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Insights – Financial adviser

Foot on the Gas? Key Forward Drivers of the Energy Sector

By Insights - Financial adviser, Insights - Institutional investor

The Energy Sector has suffered more than most in 2020, as a global collapse in the oil price and economic activity set share prices on a plunge from which we have only seen a small glimmer of a recovery.

But what are the prospects now for this sector as we come to a key signpost in the coronavirus crisis, with lockdowns starting to ease globally?

Figure 1: The chart below displays Year to Date (YTD) and 1 Month (1 mth) total returns for selected ASX listed Energy stocks as at close 7th May 2020. (Source: Refinitiv, Resonant Asset Management)

Many Levered Up Balance Sheets

Amplifying the misery has been an overly aggressive capital structure in many of the stocks, some of which may need to raise capital should the commodity remain at historic lows.

Figure 2: Net Debt to Equity (High indicated highly geared) and Interest Cover ratios (High number indicates increasing cover from EBITDA for interest payments) for selected ASX listed Energy stocks (source: Resonant Asset Management, Refinitiv)

What now for the sector ? If the oil price were to gravitate back towards the 40-50 US$ range, then all manner of financial leverage risks would suddenly be put on the back burner – a scenario that could see the stocks double.

In this note we look at the key issues driving the oil price, which whether we like it or not, is the key factor in deciding whether or not as investors we should think about adding these stocks to their portfolios.

April Madness

April was a historic month – never before have we seen oil futures fall into negative territory. How this event occurred, and the future outlook for the oil price, holds the key to understanding its trajectory over the next few months

Figure 3: WTI Futures front contract (source: Refinitiv)

Modern commodities markets are a largely symbiotic relationship between speculators, hedgers and producers.

Producers care about storage deeply, particularly when inventories are running sky high in an environment such as this, with demand so low.

Speculators haven’t historically considered storage, their focus is more geopolitical and global macro-economic.

Hedgers are merely looking to manage an existing exposure in their books, so typically price insensitive, and motivated by neutralising risk.

What happened at the futures expiry in mid-April is that some speculators suddenly realised that producers were deeply focused on storage, to an extent they had not considered possible or likely. In fact so focused, that there were no buyers a day before expiry.

Will this repeat next month?

Speculators have already modified their approach to tackle storage in a more considered way.

We know this because the major vehicles for speculators, ETFs that purport to track the oil price, have switched from buying the front to spreading across multiple future expiries, and announcing that the roll will take place over a ten day period rather than in the immediate run up to expiry (for details, see: USO Portfolio Changes).

We can therefore expect a smoother ride as a staggered and incremental roll takes over a prolonged period.

In part however this is necessary because we have seen breathtaking inflows into these ETFs, and therefore into a long oil futures position. The NTAs of many of these funds has risen dramatically (3x since year end), especially when you consider that the price of these instruments has fallen dramatically (10x unit creation in end of February).

Figure 4: US Listed USO ETF Net Tangible Assets (Source: Refinitiv/Lipper)

Figure 5: US Listed USO ETF Equivalent Number of Units (Source: Refinitiv/Lipper, Resonant Asset Management)

What this suggests to us, is that the mean-reversion trade is very well supported already, and likely priced in already into the futures market. An end to the lockdown, and something of a return of demand, is largely anticipated. So how does demand look?

Figure 6: Indicative US Oil Demand (Source: Refinitiv Eikon , EMI Gasoline US Total Sales Volume) by Year – Dip down is 2020, other lines are 2014-2019

The problem for storage, is that, with every surplus in supply over demand there is incremental pressure on storage. How is production shifting to the new environment?

OPEC has already been squeezed diplomatically to cut production by around 20% – but the main swing factor, will be US domestic production. This may be why storage is less of a concern in May than in April:

Figure 7: North America Oil Rig Count (source: Refinitiv Eikon, Baker Hughes)

Rig count is now down more than 50% in record time: suggesting that the industry is adapting to new realities.

How we are playing this in portfolios

Our exposure to the Energy sector remains modest, because we feel that despite the production cuts, considerable risks still lie to the downside, and exceed current upside risks.

This is especially true when you consider how quickly speculators have moved back to a bullish position, as evidenced by the extreme buying of ETFs and other products in the US which is essentially a mean reversion trade.

We are sitting this one out, looking to play a recovery in other ways – for our portfolios, risk management remains a critical component, we will reconsider once the situation in energy markets becomes clearer, and we can benefit from a less pronounced recovery.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

Stable Cashflows ? Time to Rethink Infrastructure and Property

By Insights - Financial adviser, Insights - Institutional investor

Infrastructure & Property

One of the key defensive cornerstones of multi-asset and equities portfolios since the end of the GFC has been the use of property and infrastructure securities. The typical structure is a trust, holding assets or part ownership of assets, an optimal quantity of financial leverage, an delivering a stable and consistent income.

We will argue in this note that selectivity and a discerning eye will now be required in this asset class, with the use of ETFs for broad passive coverage now fraught with risks now we have entered a new market paradigm.

What characterises this paradigm and how does it differ from the traditional view of this asset class?

To answer that question requires us to consider what effectively a lockdown means for our assumptions of the stability and predictability of cashflows for these assets. What the lockdown highlights, is that cashflows are far from predictable or certain, when clients and customers are unwilling or unable to utilise the infrastructure once deemed “recession proof”.

Suddenly the utilisation of the asset, and hence the revenue stream, develops a level of risk, perhaps not associated with the business cycle, but more associated with government policy around pandemic risk, and our willingness even in the absence of a lockdown, to mingle freely with our fellow citizens in a workplace or a shopping centre, where there is no exacting requirement to do so.

Sell-side forecasts are already starting to reflect the uncertainties associated:

Figure 1: In the chart below the orange line (RANGE) is the spread of dividend estimates across sell-side analysts – as the line increases, analysts are more prone to disagreement.

The blue line (STAB) is the standard deviation of estimates, a different measure of uncertainty, which essentially confirms the same trend – analysts are increasingly uncertain as to the trajectory of dividends for these assets.

(Source: Refinitiv, Resonant Asset Management)

Why does this matter

Uncertainty never was the name of the game with these securities – investors use them specifically to provide a cushion during times of market turmoil.

In addition, providers of debt capital have not factored in the incremental risk we now see: even if the RBA target rate is at record lows, the cost of debt of these assets certainly is not.
In financial markets, perceptions matter as much as reality: perceptions have now shifted, at least semi-permanently; away from stable to unstable cashflows.

The stability of cashflows and cheap cost of debt is what permits the issuers of these securities to embed financial leverage:

Figure 2: Index weighted Debt to Equity ASX 200 Infrastructure and Property Stocks (source: Resonant Asset Management calculations, Refinitiv data)

The chart above is the weighted average Debt to Equity ratio of these stocks. The series is volatile because of the way the data is reported by specific companies – suffice to say, that over the last ten years, the trend is up – from around 60% net debt to equity to at least 80% and on the latest estimate, over 100%.

Debt in itself can be a good thing for equity holders as it enhances returns. But it also increases risks, risks that are latent, not apparent to investors until they are.

What happens now

A protracted and prolonged de-rating of these securities is inevitable, particularly for assets whose cashflows were assumed immune to uncertainty, and for whom reality is now setting in. As we crunch our asset allocations, what long term risk premiums would traditionally satisfy for this asset class?

Figure 3: Risk Premium over Cash Demanded by Investors in Property & Infrastructure Stocks (source: Resonant Asset Management)

The chart above shows the return demanded by investors over cash to invest in the asset class: as you can see we have moved from a near 3% hurdle rate to invest, to near 6%, as uncertainty hits.
What is important, is how this compares to competing asset classes: and in our view, the gap between the risk premia for equities, and this asset class, is inevitably closing:

Figure 4: Risk Premium over Cash Demanded by Investors in Property & Infrastructure Stocks (Blue) vs Broad Australian Equities (Orange) (source: Resonant Asset Management)

In fact we would argue that this should not be treated as a separate asset class any longer: it is quantitatively tantamount to equity risk, and offers no exceptional or structural defensiveness, that merits its exceptional treatment.

We advocate selectivity in the main across these assets, as there are securities within the complex that will continue to offer stable cashflows, but the dispersion in outcomes across the investible universe will be large, so passive investing is the least attractive approach at this point.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

What’s the Market Worth?

By Insights - Financial adviser, Insights - Institutional investor

The Coronavirus outbreak has blindsided markets since mid February, with equities down nearly 30% off their peak. What investors need at this juncture is a line of sight on valuations, to get a sense of what sort of scenario this sell-off represents. Analysis of this sort is vital to build a profile of the probability landscape around different coronavirus outcomes.

There are two drivers of the sell-off:

1. Projected Earnings hit: the extent to which earnings are impacted is hard to gauge but will be pronounced. The market anticipates a raft of downgrades.

2. Increased uncertainty: we have little idea what to expect in terms of the length or extent of the disruption to the economy caused by this virus. Because we can’t quantify anything, realised financial market volatility becomes extreme; making equities a less attractive investment on a relative basis to alternative investments.

We can look at quantifying the impact of point 1 and 2, to get an idea of what sort of scenario the market is pricing in; and to make a decision, given the virus data that we can track, as to whether equities is likely too bullish or bearish.

Increased Uncertainty

One of the hallmarks of financial markets over the last ten years has been anaemic volatility. Driven ultimately, in our view, by a total absence of inflation, it has been a key driver of making equities incrementally attractive and driving up the market’s fair multiple.

Let’s estimate the relationship of volatility and fair multiple. As fear and risk perception elevates, the fair multiple collapses. Conversely, as visibility and a line of sight appears on earnings and the economic hit, volatility will progressively moderate, and the fair multiple of the equity market rises.

In order to quantify the relationship, Resonant has built a simple model to estimate the sensitivity of fair multiple to the implied volatility index (S&P/ASX 200 VIX Index). Clearly, this is an exercise in educated guesswork, we still feel that a rough estimate is better than no estimate at all.. It is however no substitute for following the markets closely over this period, but it helps enhance the research process.

To estimate our relationship, we look at historical data on the Australian Equities market between 2010, when the VIX series starts, and end of February 2020.

Figure 1: S&P/ASX Australia VIX (LHS, source S&P/Refinitiv) vs Equity Risk Premium (Source: Resonant Asset Management)

Based on the relationship, we have quantified every doubling in VIX, to a 1% increase in the risk premium (ie. The equity market sells off).

Earnings Hit

Volatility and earnings are intrinsically linked. Only now are we starting to see economists quantify the full impact of the virus on the domestic economy. We are looking at two quarters of negative GDP Growth for Australia, should the lockdown succeed and the virus be contained. Citi is forecasting that GDP will contract by 4.4% over 2020 (See: Forecasting the largest percentage change GDP growth contraction in history, 24th March 2020, by Josh Williamson, Citi Economics Research)

If we assume that the stock market is an adequate representation of the economy – then we can project sales revenues (as opposed to earnings, which will be much more pronounced) for companies to fall approximately 5% over 2020. The disparity in outcomes will be huge, with some industries (tourism, travel), impacted far more than others (healthcare, supermarkets, cloud computing).

To translate the sales/revenue hit to earnings we need a sense of where corporate margins sit. And their likely trajectory. Shareholders ultimately should care about Net Margins, which have a cyclical component, and a policy component, amongst other things.

Cyclical Component: We would expect that aggregate margins would fall, as companies face fixed costs of keeping the lights on, regardless of broader conditions.

Policy Component: Governments look to cushion the blow as much as possible, by implementing tax policies and stimulus to minimise the hit to margins.

In addition to the revenue hit, we need to estimate the margin hit, to get a sense of impact on earnings.

Currently the weighted average net margin for an S&P/ASX 100 ex Financials company is currently 13%. As you can see it has fluctuated with Commodity prices in particular – the trough being in late 2015.

Figure 2: Index weighted 12m forward net margins for the S&P/ASX 100 index (source: Resonant Asset Management calculations, Refinitiv data)

Over the next twelve months, what can we possibly expect to happen to Net Margins, Revenues and Earnings?
In order to answer this question, we’ve put together a matrix of outcomes, broadly splitting the economy into V-shaped (12 weeks), U-shaped (2 quarters), and L-shaped (1+ years).

Figure 3: Approximate Revenue, Net Margins under different macro-economic scenarios

Market Projections

We think the VIX will settle around 25-30 at the end of March, and trend towards 20 for the rest of the year, as uncertainty as to the course of outcomes for this virus continues to play out. For us to get to 20, we would need a clear example of a western democracy that has successfully managed to “flatten the slope” and manage the hospital overload. For example, if Italy were to consistently and successfully slow the increase in cases, then that would bring market volatility right down, as it would demonstrate to other countries what is required to achieve this, and on what timeframe.

We suspect that if the social distancing and lockdown policies in Italy have been successful, then we are looking at a U-shaped recovery for Australian corporate earnings.
That means 12 month margins of 10% (from 13%) and a 5% revenue hit, in total a 30% hit to earnings.

Figure 4: What’s the Market Worth Under Different Volatility, and Earnings outcomes

We see our base case described above, where the market is worth 5019 points, a U-shaped recovery, 5% negative GDP Growth, and a volatile equity market to the order of a VIX at 20 from April for the next 12 months, as a price target just a tick above 5000. That would correspond to a yield of around 4.5% plus franking, and an additional 5% upside from the close price on the 24 th of March.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

Coronavirus and Markets

By Insights - Financial adviser, Insights - Institutional investor

Finally Politicians are listening to scientists, and pursuing an appropriate strategy to change behaviour and minimise the infection rate. This is not only necessary from a health/humanitarian perspective, but also from an economic perspective. If coordinated properly and effectively across the globe, this could help minimise the economic disruption while simultaneously maximising the humanitarian outcomes.

Market Fragility

Another tumultuous week for equity markets last week, which began on Monday with a huge sell-off and continued throughout the week. Two events coincided to create a perfect storm for Growth assets: Coronavirus and OPEC Oil negotiations.

The signpost for us that the markets had changed to a new regime, occurred on February 28 th . That was the day that the domestic market forgot all about reporting season, fundamentals, and focused on the virus and its effects. The day’s trading sufficiently spooked us to think that a rejig of the portfolios was necessary.

Who Cares about Earnings?

The last time we saw a meaningful regime change such as this in markets was 2008. Over these periods, which naturally occur every ten years or so, the market becomes entirely focused on speculating the future prospects of companies over the next two quarters, at the expense of all else. This means typically a giant unwind of the most speculative active positions towards a more defensive orientation. And that is exactly what we have seen. As ever with these events, hedge funds are leading the charge.

In our portfolios, we looked at our individual stock positions over the weekend of the 29 th February and 1 st of March, and jettisoned any stock in the eye of the storm – first on the chopping block where travel, tourism and education, followed by deep cyclicals such as resources, retail, & media. We rotated nearly 20% of our direct stocks portfolio into cash.
The timing was fortunate, because this week has been the most volatile and unsettling for equities investors since the GFC.

Thank Goodness for Diversification

Our multi-asset portfolios have held up relatively well amongst the carnage. In our International Equities sleeve, we have been conscious of the prospect of a tail event given the strong run equities have enjoyed over the last few years, and have positioned unhedged, and overweight Japan (and most importantly the Yen), and Asia, underweight expensive US and underperforming Europe. Yen strength is an inevitable predictable consequence of a dramatic sell down such as this, given the repatriation of the enormous quantity of foreign invested capital which inevitably occurs.

The advantage from a risk management perspective of using precision instruments such as ETFs is only too apparent in these markets. The biggest delta has been from managing the currency right, just as it was in 2008.

Looking Ahead: Our Base Case

While it feels as though we are currently staring at the abyss, there are now reasons to start thinking of the future.

This morning the US announced that it was stopping any EU visitors for 30 days, a move that is both draconian but necessary. We expect Australia to follow suit – cases in Europe are now expected to escalate and the trend looks quite terrifying. We expect however that these extreme measures are indeed what is required to get this virus under control, along with school closures, minimisation of travel and public gatherings, and working from home.

We are now moving into the step where governments have a clear role to play, pulling massive fiscal and monetary leavers to manage what Boris Johnson described as the “once in a hundred year health crisis”.

The coordinated fiscal and monetary response will be massive in our view. Governments and central banks can ill afford to sit on the sidelines and moralise about cheap money, this is the difference between a transient global recession, which may last a quarter, and a prolonged depression that takes place over a number of years.

To put it in context, we have to think that we are staring down the barrel of sitting at home for much of the next six to 12 weeks, as this virus is contained. If we can successfully navigate this without business closures, job losses, and a total ramp up of unemployment, we can come out the other side of this with a huge ramp up in activity one this has passed, which you would have to think would somewhat compensate for the initial recession.

That is our base case: this is contained, we get an enormous stimulus both fiscal and monetary stimulus, in which case this is a buying opportunity to hold for the long term. Sentiment will whipsaw investors from now and certainly until the end of April, but we feel at this point that the base case is priced into markets.

A Gloomier Scenario

To construct a gloomier scenario, we would have to think that:

  1. Infection rate in developed markets of around 70%
  2. Quarantine lasts up to one year
  3. Massive speight of corporate defaults
  4. Mass unemployment, double digits.
  5. House price crash.

None of this is likely; governments have woken up to the health crisis and steps are being taken.
Under this view, you would currently be selling equities further.

Looking Even Further Ahead

Assuming our base case comes to fruition, how does this change the world?
A few geo-political risks on our radar:

1. Iranian and Middle Eastern instability. The conservative religious government in Iran came into this health crisis with waning popularity, a botched missile launch. Iran was hit harder than most, and struggled, weighed down by inadequate health infrastructure. To rub salt into the wound, the oil price collapsed to $30, likely to trigger an economic meltdown in the country if this persists. The middle east has typically been about two camps, Saudis and Iranians. The collapse of Iran could herald more wholesale changes across the region.

2. Global Supply Chains entail sovereign risks. Back on the political agenda will the repatriation of manufacturing of key products. The electorate has woken to the sovereign risks of outsourcing all of your manufacturing and production offshore.

3. Europe is ultimately re-invigorated. This is less certain but an effective fiscal response to help Italy will dramatically alter the electorate’s perception of the European project. This is potentially a second order factor, not before much economic and political pain.

4. Locally mortgage rates hit zero or thereabouts as we enter QE. Given the cashflow crisis that many over indebted households will face over coming weeks, this effectively reduces interest payments to near zero, and allows Australians to “hibernate” until the virus passes.

These four key factors will drive:

The end of the bond market bubble – we think that the massive deployment of fiscal stimulus combined with onshoring manufacturing and production will possibly raise the spectre of inflation.
A change in behaviour – this will draw a line on the post GFC period and open up the market to more volatility and risk taking behaviour. This will draw a line on income and wealth inequality. The electorate will demand this. The business cycle will return.

More selectivity and active management will be required – the pure passive ETF model will die with low volatility and non-existent inflation. Skilled stock pickers and asset allocators will benefit hugely from the regime change.

A wholesale change in work practices. Work from home, flexible work, and so forth will all become mainstream as we get a sense of our own fragility and mortality and reconsider our priorities – economic growth is not dependent on our ability to attend an office in a CBD for 70 hours a week – software and remote access, teleconferencing, will become mainstream.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

Interest Rates and Investment Portfolios

By Insights - Financial adviser

Interest Rates have been front of centre of the economic and political dialogue globally for the past year and beyond, both domestically and globally. In this note, we examine the drivers of rates and provide unique insights into how we view the impact on asset class returns of interest rate changes.

The Yield Curve: the market for interest rate expectations

In quantifying the market’s expectations for interest rates into the short, medium and long term, the yield curve is an essential guide to a shifting rate environment. This is because the yield curve reflects the expectations of the market in aggregate in terms of where interest rates are headed. In the chart below, the 10-year yield implies that the market currently expects an interest rate of around 1% to lend to the Australian government over that timeframe.

The plot below is of the Australian Government yield curve, versus its position one year and five years ago. The yield curve is dynamic and is re-evaluated on a continuous basis, driven by buying and selling activity and prices of Australian Government bonds of various maturities and characteristics.

The graph below shows how interest rates of all maturities have collapsed, both from 5 years ago (grey) and steeply from one year ago (orange).


As you can see from the chart above, expectations of rate rises have moderated over the last 12 months (As of 12th August 2019).

Asset Class Implications

The collapse in the yield curve is an issue of current paramount importance to asset allocators.

As part of our decision making, we put together a simple ready reckoner on the impact of falling rates on asset classes, and sub-sectors. When considering the impact of changes in rates, there are two key drivers to consider:

1) The “Rate Sensitivity”: the value of the asset today is a discounted sum of future cashflows. The value of the asset therefore increases as the discount rate falls.
2) The “Growth Sensitivity”: a drop in rates implies a deteriorating economy. “Growth” assets with a high dependency on economic activity tend to suffer most.

In the table below we rate the return impact of a drop in rates from both a “Rate Sensitivity” perspective, and a “Growth Sensitivity” perspective. ‘++’ suggests a strong positive return is expected if rates fall, ‘0’ suggest no impact, ‘–‘ suggests a strong negative impact.
The reverse effects are true in the table above if it proves that interest rate rises are now less likely, or are likely to be pushed out.

 

 

Positioning Portfolios

Interest rates are just one very important variable likely influencing portfolios over the medium to long term. It is also worth remembering that this effect is only one variable of many that are likely to play out. Changes in interest rates are also in the context of the global macro-economic environment, and this will inevitably include prospects for all the major economies, particularly the US and China, commodities, the Australian Dollar, credit market conditions, and so forth.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

The Advantages of Multi-Asset Managed Accounts that Incorporate Direct Securities – Part 2

By Insights - Financial adviser

In our last note on this topic, we discussed the significant advantages of Multi-Asset managed accounts that incorporate direct securities from the perspective of enhancing an adviser’s value proposition and addressing regulatory and competitive pressures. In this note we now look at the investment case for this approach.

Investment advantages of greater transparency

The most obvious characteristic of multi-asset portfolios that incorporate direct securities is greater transparency. However the benefit of additional transparency goes beyond the investor simply knowing which stocks they own. It also extends to two of the core aims of retail portfolio management, that is, the capacity for improved risk/return outcomes and higher after-tax returns.

Top to bottom risk analysis – a whole of Portfolio approach

Providing the MDA/SMA manager has direct securities expertise and the right quantitative tools at their disposal, the increased granularity of a direct securities approach allows the manager to more accurately measure and monitor overall portfolio risk. This is because portfolio risk is more than just how the different headline asset classes or funds behave relative to one another, but also how the individual underlying assets themselves behave, down to the security level. For example, a Balanced portfolio with an Australian equities allocation that is overweight in a sector which is highly correlated to international equities will contain significantly more downside equity risk than a Balanced portfolio tilted the opposite way. This is despite both portfolios potentially having the same headline asset allocation. In that regard the manager with greater transparency is arguably in a much better position to optimise the overall risk/return ratio of the multi-asset portfolio.

This increased ability to risk measure the portfolio from “top to bottom” and take a whole of portfolio approach is particularly useful during times of market stress. As direct securities managers are more acutely aware of the underlying exposures, they are in a position to more accurately monitor the cross-correlations imbedded within the portfolio, and how those correlations are changing through time.

This type of in-depth quantitative analysis is much more difficult under a “fund of fund” managed account approach, due to the unitised structure of managed funds. The opaqueness in this case is exacerbated by the fact that many underlying active fund managers can be protective when it comes to disclosing details of their holdings. Instead “fund of fund” managed account managers are usually forced to rely on what the underlying fund manager tells them, in terms of their risk exposures and fund characteristics.

Investors must also be cognisant that third party underlying active managers will be focussed primarily on their own benchmark, rather than the greater interests of the multi-asset portfolio. Indeed each underlying manager has no knowledge of any other holdings in the multi-asset portfolio outside of their own allocation. This includes managers of outsourced direct equity SMA “sleeves”.

It is partly for the reasons outlined above that many large industry super funds have begun in-housing their asset management, rather than allocating out all of the different asset class exposures to third party managers. It is not solely a cost exercise.

It is important to point emphasize that the construction of a Multi-Asset SMA that incorporates direct securities into its core investment process demands the requisite skills; hence it is prudent to seek managers who come from a direct funds management or securities analysis background.

The ability to accurately identify strong performing external managers should not be disparaged however. Indeed it is a requisite skillset for any multi-asset manager, including those that internalise components of their active management. One example where this skillset is required is in Alternatives, where typically Hedge Funds are employed, and selected based on process, transparency, management, cost and track record. A deep quantitative understanding of contrarian, trend following, and other common approaches is essential when selecting and combining appropriate strategies.

Improved After-tax returns

There are tax advantages to incorporating direct securities into multi-asset portfolios. Rather than merely owning units in a trust, the client maintains beneficial ownership of the assets held directly. This can provide material benefits in the form of capital gains tax minimisation. Latest generation platforms and accounting software packages usually allow for easy and automated tax optimisation when it comes to CGT parcel selection, improving after-tax returns. In addition, the ability to in-specie transfer existing holdings in or out of the managed account structure without requiring a sale can avoid unnecessary tax events.

Technology – The great enabler

Perhaps the main reason why this type of solution is only now coming to the fore is due to substantial advances in technology across the industry. This applies at the investment level, the platform level and at the business level more generally.

Firstly, advances in data extraction and quantitative investment techniques have significantly reduced some of the costs traditionally associated with direct securities investment management. Instead of requiring large teams of expensive analysts, an investment manager with the right skillset and tools can now extract and process large datasets of financial information to generate alpha-delivering portfolios at a much lower cost. When these costs savings are passed onto the end client, all members of the retail investment value chain can benefit.

Secondly, the ongoing platform arms race has meant that most retail platform providers can now accommodate fast and efficient processing of direct equities holdings and trades at cost effective prices. The removal of minimum trading fees in favour of fixed percentages within most SMA structures means that lack of diversification is no longer an issue. Relatively small parcels of shares can be held with no increase to portfolio cost. Further, CGT parcel optimisation and other useful tools provided by these platforms are perfectly suited to direct holdings, helping to enhance after tax returns.

Finally, innovations in business communication methods, such as automated emails and text messages, videoconferencing and portable devices can help SMA managers communicate same-day trading decisions and regular updates to advisers. Advisers can then use these same methods to keep their clients informed, requiring a minimal time investment. Not only does this enhance client engagement, but it also helps cement the adviser’s ongoing role as the trusted adviser.

Future proofing your business

In summary, in a world where client Best Interests are paramount, Multi-Asset Managed Accounts that incorporate direct securities can provide unparalleled advantages to advisers and their clients. Reduced costs associated with internalising active management can place them at a price point close to passive solutions, whilst still providing alpha opportunities normally associated with active funds. Further, increased transparency allows for improved risk management, the potential for better after-tax outcomes and greater client engagement opportunities.

If you would like to speak to Resonant about its Multi-Asset Managed Accounts that incorporate direct securities, please get in contact.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

The Advantages of Multi-Asset Managed Accounts that Incorporate Direct Securities

By Insights - Financial adviser

The business efficiency benefits of Multi-Asset Managed Accounts for advice firms are widely known. When these advantages are also on-shared with the end client, Multi-Asset Managed Accounts represent a compelling value proposition for any forward-thinking planning practice. It is therefore no surprise that these structures have had a stellar rise in take-up over the past few years.

Until recently however, the proliferation of Multi-Asset Managed Accounts has been largely focused on “fund of fund” solutions. That is, managed account products that invest in a number of underlying funds. However, there is another approach that can contain significant additional advantages for advisers when done properly, which is multi-asset portfolios that incorporate direct securities into their core investment process.

For the purpose of this note we are referring specifically to portfolios constructed using a mix of direct stocks, listed ETF’s and only a very limited allocation to external active managers. Under this approach, external active managers are only used when it is believed that a significant alpha opportunity exists, and is usually limited to asset class exposures where ETF’s or direct securities are not appropriate, eg Alternatives.

A Portfolio for the Times – Benefits for Advisers and their Clients

In the current environment it is extremely important that any product an adviser recommends can be clearly demonstrated to serve the client’s best interests. At the same time advisers are under increasing pressure to demonstrate their own value proposition. For a number of important reasons, Multi-Asset SMA’s which incorporate direct securities can help meet these dual aims.

Client Best Interests

While there is much conjecture around what exactly constitutes “best interests”, it is clear that both cost competitiveness and after-tax returns are key factors. Failure to address these twin considerations risks winding up in the cross hairs of the regulator, particularly if there is a perceived benefit to the advice business of recommending the product.

Unsurprisingly this is causing consternation. Not because advisers don’t have their client’s best interests at heart, but because often it’s very difficult to show that a strategy is the right one until after the fact. This is especially the case when it comes to investing, which inherently involves an element of risk.

Understandably, many advisers are now choosing to narrow their focus in on costs, an obvious path of safety, given that cost is the one component of investing which can be determined with certainty before advice is provided.

At the same time increasing regulation is demanding greater cost transparency within products themselves. The application of RG97 means that financial product providers, which includes SMA issuers, are now required to include the management fees of all the underlying funds held within the product in the Indicative Cost Ratio (ICR) of the Managed Account itself. This is exposing the high product costs of “fund of fund” SMA’s. Whereas previously only the headline multi-manager fee may have been included in the product disclosure statement, now the ICR is an “all in” figure, which must be disclosed in client Statements of Advice.

This is where Multi-Asset Managed Accounts constructed mostly of a mixture of ETF’s and Direct Equities can provide a distinct advantage. Unlike “Fund of Fund” SMA’s, they are not nearly as adversely impacted by RG97. This is because there are no underlying ICR’s associated with direct equity holdings and ETF’s are typically very low cost. Assuming the headline manager fee is competitive, the “all in” cost can be significantly cheaper than “fund of fund” solutions paying large fees to external managers. Despite the competitive fee structure however, the client still benefits from active management. Assuming the SMA manager incorporating direct equities has the requisite investment skills and can demonstrate alpha, then it could be argued this approach represents the “best of both worlds”. That is, active management at close to a passive price. See Figure 1: Projected Costs of Solution (Indicative Only).

Figure 1: Projected Costs of Solution (Indicative Only)

Enhancing the Adviser’s Value Proposition

Another important consideration for any advice business is the ability to demonstrate an ongoing value proposition. If an adviser cannot demonstrate the value they provide to his or her clients, then not only does it beg the question of whether they are acting in their client’s best interests, but it also risks the future of their business as a going concern.

In the race to reduce costs, many advisers have begun to abandon active management altogether, instead opting for portfolios made up purely of passive ETF’s. However there are risks for advice businesses adopting this strategy. If a client’s portfolio simply mirrors that of a cheap online robo-adviser, how long before the client questions whether they need to continue to engage an adviser at all?

A key advantage of Multi-Asset Managed Accounts that incorporate direct securities is that they can help the adviser protect and amplify the adviser’s own value proposition. This is because they allow the adviser to play an enhanced role in the ongoing investment communication and governance oversight of the portfolio, particularly in the case of private label offerings. Forward thinking SMA managers can ensure advisers are kept abreast of the investment rationale for all current holdings and any changes as they happen, allowing the adviser to become the conduit for this information. Technology can help make this process easy to the point of being seamless. For example, each time a trade is made in a direct security held within the portfolios, the adviser can be notified, and choose whether or not to communicate this with their clients depending on client preferences. There is also scope for the adviser to remain more informed regarding the composition of the portfolios, due to greater transparency and the fact that they will be dealing directly with fund manager, rather than an asset consultant. This then allows for a deeper discussion with clients.

In the case of a private label solution, the advice business may choose to play a role in setting the investment mandate. Representatives from the business can also sit on the investment committee, playing a governance role. While this is also possible with “fund of fund” structures, the level of granularity is far greater with an SMA that incorporates direct securities.

While the impact of more closely tying the adviser to the investment value proposition is considerable, the time commitment required of the adviser is little more than that of a “fund of fund” solution, enabling the adviser to focus on servicing their clients in other ways and on growing their business.

Figure 2 illustrates the three pillars of an Adviser’s value proposition when it comes to investments. A comprehensive Multi-Asset Managed Account solution that incorporates direct securities can help an adviser play a role and demonstrate value at all three tiers.

Figure 2: Three Pillars of an Advisor’s Ongoing Investment Value Proposition

Increased Client Engagement

The proliferation of smart phones and devices, as well as improvements in online platform technology, has led consumers to expect greater engagement opportunities from their service providers. The enhanced transparency that comes with owning visible direct securities feeds into this theme. Tech savvy millennials can jump onto their smartphone and view exactly which holdings they own. Older clients also enjoy remaining more informed, for example it allows them the opportunity to discuss with their peers which stocks have been the best performing in their portfolio this year.

Furthermore the inclusion of direct securities in SMA’s allows for greater expression of individual client preferences. This is especially timely given the growing social and ethical considerations of investors. Instead of having to defer to the standardised screen of an ethical fund manager, latest gen platforms allow for the specific exclusion of individual companies on a client by client basis, ensuring they line up directly with the investor’s preferences and principles.

If you would like to speak to Resonant about its Multi-Asset Managed Accounts that incorporate direct securities, please get in contact.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

Not all asset class exposures are created equal

By Insights - Financial adviser

Most advisers intuitively understand the benefits of diversification. Known as the “only free lunch in finance”, diversification is an essential tool for managing portfolio risk and smoothing client returns. Unsurprisingly there is a wealth of information available from research houses, asset consultants and other industry commentators on the right asset class mix for each client’s risk level.

However, one area which is not addressed enough in our view is the fact that not all asset class exposures are created equal. While it’s usually clear for example that a large cap international fund with a Global MSCI benchmark may behave differently to an unconstrained global tech stock fund, there are also other, sometimes less obvious things to consider. Here are a couple of examples:

Hedged vs Non-Hedged Currency on International Exposure

While again this seems obvious, many investors are often surprised at the actual extent of the difference in behaviour between hedged vs non-hedged international exposure, particularly during times of market stress. This is because the AUD, which tends to sell-off heavily during global equity market corrections, can act as a significant shock absorber on unhedged portfolios during a crisis. Conversely however, particularly during a commodities boom, a rising AUD can significantly hinder the performance of an unhedged allocation to international equities in a bull market.

For illustrative purposes, the graph below shows the historical difference in performance through the GFC between a portfolio consisting of 50% Aus equities and 50% international equities currency hedged, vs a 50% Aus Equities and 50% international equities currency unhedged*. While the currency hedged portfolio rebounded more strongly, it would have fallen by -13% more during the depth of the crisis.

Alternatives

Alternatives is another asset class where the type of exposure across products can differ significantly. This is not just due to the different strategies available, eg equities long-short vs a global macro futures based strategy, but also due to differences in individual mandates. For example a long-short equities 70/30 strategy can have a completely different risk profile to a market neutral long-short fund, the former often more closely related to a long-only equities fund in terms of beta risk.

A Total Portfolio Approach

Analysing intra-asset class risks is not just about how that asset class exposure compares to a benchmark index. It’s also about how that asset class exposure correlates with the other asset classes in the portfolio through time.

Unfortunately traditional “managed fund” structures don’t make this analysis easy. The unitised structure of managed funds is a clear barrier to transparency. Exacerbating this problem is the fact that many active managers can be very protective when it comes to disclosing much about their underlying holdings. However it is important for those constructing portfolios to demand greater transparency, or else consider seeking passive exposures where risks are more transparent.

At Resonant we believe in a “total portfolio” approach. One which gives strong regard to the underlying risks within each asset allocation mix, not just to the headline asset class mix itself. Further, these underlying risks should be measured and monitored, and compared against the correlating risks from other asset classes. Only then can a portfolio truly achieve its optimal risk return ratio.

Notes: *In the chart, Aus equities are represented by the ASX200 index, while international equities are represented by the MSCI World ex-Australia Index

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

ETF’s reduce fees, but beware the risk of being robo’d away

By Insights - Financial adviser

In the post Royal Commission world of financial advice perhaps the biggest singular issue facing advisers is their ability to demonstrate adherence to best interest duties. This is not because most advisers don’t have their clients best interests at heart, but because often it’s very difficult to show that a strategy is the right one until after the fact. This is especially the case when it comes to investing, which inherently always involves an element of risk.

It is therefore unsurprising that many advisers are now choosing to focus purely on costs. With a beefed up regulator determined to take more aggressive actions on enforcement, this is an obvious path of safety, as cost is the one component of investing which can be determined with certainty before advice is provided. This is has led many advisers to abandon active management altogether and instead adopt portfolios made up of purely passive ETF’s. And why not? Supporting this choice is a wealth of information and research on efficient markets and the inability for large swathes of active managers to outperform their stated benchmarks.

Make no mistake, Resonant is a big supporter of the strategic use of ETF’s to gain low cost beta (market specific exposure) where appropriate. But we feel the argument above misses some key points. Especially that cost, while important, should not be the only consideration:

  • Picking ETF’s is still active management – Generally, most retail investors will always require some form of asset class diversification. Given there is no worldwide benchmark for multi-asset portfolios, portfolio construction will always involve an element of active decision making. Underpinning this should be an ongoing analysis of the risks associated with each individual asset class, and their changing expected returns and correlations. While an Aus equities ETF, for example, may outperform an active manager vs the ASX200 index in isolation, other diversification or risk/return benefits for the overall portfolio may be missed.
  • Portfolio management and advice should be integrated – The best investment solutions are those that tie in directly with the client’s stated goals and are realigned to adjust for those goals through time and changing market conditions. If an adviser steps back from playing any role in client portfolios, instead relying solely on low-cost passive solutions with static asset allocations, the question then arises as to whether the portfolio remains the most appropriate at all times.
  • Advisers cannot compete on cost alone, attempts to do this may result in being “robo’d away” – Lastly, no business can avoid the fact that we live in a world where “disruption” is the new buzzword. Trying to compete with disrupters by mimicking their portfolios, but without their technology-driven pricing and scale, is a losing game. If you are not adding value outside of simply picking an allocation to ETF’s, how long before a client questions whether they should shift to a cheaper online robo-adviser?

For the reasons outlined above, Resonant favours a composite approach, where portfolios are constructed using a mix of low-cost ETF’s combined with additional holdings specifically selected to enhance the overall risk/return profile of the portfolio. In our view, portfolios like this can be constructed almost as cheaply as purely passive options, especially when direct equities are incorporated. Not only is this a sound approach to constructing portfolios, it also helps the adviser to retain and enhance their own value proposition.

Glen Holder
BCom, DipFP, MAppFin, CA
Director – Resonant

Nick Morton
MEng, MintBus
Director – Resonant

Resonant Asset Management Pty Ltd ABN 41 619 513 076 (‘Resonant’) is a corporate authorised representative 1261574 of New World Advisers Group AFSL 428451. Resonant is not licensed to provide personal financial advice.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant and NWAG does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

Estimating Asset Class Returns

By Insights - Financial adviser

Forecasting Asset Class returns is a necessary but difficult task for any capital allocator. In this note, we break down the task into key components by investment time horizon.

The Importance of Investment Time Horizon

The first component is to consider the investment time horizon of the forecast return for the asset you are evaluating. All asset returns can be broken down to a greater or lesser extent by a longer-term, more stable, component and a shorter-term, more volatile component. The best means of illustrating this is to observe the relative stability of the rolling 5-year return in Australian Equities versus its rolling 1-year return (see chart below). As you can see, short term returns are far more volatile:

The longer-term component of an asset class return forecast is commonly referred to as the “risk premium”. In equities for example, longer-term fundamentals that drive valuation, such as P/E raio, growth and earnings quality and macro-economic drivers such as inflation, rates, and GDP across developed and emerging markets are key determinants of the longer-term return.

In contrast, the shorter-term component of an asset class return forecast, will be driven by sentiment, and trend. This might include changes in aggregate earnings, profitability, or simply recent trading flows.

Match the Time Horizon to that of Your Client

Matching the horizon of the forecast to the desired average holding period of the investor is crucial.

Excessive weighting of the shorter-term less stable forecast will increase turnover dramatically in the portfolio, producing undesired tax and trading costs.

In contrast, weighting excessively towards the longer-term risk premium may leave the client feeling that a tactical opportunity may have been missed.

Asset allocators, therefore, must align the asset return forecast with the requirements of the client in terms of tax, turnover, and trading cost.

For example, a long-term investor on a higher tax rate should weight more towards the longer-term risk premium. In contrast, a shorter-term investor on a low tax rate with shorter-term liabilities should weight more towards the shorter term signals.

Just One Component of an Asset Allocation

Expected returns are just one component of an asset allocation. The framework described lends itself particularly well to a Dynamic Asset Allocation (DAA), as opposed to the more traditional separation of asset allocation into a long-term strategic component and a short-term tactical one.

Ultimately the goal of DAA is to continuously re-evaluate the optimal asset mix for a multi-asset product, and this is most practically achieved using the framework described above.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.