Spectrum Insights Damien Wood, Principal APRIL 20, 2016 All in equities - is it worth the risk? Many investors have financial goals. These presume certain returns over defined time frames. To achieve this, most Australian investors rely heavily on the local stock market. This may prove lucrative if you get your stock selection and timing right. As we have seen in recent years, however, equity returns can be highly volatile. At best, this can cause investor anxiety and at worst, it can mean financial goals are not met. If it is the latter, then important decisions, such as those relating to retirement, may need to be revisited. The good news is these risks can be reduced without necessarily giving up return expectations. An investment portfolio with asset classes, such as bonds and international equity, may deliver similar long term returns when compared to purely Australian equities - but with a sharp reduction in price risk. Different portfolios, different risk The graph below illustrates the findings of our basic study of historical five year total returns and of volatility of various portfolios. These portfolios are one with Australian equities only Portfolio A ; then we add A$ bonds split between fixed and floating rate A$ bonds for the second portfolio B ; and, finally, we add international equity in A$ for portfolio C. The graph shows that the total returns are almost identical over the last five years. They all generated around 6% per annum. So investors may ask themselves, Why should we bother diversifying away from just Australian equity? $16,000 $15,000 $14,000 $13,000 $12,000 $11,000 $10,000 $9,000 $8,000 $7,000 1/1/2011 1/1/2012 1/1/2013 1/1/2014 1/1/2015 1/1/2016 Sources: Spectrum Different strategies compared Growth of $10,000 invested over the last 5 years Portfolio A Portfolio B Portfolio C Study notes: We compare total return indices. That is those which include interest rate coupons and dividends. For Australian equities we look at the S&P ASX 200 Total Return Index. For bonds we take both the fixed rate coupon index (Bloomberg Composite Index) and the floating rate index (Bloomberg FRN Index) and for international equity the S&P100 Global 100 AUD Hedged Total Return Index. The impact of agency fees, bid-offer spreads and taxes are not included.
Annualisied Return over 5 years (%) Portfolio A Portfolio B Portfolio C Australian FRNs Fixed Income Australian FRN's International Fixed Income Australian Similar returns, different risk When looking at the risk or volatility of returns, the main benefit of diversification stands out. In short, the more diversified portfolios generate similar returns but in a far smoother pattern. Or, in other words, you got similar returns for a sharp reduction in risk by spreading your investments. 7.5% 7.0% 6.5% You can earn it the easy way or the hard way Price risk vs. historical returns of various portfolios Spectrum Strategic Income Fund Balanced Portfolio Portfolio C 50% Australian & 50% Bonds Portfolio B 100% Australian Portfolio A 6.0% 5.5% 5.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% Sources: Spectrum Standard deviation of monthly returns* *The standard deviation, which is a measure of dispersion around the average point, allows us to grasp how risk can be reduced by diversifying. Another way of looking at this is through the dispersions of returns. As the graph below demonstrates, there is a far narrower range of returns for the diversified portfolios. This benefits investors because they are less sensitive to timing when they need to draw down on their portfolio.
Jul-1969 Apr-1971 Jan-1973 Oct-1974 Jul-1976 Apr-1978 Jan-1980 Oct-1981 Jul-1983 Apr-1985 Jan-1987 Oct-1988 Jul-1990 Apr-1992 Jan-1994 Oct-1995 Jul-1997 Apr-1999 Jan-2001 Oct-2002 Jul-2004 Apr-2006 Jan-2008 Oct-2009 Jul-2011 Apr-2013 Jan-2015 % What type of bonds? If investors want to get exposure to bonds in A$, there are two basic types: fixed and floating rates. Fixed rate bonds, as the name suggests, gives you a certain coupon throughout the life of the bond. Floating rate bonds or notes (FRNs) adjust to reflect the short term market rate. Corporate bonds provide extra yield over benchmark rates. For fixed rate bonds, the benchmark is the government bond yield curve. For floating rate notes, it is the Bank Bill Swap Rate (BBSW). Our concern with fixed rate bonds is that government yields are very low from an historical perspective. Yields and fixed rate bond prices move in opposite directions. Therefore, should government bond yields revert towards their historical average and rise then sizeable losses in A$ fixed rate bonds would follow. 18 16 14 12 10 8 6 4 2 0 Oz bond yields - will they snap back? 10 year Australian government bonds Historical average 8.35% Sources: RBA, Reuters In contrast, should government bond yields revert towards the historical average there would be minimal impact on the prices of floating rate bonds.
Jan-2005 Jul-2005 Jan-2006 Jul-2006 Jan-2007 Jul-2007 Jan-2008 Jul-2008 Jan-2009 Jul-2009 Jan-2010 Jul-2010 Jan-2011 Jul-2011 Jan-2012 Jul-2012 Jan-2013 Jul-2013 Jan-2014 Jul-2014 Jan-2015 Jul-2015 Jan-2016 spread For corporate bonds, investors get extra yield over benchmark rates. These are known as credit spreads. The spread largely rewards investors for the perceived risk of default. In contrast to government bond yields, A$ credit spreads are elevated at present. This is largely due to rising default rates in the US and emerging markets. Default rates in the A$ corporate bond market are low and are likely to remain so in our view. Hence, A$ corporate bonds appear to reflect sound overall value. 900 800 700 600 500 400 300 200 100 0 Credit spreads currently elevated in A$ BBB 5 year bond margin over swaps (bps) credit spreads currently above average average 193 bps Sources: RBA. Bloomberg, Spectrum Spectrum sees value in A$ corporate bonds at present but prefers floating rate notes over fixed rate notes due to the risks of rising government bond yields. How much diversification? The portfolio scenarios above are designed to show the benefits of spreading one s risk. They are not recommended asset class weightings. Generally speaking, though, the less volatility an investor wants, the more an investor should diversify. Investors may wish to get financial advice on how they should weight their portfolios in different asset classes to reflect their risk appetite and financial needs. What type of diversification The asset class examples used are those which are readily available to investors in Australia via managed funds. The study looks at historical returns. The discussion regarding current valuations centres on A$ bonds. This is what Spectrum focuses on. To assess whether other asset classes look attractive, investors, once again, should seek financial advice. Smooth sailing or rough riding An investment portfolio of just Australian equities may enable an investor to reach their realistic financial goals. Savvy timing of the entry and exit out of the market, though, may be pivotal in achieving this. As history shows, market timing can be challenging for even the most seasoned and skilled investors. To increase the chance of realizing investment targets in a timely manner, Spectrum recommends diversification into asset classes such as A$ corporate bonds. Hamid Yahyaei, analyst at Spectrum Asset Management, assisted in the preparation of this report.
Spectrum Asset Management manages the Spectrum Strategic Income Fund. This fund invests in AUD corporate securities of which the majority are floating rate notes. The intention is to make this portfolio relatively immune from the bond yield volatility which can, in turn, hit equity and fixed income markets. The fund is also designed to deliver an income stream while generating capital gains from time to time. For more information and how to invest please go to our website http://spectruminvest.com.au or contact your mfund broker http://www.asx.com.au/mfund/foundation-members.htm#tabs-218. Spectrum and the author have investments in either securities mentioned in this report or comparable securities DISCLAIMER This report has been prepared by Spectrum Asset Management Limited (ABN 31 096 442 198, AFSL 225069). It is for information purposes only and does not constitute or form part of, and should not be construed as, an offer, invitation or inducement to purchase or subscribe for any securities or funds nor shall it or any part of it form the basis of, or be relied upon in connection with, any contract or commitment whatsoever. It also does not constitute a recommendation regarding any securities or funds. The information in this document has been obtained from sources believed to be reliable but no representation or warranty, express or implied, is given hereby as to the fairness, accuracy or completeness of the information or opinions contained herein. This presentation reflects the information available as of the date this presentation was prepared and is subject to change without notice to the recipient. Past performance may not necessarily be repeated and is no guarantee or projection of future results. This report is intended solely for the information of the person to whom it has been delivered. It is not an advertisement and is not intended for public use or distribution. No part of this report may be reproduced or distributed in any manner without prior written permission of Spectrum Asset Management Limited.