How to invest like the professionals in volatile markets

By Tony Kaye

AUSTRALIAN investors have legitimate cause to be nervous amid escalating volatility on equity and other financial markets, heightened geopolitical tensions, a falling residential property market and rising US economic concerns.

After a sharp fall in global stockmarkets in March triggered by the first salvo in a massive US-China trade war, relative calm returned for share investors until October when another bout of instability wiped billions off the value of many stocks.

That volatility – right in the middle of a buoyant US third-quarter corporate earnings season – links to fears that US interest rates may be increasing more quickly than many companies and individuals in the world’s largest economy and beyond can handle.

US President Donald Trump even went as far as stating he was unsure whether he had made the right choice in appointing new Federal Reserve Bank chairman Jerome Powell, who has not refrained from outlining his program for multiple interest rate rises. The concern is that rapid rises will not only cause pain for borrowers but spur inflation, putting pressure on consumers at all levels.

Yet, while many retail investors are worried by the current proceedings and what could be around the financial corner, most seasoned financial professionals are taking events in their stride.

Rather than panicking, those with long markets experience are positioning their investment portfolios for new “value” opportunities. Even dark investment clouds can have silver linings – especially for investors with defined strategies and longer-term horizons.

Stockmarket downturns always create buying opportunities for investors when high-quality companies with strong business fundamentals are oversold. The same is applicable for other asset classes, including investment property.

However, instead of making severe changes to their portfolio allocations, most fund managers will be adjusting and finetuning their holdings across Australian and international equities, fixed interest, property, infrastructure, private equity, cash and other alternatives.

Even dark investment clouds can have silver linings – especially for investors with defined strategies and longerterm horizons

Put into perspective, what happens in the near term will have little impact on the long term.

Over the last 20 years, the Australian Securities Exchange (ASX) has seen five major corrections of 10 per cent of more.

But over the same period it has had the same number of bull markets and achieved a solid base return of around 150 per cent. On a total return basis (including all dividends paid) that return is significantly higher, at more than 480 per cent.

This shows that, rather than trying to time the ups and downs of markets based on events, the secret to successful investing is total time in the market coupled with proper asset diversification.

THE NEED FOR DIVERSIFICATION

Heightened stockmarket volatility is often a time when investors recede to higher holdings of cash, and many professional fund managers have lifted their allocations in this asset class over recent times.

Cash is effectively the lowest-risk asset class, especially in Australia where there is a federal government guarantee on all bank cash holdings up to $250,000 per individual. However, while retail investors tend to cash out their asset positions as a safety mechanism, professional investors generally exit into cash with a view to reinvesting into higher-return assets.

In the current environment of record low interest rates (with bank accounts on average returning less than two per cent) sophisticated investors – including retirees seeking good income streams – are searching for higher yields in stocks and other growth areas including peer-to-peer lending.

Rob Holder, an asset allocation specialist at Crestone Wealth Management, says diversification – both across and within asset classes – is essential in terms of achieving optimal portfolio results.

“So, if you’re looking at an equity portfolio, it’s obviously about not having all your eggs in one basket and leaving yourself open to company-specific risk or industry specific risk or any of those kinds of things,” Holder says. He adds that investors should look to take advantage of divergences between different asset classes.

“At the most basic level, look at the split between equities and bonds and try to get that right, depending on your risk tolerance, in order to reduce overall portfolio volatility … and then also look at asset classes like alternatives. It’s extremely important and it’s one of the things that we spend a lot of time, energy and effort into getting our clients’ strategic asset allocations right so that the diversification is there.”

Jill Nes, chief executive of investment advisers BMF Wealth, says investors should be “cautiously positioned” in the current market conditions, “have adequate liquidity, good diversification across asset classes, stay calm, and be prepared to take a five-year view”.

“Each investor needs to assess their own situation with the guidance of their wealth manager,” Nes says. “We have been advising our clients to decrease their listed equity allocation and are redeploying the cash from these equities into other more defensive asset classes.”

While more investors are taking a bigger interest in private equity opportunities as a means of diversification, Nes says it’s important to exercise great caution in selecting a private equity manager.

 

LOOKING BEYOND AUSTRALIA

Despite being buffeted by powerful headwinds of late, the US stockmarket in particular has delivered exceptional returns for investors over recent years.

Australian investors who have bought exposures to the US – especially into the technology sector directly through companies such as Apple, Amazon, Facebook, Alphabet (Google) and others – have achieved huge returns. Likewise, an increasing number of Australian investors are accessing the US and other markets and global sectors via the ASX using low-cost exchange-traded funds (ETFs).

Ted Alexander, portfolio manager and head of investments at Evans Dixon, says all investors should have exposure to international stockmarkets in addition to Australia.

“While there are many excellent investment opportunities in the Australian market, the risk is concentrated, with 50 per cent of listed companies exposed to banking and insurance or commodity prices. Investing overseas allows the individual to diversify their risk and access the world leaders in technology, industrial goods, consumer products, and pharmaceuticals.”

Alexander says while recognising that economic recessions are always a risk, his view is that the market is currently “in a fairly benign part of the cycle”.

fairly benign part of the cycle”. “Technology stocks have risen strongly, benefiting technology investors, but we think they are now more expensive than the rest of the market, so we have a lower weight. Our biggest investment is in pharmaceutical stocks. The stocks are priced at a discount due to political risk from Trump in the US but we feel he is unlikely to take meaningful action on medication prices due to the many political distractions he faces. This political risk could resurface at the upcoming mid-term elections, so we do have some caution.”

The falling value of the Australian dollar, particularly against the US dollar, has delivered unexpected tailwinds for Australian investors. For every fall in the value of the Australian dollar against the US dollar, the exchange rate return on a US dollar investment will increase.

dollar investment will increase. Australian investors have access to a wide range of ETFs and managed funds that offer both currency-hedged and unhedged options. The advantage of being hedged is that currency risk is largely removed. However, Australian investors who have invested into hedged funds in recent times have effectively missed the strong benefits associated with our falling dollar.

“In my opinion, hedging currency is rarely effective,” Alexander says. “Our analysis very strongly supports US dollar strength and Australian dollar weakness as long as the Reserve Bank stays on hold on interest rates.

“This benefits the Australian investor in international shares if they stay unhedged. Our recommendation is to stay unhedged with exposure to the US dollar. But watch the RBA, if we go into a rate hike cycle I would expect the Australian dollar to stabilise.”

KNOW YOUR RISK TOLERANCE

Crestone’s Holder says that from an investment perspective, the factors investors really need to get right and focus on in the first instance are establishing their risk tolerance.

“The ability to take risk is really dictated by things like the size of your asset base and then your time horizon, which you have in mind through investing. And then, you weigh that up against the combination of your return objectives, so what you either need or want to achieve out of your investment portfolio, with things like specific liquidity requirements.

“They can be just general requirements in terms of holding a cash balance, or for specific liquidity events. We would consider these factors at the outset, which is really about setting up a strategic long-term asset allocation.”

THE FOCUS ON FEES

Australia’s sovereign wealth fund, the $150 billion Future Fund, made headlines in October when it revealed it had switched all of its Australian shareholdings to exchange-traded index funds, saving more than $50 million in annual management fees in the process.

It is a valuable lesson for all investors because fees rather than market volatility remain the biggest long-term threat to wealth creation.

New research from digital wealth provider InvestSMART shows someone who had invested $100,000 in Australian shares over the 30 years to June 2018 at a fee of 0.5 per cent would have $1,207,807 at the end of the period, while a fee of 1.5 per cent would have netted them just $896,508 – almost 26 per cent less.

High investing costs are caused by “fee stacking” – an accumulation of fees including financial advice fees, implementation fees, platform administration and investment management fees, which can easily add up to 2 per cent per annum.

In the current climate where returns are being eroded through general markets activity, and taking into account one’s long-term horizon, those investors using managed funds should do their homework. Reducing fees by shopping around may be a wise decision.

Tony Kaye is editor with InvestSMART Group.