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News & Commentary
Helm April 2009: Can we see the bottom yet?
Can we see the bottom yet?
Editor's letter
Technical insights
Outlook
Your say
Can we see the bottom yet?
The water is tempting … but investors are naturally reticent about diving back into sharemarkets having just weathered a storm the likes of which we haven’t seen since the 1930s. By Robin Bowerman
Given the decline in sharemarkets globally, investor confidence has fallen almost as fast as sharemarket values. The speed of the decline and the volatility around it has been dramatic by historical standards. For example if you look at the US sharemarket as measured by the S&P500 index to the end of December
2008 the fall from the market peak was both steeper and deeper than the two most recent market declines in 2000-02 and 1973-74. This time the US market has taken only 300 days to get to the same point that in 2000-2002 took more than 600 days.
In Australia the speed of the 1987 crash still wins handsdown in the race to the bottom because it took less than 50 days to fall as far as this decline covered in around 300 days. If there is one clear message out of this market decline it surely has to be the irresistible power of markets when in full retreat. So it highlights the importance of the asset allocation decision and how much of your portfolio you allocate to various asset classes.
Warren Buffett – widely acknowledged as one of the canniest investors of our time – has had his worst year ever in 2008 with Berkshire Hathaway losing $US11 billion in value. Perhaps the rest of us mere mortals should take some comfort from that.
It clearly mattered a lot less which shares you own compared to how much of your portfolio you had invested in the share market.
The most important decision that investors could have made last year was how much they invested in shares versus fixed interest.
Quality, defensive fixed interest assets were the one asset class in 2008 that delivered on its promise to investors. Performance figures show that Vanguard’s range of fixed interest funds deliver in difficult markets.
If you accept the premise that it is more about markets than trying to pick individual shares (or active managers) it leads you to the question of how much do you want exposed to the sharemarket and perhaps, more pertinent at the moment is how – and when – do you get that exposure?
You do not have to be an avid student of the investment world to have heard the adage that it is ‘time in the market not market timing’ but that does not stop people looking for signals that the market has hit bottom and it is safe to go back into the market. Both large institutional investors and individuals are looking for some sign that markets are returning to more normal patterns – lower volatility being possibly one of the key indicators of that return to normality.
The challenge is that it is very tough to call market turns – be they the peak of a bull run or the bottom of a decline. The inescapable reality is there is no clear, reliable predictor of when markets are about to turn and when it is safe to invest again.
So it is perhaps tempting to stand on the sidelines and wait until normal service is resumed.
But sitting on the sidelines is not a risk-free option either. We constantly counsel people of the danger of looking at past performance but in situations like this there is little alternative but to look at long-term history for context.
That market history tells us just as market peaks are hard to accurately describe until after the event, the same holds true for recoveries. For example you may say to yourself you want to see some steady gains over a three month period before you invest more into the sharemarket.
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Quality, defensive fixed interest assets were the one asset class in 2008 that delivered on its promise to investors. Performance figures show that Vanguard’s range of fixed interest funds deliver in difficult markets.
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In the US market missing the first three months of the recovery would cost you about 16% in returns. Australian market declines and rallies since 1979 tell us the average return for the first three months of the recovery is 13%.
So just as market sentiment can turn pessimistic very quickly, when confidence begins to return that can also happen quickly. And in the Australian market context, our superannuation system with its mandatory contributions is providing quarterly cashflow that has to be invested somewhere. Market indicators suggest there has been quite a staggering build up of cash in term deposits and cash management funds.
So is there a way to manage the risk of going back into a market too early and seeing it fall further? One strategy is to scale into markets over time. Spreading your investment over different time periods or dollar-cost averaging – has both its supporters and critics.
To illustrate the impact of dollar cost averaging, Vanguard has modelled the difference between investing a single lump sum compared with averaging your money into the market in equal parts over various time periods.
Vanguard’s strategy group in the US modeled the different approaches using US market data from January 1976 to November 2008 for both shares and bond markets.
The results show that for investors concerned about the risk of ‘buying early’ the dollar cost averaging approach works well. This approach narrows the range of outcomes – both in terms of potential loss and potential gain. So the lump sum approach produces higher highs and lower lows than averaging in.
For example using the data set for the US market, and assuming a mid-point market return, a person who invested equal amounts over 12 months received an annual return of 8%. A single investment at the start of the period delivered a 14% return. That may seem like an argument against averaging-in but of course we do not know when markets will begin growing again.
So in the case of an extremely negative market, the potential loss was -26% compared with an -18% loss for the investor who averaged-in over time.
Why not wait until the signs are stronger and recovery is well underway?
Certainly Vanguard’s US economists are forecasting this will be the longest recession since the 1930s. Sitting on the sidelines may feel more comfortable now but it is not a riskfree option. There is the opportunity cost that comes from missing the first leg up of a growth market.
So it comes down to a question of risk: a single one-off investment carries substantial timing risk. Averaging-in over time definitely lowers the risk of being early – and wrong. It also significantly offsets the opportunity cost of missing out if markets turn quickly.
Editor's letter
Robin Bowerman, Principal and Head of Retail
It is a challenge to keep a personal context around the world economic situation. The International Monetary Fund has forecast that our global economy will go backwards for the first time since World War II while world political and financial leaders work out elaborate bailout packages to restore our financial system to functioning health by rebuilding balance sheets to allow credit to flow once more.
There is one reassuring certainty about the global financial crisis – it will end at some time and the world’s economy will again begin growing. The bad news is that no-one knows when that will be and the expectation is that the recovery will be tempered because of the debt overhang.
While good news has been hard to come by in recent months, the US Government’s plan for cleansing the US banking system of bad debt has at least provided a circuit breaker and perhaps points to a way out of the debt morass that has engulfed the world’s financial system. Getting the US banking system functioning again has to be the first step along any path to recovery.
More importantly the detailed plan revealed by US Treasury Secretary Tim Geithner is encouraging on another level. The effectiveness of the plan will be debated long and hard over coming months but the message it does send clearly is that governments and financial regulators are continuing to work on solutions to restore the
solvency and liquidity to the financial system. The stimulus packages and rapid setting changes on monetary policy are unparalleled in both size and scope.
No-one can doubt the determination to fix the problem and while there are clear parallels with the 1930s, this level of government intervention is one of the stark differences. But while governments can effectively borrow money against the ability of future generations to fund it the same luxury is not extended to the personal household. We have to take a much more personal view of the situation and how we repair our own balance sheets.
Everyone’s situation will be different but one thing is common – now is the time to review the situation. A written financial plan is a practical tool during volatile times like these. Goals may well have to change, lifestyles adjusted to allow for more savings, retirement timeframes pushed back or asset allocations adjusted but a plan can provide the personal context for all those decisions.
At Vanguard, the markets have proved a challenging business environment to operate in. But our belief and commitment in the underlying investment principles that have shaped the organisation here and in the US is not simply intact but reinforced.
Taking a long-term perspective, having realistic expectations and understanding risk are key planks of Vanguard’s approach to investing. Building a well-diversified investment portfolio while keeping a sharp eye on costs remains as valid today as it was a year ago.
Technical Insights
Michael Houlihan, Manager, Retail Products and Technical Services discusses strategic core-satellite asset allocation decisions
When building investment portfolios it is very easy to get distracted by performance – and this was particularly evident looking back to 2007 when we were in the middle of a very strong bull market. In fact it would have been very difficult not to invest in assets that produced large positive returns. However, what some forgot
about in those heady days was the basic premise of how to construct an appropriate investment portfolio – the concept of diversification and risk protection.
In the previous edition of the Helm we spoke about the broader concept of using a core-satellite approach to create a portfolio. In this edition we would like to delve deeper into the first step of building a core-satellite portfolio – the strategic asset allocation decision.
But firstly, what is asset allocation and why is it important?
One of the first issues to consider when building your investment portfolio is to understand the concept of risk – in particular market risk. Market risk is the possibility that the market has negative returns over short or even extended periods. Cash investments have the lowest market risk. Bonds then property securities then equities (shares) have increasing levels of market risk.
Asset allocation refers to the allocation you make across different asset classes, i.e. shares, property, bonds and cash with the objective being to create a diversified portfolio of investments. Asset allocation allows you to spread your investments across the different asset classes to better protect you from the downside
risk of being only exposed to one asset sector.
For example, if your investment portfolio was only invested in Australian shares for the year to December 2008, you would have received a return of -39%. However, Australian bonds achieved a return over the same period of +14%. Therefore, if you had allocated a portion of your portfolio to Australian bonds
you could have reduced the overall loss on your portfolio.
The performance of your investment portfolio depends on three interrelated decisions – stock selection, market timing and asset allocation.
In their landmark 1986 paper, Brinson Hood and Beebower found that stock selection and market timing had very little impact on an investors’ final return, and that long-term asset allocation was the primary determinant of performance. Later research conducted by the Vanguard Group also confirmed that in the long-term asset allocation decision is the primary driver of the performance of a portfolio.
But how much do I allocate to each asset class?
When setting your asset allocation you need to take a number of things into account.
Why are you investing?
- What are your short term goals? (1 to 3 years)
- What are your medium term goals? (3 to 5 years), and
- What are your longer-term goals? (5 years plus)
What is your time horizon?
Your timeframe is simply how long you are planning to invest your money. Usually the longer your timeframe the more aggressive you can be with your investments.
What is your risk profile?
Understanding your attitude to risk and return is arguably the most important decision when planning your investment strategy.
As indicated above, growth assets, such as shares and property, generally have a higher level of risk than income assets such as bonds and cash. Therefore, if you have a longer investment timeframe and are willing to accept more risk in your portfolio, then you might consider a higher allocation to growth assets.
Diversifying your investment portfolio across asset classes and allocating the appropriate proportions to those asset classes (depending on your investment objectives/strategy) is also a key decision that you need to make so it is worthwhile taking the time to get it right. In times of extreme market volatility, this can be easier said than done when emotions are factored into the equation. This is one reason to consider speaking with a financial adviser.
Outlook
Vanguard news and information
"Once you’ve set up a conservative, balanced, broadly diversified portfolio, as well as a way to add to it regularly, try to let it be. Don’t check your returns daily."
John J. Bogle, October 2008
Vanguard wins Morningstar Fixed Interest Fund Manager of the Year
Vanguard was recently named the Morningstar Fixed Interest Fund Manager of the Year at the 2009 Morningstar awards held in February. For more information on this award, click here.
Vanguard announces plans to launch Exchange Traded Funds
Vanguard has recently announced its plans to launch a range of exchange traded funds (ETFs) for Australian investors.
Vanguard will now be able to offer investors the option of buying indexed based investments through managed funds or ETFs depending on your personal circumstances and preferences.
ETFs are managed funds that are traded on the stock exchange. Index-based ETFs deliver all of the diversification and low cost characteristics of indexed investments coupled with the trading flexibility, liquidity and transparency of shares.
Stay tuned for full details of Vanguard’s ETF product offering, once regulatory and legal approvals are finalised.
You can register to receive further information on these new funds here, or read the press release about ETFs here.
Vanguard SMSF Seminars
When the going gets tough...the inside story of how to build SMSF portfolios
If you would be interested in attending a seminar specifically for SMSF investors where we will share some of our insights on:
- Investing in volatile markets – can we see the bottom yet?
- The opportunity cost of missing out on market rebounds
- Constructing portfolios that will allow minimisation of risk while taking advantage of the investment control that only an SMSF offers
- Identifying and managing the risks inherent in any portfolio
Simple tips for a successful investment strategy
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Your say
Martin Carr, Head of Investor Relations, discusses some questions you have asked recently, relating to our fixed interest funds.
What are the risks associated with investing in bond funds?
While bonds generally do not fluctuate in value as much as shares, bond prices can still go up and down. An investor that selects a bond fund needs to be aware of the following risks;
- Interest rate risk – a bond fund’s value goes down when interest rates rise and increases when interest rates fall. Bond funds with a mixture of short term and long term bonds can reduce this risk as they are more diversified.
- Credit risk – if an issuer’s credit rating reduces or if a bond defaults on its bond obligations this will impact on the performance of a bond fund. Managed funds such as Vanguard that diversify their bond exposure and holds only investment grade bonds across a wide variety of issuers help reduce this risk.
- Currency risk (for international bonds) – fluctuations in the value of the Australian dollar and foreign currency can seriously affect returns from overseas investments. When international investments are hedged as in the case of Vanguard’s Diversified Bond Fund, gains and losses due to currency fluctuations are offset by opposing losses and gains on the currency hedges. Returns are then only a result of movement in the fixed interest market.
Why has the Vanguard Index Diversified Bond Fund and Australian Fixed Interest Fund had negative performance for February 2009?
The value of a bond can change continually due to many factors, including interest rate movements, supply and demand of bonds and changes in market expectations of the financial health of the bond. In February 2009, the market expected the RBA to announce an interest rate cut and subsequently factored this into the price of bonds.
When no change was made to the cash rate, bond market yields increased. The decrease in the capital value of the bonds outweighed the return from bond coupon payments. This led to the negative return for February.
This is an uncommon event, but can occur from time to time. Importantly, over longer timeframes the likelihood of negative returns diminishes. Remember that even when the capital value falls, the bonds continue to pay the coupon.
