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Insights – Financial adviser

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.

The Dangers of “Top 10” Super

By Insights - Financial adviser

One of the policy initiatives from the productivity commission into the Superannuation Industry¹, is the concept of a ‘best in show’ list of products, to simplify choice for consumers, and ultimately should they not make an active decision within 60 days, should become their default. We think this is an extraordinarily bad idea for great number of 6 clear reasons, which we will spell out in this note.
It is intended that an independent panel meet on a four-year cycle to determine with a set of clear set of criteria the ‘best in show’ 10 superannuation funds, using returns, and other criteria.

¹ Read the Productivity Commission Inquiry Report

Moral hazard

The first and most obvious issue with this policy is that it creates incentivises for managers to dial-up risk towards the end of a mediocre year in the hope of entering the top 10. Clearly one of the significant criteria used by the panel will have to be 4-year rolling returns. Entering into the final quarter immediately prior to the convening of the panel will inevitably shorten investment horizons for those funds seeking to drive up returns in a hurry.

The experience of the banking industry with regards to moral hazards and bonus led remuneration schemes is clear. It encourages excessive and inappropriate risk-taking and a winner takes all industry structure incentivizes such behaviour.

Standardised risk structures

The second issue relates to the assessment of the “top 10”, which necessarily must take place within certain risk categories – what is appropriate for a 23-year-old first jobber may not be appropriate for a 60-year-old approaching retirement. Who will administer the assessment of product risk categories? and how will decisions be made? The classification of many asset classes into ‘Defensive’ vs ‘Growth’ will inevitably be contentious in itself, and steer outcomes towards one group of funds versus another.

Whoever manages the process to administer the risk classification of products is put in an unassailably powerful position, with a monopoly on one vital component of the system that determines the future commerciality of different players within the superannuation sector.

Incentivises a preference for private assets

Arguably one of the success stories of the last ten years in a world of cheap credit and a preference for stable cashflows has been unlisted or private infrastructure. These assets, because they are unlisted, are only assessed on a periodic basis. This makes them appear negatively correlated to listed equivalents – they are not. This is merely a function of how often the value of the asset is assessed. Performance in down markets for listed assets is artificially enhanced for super funds with a high allocation to private assets, so they are more likely to use this asset class in a bid to hit the top 10.

While private assets have an important role in many superannuation portfolios, they are subject in aggregate to the same macro forces as their listed equivalents, excessive allocation to this asset class ultimately will not improve necessarily improve returns, and will come at a higher cost.

Ignores the economics of funds management

Capacity is a significant problem in funds management. Typically returns deteriorate with scale, as building positions in mid and small cap stocks become incrementally more difficult. Super Funds can mitigate this somewhat but are still obliged to potentially increase the number of fund managers they engage with or increase their allocation to the internally managed money. Either way, a point is reached where the funds are incrementally more likely to see a deterioration in performance as they over-diversify and essentially return an index-like performance ².
Therefore, so often in funds management the top 10 funds struggle to consistently outperform rivals and maintain their pre-eminence over the competition. What is required is an emphasis on process and product quality and context in addition to performance.

² Read The Economist’s article

Will create distortions in asset markets

An effective equity strategy to profit from a top 10 system might be to buy a basket of highest returning stocks over a trailing one or two-year period. If the top 10 are to forcibly attract most of the growth in assets over the subsequent period, I just need to identify those stocks that are most likely to be in a top 10 portfolio. Picking last year’s winners is one way of doing this. You are effectively front-running super in-flows.

Distortions are an unambiguous negative in the functioning of asset markets in its duty to allocate capital effectively to the economy. This is one of the key roles played by the superannuation sector. It will essentially be a huge boon for smart beta players with little regard for business or macro-economic fundamentals, and ultimately an inefficient allocation of capital, purely targeted at pre-empting short term flows, rather than longer-term profitability.

Competition

A top ten list of funds would decrease competition by steering members towards incumbents. Growth outside the top 10 would be harder to come by. This is perhaps an issue best expressed by the Financial Services Council CEO Sally Loane, “The FSC is very concerned about the potential unintended consequences for the economy of a ’10 best in show’ model because it could create a monolithic concentration of funds, stifle competition and create huge barriers for innovative new products”.

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.

Geeks and Flash Boys – The Importance of Understanding Trade Execution

By Insights - Financial adviser

Most advisers and wealth managers have placed listed investment trades at some stage in their career. Consequently, most are aware that trade execution can have a big impact on price, particularly when it comes to larger or illiquid orders. In fact, poor trade execution can mean the difference between strong investment performance and a poor outcome. This is why a whole section of the finance industry is dedicated purely to trade execution. In this note we explore this topic, why it is important, and what it can mean for investment returns.

The Basics

When it comes to executing a listed trade the quickest and simplest way is to sell into the best bid, or buy the best offer, as quoted on the listed market. This is known as “crossing the spread”, however on the balance of averages it comes with an immediate cost (in addition to brokerage), being the price differential between the best bid and offer. For small orders in large liquid companies this cost is usually small. However the larger the order (or the more illiquid the stock) the more likely there won’t be enough volume to fill the entire order at the best quoted price on the other side. Meaning you must accept a poorer price as your trade moves through the quoted price levels.

Rise of the Geeks

Given large funds need to execute large orders this poses a problem, as their trades will inevitably impact the market. This is where the resident geeks at sell-side (broker) investment banks come to the fore. By creating “algorithms” that, in most cases, essentially drip feed the orders into the market over time, the overall impact can be greatly reduced. However it is a delicate balancing act…the longer it takes to drip feed the order, the more chance the stock has of moving away from the intended purchase/exit price. The optimal answer, therefore, involves complex math’s equations with a number of inputs, including the urgency of the order and the historical price behaviour of that particular stock.

Rise of the Flash Boys

Whenever you have clever people trying to outsmart a market, you will have people who are even more clever trying to outsmart them. This is where the “Flash Boys” come in. Also known as “high frequency traders” or “HFT”, these guys build algorithms that are designed to “game” the sell-side algorithms, essentially creating a geeks arms race. A simple example of a common HFT strategy is for them to work out when a broker algo is buying a large order, then purchase some of that stock ahead of that algo. They then sell it back to the algo at a more expensive price. All of this can take place within the blink of an eye. In fact these strategies can be so lucrative that in some cases HFT firms pay stock exchanges big bucks to have their computers “co-located” at the stock exchange office, so that the physical length of the cord between the HFT computer and the exchange is as small as possible, giving their computers a speed advantage. The sell-side brokers of course try to defend their algorithms against HFT, but sometimes with only limited success. Michael Lewis’s entertaining expose, “Flash Boys”¹, examined this side of the market and the lengths that some of these firms will go to obtain an advantage.

There are other options to help reduce market impact and the predatory actions of the Flash Boys, such as “block crossings” and “dark pools”, but these avenues come with their own pitfalls and would require a whole piece on their own to delve into.

Meaningful impact on returns

While the above makes for entertaining (if slightly nerdy) reading, understanding trade execution is important. Especially as it is up to the fund manager or investor to decide the best way to execute their order. While institutional sell-side brokers will provide the algorithms, each algorithm has its own distinct features. Not all algorithms are created equal and they all come with trade-offs. Having spent some of my career on the algorithmic trading desk of a large investment bank, this is something that I am acutely aware of.

Getting it wrong, particularly for larger fund managers, can have a big impact on returns. It must also be understood that some degree of market impact cannot be avoided, particularly for the larger funds. This is why hedge funds often close their doors to new money once they reach a certain size. When it comes to trade execution smaller funds are at an advantage, as being more nimble means being able to get in and out of holdings with minimal “slippage cost”. Something to keep in mind when selecting an investment manager.

Murrough O’Brien, former head of Electronic Trading at Citigroup and former board member of the Stockbroker and Financial Advisers Association and Chair of their Institutional Committee put it this way. “Sophisticated trade execution has become a vital part of today’s investment process… utilizing all of the tools that a trader has in their arsenal, from algorithms and transaction cost analysis to executing on different trading venues, truly differentiates funds with good performance from those with exceptional performance. Execution is also in the cross-hairs of regulators globally at the present time and with the emergence of MiFID II in Europe and RG97 in Australia. The need for funds to achieve “best execution” for their clients has never been more important.”

References
¹ Lewis, M, 2014, Flash Boys: A Wall Street Revolt, W. W. Norton & Company, US.

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 Right Number of Stocks for Portfolio Diversification

By Insights - Financial adviser

When it comes to constructing a direct equities portfolio a common dilemma faced by investors is the decision around how many stocks to include. Too many can make a portfolio harder to monitor, can increase transaction costs and can often be interpreted as a lack of conviction. Too little and a portfolio risks being over concentrated, unnecessarily volatile and can contain risks that could easily have addressed via diversification.

As with most things in life, the first thing to consider is what are you are actually trying to achieve. If you are looking to track and potentially outperform a specific benchmark index, then a larger number of stocks is generally going to be required. However, if you are less “benchmark aware” and are more focused on simply reducing volatility whilst maintaining conviction on your stock views, then a smaller number will be needed.

Putting some Numbers Around It

Academic studies² have shown that if your aim is simply to reduce risk, measured in terms of portfolio volatility, then holding as little as 20-30 equally weighted positions can provide 90% of the diversification benefit as owning the whole index. Diversification beyond that number only provides a limited and diminishing level of benefit, as shown in the chart below:

 

 

On the other hand, if your portfolio is heavily benchmark aware it will take a much larger number of equally weighted holdings to address your “risk”. This is because risk takes on an additional dimension. Not only are you trying to reduce overall volatility, but you will also want to manage the performance risk relative to the index itself. A study by Surz & Price shows that upwards of 60 equally weighted holdings are needed to significantly reduce risk that incorporates “tracking error”. The cost of course of holding such a large number of stocks is that it inevitably means including companies over which you have much less conviction!

True diversification involves more than a min number of holdings

While the number of holdings undoubtedly impacts portfolio risk, true diversification is more about how the holdings within your portfolio behave relative to each other. For example, constructing a portfolio that consists of the 20 largest Australian “blue chip” stocks weighted according to their market cap (size) may seem like a sound investment strategy and one that would help address tracking risk. However in Australia this would mean allocating over 48% of your portfolio to the Financials sector, with less than 18% in total allocated across important sectors such as Industrials, Healthcare, Energy and Consumer Discretionary companies. The graph below shows how a portfolio constructed this way from the start of 2017 to April 2018 would have performed vs the ASX200 Index:

 

 

It goes without saying that companies within the same sector are more highly correlated than those that are not. The impact of the Royal Commission on the Financials sector being a case in point! In this case not only did the “top 20” portfolio significantly underperform over this period, but it also exhibited considerably more volatility.

A number of considerations

In summary, diversification is an extremely important ingredient when constructing a direct equities portfolio. It is no accident that it is known colloquially as the only “free lunch” in finance. However, it’s important to be aware that there are a number of factors which play a role in diversification, from the number of holdings to the correlation of the individual assets themselves. This is where professional investment tools that enable investors to understand and quantify these sources of portfolio risk and expected return can play such an important role. Finally, it is important to consider the objective of the portfolio itself and the investor’s tolerance for volatility, both in absolute terms and in reference to the index benchmark.

References

  1. Surz, R, Price, M, 2000, ‘The Truth About Diversification by the Numbers’, The Journal of Investing, Winter 2000.
  2. Vitali A, Francis T, 2012, ‘Equity Portfolio Diversification: How Many Stocks are Enough? Evidence from Five Developed Markets’, SSRN, November 29, 2012

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.

Advice not the only sector under pressure

By Insights - Financial adviser

With the spotlight shining so intensely on financial advice at the moment, one could be forgiven for thinking that it is solely this end of the asset management industry facing wholesale regulatory-driven change. However, Fund Managers and Institutional Brokers are also facing their own pressures, which could have significant read-through for their businesses and for the nature of financial markets as a whole.

International forces at play

While most of the change in the advice sector is being driven by domestic forces, the pressure at the broker/fund manager end is being driven by international regulation. On 3rd Jan 2018 the EU implemented the latest tranche of its “Markets in Financial Instruments Directive”, otherwise known as MIFID II.

One of the key components of this legislation is that it forces fund managers to separate out the fees they are charged for research vs those charged for trade execution. You may ask so what? Well traditionally fund managers have paid for both research and trade execution via a single bundled fee, paid for out of the fund itself…that is, it was paid for by the end investor. In the view of the EU, this lack of transparency meant that investors were often being ripped off, as large annual sums were paid to investment banks and brokers for often questionable value-add. The long and short of the change is that it is forcing fund managers to become significantly more accountable for their research spend, reducing the amount of money going into the pockets of investment banks globally for research.

It is also important to point out that while the changes are European driven, they impact most global fund managers, therefore the impact itself is global. There is also an expectation that sooner or later the same regulations are likely to be adopted globally.

Why this matters

With less money flowing to institutional brokers many investment banks have already started shrinking their research departments. If this trend continues, and there is all likelihood that it will, the number of sell-side analysts covering each sector will shrink considerably. Not only that, but the brokers that remain will become increasingly sensitive as to who they share their research with. For example, in 2018, UBS withdrew its research from Bloomberg as a result of MIFID II, in order to gain more control over who can access it.

While the stated aim of MIFID was to protect the end investor, there is a real possibility that the actual effect will be to make markets less efficient, as a smaller and smaller percentage of market participants have access to high quality research. The impact is likely to be exacerbated by the rise of ETF’s, as more and more capital is invested without reference to company specific analysis of good quality.

For the first time in a long time, the pendulum may be starting to swing back in favour of using active managers with access to quality investment research over passive and semi-passive strategies. In our view, having a detailed understanding of the pros and cons of active vs passive management and when to use each remains a key component of constructing an optimal investment portfolio.

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.