Fund Managers Archives - Page 2 of 8

Are you reviewing your SMSF’s investment strategy?

by Anthony Picone | Jan 28, 2020 | Financial Planning, Investments, Wealth Management

As trustee of a SMSF, you have many obligations to ensure the smooth running of your fund. One such obligation, which is often overlooked, or inadequately prepared, is your fund’s investment strategy.

The Australian Tax Office (ATO) has issued letters to nearly 18,000 SMSF trustees as part of a campaign to ensure trustees are aware of their investment obligations.

The primary concern is ensuring that trustees have considered the diversification and liquidity of their assets when formulating and executing their fund’s investment strategy.

Importantly, it should be noted the ATO is not attempting to regulate and limit the control and freedom SMSF trustees have, but rather ensuring that if trustees wish to invest their assets in a certain way that they must clearly articulate their reasons for doing so.

An investment strategy should be considering the SMSF’s blueprint when dealing with the fund’s assets to ensure the fund’s investment objectives and the members’ goals are met. It provides the parameters to ensure you invest your money in accordance with that strategy. This is where the ATO has a primary function to ensure that trustees act in accordance with these obligations. Strategies can change, and there is no reason why you can’t change the way you invest. However, your investment strategy should be updated to reflect this.

An SMSF investment strategy must take into account the following items:

The risks involving in making, holding and realising the SMSFs investments, their expected return and cash flow requirements of your SMSF.
The diversification and composition of your SMSF investments.
The liquidity of your SMSF investments, having regard to expected cash flow requirements.
The SMSFs ability to pay your current and future liabilities, including benefits to the members.
Considering whether to hold insurance cover for each member of your SMSF.

An important requirement for you as trustee of your SMSF is to have an investment objective and a strategy to achieve that objective in place, before you start to make decisions about how you want to invest your SMSF’s money and change the investment objectives you have set for your SMSF at any time.

It’s not uncommon for SMSFs with lower member balances to find diversification a challenge as there is limited money to invest. Nonetheless, you are still required to demonstrate that you adequately understand and mitigate the associated investment risks.

If you find yourself in this position, it is important your investment strategy reflects these risks.

If you have invested in a large illiquid asset such as real property which may form the majority of your fund, it is timely to ensure your strategy reflects the concentration and liquidity risk associated with this investment.

For example, we met with a trustee who was running an account-based pension within his SMSF. His fund was fully invested in just the one asset being a commercial property. The challenge he faced each year was that the net rental income wasn’t sufficient to cover his minimum pension payments and the costs of running the fund. He relied on making annual contribution to his fund in order meet his pension obligations. This liquidity risk wasn’t adequately reflected in his investment strategy.

Where you have an investment strategy in place that deals with these risks and can provide the necessary evidence to support your investment decisions, no further action is expected.

Where your fund has not complied with its investment strategy requirements under superannuation law, you may be liable to administrative penalties being imposed by the ATO, as Regulator of the SMSF sector.

Your investment strategy does need to be reviewed at least once a year and this will be evidenced by your approved SMSF auditor. It is also important to review your strategy whenever the circumstances of any of your members change or as often as you feel it is necessary. The following practical tips will help you keep on top of your obligations:

Put your investment objective and strategy in writing
Set an investment objective that you can realistically achieve with the investments you are comfortable to invest in
There is no template for an investment objective and strategy, but make sure they reflect how you intent to invest your fund
The investments you actually make must be accommodated by the investment strategy you have set
Most importantly, document your actions and decisions, as well as your reasons, and keep them as a record in order to demonstrate that you have indeed satisfied your obligations as a trustee in this important area

How can we help?

If you need assistance with your fund’s investment strategy, please feel free to give us a call to arrange a time to meet so that we can discuss your particular requirements in more detail.

First Home Loan Deposit Scheme

by Cameron Purdy | Nov 18, 2019 | Investments, Property Loans, Wealth Management

In the lead up to the last federal election the issue of first homeowner’s inability to enter the property market was poignant with voters and Scott Morrison released details of a new First Home Loan Deposit Scheme. From 1 January 2020, eligible Australian first home buyers with a 5% deposit can get home loans without lender’s mortgage insurance (LMI) through a government scheme.

Previously a borrower would need to save a 20% deposit in order to avoid paying LMI, which is an insurance, paid for by the borrower, to protect the lender against loss if the borrower defaults. If the lender is forced to sell the property and the full amount of the loan is not recovered, the insurance guarantees the difference. The additional expense of LMI has been a barrier to entering the property market in the past as, for example, the estimated LMI on a $400,000 property with a 5% deposit is around $12,700.

Whilst the first homeowner must still repay the full loan amount, the scheme allows them to enter the market earlier as they can spend less time saving for the deposit. This can be combined with other existing state-specific schemes such as the First Homeowners Grant (FHOG) and relevant stamp duty concessions.

The scheme is further restricted to:

Owner-occupied loans on a principal and interest repayment schedule
The applicant(s) cannot earn more than $125,000 a year as a single or $200,000 as a couple
Access to the scheme is limited to the first 10,000 applicants per year on a ‘first in first served’ basis.
The maximum value of the purchased home under the scheme varies by state to state and between city and regional areas.

Whether the scheme will in fact increase first homeowners’ access to the market is being widely debated. Arguments are focussed on whether those people who could benefit from access to this scheme may struggle to be able to gain approval for a loan of that size based on current banking regulations. The effectiveness of capping the scheme to 10,000 applicants has also been drawn into question as this only represents around 10 percent of all Australians who bought their first home last year. Banks have also indicated that they are considering charging higher interest rates for the applicable loans. Their justification is that a borrower who has only been able to save 5% is at greater risk of default than one who has displayed a better saving history and saved more. Only time will tell.

Low inflation explains everything

by James Weir | Sep 13, 2019 | Financial Planning, Markets and Economy, Wealth Management

Low inflation is a global phenomenon that has central bankers tearing their hair out: nobody can tell you exactly what’s causing it and, so far, nothing seems to be able to stop it. And its effects on financial markets, and therefor every investor’s portfolios, are profound. In fact, this very low inflation environment can explain an awful lot of what seems to be peculiar in markets at the moment.

Just how low is inflation?

Australia’s ‘core CPI’, which excludes the more volatile prices like food and energy, averaged 3.7% since 1983, compared to the June reading of 1.6%. That’s not far off one-third of the average.

The poster child for low inflation is, of course, Japan, where, over the past 20 years, the core CPI has averaged -0.2%.

Lower bond yields

Inflation is like kryptonite for bonds: the higher inflation is, the weaker are bond prices, and vice versa. Across the world bond yields are plumbing record lows, including Australia where our 10-year bond yield is comfortably (or is that uncomfortably?) below 1%.

You might read how low bond yields indicate the bond markets are pricing in disastrous economic growth scenarios. In fact, what they’re pricing in is low inflation, and conventional economics dictates that you only get low inflation as a consequence of low economic growth. That may or may not happen, the truth is, nobody knows.

It can explain negative bond yields

There are experienced bond fund managers saying negative bond yields make no sense at all and pointing the finger at ‘central bank manipulation’. Bond markets are massive, reflecting the wisdom of a very big crowd, and they’re driven by a combination of human sentiment and some pretty funky mathematics.

If an investor has a view that disinflation (where inflation rates decrease over time) is here for the foreseeable future, then it’s perfectly rational to prefer the certainty of losing 0.4% of the value of their capital by buying a negative yielding bond, than sticking it under the mattress and losing 0.5%.

It can explain rising equity valuations

Investing 101 will tell you that a share price is supposed to reflect the net present value of a company’s future cash flows. To make that calculation you need to use a ‘discount rate’ that you apply to those future cash flows so you can work out what they’re worth in today’s money, the lower the discount rate the higher the valuation in today’s money.

That discount rate will normally be based on the ‘risk free rate’, which is typically the 10-year bond yield, but most analysts will add a bit extra to account for what they think might happen to bond yields going forward, or to reflect what they reckon might be added risks associated with the company they’re analysing.

In a recent interview, the well-known Magellan fund manager, Hamish Douglass, explained how small changes to your discount rate can have a magnified effect on a stock valuation: by reducing your risk free rate from 5% to 4%, the valuation of a business with 4% earnings growth increases by almost 20%, and a reduction from 4% to 3% sees a 25% increase.

Nothing else has changed, just your view on how long inflation will stay low, but now you’re prepared to pay significantly more for the same share. No wonder a talented fund manager friend of mine likens a DCF valuation to the Hubble telescope, where the tiniest shift can have you looking at a whole new galaxy.

Now imagine the pressure on fund managers across the world this year, with bond yields grinding downwards, forcing them to wrestle with whether or not they lower their discount rate and increase their valuations.

It can explain why so many fund managers have underperformed

Over the past nine years, so-called ‘value’ stocks have substantially underperformed ‘growth’ stocks, for example in the US by almost bang on 100%.

It’s probably not a coincidence that, according to Mercer, in the 2019 financial year, 87% of large cap Australian equity fund managers underperformed the ASX200, and in the 2018 calendar year it was roughly the same in the US. Not surprisingly, you’ll also read confounded fund managers, sounding like jilted lovers, complaining that markets are super expensive and being driven by a narrow cohort of sometimes defensive and sometimes growth stocks.

The problem is, if your frame of reference for valuations is the last, say, 40 years, you’re comparing a time of radically different inflation rates and bond yields – and therefor valuation metrics. It would not be surprising to find a lot of those underperforming fund managers are either resolutely (stubbornly?) sticking to their higher discount rate valuations or chasing their valuations higher as they begrudgingly accept lower and lower bond yields.

Those fund managers complaining about markets being expensive may end up being right, maybe inflation will go up and things will look like they used to once again, a process they call ‘normalisation’. Then again, maybe it won’t, and they’ll be left failing to adapt.

How long will low inflation last?

Because we can’t be sure of what’s caused inflation to be so low, nor can we be sure of how long it will stay that way. Who knows, this time next year we might look back wistfully on the days when we worried about inflation not being high enough, or in 10 years we may look back on the days when inflation was positive.

What you need to know about fixed income

by James Weir | Aug 22, 2019 | Investments, Wealth Management

This article appeared in the Australian Financial Review

Every interest rate cut is another turn of the screw for investors looking for a decent, low risk return. Many a risk averse investor is finding they’re no longer able to rely on cash or term deposits to generate a reasonable return, and are instead considering other fixed income alternatives, of which there is an almost bewildering range. As usual, however, for every extra percent of return you try to get, you have to accept higher risks, so to avoid nasty surprises, you need to understand what those risks are.

The explosion in the number of fixed income managed funds, ETFs and LICs over the past couple of years has come as product providers sniffed an opportunity to meet the demand for income in a low interest rate environment. According to BetaShares, in F2019 more money went into fixed income ETFs than any other category, in fact, 60% more than Australian equities.

Investors need to be aware the name ‘fixed income’ covers an enormous range of products, and they come with an equally enormous range of risk. The last thing a risk-averse investor should be doing is dumping a bunch of money into the highest yielding fixed income product they can find, without knowing what they’re getting in to.

Here are some basics to help you understand what you’re buying:

What is a bond?

A bond is a security that a government, or some other kind of entity like a company, issues that says ‘if you lend me $100 today, I’ll pay you an interest rate on that money (the yield), and every year I’ll pay you the coupon (the technical name for the amount of money paid, so if you have a $100 bond with a yield of 10%, the coupon will be $10) every year until the bond matures (it could be anything from 30 days to 100 years), and at the end of the bond’s life, I’ll give you your $100 back.’ It’s similar to a term deposit, except being a security, it can be bought and sold.

A bond’s maturity is usually fixed

Most bonds, especially government bonds, will have a set maturity date. There are some perpetual securities but they’re few and far between.

A bond’s yield will reflect the issuer’s credit worthiness

The less risk you’re taking to get your money back the less yield you’re going to receive. That can be reflected in an issuer’s credit rating from a company like Moody’s or Standard & Poor’s, but other factors also come into it. Interestingly, there are only 11 countries with a AAA credit rating from S&P, Australia being one of them, while the US’s rating is only AA+.

Bond yields can be fixed or floating

A bond’s yield can either be ‘fixed’, meaning it will pay the same coupon until it matures, or ‘floating’, meaning the coupon will be above some kind of benchmark (like the Bank Bill Swap Rate or LIBOR) and will be reset to reflect that rate from time to time.

Bond prices are not fixed

Bond prices can fluctuate, a lot. The average investor is almost certain not to buy an actual bond, but instead will invest in a fund or ETF, and it’s important to realise a fund’s unit price can jump around, depending on what kind of fixed income securities it invests in.

What makes a bond’s price change?

There can be a number of factors, but the main influence is expected inflation. If the market thinks inflation is falling, as it has recently, it will happily accept a lower yield to compensate for the reduced risk of the value of any future payments being eroded by inflation. If a bond’s coupon is fixed, meaning a 5% bond will pay no more or no less than $5 per year for every $100 bond, then it’s the price you pay for the bond that will increase instead. This is where you end up with the what seems weird at first: as a bond’s yield goes down, its price goes up, but in fact, it’s exactly the same as shares: if a share price goes up, its dividend yield goes down.

Duration risk: the bond price’s sensitivity to changes in yield

A bond’s ‘duration’ tells you how much the price should change when the yield changes. For example, according to JP Morgan, the Australian bond index has a duration of 5.4 years, which means if interest rates go up by 1%, the price should fall by 5.4% (and vice versa if rates go down).

That’s really important because the longer a bond’s life, in normal times the higher should the yield be, which appeals to income-oriented investors, who are normally more conservative. However, while a bond’s maturity and duration are not the same thing, the longer a bond’s life the more duration risk it has, and with interest rates already so low, there is heightened risk they could go back up, and even if that’s only by a little bit, those longer bonds could lose a fair bit of their value.

Credit duration: the bond price’s sensitivity to changes in ‘credit spreads’

Bonds issued by a company will typically pay a yield premium to reflect the increased risk that you might not get your money back. That premium is normally calculated as a certain percentage above some kind of benchmark, like the 90-day bank bill rate, and the gap between the two is called the credit spread.

‘Credit duration’ measures how much the price of the bond will change if the credit spread changes; a bond with credit duration of 3 years will fall 3% if the credit spread goes up (widens) by 1%, and vice versa.

Bonds have had an extraordinary start to the year, with the benchmark Bloomberg Composite Index rising 6.5% to the end of June. But almost all that return is because bond yields have fallen, with the 10-year Australian government bond yield dropping a full percent to 1.32% to the end of June, and it’s now even lower at 1.09%.

In fact, bonds have been a great investment since the GFC as yields have plumbed record lows. If you’re going to invest in fixed income securities now, you are, in part, placing a bet that yields will continue to fall, which may or may not happen. For investors looking to replace term deposits, you just need to keep in mind that fixed income does not necessarily mean low-risk.