exist for the high yielding investment.

However for the other funds, which had conservative bonds as a high proportion, their low correlation with hedge international shares shows their diverisifcation benefits in tact.

So a simple conclusion is...whilst high yielding investment may giove you the opportunity for higher returns, don't think they will provide diversification benefits if sharemarkets tank. With a weak outlook for shares, so too is the outlook for companies to pay their debt so the price of low-grade credit can fall significantly also. A final point, which is often overlooked...bonds have limited upside...at maturity the most you will ever receive is the face value...that's it.

Is there value in inflation linked bonds?

The RBA provides daily reporting on three Treasury Capital Indexed bonds. They each mature in the month of August in 2010, 2015, and 2020 and are currently yielding 2.40%, 3.11%, and 3.02% respectively as at 30th June 2009. If we compare these Capital Indexed yields to the Treasure Fixed Rate yields for similar maturing securities we achieve the market's estimation of inflation over the term to maturity.

The yield of the Treasury Fixed Rate Coupon Bond maturing August 2010 is 3.45% indicating the expected inflation through to August 2010 is 1.05% (i.e. 3.45% - 2.40%) which is clearly very low.

Applying the same logic using April 2015 and April 2020 Fixed Rate Bond yields of 5.32% and 5.62% respectively we achieve an inflation outlook of 2.21% and 2.60% over each respective term.

The inflation outlook is:

• 1.05% to August 2010
• ~2.21% over the next 6 years to 2015, and
• ~2.60% over the next 11 years to 2020

Whilst I agree that inflation is likely to be relatively low over the coming years, for the fixed rate investor, inflation will always be a significant risk. If you invest in a government bond yielding 5.62%pa over the next 11 years high inflation could easily wipe out any value in this type of investment. As a result, despite, these subdued inflation outlooks, there appears to be significant long term value in inflation linked bonds whilst yields appear to be at historically low levels and also whilst the outlook for inflation appears low.

The risk for the inflation linked bond investor is that inflation turns out to be even lower than the above-mentioned forecast...if you think inflation will be lower than stick to the fixed rate bond, otherwise inflaiton linked bonds are definnitely worth serious consideration.

Australia's Steep Yield Curve

An incredible steepening of the yield curve has occurred throughout 2009. As can be seen the latest 10 year bond yield isn't too far from where it was in the middle of 2008. This yield curve tells us several things about the state of current markets and economy...

• the market is starting to think that the next RBA move will be an increase in interest rates and not a drop...the 3 month yield is only 2.95% versus the 3% cash rate and longer term yields are above 3%
  
• The steep normal looking yield curve is typically a sign that Australia's economy is looking up and this steepening has increased throughout the year in line with increasingly positive news
  
• The sharp increase in steepness has happened so quickly....does this mean that bonds are oversold?

Overall this is a good looking positive yield curve despite global economic news continuing to be mixed. We are still in the 'green shoots' phase of a global economic recovery so this steep yield curve looks to be a relatively attractive buying opportunity to me.

Style Biased Index Funds - the Future of Managed Funds

Index funds were born out of modern portfolio theory which suggested that the highest risk-adjusted return should come from purchasing the market portfolio. As it is impossible to purchase market as a whole, the index fund effectively replicates the market by purchasing a large proportion of the market with each stock’s weighting proportional to its market capitalisation. Around the world, this method has been replicated across all asset classes. In Australia, the available index funds are mostly limited to the major asset classes. Some geographic index funds, like BRIC, China, S&P500, etc are also available as well as specific sub asset classes like Global Credit index funds. There is little doubt index funds provide a low-cost way of providing investors exposure to specific markets without the active management risk of the 'bad bet'.

The current bear market has resulted in many investors looking for simplicity, transparency, and low costs and index funds satisfy all criteria. Whilst many wealth and funds management companies have suffered during the Global Financial Crisis, index funds have thrived. Barclay’s have released a wide array of listed international index funds, Vanguard also released some exchange traded funds and only yesterday announced they are moving into larger premises and hiring an additional 8 sales professionals. And now, in Australia the index fund has another variety with the introduction of Research Associates' Fundamental Index (RAFI) and various investment products linked to this index approach.

In recent weeks I have received more queries regarding this new index method than anything else (except the ubiquitous structured product). It is marketed as an alternative to traditional index funds and its difference is that it doesn’t use a company’s market capitalisation as the weighting determinant but uses measures such as sales, profits, dividends, amongst others. The founders of RAFI believe traditional indices overweight overpriced stocks and underweight underpriced stocks and they believe this new method overcomes this flaw. Despite the strong support the fundamental index has received locally and overseas, there have been many critics.

The main criticisms of the Fundamental index method are that it resembles an ‘active value strategy in disguise’ requiring numerous subjective decisions around stock selection. As a result of this, many believe the fundamental index is not efficient when compared to multi-factor quantitative strategies. Even if these arguments are true, at this point in time they are fruitless arguments in Australia because accessing passive strategies that are different but priced similarly to traditional index funds are few and far between (the one exception is DFA which is not necessarily easy to access as an adviser). At least the fundamental index investments are around 40bps cheaper than active equity managers and this is a significant cost saving over the long term. With this cost saving if its stated return premium is due to a value bias then as long as this bias/risk is understood there is nothing wrong with that. With the exception of the DFA funds, to achieve a value bias typically costs a lot more than the RAFI funds.

Back to the critics opinions…belief in the so-called efficiency of multi-factor quantitative strategies creates an opportunity in the Australian funds management industry. Globally, it is widely acknowledged that over the ‘long term’, equity portfolios biased towards...

• low price to book,
• small companies, and more recently,
• companies exhibiting performance momentum (i.e. performed well over the last 3 to 12 months)

...outperform traditional indices on a risk-adjusted basis. Accessing these style biases in low cost ways cannot easily be achieved in Australia for the retail investor. Perhaps this is the future of equity index investment in Australia.

For the active manager style biased index funds will be a significant threat. The active manager will have new truly investible benchmarks and they will have to prove their skill against low cost funds with similar style biases. This in turn could reduce costs due to increased competition and only the strong will remain. The active manager often hides behind their style bias when underperformance occurs, however, with style biased index funds in direct competition this will not be an excuse.

The introduction of the fundamental index products are an excellent addition to the Australian managed fund scene and moving forward I look forward to seeing more low cost, style biased index funds to provide more efficiency and choice for the retail investment portfolio.

Deflation...how to invest?

Source: IMF

The above chart shows the IMF's global inflation forecasts and they don't look pretty. They are forecasting that advanced economies might by in a position of deflation similar to what Japan experienced in the 1990s. Many would argue that deflation is just as or almost as bad as high inflation. Deflation is simply the decline in prices and what this means is that if you as a consumer believe that prices will be cheaper tomorrow then you will not spend today and save your money. Not spending means lower revenue today, therefore costs need to be cut, jobs are lost, followed by less spending and the vicious cycle continues.

From an investment perspective, the above-mentioned vicious cycle results in declining profits which is therefore a negative for equities, credit, and as it often leads to near zero interest rates is not particularly good for cash either. The one asset class that is a good place to be in times of deflation are high grade bonds. Because inflation is the bond investor's enemy, deflation is their friend. As interest rates, prices, and profits decrease during the deflationary cycle, high grade bond investors receive a fixed interest rate that doesn't lose its purchasing power but actually increases it.

So whilst, governmet bonds had an incredible run in the 2008 calendar year, with deflation looking like a possibility in 2009 perhaps now is not the time to discount their value in a diversified portfolio.

Hedge Funds...struggling

Back on January 20 in this blog I predicted that one of the trends of 2009 will be the demise of the hedge fund...

http://www.bloomberg.com/apps/news?pid=email_en&refer=home&sid=a8uLPVL9X8yY

...I might be right. The hedge fund used to thrive in tough times...not this time.

Target Date Managed Funds - the next big managed fund in Australia?

There’s a big trend in the USA for target date retirement funds. These are managed funds whose goal is to provide funds for a specific date and the investment strategy is such that it invests in equities in the early part and progressively switches to bonds through to maturity whereby the majority of funds will be invested in bonds (or at least a large proportion). The logic appears sound whereby take all the risk when there’s lots of time before expiry and reduce the equity market risk as the target date approaches. Given the dissatisfaction of the ‘set and forget’ asset allocation approach, will Target Date Funds become the next big thing in Australia?

 

Either way, they are loaded with efficiency problems and although Vanguard appear to supportive of them there’s 2 academics in Queensland currently doing some interesting papers on these funds, Professor Michael Drew and Dr Anup Basu, and exposing some of their problems. Look out for their upcoming paper in the Journal of Portfolio Management.

Trends for 2009

• Demise of the “absolute return” hedge fund…they said they can provide positive returns in any market and in 2008 they didn’t deliver. Marketing hype that will hopefully go away and replaced with full transparency that discloses where their true risks lie. On the positive side, many hedge funds are wonderful investment vehicles that have the potential of providing a portfolio with return potential and diversification by taking on “non-traditional” risks…whether it be credit, emerging market, optionality, commodities, etc.
• The comeback of simplicity…traditional investments like shares, cash and bonds will be back in vogue for the adviser ahead of structured products and hedge funds. Multi-manager funds also could make a comeback as advisers and/or their clients realise they need to keep investment selection simple. Ditto for index funds as many active managers have once again shown themselves not to be so skilful after all.
• Increased regulation for financial services… ASIC is taking margin lending under its wing and with the demise of Storm Financial, and numerous diversified financial services companies there is only one way for regulation to go.