Bridge_Autumn.pdf (PDF - 471KB)
BRIDGE AUTUMN 2008
Market Update: Predicting the market is like a dog chasing its own tail
Editor's letter: Ignore risk at your peril
Attend a Vanguard Portfolio Construction Workshop
AML/CTF Act now in force
Taxing times:Why tax matters even more in volatile times
Is fixed interest back in vogue?
Market Update: Predicting the market is like a dog chasing its own tail
Have we seen the worst of the share market correction or is the share market/economy dog going to continue chasing its tail until it ends - to put it politely - up its own abscissa?
When a market bubble bursts, irrational optimism quickly turns to irrational pessimism.
Market fundamentals and rational analysis are then replaced by unmeasurable and unpredictable psychological factors.
Consumer and business confidence falls in response to the market falls and the share market/economy dog gets another unpleasant kick.
This is the state most global share markets are now in.
Why is uncertainty still high on Wall Street and likely to remain so? The first reason is the US and global economic outlook.
In its latest global update, the IMF lowered its global growth rate prediction for 2008 from 4.4 to 4.1 per cent and stressed that a global slowdown is now in progress.
Note though that the IMF has not predicted the US will actually suffer a recession - two consecutive quarters of negative GDP growth. But all the talk about such has added to share market pessimism around the globe.
The second reason for continuing uncertainty is the likelihood that we will see further disclosures of US financial market problems.
Two particular, double-whammy problems stand out: leveraged buy-out (LBO) debt and the collapse of the market for mortgage-backed securities and for collateralised-debt obligations (CDOs), which are backed by such securities.
Until recently, US banks had lent happily to finance huge private-equity deals and then unloaded all or part of the debt into a deep and liquid secondary market.
However, increasing defaults on this debt have made it a lot harder for the banks to unload LBOs, thus forcing them to cut their lending dramatically.
Additionally, at the end of January, S&P downgraded or threatened to downgrade more than 8,000 bonds and CDOs and warned that financial institutions' losses tied to them could more than double to a mind-boggling $US265 billion.
Hence the importance of the string of the US Federal Reserve's cuts in official interest rates and the Bush Government's $US152 billion tax cuts and business stimuli package announced in mid February.
The trouble is such measures take time to give a boost to the economy - and general optimism about share markets.
What is likely to happen over the next few months? The worst case scenario is that further disclosures of US financial problems will occur and that the monetary and fiscal stimuli already put into place will not stop a sharp slide into a US recession.
The general consensus puts about a 25 per cent chance on this happening. The more optimistic outlook is that these measures and stimuli will prevent a serious US recession and that the rest of the global economy will experience only a moderate slowdown.
Certainly continuing strong growth in China will keep a very important prop under the global economy and resource exporting economies such as Australia.
The most likely course of US equities over the next few months is thus a series of crab-like movements until it is clear that the major problems in the US are fully out of the woodwork and that the Federal Reserve interest rate cuts and the fiscal stimulus have had sufficient positive impact to prevent a serious recession.
In short, the recent downturn is a long overdue reminder that periods of excessively good performance are inevitably followed by more moderate and rational ones.
As the accompanying graph shows, it is investing for the long-run that really matters. 
Dr David Clark taught Business Economics at the University of NSW for 35 years, was an AFR and Personal Investor columnist for over a decade, and is now an investor educator. The views expressed are those of Dr Clark's, not necessarily those of Vanguard's.
Top
Editor's letter: Ignore risk at your peril
Robin Bowerman, Head of Retail
Markets have a way of bringing us all back to earth. After four stellar years, the unravelling of the US sub-prime mortgage mess and the subsequent credit crunch has reminded investors, advisers and fund managers that risk may hibernate for extended periods but it can never be removed from the equation no matter how clever the financial structure.
These periods of extreme market volatility, while stressful for clients and advisers alike, also provide opportunities not just in an investment sense for those with funds but also in terms of strengthening and underscoring the real value of a long-term financial plan that is properly crafted around a client's goals and risk profile.
It is also a good time to check whether ways of operating have stood the stress test of a major market correction. For example one of the propositions that Vanguard often hears is that index funds are not the place to be when a market is nearing record highs. The theory goes that a correction may not be far off and that active managers have the capacity to sell out of markets when valuations are inflated.
The theory sounds fine. It is just that few active managers actually can get that timing right. That is not being critical, because no-one really understood the scale or could predict the global knock-on effects of the sub-prime crisis which really destroyed confidence in banks to lend to each other. The great strength of an index approach is its diversification of risk and that has held our equity funds and most importantly our clients in good stead.
So just as the evidence suggests few active managers outperform the index over the long term after fees and tax. There is scant evidence that active managers outperform in bear markets.
On the fixed interest front our funds have maintained their focus on high quality corporate and government bonds. As we have seen in recent months when markets are bordering on panic you want your defensive assets to be just that - high quality and defensive. The role of fixed interest in portfolio construction was being strongly questioned in some quarters 12 months ago. However, recent events have reminded us that you ignore risk at your peril. Many investors that chased higher yields through hybrid instruments have learned that lesson the hard way.
Finally, there is the after tax return. Vanguard has lead the way with aftertax reporting and while market jumps and dives have grabbed the headlines advisers would do well to examine how their favourite funds performed to the end of December 2007. The income and growth splits reported by Morningstar suggest that some investors may cop a double whammy come end of tax year - an investment that has lost capital value and delivered a tax bill at the same time.
Markets are capable of providing more than enough surprises; advisers do not need fund managers to add their own.
Top
Attend a Vanguard Portfolio Construction Workshop
Throughout 2008, Vanguard is continuing its popular series of Portfolio Construction workshops. Learn about the latest trends in portfolio construction, asset allocation strategies, rebalancing techniques and earn CPD points at the same time.
Presented by Michael Houlihan, Manager - Retail Products and Technical Services, the workshops run from 9:00 am to 12:00 noon and include lunch. Places are limited to 25 per workshop so register now at vanguard.com.au/coresatellite
Upcoming workshops
16 April - Brisbane
17 April - Cairns
22 April - Perth
23 April - Adelaide
29 April - Newcastle
May - Melbourne
May - Sydney
Top
AML/CTF Act now in force
After a hiccup delayed the introduction of mandatory identification requirements for managed funds, the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (Cth) (the AML/CTF Act) is now in force.
Under the new regulations, it is now mandatory for investors to verify their identity when submitting their initial application.
Details of the verification requirements are outlined in Vanguard's Product Disclosure Statements. IFSA/FPA standard identification forms are available online at vanguard.com.au/financial_advisers/resources
Top
Taxing times:Why tax matters even more in volatile times
The role of the financial adviser is rarely more valuable to an investor than at times of extreme market volatility. Managing expectations, soothing jangled nerves and helping clients stay on track with their financial plan can strongly reinforce an adviser's value proposition.
Trust earned in the heat of market turmoil can turn a good client into a loyal advocate. But unexpected surprises at a time when markets are already testing client's faith can quickly reverse all that good work. So consider how lients will react if they get their portfolio report and see that their Australian share fund has not only lost capital value but has pumped out large distributions which the investor may have to foot a hefty tax bill.
It is understandable that when markets are gyrating wildly, the focus is on the absolute return. But when the volatility settles the after-tax return again becomes the most important number for most investors.
At present, many advisers will be grappling with how best to manage the expectations of their clients who have become conditioned to the exceptional equity market returns of the past four or so years. But when you look at the Morningstar performance data for 2007 some major funds are on track to give investors a double whammy - capital losses and large distribution of realised capital gains that will come with a tax bill attached.
Booming markets hide a multitude of sins
When funds are delivering annual returns of 20 or 30 per cent, the tax consequences tend to be overlooked. Michael Houlihan, Vanguard's Manager of Retail Products and Technical Services said: "The next six months should be interesting, if markets stay flat what you're going to have is a zero total return with funds still paying income."
Australian equities: growth or income investment?
The table below compares the average income and growth returns of the top 20 Australian equity wholesale funds by size and the total market based on Morningstar data. As the data shows over the past year, the top 20 funds delivered an average negative growth with high income. This compares to the total market, which delivered almost no growth while income levels effectively matched the total return.
Comparing these returns to the index using the Vanguard(r) Australian Shares Index Fund you get a different story. Vanguard's index and growth data is more akin to what you might expect from an Australian equity fund, with two-thirds of the return delivered in growth and one-third in income.
You can run but you can't hide
The mixed performance results for 2007 come after an extended period of exceptional equity market returns. There are several factors at work here but Michael Houlihan says: "A major influence on the large income component of returns is caused by high turnover in actively managed portfolios. By contrast, Vanguard's index fund uses a buy and hold approach so it has very low turnover."
This is a case of advisers understanding each manager's investment style. For some retiree investors who are not paying tax the high level of income distributions is largely irrelevant but for tax-paying investors in the accumulation phase it is a much more important consideration.
The latest results do not mean that active managers are doing anything different: the level of income as a result of portfolio turnover doesn't necessarily change in any given year as active managers are still turning over portfolios whether it is a bull or a bear market.
What should advisers focus on?
The key point here is for advisers to match the investment outcomes on an after-tax basis to client needs and expectations. Advisers need to be aware of the breakdown of the income components that each fund delivers - important information for any adviser as it gives an indication of how often a fund manager turns over their stocks.
While it's reasonable to assume that funds with higher income returns will deliver lower after-tax results, it is not always the case. Advisers need to look at the turnover of the manager's portfolio to see whether the distribution is made up of long-term discounted capital gains or short-term gains. For example, a fund might produce a high-income return but if the stocks sold had been held for more than 12 months then it will provide a better after-tax outcome courtesy of the discounted capital gains tax rate than a fund that sells stocks held for less than a year.
Efficiency is king when it comes to tax
Portfolio turnover provides a good indication of the tax efficiency of a fund manager's investment approach. In Morningstar's last review of Australian equity funds it found the median expected turnover was 50 per cent per year with actual turnover levels ranging between five to 150 per cent.
This is no short-term aberration
Interestingly, the longer-term data in the previous table shows similar results to the 12 month returns. For example, over the five year period, the total return for the top 20 funds was slightly below the index fund, but delivered more than double the income levels.
An index manager does not make bets on specific stocks so there is no driver to buy and sell stocks unless the index changes. Further, Vanguard's optimised indexing approach minimises turnover as it holds a representative sample of stocks rather than the full universe.
Michael Houlihan says: "Vanguard's data shows this is not a short-term aberration but a medium to longer-term reality of what active managers do." It also highlights how over the longer term the active manager returns perform close to benchmark. On an after-tax basis, you would expect the returns to fall below the benchmark depending on the efficiency of the fund manager's investment process.
Beware, not all index funds are the same
Quite surprisingly, there is a distinct difference in index manager returns when you look at the income and growth return data. This can partly be explained by the different approaches to indexing.
Vanguard uses an optimised approach to indexing rather than full replication. Full benchmark replication usually results in higher turnover of the portfolio with typical benchmark turnover of around 5 to 10 per cent. This compares to Vanguard's average turnover of around 2 to 5 per cent.
Could your clients do with fewer surprises this financial year?
The returns to 31 December 2007 could be regarded as early warning of a poor tax outcome so now may be the time to delve a little deeper into the composition of fund manager returns as clients receive their end of year statements.
In a roaring bull market perhaps the after tax numbers get less focus than the total return number but when markets are flat, or declining, costs - and tax is the biggest cost to most investors by far - get a lot more attention.
Index income/growth returns for the year ended 31 December 2007 1 year % return Income Growth Total Vanguard(r) Australian Shares Index Fund 5.3 10.6 15.9 Average - index funds universe 11.2 4.9 16.1 Source: Morningstar subscription data (after fees, before tax) Past performance is not a reliable indicator of future performance.
Top
Is fixed interest back in vogue?
Roger McIntosh, Vanguard Principal and Head of Fixed Interest and Investment Solutions, explains why many investors are re-examining their asset allocations and revisiting traditional fixed interest investments.
The equity market bull run over the last four and a half years has had an impact on investor's perceptions of fixed interest as an asset class. With equity and listed property markets delivering annual returns in the vicinity of 20 per cent, many investors have questioned why they hold bonds. At the same time, some income seeking investors turned to sub-investment grade debt instruments in their efforts to secure higher yields.
The recent equity market turmoil reinforces the importance of including bonds in a diversified investment strategy. There is, however, a case for holding bonds in a diversified portfolio in all market conditions whether markets are volatile or not. Why?
Diversification
Bonds are a defensive asset class and should provide a stabilising effect during periods of share market weakness. One of the best ways to demonstrate the diversification benefits of fixed interest is to look at the correlation data. The table below shows the correlation between fixed interest and equities and listed property trusts over the last 10 years. As the data shows, fixed interest is negatively correlated with equity markets and importantly this correlation does not change significantly over different time periods.
Asset classes with correlations below one are important for diversification as they improve portfolio efficiency by lowering return volatility. Negative correlations, like those between fixed interest and equities, offer more substantial diversification benefits.
Fixed interest has typically produced positive returns when equity markets have fallen so including fixed interest assets in a portfolio can help offset or reduce negative returns during periods of market volatility. For portfolios with a low risk aversion, with a higher allocation to equity assets, an allocation to fixed interest can reduce the extremes of portfolio returns and reduce total risk, or standard deviation. For those with a higher risk aversion, it helps to preserve capital.
Creating the perfect storm - the pursuit of higher yields
Strong equity returns over the last few years have caused the marginalisation of bonds to a certain extent. In an effort to become more appealing to investors, product manufacturers have spiced up their offerings introducing higher yielding, or sub-prime investments. But in the pursuit of higher yields we are now seeing compelling evidence of higher - in some cases much higher - levels of risk.
Staying true to label
The new breed of fixed interest investments has introduced more equity type attributes into what should be a defensive asset allocation. At the same time, they have created unrealistic return expectations. Unfortunately, many of these strategies backfired on unsuspecting investors who didn't fully understand the risks. Basis Capital, Absolute Capital Investments and Westpoint are cases in point.
Products that looked great when credit markets were strong have given up much of their returns in the last six to 12 months during this period of volatility in credit markets. In contrast, Vanguard's ultra-diversified indexed strategy has outperformed the majority of active managers over the last 12 months based on Mercer survey data to 31 December 2007.
It looks like a diversified allocation to quality investment grade bonds could be the height of fashion for diversified portfolios this season.
Indexing for efficiency and diversification
One of the most efficient ways to gain exposure to bond markets is through indexing. Indexing offers a well-diversified, transparent long-term investment strategy delivered at low cost.
Vanguard's fixed interest product suite covers approximately 80 per cent of global bond markets and excludes mortgaged-backed securities.
The funds had no direct exposure to sub-prime instruments like collateralised debt obligations.
The suite encompasses the Vanguard® Australian Fixed Interest Index Fund, Vanguard® International Fixed Interest Index Fund (Hedged) and Vanguard® International Credit Securities Index Fund (Hedged).
Top
