Proactive Asset Allocation Handbook - MC2 Wealth · Page 4 of 24 farrelly’s Proactive Asset...

Proactive Asset Allocation

Handbook

Australian Edition March 2012

of 24 farrelly’s Proactive Asset Allocation Handbook (Australian Edition) – March 2012

Disclaimer, disclosure and copyright © 2012 Farrelly Research & Management Pty Ltd (‘farrelly’s’) ABN 63 272 849 277. All rights reserved. Reproduction in whole or in part is not allowed in any form without the prior written permission from farrelly’s. This document is for the exclusive use of the person to whom it is provided by farrelly’s and must not be used or relied upon by any other person. This document is designed for and intended for use by Australian residents whose primary business is the authorised provision of securities advice as that term is defined in Corporations Regulations and, in particular, is not intended for use by retail investors. The material is not intended to be investment advice (either personal or general), a securities recommendation, legal advice, accounting advice or tax advice. The document has been prepared for general information only and without regard to any particular individual’s investment objectives, financial situation, attitudes or needs. It is intended merely as an aid to financial advisers in the making of broad asset allocation decisions. Before making any investment decision, an investor or prospective investor needs to consider with or without the assistance of a securities adviser whether an investment is appropriate in light of the investor’s particular investment objectives, financial circumstances, attitudes and needs. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information contained in this document, which is based solely on public information that has not been verified by farrelly’s. The conclusions contained in this document are reasonably held at the time of completion but are subject to change without notice and farrelly’s assumes no obligation to update this document. Except for any liability which cannot be excluded, farrelly’s, its directors, employees and agents disclaim all liability (whether in negligence or otherwise) for any error or inaccuracy in, or omission from, the information contained in this document or any loss or damage suffered by the recipient or any other person directly or indirectly through relying upon the information.

Tim Farrelly Available exclusively throughPrincipal, farrelly’s PortfolioConstruction Forum+61 416 237 341 +61 2 9247 [email protected] [email protected]

ContentsEditor’s Update - Building debt portfolios 3farrelly’s Forecasts - Occam’s Razor Approach to forecasting 11 - Expected 10-year returns and underlying assumptions 12 - The long-term outlook for debt 14Implementation - more than one way to skin the cat 19Directed Approach - Leave it to the experts - Explanation 20 - Model Allocations 21Advised Approach - Swim between the flags - Explanation 22 - Model Allocations 23Bespoke Approach - Plot your own course - Explanation 24 - Benchmark Allocations 27Crockpot 28

Available exclusively through PortfolioConstruction.com.au of 28

Building debt portfolios

This used to be easy. You worked out the right mix of growth and income assets, set aside some cash and put the rest of the income assets in a fund that invested predominantly in government bonds. Job done. Of course, it is much harder now. Investors are demanding larger exposures to defensive assets, but what assets qualify as defensive? We have rather attractively priced term deposits (TDs), global bond funds, corporate debt funds, listed debt, hybrid securities, etc. We can’t even call it “fixed interest” as much of the income is anything but fixed.

As usual, the solution to this dilemma is to go back to basics. What are we trying to achieve with debt portfolios? How do the different asset types help achieve those aims?

What are we trying to achieve?

The debt, or income, part of the portfolio can have many, often competing, objectives. Security, regular income, liquidity, cash flow, high returns and volatility reduction are some of the more common. In designing a portfolio, it is useful to break these objectives down and ask the questions: How much security is needed? How much income? How much liquidity? How much cash flow? How much volatility is acceptable? What returns can we achieve? And, most of all, what is the relative importance of each objective? In our view the importance should generally be in the order shown in Figure 1.

Figure 1 : Relative importance of objectives when designing a debt portfolio

We believe the primary role of the debt part of portfolios is to reduce the range of long-

Editor’s Update

Debt portfolio objective Importance Rationale

Security/certainty

Critical Without the certainly provided by debt instruments, we would be unable to be confident about our ability to meet the investor’s objectives.

Cash flow Critical The point of investing is to have cash flow when needed.

Returns Important Should only be considered after security is assured.

Volatility reduction

Useful Volatility can be disturbing but it is not the biggest risk faced by investors.

Liquidity Useful Generally only a small part of the portfolio is needed to be liquid in order to meet cash flow objectives.

Income Useful Cash flow needs can be met by income from debt assets, equity assets, running down cash and from the sale of other liquid assets. There is nothing magical about the income produced by debt.


EDITOR’S UPDATE

term investment outcomes of the overall portfolio to an acceptable level. Given that the returns from equities are inherently uncertain, without the certainty provided by debt instruments, we would often not be able to confidently plan for the future.

After we have set the appropriate level of secure assets in a portfolio, we can start thinking about meeting cash flow needs. Will we have the funds we need when we need them? What might we need funds for? To fund income in retirement? To meet unexpected expenses or to take advantage of investment opportunities that may present themselves? We should set aside funds sufficient to meet these cash flow needs.And then we can start thinking about returns. What debt assets give us the best returns (after first meeting security and cash flow requirements)?

Finally, we can turn to issues such as volatility, liquidity and income production. These are second order criteria, in farrelly’s view. If we have managed the risk of long-term poor returns, volatility reduction can assume lesser importance in portfolio design. Similarly, if we have set the portfolio to allow for cash flow requirements (both planned and unplanned), liquidity and income become of lesser importance.

With that backdrop, farrelly’s recommends the following steps to design the debt part of portfolios.

1. Determine the split between risky and secure assets

This is the first step in the asset allocation journey. Typically, the decision will depend upon an investor’s psychological tolerance for risk and their financial capacity to accept risk. In some cases, investors will have a higher psychological tolerance for risk than they can accept financially - while in others, investors will have an enormous financial capacity to accept risk but a much lower psychological ability to accept the short-term ups and downs that go with higher risk. Essentially, this step is the outcome of the risk profiling process. This has been discussed in this Handbook before and we also refer you to the farrelly’s Guide to Risk Profiling (on the farrelly’s subscriber site) for a lengthy discussion.

The outcome of the process should be a suggested allocation to secure or defensive assets. For the purpose of this discussion, we will assume that the investor has a long-term allocation of around 60% risky assets, 40% secure assets.

2. Determine which fixed interest assets are secure and which are risky

Once the split between risky and secure assets has been set, it is important to be absolutely sure that the secure assets are just that – secure. The role of the secure part of the portfolio is to ensure that the investor’s minimum objectives are met even in the event that risky markets produce poor long-term returns. Japanese investors have long accepted this as a real possibility, US and European investors are beginning to understand as much, and Australian investors should also accept the possibility.

Because of the need to ensure that secure assets are secure, farrelly’s divides debt investments into secure debt, called Tier 1 Debt, and risky debt which we describe as Tier 2 Debt.

Because Tier 2 debt does not grow and is not secure, farrelly’s eschews the old growth/


income terminology in favour of risky/secure. The old terminology implies that anything that produces income is low risk and, as has been amply demonstrated over the past five years, this is simply not true. The old approach has been a great source of misery for investors who loaded up with risky income assets in order to spice up returns from their supposedly ‘safe’ income assets. Only secure debt securities should be allocated to the secure part of the portfolio. Tier 2 Debt – which is an entirely valid and useful asset class – should form part of the risky allocation.

3. Divide the secure part of the portfolio into three buckets farrelly’s recommends that the secure part of the portfolio be divided into three:• an amount sufficient to meet cash flow required for living expenses;• set aside an Asset Allocation Reserve where liquid funds are parked to wait for future

opportunities or as somewhere to hide when markets appear unusually risky; and, • the reaminder is the core, Long-Term Debt Portfolio.

The Cash Flow Reserve

For this, we suggest putting aside sufficient funds to meet two years’ worth of living expenses. Market values can fall, assets can be frozen, distributions and interest rates can fall - without causing the investor short-term distress. The Cash Flow Reserve should sit at the base of every portfolio. For example, if an investor was in retirement and needed to draw 5% of their capital base each year for living expenses, they would put 10% of the overall portfolio aside in cash and short-term TDs so that, at the very least, the next two years of living expenses were covered. Given our hypothetical investor started with 40% in secure assets, we now have 30% left to allocate.

The Asset Allocation Reserve

This Asset Allocation Reserve ensures that sufficient liquid funds are available to take advantage of opportunities to buy assets as they arise from time to time. The amount required will change over time. If a dynamic asset allocation approach is used, the weighting to this Asset Allocation Reserve will be very high when a bearish market outlook means large holdings in defensive assets, versus a near zero holding when at maximum weight risky assets. (If a Strategic Asset Allocation approach is used, then just enough has to be put aside to ensure that there is sufficient cash to rebalance in the event that markets fall and buying needs to be done to re-establish the strategic weights.)

Assume our hypothetical investor is at neutral weight risky assets right now, and is prepared to go 5% overweight in the event markets appear very cheap. They would probably hold about 10% in the Asset Allocation reserve; about 5% to re-establish neutral weights in the event of a market fall of 20%; and, a further 5% to go overweight should they wish.

The Long-Term Debt Portfolio

Whatever is left goes into the Long-Term Debt Portfolio. This will always be invested in secure assets because we have already set aside the amounts needed for living expenses and future investment opportunities. This part of the portfolio is long term in the sense that we should expect it to remain invested for the long term, therefore the

EDITOR’SUPDATE

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EDITOR’S UPDATE

duration of the securities can also be very long term, depending on market conditions. Furthermore, this part of the portfolio can be invested in illiquid assets if desired because it won’t be required for short-term cash flow (that’s the role of the Cash Flow Reserve) nor will it be required to take advantage of market opportunities (that’s the role of the Asset Allocation Reserve). For our hypothetical investor, 20% of their overall portfolio can be allocated to the Long-Term Debt Portfolio - the 40% overall weight to secure assets, less the 10% allocations to each of the Cash Flow Research and Asset Allocation Reserve.

What sort of securities are suitable for the different buckets?

Having determined how much capital to allocate to each of the three buckets, we can turn to investing the funds in those various buckets. The first thing to consider is the various securities we can choose from, and which buckets they may suit.

For the Cash Flow Reserve, assets must first and foremost be secure. After that, they must be liquid at the time the investor needs the cash. At its simplest, this bucket could be invested entirely in cash. Alternatively, if it was invested 25% in cash, 25% in 180-day TDs, 25% in one-year TDs and 25% in 18-month TDs, there would be sufficient cash coming due every six months to meet the next half year’s living expenses. Choosing which strategy to pursue, or which combination of the two is a matter of looking at TD rates on offer and working out where the best value lies.

The Asset Allocation Reserve is a little trickier. Here again, the assets must be absolutely secure and they must also be liquid. It is no point having a reserve available to pick up bargains or opportunities only to find that when an opportunity presents, the reserve is not liquid. That said, if purchases are to be staggered over time as we suggest, having a reserve invested in TDs with maturity dates matching the times assets are planned to be purchased could be sensible if TDs were likely to give better returns than cash.

The role of domestic government bonds in the Asset Allocation Reserve is potentially very interesting. Government bonds have been negatively correlated with equities for the past five years - that is, as sharemarkets have fallen in value, bonds have tended to rise. The fact that they are absolutely secure from a long-term perspective makes them an ideal candidate for this part of the portfolio. What better than having a reserve that increases in value and thus provides more dollars to spend when the assets we are buying have fallen in price – it’s a double bunger.

We like the idea of having domestic bonds in the Asset Allocation Reserve – but with one major caveat. They must be reasonably priced. If you buy government bonds at low yields/high prices then be prepared for trouble – you may find that the value of your reserve has fallen at a time when still cheap shares have risen somewhat. And that hurts. For most of the past decade, 10-year Australian government bonds have traded at yields between 5.2% and 5.8% per annum. Right now, yields are much lower. They may well stay down in the sub 4% per annum area but, equally, they may well revert back to more normal levels. In any event, they appear to have more chance of producing very poor short-term performance than very good - so at this time, farrelly’s would strongly prefer to leave them out of the Asset Allocation Reserve.

Which brings us to the rest of the secure portfolio – the Long Term Debt portfolio. This part of the portfolio has one major role, being to provide long-term certainty to the overall

Page 6 of 24 farrelly’s Proactive Asset Allocation Handbook (Australian Edition) – March 2012


portfolio. So again, it must be secure. Where this bucket differs from the Cash Flow Reserve and Asset Allocation Reserve is that it does not have to be liquid, as previously discussed. This is the ideal place for a range of securities that don’t easily fit elsewhere in the portfolio.

Amongst assets that can be considered are:• Cash• Term deposits• Long-dated term deposits• Government bonds• CPI-Linked government bonds• Long-term annuities• Lifetime annuities• Major bank hybrids

All are eligible on the proviso that the assets are absolutely secure from a credit perspective. We shouldn’t mind short term volatility in these assets. If we are absolutely satisfied that we will get our capital back at the end of the term, volatility is essentially harmless.

A note on bond funds, annuities and hybrids

Are these assets really secure? Are they really Tier 1? After all, within bond funds, assets are not held to maturity, and managers go from being long dated to short dated and back again. And sometimes, they permanently lose money on those trades. Nonetheless, I cannot think of any government bond fund that has produced negative returns, or anywhere near negative returns if held for a period of five years or more. Most government bond fund managers are very conservative, and hate to stray very far from benchmark. Bond fund managers who outperform by 0.2% per annum are heroes in their fields and very well rewarded. The end result is that most government bond funds produce long-term returns within 0.5% of the index – in other words, there isn’t much difference in long-term outcomes between active and index bond funds which is the same as saying that, over the medium term, there isn’t much difference between owning direct government bonds and owning a fund.

Annuities are a different kettle of fish. The funds supporting an annuity are statutory funds (separate entities to the life company offering the annuity) and are strictly regulated and monitored by APRA. So you could take the view that they are highly unlikely to fail. Is ‘highly unlikely’ good enough? Probably – but it does come back to a personal judgement on behalf of the person designing the portfolio. farrelly’s is agnostic on the subject; there are good arguments both ways.

Finally, a comment on bank hybrids. In some respects, they are very similar to annuities. Banks are also strictly regulated and monitored by APRA and, by and large, appear to be well managed. However, investors should be aware that just because the major banks are almost certainly too big to fail, this doesn’t mean hybrid investors cannot lose most of their capital. In the extremely unlikely event that a major bank became insolvent, it is likely that the government would ensure that it would be bailed out and depositors protected. However, the mechanics of hybrid securities are such that investors would almost certainly lose most of their capital even if the bank ultimately did not fail. So the

EDITOR’SUPDATE


question for investors in hybrids is ‘Will the bank ever get into sufficient trouble to need to be bailed out?’ If you are comfortable that the chance of a major bank getting in serious trouble is neglible, then consider these securities Tier 1. If not, treat them as Tier 2.

Choosing amongst the eligible securities

At last, life becomes simpler. Having decided which securities are potential candidates for each of the buckets – all deemed absolutely secure – the job is simply working out which are likely to give the best returns. Fortunately, there are some very simple and reliable techniques for doing this, and an extraordinary amount of value can be added in the process.

Choosing between TDs and government bonds

This is not one of the most difficult tasks in finance. Is the rate on a five-year TD higher than the rate on a five-year government bond? If it is, buy the TD. If not, buy the government bond. (For more discussion on the relative merits of government bonds versus TDs, refer to this issue’s Crockpot.) The only exceptions to this rule are:• If you are a highly skilled bond trader and can pick short- to medium-term moves in

interest rates. (Good luck!); and• Where long-term TDs are inappropriate, such as in the Asset Allocation Reserve.

Which TDs should be bought?

Unlike government bonds or bank bills, TDs are not an efficient market and there is lots of value to be added by a diligent adviser. Firstly, since most TDs offered by Approved Deposit-Taking Institutions (ADI) are government guaranteed, they all carry essentially the same risk and simply scanning the available rates to pick the highest rate is the first, and very obvious, source of value add.

What happens when an ADI fails?

The process is quite simple. When it becomes apparent that an institution is insolvent, APRA will apply to have it wound up and at that point the Financial Claims Scheme (FCS) swings into action. At call accounts are expected to be repaid within a week with TDs taking a little longer. The tone of the APRA policy adviser was that ‘a little longer’ would still be very quick. Importantly, TDs with some years to run will still be repaid within weeks of the failure, not at the end of the deposit term. Hence, interest payments will not be at risk. Of course, only the first $250,000 with any one institution is guaranteed, so larger investors will need to spread around their deposits if they wish to be protected by the guarantee.

Choosing the term of a TD

This is another source of value add. Left to their own devices, most investors in TDs choose 90 to 180 day TDs. Often, but not always, there is real value in the long end of the curve. Making the decision about appropriate terms is neither difficult nor trivial. The key lies in thinking about the forward rate curve, which is jargon for breakeven rollover rates. For example, if an investor had to choose between a five-year TD at 6% and a three-year TD at 5.5%, the choice can be boiled down to answering one question – at what rate will I

EDITOR’S UPDATE


have to roll over the TD in three years’ time in order to get the same rate of return from either strategy? In this case, simplistically, five years at 6% is equivalent to three years at 5.5% per annum and two years at 6.75% per annum. In other words, unless I believe I can roll over the three-year TD at a rate better than 6.75% in three years’ time, I am better off with the five-year security.

This sort of analysis can be done when choosing between 90-day and 180-day TDs, one- and two-year TDs – in fact, TDs of any duration. If the answer seems clear, go with the best option. If not, invest in some of each. As described earlier, it’s non-trivial, but hardly rocket science.

When do we buy government bonds in the Asset Allocation Reserve?

This is getting harder to decide as we are now trying to pick the direction of an efficiently traded market, and this is notoriously difficult. farrelly’s general view is that the default should be for a significant portion of the Asset Allocation Reserve to be in Australian government bonds – unless they look very expensive.

Of course, this begs the question of how to tell whether they are expensive. This could be the subject of a book, but for now, we offer this very simplistic rule: if the 10-year bond yield is below 5.2% per annum, bonds are expensive. This rule assumes that:• the RBA continues to consider its neutral position on short-term interest rates to be

between 4.5% and 5% per annum; and,• long-term average inflation is likely to stay in the 2% to 3% per annum range.

The logic around this view is that the market sets bond rates at a level that estimates the average cash rates over the term of the bond, plus a premium of 0.5% to 1.0% per annum for taking on the duration risk. If inflation stays in the RBA target band for the most part, cash rates will oscillate around 4.5% to 5.0% per annum on average and so we end up with 10-year bond rates of around 5.5%. Given this view, 10 year bond rates below 5.2% start looking expensive as shown in Figure I below.

Figure 2: Australian 10-year government bond rates

10-y

ear g

oven

men

t bon

d y

ield

s (%

pa)

Source: RBA

8.0

7.5

7.0

6.5

6.0

5.5

5.0

4.5

4.0

3.5

3.01999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Cheap

Expensive

EDITOR’SUPDATE


Tier 2 Debt

And then, there is all that other debt. Those securities that carry appreciable credit risk do form a useful role in portfolios – but not in the secure part of portfolios. As tempting as it is to put investment grade securities into the secure section of the portfolio – and it is tempting – farrelly’s urges restraint. The whole purpose of the secure part of the portfolio is to provide security, not high returns. And, while we should seek the best returns once we have satisfied the security question, it is always after meeting the security requirement.

And just in case there is still any doubt as to just how secure different types of debt securities are, study Figure 2 which shows the long-term default rates of securities of different ratings. This shows the percentage of all corporate securities that were issued with a particular rating, that then failed some time over the ensuing decade. In other words, if a corporate bond was issued at Aa, and was subsequently downgraded to B prior to defaulting, say, seven years after issue, it is still counted as an Aa default. This data does not include the CDO debacle, which, if anything, would make this table even more frightening.

Of the so-called ‘Investment Grade’ securities (rated Baa or better), on average, 1-in-20 failed over the course of the next decade. This figure rose to as high as 1-in-12 in the 1980s. Even those securities issued with an A rating had a casualty rate of 1-in-17 in the 1990s. The message is clear – these securities carry genuine risk and belong in the risky part of the portfolio. Here they can perform a useful role, particularly when some assets become fully priced or expensive.

Figure 2: 10-year default rates of various securities (1970 -2011)

Get adequate diversification

Because Tier 2 securities do fail – and fail reasonably often – it is critical to design reasonably well diversified portfolios. At a bare minimum, farrelly’s recommends that no more than 2.5% of any one portfolio is exposed to a single corporate entity. Managed funds are a very good way of getting the required diversification.

Securities originally rated Average 10-year default rate Worst 10-year default rate

Aa 0.6% 2.5% (1981-1991)

A 2.1% 5.8% (1988-1998)

Baa 4.9% 8.4% (1981-1991)

Ba 20.0% 34.5% (1984-1994)

B 29.2% 55.6% (1984-1994)

Source: Moody’s

EDITOR’S UPDATE


Occam’s Razor Approach to market forecasting

farrelly’s forecasts

In 1991, John Bogle wrote his seminal paper “Investing in the 1990s: Remembrance of Things Past and Things Yet to Come.” (Journal of Portfolio Management, Spring 1991, pp. 5-14.) He described what he called the Occam’s Razor approach to forecasting, named after Sir William of Occam, who in the fourteenth century declared the simplest explanation is generally the best. The Occam’s Razor approach to forecasting decomposes market returns into three elements: income; growth in income; and, the effect of changing valuation ratios. This can then be used to explain past returns and, more interestingly, forecast future returns with remarkable accuracy. The three elements combine to produce the following formula:

Returns = Income + Growth in income + Effect of changing valuation ratios R = Y + G + V Where: Y is the current investment yield, a known quantity, hence no forecasting is required for this input. G is the annualised growth in income or earnings for the asset. For: • Property, it is growth in rents • Equities, it is growth in Earnings Per Share • Fixed interest, growth is zero, by definition! V is the Valuation Effect. It is the compound effect of an increase or decline in PE ratios or yields on the returns produced by an asset. For example

For equities over a one year period: V= (PE at end of period / PE now ) –1

If PEs rose from 10 to 12 then: V = 12/10 – 1 = 0.2 or +20%

For longer time periods, say 10 years, we use the compound growth rate: V (%pa) = (PE at end of period / PE now)1/10 –1

Using the previous example, over 10 years: V= (12/10)1/10 -1 = 1.0183-1= +1.83% pa Why use 10-year forecasts? They are more accurate than short-term forecasts. EPS growth is steadier over 10-year periods than one-year periods. The effect of a change in PEs is much smaller over ten years than one year, as we have just seen.

The long-term outlook for markets

The forecasts shown below are based upon the Occam’s Razor approach outlined on page 5. This approach to forecasting has many attractions including accuracy, simplicity and transparency. By making available the underlying logic and assumptions (Figure 1 below), subscribers are able to quickly understand the rationale for the forecast and determine the effect of changing the assumptions.

AuEquities

Int’lEquities

AuREITs

Tier 1Debt12

Tier 2 Debt13

Fund of Hedge Funds

PrivateEquity

Cash

Current Yield 6.3%1 2.7%4 6.4%8 6.0%11 8.9%14 - - 4.9%17

+ Currency Impact - 2.1%5 - - - - - -

+ EPS growth (f) 3.6%2 1.0%6 2.3%9 0.0% -1.4%15 - - -

+ Valuation effect 2.3%3 2.1%7 -0.5%10 0.0% -0.2%16 - - -

Index return (pre-tax) 12.3% 7.9% 8.1% 6.0% 7.3% 4.9%19 12.3%18 4.9%

+ Manager value-add 0.0%20 0.0%20 0.0%20 0.0%20 0.0%20 2.0%19 0.2%18 0.0%20

Total Return (pre-tax) 12.3% 7.9% 8.1% 6.0% 7.3% 6.9% 12.5% 4.9%

Total Return (15% tax) 10.7% 6.5% 7.0% 5.1% 6.2% 5.8% 11.3% 4.1%

Total Return (46.5% tax) 8.0% 4.8% 5.0% 3.2% 3.9% 3.7% 9.6% 2.6%

PE Now 12.7 13.7 - - - - - -

PE 2021 (f) 16.03 16.97 - - - - - -

Yield 2021 (f) - - 6.7%10 - - - - -

Worse case long-term scenarios: 10-year REAL total return (pa) is less than…

1 in 50 chance -4.4% -6.7% -5.8% 0.5% -2.2% -4.4% -11.8% -0.7%

1 in 20 chance -0.8% -3.5% -3.8% 0.7% -0.7% -2.7% -7.8% 0.4%

1 in 6 chance 3.9% 0.5% -0.5% 3.0% 0.5% -0.4% 2.2% 1.6%

Worse case short-term scenarios: 1-year NOMINAL total return is less than…

1 in 50 chance -65% -65% -61% -18% -44% -21% -37% 0%

1 in 20 chance -38% -38% -35% -9% -25% -11% -20% 2%

1 in 6 chance -15% -15% -13% -2% -9% -2% -6% 3%

Frequency of years with negative returns

1 year in... 3.0 3.0 3.1 6.3 3.4 6.5 NA Never

Notes(f) denotes a farrelly’s forecast variable.

Figure 1: Expected 10-year returns and underlying assumptions

farrelly’sFORECASTS




Key assumptions (as at 1 March 2012)

For Australian equities forecasts we have assumed:1. Current dividends on ASX S&P 300, grossed up for franking credits;2. EPS growth of 3.6%, vs forecast inflation of 2.5%pa, and real GDP growth of 3.0%pa; 3. PEs moving to 16.0, the long-run PE ratio forecast for inflation in the 2-4%pa range.

For International equities forecasts we have assumed:4. Current FTSE All World Index yield.5. Currency impact will equal the difference between the Australian 10-year bond rate

and that of a FTSE World Index-weighted basket of bonds. This is the return pickup that could be achieved by fully hedging currency.

6. EPS growth worldwide of 1.0%pa, compared with anticipated global inflation of 2.5%pa, and worldwide real GDP growth of 2.2%pa.

7. PE ratios at 16.9, the long-run PE forecast for inflation in the 2-4%pa range.

For Australian REITs we have assumed:8. Current yield of ASX A-REIT index.9. Distribution growth of 2.3%pa which includes the impact of rental growth,

development activities and gearing.10. Yield in 2021 of 6.7%, which is consistent with long-term averages.

For Australian Tier 1 Debt we have assumed:11. Yield is the expected return on the Big 4 Bank term deposits; and,12. Investments rated A or better.

For Australian Tier 2 Debt we have assumed:13. A well diversified portfolio equal to a mix of 50%BBB, 30%BB, and 20%B issues.14. The pre-default yield pickup is 4.9%pa versus government bonds.15. The impact of defaults will be equivalent to -1.4%pa.16. Assumed impact of lower reinvestment rates.

For Cash we have assumed:17. Government bond yields plus 0.8%.

For Private Equity we have assumed:18. A premium of 0.2% above the return on Australian equities on amounts invested,

with an average exposure of 70% private equity, 30% cash.

For Fund of Hedge Funds we have assumed:19. Cash plus a premium for fund manager value add (alpha) of 2.0%.

For Returns we have assumed:20. Returns for Australian Equities, International Equities, Property, Fixed Interest and

Cash reflect index returns. No allowance has been made for the after-fee impact of active management on returns or yields as these vary by fund manager. This may be done by the subscriber using the Proactive Asset Allocation Implementor software.

In this discussion, we look at a number of different interest-bearing assets including cash, government bonds (both nominal and inflation linked), term deposits (TDs), plus high grade and low grade credit risks. farrelly’s has long separated debt securities into Tier 1and Tier 2 Debt – Tier 1 being those securities where you are almost certain to get your money back and Tier 2 being those where the return of capital is more uncertain. The reason for considering these as different asset classes has become starkly obvious over the past five years. On the other hand, farrelly’s doesn’t believe domestic and overseas fixed interest are sufficiently different to require separate examination as, once hedged back to Australian dollars, the medium-term returns are virtually the same where they both carry similar levels of credit risk.

The outlook for Tier 1 Debt

As discussed in this issue’s Editorial, this asset class is currently made up of government bonds, bank TDs which are explicitly government guaranteed and perhaps, hybrids offered by the big four banks.

Estimating 10-year nominal returns on Tier 1 Debt used to be the simplest forecasting task of all – take the 10-year government bond rate and, well, that was it! A 10-year government bond bought at a yield of 4.0% per annum gives a return of 4.0% per annum, if held to maturity. But that was before the banks became generous. As can be seen in Figure 1 the rates paid on TDs are now 1.5% to 2.5% per annum higher than those available on government bonds of similar maturities.

Figure 1 : Bank three-year term deposit rates versus three-year government bonds

Are the banks likely to keep this generosity up? We think so. The banks are keen to replace funding from skittish international markets with more stable domestic retail deposits, and, given the long-term nature of the problems in Europe, this stance is unlikely to change any time soon. Furthermore, under Basel III banking guidelines, deposits from domestic retail investors will be rated more favorably for capital adequacy purposes than wholesale deposits. This means that the banks are likely to pay well for retail deposits for some time

The long-term outlook for debt



Yiel

d d

iffer

ence

(%pa

)

Source: RBA

3.0

2.5

2.0

1.5

1.0

0.5

0.0

-0.5

-1.0

-1.5

-2.0

-2.51992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

yet. And, because TDs are government guaranteed, they have become farrelly’s new benchmark for T1 Debt.

To arrive at a 10-year forecast for TDs in the absence of a 10-year TD rate, we take the current rate on five-year TDs and then estimate rollover rates in five years’ time – which we estimate to be 6.2% per annum, in part reflecting an assumption that government bond rates are more likely to be back above 5% per annum in the medium term (as discussed in the Editorial) and lower spreads above bonds than those currently on offer. The end result is a forecast return for T1 Debt of 6.0% per annum.

The Outlook for Tier 2 Debt

Tier 2 Debt includes all those securities where we can’t be sure of repayment and for which we get paid a premium or spread over the risk free rate. After years of very skinny premiums, the Global Financial Crisis caused these spreads to soar to levels that have rarely and, in many cases, have never been seen before. As shown in Figure 2, spreads have since settled somewhat, but are still quite high compared to historical averages.

Figure 2 : Spreads on BBB and High Yield Securities

Within Tier 2 Debt, we will look at investment grade assets rated BBB (Baa for Moody’s) or better and High Yield assets which are typically rated BB(Ba) or worse. These have also been described as junk bonds, non-investment grade and speculative – we’ll stick with Hi Yield but the other terms are, perhaps, more accurate. Typically, these securities have maturities of around five years. To produce a 10-year forecast, farrelly’s assumes that the current spreads will fall and be rolled over at slightly lower levels in five years’ time; around 3.0% per annum for investment grade and 6.0% per annum for Hi-Yield securities.

Credit failure

High credit spreads tend to be a rather good predictor of future failure rates. And it was no surprise that the last few years produced high failure rates – high, but not nearly high enough to offset the high spreads that were on offer. Today, spreads are much lower reflecting a general belief that the worst of the GFC is over and the generally sound



Spre

ads

Source: Credit Suisse; Federal Reserve of St Louis

18

15

12

9

6

3

01978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011

state of corporate blance sheets, particularly in the US. Figure 3 shows the failure rates for Investment Grade and Hi Yield bonds during two of the worst periods on record and the farrelly’s forecast for the next decade.

Figure 3 : 10-year failure rates - historical average and worst-case, and forecast

Assessing the outlook for failure rates over next decade is not straightforward. On the one hand, the long term economic prospects of much of the developed world are grim. The next decade is likely to be characterised by low growth and recurring financial crises. On the other hand, large corporations world-wide have reduced gearing, are sitting on large cash balances, and are well aware of the difficult economic environment that lies ahead. Similarly, lenders are also cautious about new loans and finally, many of the weakest borrowers have been weeded out during the credit crisis.

And then there is the great wildcard – a full scale banking meltdown accompanied by rapid and uncontrolled contraction of credit which could send failure rates soaring. In this respect, the European credit crisis in the second half of 2011 is perhaps instructive of how such a crisis may play out. In an environment where many, if not most, European banks would have been revealed as insolvent if their assets had been fully marked to market and, with the credit markets going into gridlock, the European Central Bank moved decisively to reliquify the banks with its Long-Term Refinancing Operation pumping more than one trillion Euros into the banking system. This reopened credit markets and has given the banks the opportunity to start rebuilding their balance sheets.

Notwithstanding the irony of helping the banks out by getting them to do more of what got them into trouble in the first place – buying government bonds of dubious credit quality – this looks as it may actually work. By borrowing from the ECB at 1% and reinvesting at 3% to 6%, the banks are receiving what is effectively a capital injection. And, because the funds are being used to refinance sovereign debt, the operation is relieving pressure some of the worst placed countries. An inspired master stroke or a house of cards? It’s hard to tell.

For our purposes, we have seen again that governments around the world will move heaven and earth to prevent a collapse of the banking system. And that means the chance of a full scale banking meltdown – which looked a real possibility late last year – can be assigned to the possible but unlikely bin.

The end result of all of this is that we can assume that from this point onwards, failure rates will be around usual levels.



Failure rates BBB Hi Yield

average (1970-2011) 4.9% 24%

1931 - 1941 14-20% (e) 39%

1981 - 1991 8.4% 41%

2012 - 2022 (f) 5% 35%

Source: Moody’s. (e) = farrelly’s estimate. (f) = farrelly’s forecast

Recovery rates Recovery rates are a different story. While the credit salesmen are quick to point out that even when companies go belly up, bond holders typically end up recovering around 60 to 70 cents in the dollar, we expect that going ahead recovery rates will be quite a bit lower than usual. In a world of low growth, distressed asset sales are unlikely to attract good prices. farrelly’s assumes that Investment grade debt will have average recoveries of 50% with Hi Yield debt averaging recoveries of 30%. The combination leads to an estimated impact of defaults of around 1.4% per annum – somewhat higher than the long-term average of 1% per annum reported by Moody’s.

Forecast returns for Tier 2 Fixed Interest

All this adds up to reasonable, if not spectacular, returns. Hi Yield securities, on these assumptions, offer only marginally better returns than investment grade securities, but with a lot more risk. As such, the higher quality end of the Tier 2 spectrum seems the most sensible place to invest. Even then, spreads above TDs are quite skinny and, as a result, the allocations to T2 Debt in the farrelly’s models have come down somewhat when compared to last year.

Figure 4 : Expected returns from Tier 2 Debt

Inflation-linked bonds

Notwithstanding our expectation that Australian inflation will stay low for many years, it remains a real concern for many investors and they may want to consider investment linked bonds (ILBs). ILBs yields are at 1.5% plus inflation and, given nominal yields of 4.0%, will outperform nominal government bonds in the event that inflation averages more than 2.5% per annum, exactly in line with farrelly’s inflation forecast. However, in order for ILBs to outperform TDs (as opposed to government bonds), inflation will have to average over 4.3% per annum over the next decade. Furthermore, in the event that we do see an inflation breakout above 4% per annum, it is reasonable to assume that five-year TDs will be able to be rolled over at higher than the 6.0% rates assumed in the above discussion. The end result is that an investor would have to fear inflation rising above 5% per annum



Base case Pessimistic casePeriod BBB Hi Yield BBB Hi Yield

10-year risk free rate (%pa) 4.0 4.0 4.0 4.0

Credit spreads 3.2 6.5 3.2 6.5

Current Yield to maturity (5 yr, %pa) 7.2 10.5 7.2 10.5

Less impact of rolling over at lower spreads in 2015 -0.1 -0.2 -0.1 -0.2

10-year average yield (%pa) 7.1 10.3 7.1 10.3

Less annualised impact of failures -0.3 -2.5 -0.7 -6.5

Forecast returns (%pa) 6.8 7.8 6.4 3.8

Assumed failure (10-yr cumulative %) 5 35 8 50

Assumed recovery (%) 50 30 30 20

Source: farrelly’s

on average over the next decade before ILBs look attractive. This is very unlikely - don’t buy them.

Cash

Cash has also been a very good inflation hedge over the years and obviously has done so without the volatility associated with bonds. Short-term rates in Australia have been highly responsive to short-term ups and downs in inflation and for the most part, 2% or so higher than inflation.

The less favourable aspect of cash is that in the event that the Australian economy hits a wall somewhere down the track, short-term interest rates could plunge as has occurred since the GFC in the US and Europe and for much longer in Japan. It’s not likely, but it is possible. If this occurred, long-dated fixed interest will be about the only asset that would produce higher than expected real returns and for that reason, is a great diversifier and is actually a much lower risk asset in the portfolio than cash. Despite what the ‘volatility is risk’ crowd might tell you, long-dated securities give higher returns for less portfolio risk than cash. Buy them!

Summary

TDs remain very attractive in the current environment from the perspective of both a secure return and portfolio risk management. Tier 2 assets are similarly quite attractive when compared to government bonds and cash, but less so than TDs. Government bonds are expensive and even more so when compared to TDs which are also government guaranteed. Cash and inflation-linked bonds are good hedges against inflation, but inflation is quite unlikely to get to levels that will cause these assets to outperform traditional TDs. We recommend that for the secure part of portfolios, you ensure that all cash flow needs are satisfied and then get the rest set in long dated TDs.



Implementation

More than one way to skin a cat

Asset allocation is not an exact science. Forecast returns are approximate, risk is multi-dimensional and difficult to forecast and, most importantly, the efficient frontier is more like an efficient band or an efficient cloud rather than a line. All of which says that there are many good portfolios that can be built to achieve a particular objective – in other words, there is more than one way to skin a cat.

Proactive asset allocation

The asset allocation approaches described in these pages come under the broad heading of Proactive Asset Allocation (PAA). PAA is very different from both Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA). With SAA, asset allocation changes are made very infrequently and are generally small changes when they occur. Under SAA, investors must be prepared to hold and, worse still, buy assets that are manifestly overpriced. On the other hand, TAA is generally about making decisions about short-term price moves over a period that may vary from one to 18 months, which means it is crucially dependent on correctly timing both the entry and exit.

PAA is all about moving ahead of events, sometimes up to two to three years in advance of an event occuring – and as such, PAA is not dependent on correctly timing either the entry or the exit to a position. PAA is essentially a long-term strategy but unlike SAA, it is not blind to valuation excesses. PAA is all about investing in quality assets that are reasonably priced, and more importantly, avoiding investment in overpriced assets.

Different approaches suit different advice models.

farrelly’s offers three different approaches to suit three different types of advisers:

• those who want to create bespoke portfolios to suit their preferences and beliefs and those of their investors;

• those who believe asset allocation should be left to the experts and who want to follow a model allocation that is managed proactively; and,

• those who prefer to make an asset allocation change only when it is essential. Effectively, all this group wants is a quick practical check of their existing asset allocations to see if a change is needed, otherwise they prefer to leave well alone.

The farrelly’s Proactive Asset Allocation Handbook caters to all three appraoches, with three distinct sets of guidelines as outlined on the following pages.


This approach will suit those advisers who believe that allocating between asset classes is something best left to a suitably qualified third party. They should be followed exactly once a suitable level of risk has been selected for the investor. The process farrelly’s uses to create these Model allocations is:

1. Create Benchmark Allocations – to give high returns for a given, stable level of risk.

2. Reduce weights below Benchmark Allocations if assets are fully valued – Even if most risky assets are fully valued or over valued, the Benchmark allocations will have a full al-location to those risky assets because the Benchmark allocations carry a stable level of risk. (For a longer discussion, see page 20). In the event that most assets are fully valued or overvalued as they were in 2007, the overall weights to risky assets will be reduced in these Model Allocations.

3. Assign zero weights to overvalued assets – In the event an asset becomes overval-ued, that is it’s expected return is less than that of government bonds, we will assign a zero weight to that asset class.

These three steps result in Target Allocations.

4. Implement changes slowly over time – The first three steps of this process are all value based and as such, suffer from the curse of all value based approaches; they tend to buy and sell too early. To overcome the value curse, we then stagger changes over time – generally over 18 months to two years. For example, if the Target allocation of a particular asset falls from 16% to 0%, the Model allocations would generally reduce by about 2% a quarter until the Model allocation was 0%. Implicit in this is the idea that when assets become overvalued, they often go on to become extremely overvalued, and, similarly, if they become cheap, they often go on to become very, very cheap. As a result, it is normally a good idea to average in and out of positions over time.

Notes on using the directed approach

1. The Model allocations may be unsuitable as a long-term buy and hold portfolio – This is generally where an overpriced asset is in the process of being sold down over time, and the Model Allocation to that overpriced asset would be too high without a plan for selling down that asset.

2. Investor portfolios should be rebalanced either quarterly or half yearly – If the Model Allocation contains overpriced assets that are gradually being sold down, it is essential that the selling process does take place over time. As a result, it is important that those investors following the Model Allocations review them at least half yearly.

3. New money should follow the Target Allocation rather than the Model Allocation – New cash should be invested in line with the Target Allocation rather than the Model Allocation because the latter will, from time to time, hold assets that are in the process of being sold down. It would be counterproductive to buy an overpriced asset one quarter and sell it down the next. Hence, new money should be invested more in line

A directed approach – leave it to the experts

IMPLEMENTATION



with the Target Allocations rather than the Model Allocations. Similarly, when moving a portfolio from a different asset allocation approach to the Model Allocation process, the farrelly’s Asset Allocation Wizard software provides a quick guide to what moves should be made, and provides backup documentation for compliance purposes.

Figure 1: farrelly’s Model Allocations – March 2012

Note: Model Allocation is for use with existing portfolios. Target Allocation is best used for new monies.

1 2 3 4 5

Model Target Model Target Model Target Model Target Model Target

Risky Assets

Australian Equities (%) 11 12 17 21 29 33 39 44 54 61

International Equities (%) 2 2 4 3 7 6 11 8 16 10

Australian REITs (%) 2 2 2 3 3 6 5 7 6 8

Tier 2 Debt (%) 9 6 11 5 14 5 12 5 6 5

Fund of Hedge Funds (%) 0 0 0 0 0 0 0 0 0 0

Private Equity (%) 0 0 0 0 0 0 0 0 0 0

Total Risky Assets (%) 24 22 34 32 53 50 67 64 82 84

Defensive Assets

T1 Debt (%) 51 55 47 53 37 42 23 26 7 7

Cash (%) 25 23 19 15 10 8 10 10 11 9

Total Defensive Assets (%) 76 78 66 68 47 50 33 36 18 16

Returns1

10-yr total return (%pa, pre-tax) 6.7 7.4 8.3 9.1 10.3

10-yr total return (%pa, 15% tax) 5.7 6.3 7.2 7.9 8.9

10-yr total return (%pa, 46.5% tax) 3.8 4.3 5.0 5.7 6.5

Yield (%pa pre-tax) 5.9 5.9 5.9 5.9 5.9

Worse case long-term scenarios2: 10-year REAL total return (%pa) is less than…

1 in 50 chance 1.4 1.2 0.3 -1.0 -2.9

1 in 20 chance 1.9 1.7 1.0 0.5 -0.6

1 in 6 chance 2.8 2.9 2.9 3.0 3.2

Worse case short-term scenarios3: 1-year NOMINAL total return (%) is less than…

1 in 50 chance -12 -17 -28 -38 -52

1 in 20 chance -5 -9 -15 -21 -30

1 in 6 chance 0 -1 -4 -7 -11


1 year in …. 12.6 7.4 4.7 3.8 3.3

IMPLEMENTATION

For advisers who prefer to leave portfolios alone for the most part but want a quick second opinion on how the portfolios are positioned at any point in time, the Advised approach is suggested.

Under this approach we set upper and lower ranges for the various asset classes as shown on page 19. These ranges are above and below the Model allocations which are constructed as described on page 16.

The Advised approach consists of two steps:

1. Compare the investor’s current allocation with the ranges shown in Figure 2 on page 19. If outside the range bring that allocation back within the range.

2. Add up the exposure to risky and defensive assets and if inside the ranges then all is well. If the risky allocation is higher than allowed, reduce the allocation to the least attractive risky assets and apply that allocation to the defensive assets. Similarly if the allocation to risky assets is too low, then reduce the exposure to defensive assets and apply the balance to the most attractive risky assets.

As an administrative process, this is very similar to strategic asset allocation – check the investor’s current allocation against a maximum and minimum range for each asset class and, if outside those ranges, rebalance the portfolio back inside the ranges. However, while administratively similar, the two approaches have very different outcomes.

The two main differences are, clearly, that the Model Allocation ranges vary over time as you would expect, but also that the size of the band on either side of the Model Allocations also varies. Instead of just being plus or minus 5%, farrelly’s believes it is reasonable to be much more defensive when assets are fully or over priced – it’s just not sensible to be very aggressive at such times. Similarly, when assets are cheap, the minimum weight will be close to the Model Allocation weight but there will be much more flexibility to go overweight. That is, at these times, it’s not a good idea to be ultra defensive; taking a little more risk than usual is fine.

Notes on using the Advised approach

1. Investor portfolios should be rebalanced either quarterly or half yearly – The upper limits allow investors to hold overpriced assets because these upper limits will be reduced over time causing these assets to be sold down over time. Accordingly, it is essential that the review and selling process does take place either quarterly or least half yearly.

2. The limits on exposure to risky assets should be closely followed – Because the ranges on the exposures to individual risky assets is quite broad, it would be very easy to have far too much risk in a portfolio if it were not for the limits on exposures to risky assets as a whole. This provides much of the discipline in the system and therefore should be closely followed.

An advised approach – swim between the flags

IMPLEMENTATION



Figure 1: farrelly’s Model Allocations ranges – March 2012

1 2 3 4 5

min max min max min max min max min max

Risky Assets




Tier 2 Debt (%) 0 9 0 11 0 14 0 12 0 7

Fund of Hedge Funds (%) 0 5 0 5 0 5 0 5 0 5

Private Equity (%) 0 5 0 5 0 13 0 12 0 11

Total Risky Assets (%) 25 30 30 44 44 65 65 79 79 98

Defensive Assets

T1 Debt (%) 39 69 31 56 20 44 12 28 0 11

Cash (%) 4 31 3 25 2 16 2 12 2 13

Total Defensive Assets (%) 70 75 56 70 35 56 21 35 2 21

Returns1

10-yr total return (%pa, pre-tax) 6.7 7.4 8.3 9.1 10.3

10-yr total return (%pa, 15% tax) 5.7 6.3 7.2 7.9 8.9

10-yr total return (%pa, 46.5% tax) 3.8 4.3 5.0 5.7 6.5

Yield (%pa pre-tax) 5.9 5.9 5.9 5.9 5.9


1 in 50 chance 1.4 1.2 0.3 -1.0 -2.9

1 in 20 chance 1.9 1.7 1.0 0.5 -0.6

1 in 6 chance 2.8 2.9 2.9 3.0 3.2


1 in 50 chance -12 -17 -28 -38 -52

1 in 20 chance -5 -9 -15 -21 -30

1 in 6 chance 0 -1 -4 -7 -11


1 year in …. 12.6 7.4 4.7 3.8 3.3

IMPLEMENTATION

This approach best suits those advisers who want to take control of the asset allocation process but want to do so within a disciplined and logical framework. Long-time farrelly’s subscribers and those looking though past issues of the Handbook will note that this approach was the only one offered prior to the September 2009 issue. The principal tools to use to create bespoke asset allocations are the farrelly’s Benchmark Allocations (see page 23) and the farrelly’s Investment Strategy Implementor.

The role of the farrelly’s Benchmark Allocations

The farrelly’s Benchmark Allocations are designed to indicate what sort of return you should achieve for taking on a particular level of risk – that is, they are intended to be used as benchmarks against which to assess the efficiency of investor portfolios. If a investor portfolio is delivering close to the expected returns of the equivalent Benchmark Allocation, then the investor portfolio is efficient and doesn’t need to be changed. But, if the returns of the investor portfolio are well below those of the equivalent Benchmark Allocation, then the asset allocation of the investor’s portfolio should be changed – using the farrelly’s Implementor software – until returns are close to that of the equivalent Benchmark Allocation. Quite often, the investor’s new asset allocation will be very different from the Benchmark Allocation, but nonetheless it will be an efficient portfolio.

The Benchmark Portfolios are NOT designed to be followed slavishly

Because the Benchmarks Allocations are based on current valuations, they respond quickly to changes in relative valuations in markets. As a result, they vary by more each quarter than is sensible to track because, if followed slavishly, they would generate unnecessary turnover and resulting costs and taxes.

In addition, while the Benchmark Allocations change quickly based on current valuations, markets often respond quite slowly to valuation imbalances. Once overvalued, a market can remain so for years and go from being mildly overvalued to massively overvalued over time. Similarly, when in free fall, a market can move from fair value, to cheap, to very, very cheap – as was the case in the second half of 2008 and early in 2009. As a result, the Benchmark Allocations share the curse of all value-based approaches – they tend to buy too early and sell too early. Hence, better results will normally be achieved by following the Benchmark Allocations at a lag.

Finally, in order to fulfil their benchmarking role, the Benchmark Allocations maintain a constant exposure to risk even when risk is unattractively priced. The risk is aligned to the risk level of standard industry portfolios. So Benchmark Allocation 2 will always have the same level of risk as a typical Capital Stable Fund and Benchmark Allocation 4 will always have the same level of risk as a typical Balanced Fund. This means that even if markets are all highly overvalued, Benchmark Allocation 4 will have significant exposures to risky assets (equities, property and Tier 2 fixed interest) in order to match the level of risk inherent in a typical balanced fund. This is because the Benchmark Allocations are intended to describe the return to expect for taking on a certain level of risk. They do not suggest whether it is prudent to take on that level of risk. That is the

A bespoke approach – plot your own course

IMPLEMENTATION



role of the adviser in creating the bespoke allocations. In many respects, the bespoke process should mirror that descibed in the Model Allocations - but with much more control in the hands of the adviser.

When building bespoke asset allocations, the following principles should be followed.

Keep transaction costs lowTranasction costs and taxes eat returns. The keys to keeping them low are pretty clear. Firstly, make as small a change as possible when bringing portfolio expected returns in line with those of the Benchmark Allocations. To do this, you need to use the farrelly’s Investment Strategy Implementor software (available to all subscribers on the private farrelly’s forum). You will find that it is generally possible to find allocations that have entirely acceptable expected returns but require much less change than implied by moving all the way to the Benchmark Allocations.

Rebalance infrequently or stagger changesIn order to avoid the value curse, either make infrequent reviews of investor asset allocations or, when making changes, stagger them over time. We suggest reviewing bespoke portfolios every one to two years. This way, when assets move into over valued territory, you will not sell out at the very first moment and miss out on any move to the very, very over valued status assets can achieve in a bubble. Or, you could choose to make more frequent changes, but implement them gradually over time. For example, a decision to increase allocations to international equities vis a vis Australian equities could be made today, but implemented in six quarterly, or three half-yearly moves over the next 18 months. How you choose to do it will depend on the nature of your practice and systems, and the attitudes of your investors.

Vary the risk level as market valuations varyBecause the risks inherent in the Benchmark Allocations are anchored on typical industry balanced and capital stable funds, they don’t reduce risk when markets become over valued. Subscribers using a Bespoke Approach need to make that decision. Generally speaking, that will mean taking a risk 4 (or balanced) type of investor down to a risk 3 or 2 level gradually over time if a bull market continues unchecked.

Don’t buy expensive assetsHolding over priced assets is a real problem if they were bought at over priced levels. It’s less of an issue if they were bought at fair value. So, one of the keys to building bespoke portfolios is to simply not buy expensive assets. Assets are considered expensive when their expected return falls below the rate of return available on government bonds. The Benchmark Allocations don’t help here. Because they always take on market risk, they may still have significant exposures to expensive assets, particularly in environments where all risky assets are expensive, as was the case in late 2007.

Dollar cost averaging can help when placing new moneyDollar Cost Averaging (DCA) is simply staggering a purchase of assets over time, typically when investing new money. Despite a lot of hype surrounding DCA, farrelly’s research suggests that DCA costs dollars on average. This is because it increases the amount of time spent invested in cash, which tends to be the lowest returning asset in the long term. Having said that, here are some guidelines about when it does and doesn’t make sense to use DCA:

IMPLEMENTATION

1. When markets are fully priced according to the farrelly’s Tipping Point Tables (that is when they are expected to return less than 2.5% per annum above government bonds), DCA doesn’t cost much and may help ease investors’ anxieties. Quite a good idea, in other words. However, make sure that the DCA program is relatively short term – no more than six months is our suggestion.

2. When markets are overpriced (expected returns are less than government bonds) DCA is not a bad idea – but not buying at all is a much, much better one. Again, just don’t buy over priced assets

3. When markets are at fair value (returning 2.5% to 5% per annum above government bonds) DCA is very costly and unnecessary. It’s much better to invest immediately.

4. When markets are cheap and in particular, cheap and falling, then DCA comes into its own. In this circumstance, it will probably make money as well as relieving anxiety (critical at these times). Again, keep the program fairly short, ideally a six month period, but no longer than 12 months.

IMPLEMENTATION



IMPLEMENTATION

Figure 1: farrelly’s Benchmark Allocations – March 2012

Traditional asset class portfolios Portfolios including alternative assets1 2 3 4 5 6 7 8 9 10

Risk Assets




Tier 2 Debt (%) 6 5 5 5 5 6 5 5 5 5

Fund of Hedge Funds (%) 4 4 0 0 0

Private Equity (%) 0 0 5 5 5

Total Risky Assets 24 35 54 70 90 28 39 56 72 92

Defensive Assets

Tier 1 Debt (%) 55 53 42 26 7 55 52 41 25 5

Cash 21 12 4 4 3 17 9 3 3 3

Total Defensive Assets 76 65 46 30 10 72 61 44 28 8

Returns1

10-yr total return (%pa, pre-tax) 6.7 7.4 8.3 9.1 10.3 6.7 7.4 8.6 9.4 10.5

10-yr total return (%pa, 15% tax) 5.7 6.3 7.2 7.9 8.9 5.8 6.4 7.5 8.2 9.2

10-yr total return (%pa, 46.5% tax) 3.8 4.3 5.0 5.7 6.5 3.8 4.3 5.3 5.9 6.8

Yield (%pa pre-tax) 5.9 5.9 5.9 5.9 5.9 5.7 5.7 5.7 5.7 5.7


1 in 50 chance 1.4 1.2 0.3 -1.0 -2.9 1.4 1.2 -0.2 -1.5 -3.4

1 in 20 chance 1.9 1.7 1.0 0.5 -0.6 1.9 1.7 0.9 0.3 -0.9

1 in 6 chance 2.8 2.9 2.9 3.0 3.2 2.7 2.8 2.9 3.0 3.2


1 in 50 chance -12 -17 -28 -38 -52 -12 -17 -28 -38 -52

1 in 20 chance -5 -9 -15 -21 -30 -5 -8 -15 -21 -30

1 in 6 chance 0 -1 -4 -7 -11 0 -1 -4 -7 -11


1 year in …. 12.6 7.4 4.7 3.8 3.3 12.9 7.5 4.8 3.9 3.3

Notes1. Returns and yields for Australian Equities, International Equities, Property, Fixed interest and Cash reflect index returns. No allowance

has been made for the after-fee impact of active management on returns or yields. This may be done by the subscriber.

2. Long-term worst case scenarios are real (ie after Inflation) returns. If subscribers wish to get a sense of nominal worst case scenarios they should add expected inflation, 2.0%, to these figures.

3. Short-term worst case scenarios are shown in nominal terms, given investors generally think in nominal returns during falling markets.

CROCKPOT

They are safe. They are negatively correlated with equities. And, best of all, their performance has been excellent. Sounds like the perfect diversifier. What could be wrong with this story? Quite a bit, actually!

Firstly, a good diversifier will normally decrease risk without reducing returns or increase returns without increasing risk. Government bonds over the past few years have delivered on both counts, increasing returns and decreasing risk – yes, they have been a great diversifier. Have been. Past tense. What we need to know is whether they will be a good diversifier going ahead. In fact, compared to term deposits, government bonds offer much lower returns. Current term deposit rates with major banks are around 2% per annum higher than those of government bonds with equivalent maturities. That means TD investors will have 10% more capital after five years compared with passive government bond investors. Not might have, will have.

We could end this here, as our definition of a good diversifier doesn’t allow for an asset that reduces returns. However, it is conceivable that a low returning asset reduces risk by so much that it allows other low risk assets to be replaced by higher returning, higher risk assets. Government bonds strike out again. They have the same security as TDs – both are government guaranteed. From a medium-term perspective they have the same level of risk – that is, the same level of medium-term return uncertainty – none!

So, going ahead, government bonds will reduce portfolio returns without reducing portfolio risk. This is the opposite of good diversification, and makes them a bad diversifier.

What about that negative correlation with equities? It can be argued that negative correlations reduce risk – but only if you believe that short-term volatility is better than long-term return uncertainty as a measure of the true risk investors face. And, even if you buy that story, you need a lot of risk reduction to make up for the 2% per annum lost return to just break even.

What if bond rates keep falling? From a medium-term perspective, it makes no difference. If rates fall from 3% to 2% then in the short-term, your 3% bond may return 7% in the first year. But that will be followed by 2% per annum in the next four years to average – who would have guessed – 3% per annum over five years! If you are a gun short-term trader, bonds may make sense if rates fall. However, for medium- to long-term investors, the pattern of returns is just a distraction.

What about international government bonds, surely they are a source of additional diversification? Spare me! Once hedged, these will offer close to the same returns as Australian government bonds but with dramatically higher risk. There is a long-term sovereign debt crisis playing out in most of the developed world. These securities offer lower returns and higher risk than TDs – the definition of a very bad diversifier.

Good diversification is not just about buying different or uncorrelated assets, it is about lowering portfolio risk without reducing returns. Everything else is bad diversification.

Government bonds as a good diversifier for the next few years?

It’s nuts and you can clearly see it’s nuts!

Government bonds, the essential diversifier?

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012

Proactive Asset Allocation Handbook - MC2 Wealth · Page 4 of 24 farrelly’s Proactive Asset...

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