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James Dunn
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+ About James Dunn

About James Dunn

James Dunn is a freelance finance journalist and media consultant. James was founding editor of Shares magazine, and formerly, the personal investment editor at The Australian.

His first book, Share Investing for Dummies, was published by John Wiley & Co. in September 2002: a second edition was published in March 2007, and a third edition was published in April 2011. There have also been two editions of the mini-version, Getting Started in Shares for Dummies.

James is also a regular finance commentator on Australian radio and television: he gives a daily finance report on Radio 3AW in Melbourne and is a weekly commentator on Sky Business.

Combining active and passive strategies with ETFs

Thursday, January 19, 2017

By James Dunn

Part of the explanation for the huge growth in exchange-traded funds (ETFs) in recent years is the fact that they offer investors cost-effective, simple, instant and liquid exposure to different markets, different asset classes and different strategies by buying one product, which is itself, a listed stock.

ETFs are very flexible investment tools, which allow investors to either instantly improve their portfolio’s diversification, or employ a range of investment strategies that were once too complicated or expensive for them to consider.

Investors can use ETFs to get market exposure very quickly and easily to implement their views and meet their investing objectives.

But ETFs can also work well with traditional investment tools, such as managed funds, and direct shares.

ETFs at the heart of “core/satellite” strategy

An increasingly common approach, which works in any asset class, is to use ETFs as the “core” of a portfolio – the foundation of your investment strategy – and then add some more specialised “satellite” investments around this core. In this approach, the core investments account for the main part of the overall portfolio: a typical allocation to the core investments would be about 70%.

The core is often held in a low-risk vehicle that offers low-cost, broadly diversified exposure to an asset class, market or index. ETFs are very well-suited to this role, which is to deliver a return in-line with the performance of the asset class, market or index you want to pick up. This is often referred to as the “beta” return – in a highly liquid form.

Around this core, the investor can add the satellite investments with the aim to earn returns above what the market generates. This is often referred to as “alpha”.

For example, an investor might hold a broad Australian equity ETF in the core portion of their portfolio, and add active managed funds to the satellite portion of the portfolio to seek to enhance performance. Using ETFs will help to keep the overall portfolio costs low, allowing the investor to choose unconstrained, high-conviction or absolute-return managers that represent the best chance for alpha. It’s important to ensure that the satellite funds generate a return that differs as much as possible from the market return.

This “blending” of a passive, low-cost indexed core and higher-cost active management can deliver market outperformance for less than a fully active portfolio would cost.

Using active strategies raises the risk, for chance of extra return

The satellite investments to an Australian equity core ETF can also be direct shares. This is a popular strategy given the prevailing low-interest environment, where franked dividends are a crucial source of income for yield-oriented investors. This is especially the case for self-managed superannuation funds (SMSFs) that are able to use the partial or full rebate of the unused franking credits (depending on whether the fund is in ‘accumulation’ or ‘pension’ phase, where the applicable tax rate is 15% and nil respectively.)

When using active managers as satellite holdings, make sure you do not get panicked out of the investment by short-term underperformance – which is the bane of active management. Make sure you hold the managers long enough – at least through a full economic cycle – to give each enough time to potentially generate positive active returns through their skills and insight.

Active managers give you the possibility of outperforming the index – which of course the traditional ETF cannot do – but the flipside is much higher return variability, and much higher management costs.

Even though ETFs are usually passive investment vehicles, they can be used actively, to make tactical tilts to certain markets and asset classes, based on the investor’s view of changing short-term market conditions, or to tap into a strong global investment “thematic” exposure in a precise manner.

A good example of this is the iShares S&P Global Healthcare ETF, which taps into the increased spending on healthcare as populations in many countries – developed and developing – age. Adding this exposure – which is difficult to achieve on the Australian Securities Exchange (ASX) – can provide a targeted investment while also improving the portfolio’s international diversification.

Factor-based ETFs combine active and passive investment

Within the equity asset class, the latest generation of ETFs provide exposure to fundamental factor-based or ‘style-based’ strategies, to allow more systematic investment allocation. These newer ETFs target particular “factors,” which are fundamental underlying drivers of equity return.

For example, “value” stocks – which have low prices relative to fundamental measurements (such as price/equity ratio, dividend yield or net asset value) – have historically out-performed the broad share market over the long term. Value stocks are those that are out of favour with the market, being priced low, relative to the company’s earnings or assets.

A value stock is usually considered to have a relatively low price/earnings (P/E) ratio and a low price-to-NTA (net tangible assets) value, but a high dividend yield (because its price has fallen). Value investors buy these stocks because they believe that the market will eventually recognise its true value and the stock will be re-evaluated (bid up in price). Cheap stocks – relative to these fundamental measurements – have tended to outperform in the past.

Other common factors include size (market capitalisation), company “quality” (as indicated by a range of fundamental criteria indicating financial health), “momentum” (trending stocks) and low-volatility i.e. the stocks that historically have fluctuated in price less than the overall index. Identifying these factors and creating rules-based indexes based on them can allow investors to seek improved returns, reduced risk or enhanced diversification, within the Australian or global shares asset class. For example, the iShares Edge MSCI World Multifactor ETF combines value, smaller size, quality and momentum stocks to seek outperformance compared to a traditional index of global shares.

These “smart beta” strategies combine elements of both passive and active investment, giving the investor the opportunity to make more targeted allocations to potential sources of risk and return at a lower cost.

Disclaimer: This is a sponsored article by BlackRock Investment Management. This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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3 ways smart beta can enhance your portfolio

Wednesday, November 30, 2016

By James Dunn

The first exchange-traded funds (ETFs) offered investors ‘beta’ – the return of a market index representing a particular asset class. Therefore, ETFs allowed investors to improve diversification in their portfolios – filling gaps with cost-effective, simple, instant and liquid exposure to different markets and asset classes.

The initial use of ETFs in retail portfolios was as simple buy-and-hold passive exposure to a chosen asset class. Investors found them particularly suitable to “core-satellite” strategies, where the ETFs formed the portfolio core, established to garner the beta of a particular asset class, while satellite strategic decisions were put in place to pick up alpha, or return above the beta. 

What is smart beta?

As ETF issuers have developed products to target specific investor needs, ETFs offering particular strategies (for example, high-dividend-yield stocks) or investment styles, have become popular. Prevailing market volatility and low yields have driven many investors to search for an investment approach that better aligns with their needs. 

Strategic ETFs are designed to deliver “smart beta,” which is an approach based around capturing investment “factors,” or market inefficiencies, in a rules-based, transparent manner. 

Factors have been identified for many decades as fundamental underlying drivers of return. These factors could be macro-economic, such as the pace of economic growth and inflation, which can explain returns across asset classes like stocks and bonds: alternatively, these factors could be “style” factors (for example, “value” or “quality”) which help to explain returns within asset classes.

In effect, smart beta ETFs are built around a different index to the traditional market-capitalisation-based indices, with the index designed to harvest a different return. That allows heightened diversification, as well as the opportunity to earn enhanced, risk-adjusted returns. 

Smart beta is a strategy that involves following an index designed to capitalise on inefficiencies in the market. Smart beta ETFs sit between active and index investment approaches, incorporating elements of both. 

The three major smart beta strategies used in equity ETFs are: 

1. Low volatility - Protect yourself from market shocks 

Low-volatility ETFs take the broad stock index and choose from the stocks that show the lowest historical volatility – that is, they fluctuate in price less than the overall index. 

Lower-volatility stocks tend to be more mature companies that are less dependent on continued economic growth – such stocks also tend to have higher-than-average yields. They tend to fall by less in market downturns, but they also tend not to rise as much in market rallies. 

The theory behind low-volatility ETFs is that they give the investor roughly the same equity exposure as a broader equity ETF, but in a form that helps a nervous investor sleep better at night. The lower volatility means that over the long run, the investor is less likely to be panicked out of their investment in the stock market. 

Low-volatility ETFs have become very popular in the US market, where a number of risks have been identified. 

The first is that the strategy is in danger of becoming a classic “crowded trade.” That’s when the individual stocks are bid to higher valuations than they would otherwise justify, and the very success of the low-volatility ETFs in attracting money actually increases the likelihood of lower risk-adjusted returns going forward.

The second is the fact that the low-volatility ETFs have tended to cluster in similar stocks: as a group they are heavily weighted in financial, consumer staples, health care, utilities and telecom stocks. Despite low volatility ETFs capping exposure to these sectors, US analysts have noted that these sectors often behave like bonds, doing best in periods of falling interest rates. With the US Federal Reserve expected to lift interest rates in 2017, it may be an inopportune time to buy low-volatility ETFs.

2. High-dividend yield: Target higher income

As the term suggests, high-dividend-yield ETFs target higher levels of equity income while being diversified across sectors. To avoid ‘dividend traps’ (companies where the yield appears artificially high because the share price has fallen) the high-dividend-yield is biased to companies that have a strong track record of paying a rising dividend stream, through consistent earnings growth. 

The strategy ensures that any high yield is not due to a large one-off dividend and that the companies have the capacity to increase their dividends, through a sustainable payout ratio. 

In the Australian context, these stocks also deliver a high level of tax-effective franking credits and are therefore seen as particularly attractive investments for retirement portfolios and self-managed super funds (SMSFs). 

In the US, there’s a wide variety of criteria used by high-dividend ETFs. For example, some focus on companies that consistently raise their dividends, not simply stocks with high yields, some apply other financial strength measures such as return on equity (ROE), while others equally weight the portfolio to the highest yielders in each sector of the S&P 500 Index. 

In the Australian context, high-dividend yield ETFs run the risk of high concentration risk. They will be biased to the big four banks (Westpac, ANZ, National Australia Bank, Commonwealth Bank of Australia) and Telstra, and the real estate investment trusts (REITs) that pay large distributions. The portfolio is likely to be overly influenced by the performance of the Australian finance sector. US high-dividend-yield ETFs do not have this problem, a legacy of the financial crisis, which forced many banks to cut dividends or, at best, maintain them.

High-dividend-yield ETFs also run the risk of bidding up the target stocks. 

3. Outperformance: using style factors to beat the market

Over long periods of time in the stock market, ‘style’ factors have demonstrated the ability to earn higher long-term returns than the broad market indices, while bearing level of risk to a broad market investment. Because they’re driven by different market characteristics, these factors can be most rewarded in different market environments, and points in the economic cycle. 

For example, company ‘quality’ is usually assessed on fundamental financial criteria such as balance sheet strength, low debt levels, record of consistent earnings and dividend growth, high return on equity (ROE), profitability, management efficiency, consistently rising cash flow generation, high dividend payout ratios and sustainable competitive advantage.

The term “quality” generally denotes companies that historically have weathered economic and market downturns better than other stocks. Quality stocks, traditionally, have their strongest relative performance late in the economic cycle, when earnings are deteriorating, or in actual recessions. Quality can also be considered a defensive attribute - it has tended to only under-perform, on a relative basis, during stronger economic times.

‘Value’ stocks are considered cheap because they are out favour with the market and are consequently priced low, relative to the company’s earnings or assets. A value stock is usually considered to have a relatively low price/earnings (P/E) ratio and a low price-to-NTA (net tangible assets) value, but a high dividend yield (because its price has fallen). Value investors look for such value anomalies and buy the stock because they believe that the market will eventually recognise its true value and the stock will be re-evaluated (bid up in price). ‘Value’ stocks tend to outperform early in the economic cycle.

‘Size’ refers to market capitalisation, or the value of the company’s equity on the stock market at any time. Small caps – or small market capitalisation companies – generally tend to outperform their larger counterparts, for a range of reasons. They often have high growth rates, there is often an ‘information gap’ because they are poorly covered by analysts: this can lead to a valuation gap, and as these gaps are filled, the small-cap stocks can appreciate in value quite quickly. 

Small, high-growth companies are often more nimble than their larger counterparts, and tend to outperform them, especially in the early stages of economic recovery, and in rising interest-rate environments. 

(There is no universal definition for “small capitalisation,” which differs from market to market: in Australia, for example, “small caps” usually refers to stocks in the S&P/ASX Small Ordinaries index, which have a market value of about $2 billion or lower.)

Lastly, ‘momentum’ stocks – where the stock price is changing quickly – can come into their own when the economy is growing strongly, toward the peak of the economic cycle. There is an empirically observed tendency for stocks rising in price to keep rising, and for stocks with falling prices to keep falling. Momentum investing seeks to ride this trend.

All of these factors can be used in a smart beta strategy. Smart beta ETFs are not a magic bullet – they do not offer a safer route to returns, nor can they be expected to always outperform traditional market-cap-weighted equity ETFs. But the benefits can include improved diversification, and the ability to capture a wider spread of risk premiums than broader ETFs. Smart beta ETFs can harvest risk premiums previously only available through expensive active strategies, in a cheaper way.

Disclaimer: This is a sponsored article by BlackRock Investment Management

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Treat your SMSF cash as an investment (and diversify it)

Tuesday, November 29, 2016

By James Dunn

Cash is a very important component of Australia’s growing army of self-managed superannuation funds (SMSFs).

According to Australian Taxation Office (ATO) data, SMSFs holdings of cash and term deposits rose to a record high of $158.9 billion in the June quarter, up from $157.3 billion in the March quarter. Cash investments now represent 26% of total SMSF assets.

SMSFs invest in cash as an asset class, as part of the defensive portion of their asset allocation, and also use cash investments as a parking place for monies on their way into or out of the fund.

Different cash products in the marketplace cater to these two ways in which SMSFs use cash. But whether it is cash that the SMSF needs to handle as part of its investment activity, or cash that is invested, the cash holdings should be treated as an investment in their own right. This means thinking about how to earn the best return on your SMSF’s cash.

Savvy SMSFs operate a savings account in addition to their cash management account, ensuring that all of their cash assets are working as hard as possible. The cash management account should hold cash for paying the costs of running the SMSF, with the remainder eg. monthly superannuation guarantee (SG) contributions held in the savings account.

Savings accounts – particularly online accounts – are a very competitive market, and as an SMSF holder you should always be prepared to check the market for a better rate. There are a range of savings accounts available and with differences of over 1.40%, it’s important to understand your options.

In addition to the standard online savings accounts, there are also accounts that pay you additional interest when you increase your balance by a minimum amount each month, as well as a new breed of accounts from RaboDirect called ‘Notice Savers’. The RaboDirect Notice Savers require customers to notify the bank about withdrawals in advance (the notice period) in return for a higher rate of interest. The longer the notice period, the higher the rate of interest. Using a mixture of these savings accounts, as well as term deposits, will enable you to maximise your cash returns, while also giving you the flexibility to invest in any opportunities that may come along.

When managing your term deposits, it's also important to take into account any loyalty bonuses that your bank may provide. As an example, RaboDirect offers a 0.10% bonus for rolling over a term deposit.

Understanding how to maximise your cash returns makes a lot of sense, especially if you’re thinking of making additional contributions to superannuation. In our next article, I’ll shed some light on some of the changes that the government has made to super, and how you can take advantage of the current rules.

Disclaimer: This is sponsored content by RaboDirect.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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How to access hard-to-reach asset classes

Thursday, September 22, 2016

By James Dunn

Exchange-traded funds (ETFs) have become, arguably, the fastest-growing investment product in the world. There is now US$3.3 trillion ($4.4 trillion) held globally in ETFs and exchange-traded products (ETPs), up 11.5% on a year ago (July, 2015). Around the world, investors pumped US$55.2 billion ($73.6 billion) into ETFs in July, the highest monthly flow since December 2014.

Why investors like ETFs

The prime attributes that have driven this growth are the simplicity of the ETFs in offering investors exposure, through one listed stock, to a wide range of asset classes and investments.

These range from share and bond market indices, to commodities and currencies, to various investment styles, strategies and themes. This makes ETFs very efficient in diversifying a portfolio in a cost-effective way, given the typically lower management and transaction costs of ETFs compared to actively-managed funds.

All kinds of investors can use ETFs for a variety of roles, but achieving precise exposure to certain asset classes and investment niches is a feature most retail investors would certainly find handy.

Tailor your exposure

Investors can now diversify a portfolio much more effectively than before using other asset classes, and benefit from the fact that asset prices are not perfectly correlated. In other words, not all asset prices move in concert, and price movements in one asset in a portfolio can counteract price movements in another asset. A properly diversified portfolio can achieve higher levels of return, while reducing overall portfolio risk.

Even within asset classes, different sectors can give varying exposures, decreasing correlations. ETFs allow retail investors to tailor their exposure.

Within an investor’s core Australian equities allocation, for example, investors can segment their investment by factors such as market capitalisation, level of yield represented by the stocks’ dividend payout ratios, or ‘style’ considerations (whether the stocks represent “value” or “growth” opportunities). Again, this segmentation taps into differing correlation records.

Simple exposure to hard-to-reach investments

ETFs can be particularly helpful in achieving exposure to asset classes which retail investors would otherwise find hard to access. For example, fixed-income has historically been a difficult asset class for Australian retail investors to enter, as most kinds of bonds were sold in prohibitive minimum investment parcel sizes. Effectively, this locked retail investors out of the market, unless they wanted to use unlisted bond funds. But fixed-income ETFs offering exposure to investment-grade securities in the Australian commonwealth government and state government bonds space, and the global corporate bond market, have opened up these asset classes for investments of any amount.

For example, the iShares Core Global Corporate Bond (A$ Hedged) ETF (ASX code: IHCB) offers investors exposure to a portfolio of thousands of global corporate bonds, through simply buying one stock on the Australian Securities Exchange (ASX).

Small caps don’t always march to the market’s tune!

The capitalisation issue is relevant to the Australian share market, which has become one of the most concentrated in the world. The top 20 stocks account for about 62% of the total value of the benchmark S&P/ASX 200 Index. The top seven stocks represent almost half of the index. Therefore, these stocks account for most of the movement of the index.

When large-cap stocks are lagging, the index lags with them – but small-caps may be performing well, independent of this movement. For example, in the year to June 30 2016, the benchmark S&P/ASX 200 earned a return of just 0.2%, but the S&P/ASX Small Ordinaries index surged by 14.4% over the same period1 (The S&P/ASX Small Ordinaries index represents members of the S&P/ASX 300 Indexthat are not in the S&P/ASX 100 Index). 

Australian small-cap companies are easily accessible directly to local investors, but there is an information risk in the fact that the small-cap stocks are not as widely covered by investment analysts, making it a potentially troublesome sector for individual investors.

However, investors who are aware of the concentration effect of the Australian share market, and who understand the lack of correlation of the small caps’ performance with that of the market’s benchmark index, can customise their domestic stock allocation – and further diversify their portfolios – by holding a broad ETF that gives them the performance of the sector. For example, the iShares S&P/ASX Small Ordinaries ETF (ASX code: ISO) is designed to capture the performance of those 200 Australian small-cap companies not part of the S&P/ASX 100 Index.

Emerging markets give a portfolio a distinct twist

Similarly, investors can tailor their global equities exposure in a number of ways to pick up on differences across regions, sectors and markets. Within global equities, for instance, emerging markets (those countries classed as not yet at the level of developed nations) are considered a discrete asset class, with a risk/return profile different to that of standard international equities investment.

Emerging markets equities show little correlation to the developed share markets, and thus can work to reduce the overall volatility of the portfolio. Allocations within emerging market funds vary, but China usually represents the largest exposure.

China, South Korea, Taiwan and India account for almost two-thirds of the MSCI Emerging Markets Index, and therefore, an investment in emerging markets is increasingly a bet on Asia. 

Emerging markets have usually shown a strong correlation with commodity prices, being seen as producers. Returns from emerging markets shares have been largely weak since the GFC, hurt by soft commodity prices and the slowdown in China. Emerging market assets are typically considered vulnerable to periods of strength in the US dollar. For example, following US interest rate rises, because that depresses commodity prices and relatively low returns in US$ keeps money invested in emerging markets. Usually, rising US rates causes a flood capital to flow back to the US, and emerging markets are usually one of the first assets to suffer.

However, emerging markets as an asset class are changing. The emerging markets-commodities correlation – while strong between 2005 and 2013 – has lessened. The combined energy and materials sector weights in the MSCI Emerging Markets Index have come down from close to 40% at the height of the commodity boom to just 13.8%, not much greater than the 11.7% in the MSCI World Index.

The performances of the MSCI World Index and the MSCI Emerging Markets indices can diverge widely. In 2013, for example, in US$ terms, the Emerging Markets lost 2.3%, while the World Index gained 27.4%. But it would have been helpful to hold the Emerging Markets in 2009, when it gained 79%, compared to the World Index’s rise of 30.8%.

The MSCI Emerging Markets Index is heavily weighted at the top end to IT stocks. Its five largest holdings are internet company Tencent Holdings, Korean giant Samsung Electronics, Taiwan Semiconductor, Chinese online marketplace Alibaba and Chinese telecommunications company China Mobile. This makes it a different exposure to a standard global investment, picking up on different themes. The problem can be that many emerging markets are restricted to foreign investors, and expensive to enter even if not restricted. But investors wanting to tap into this exposure can easily allocate some of their international share portfolio weighting to an ETF like the iShares MSCI* Emerging Markets ETF (ASX code: IEM), which seeks to track the performance of the MSCI Emerging Markets Index. This kind of portfolio tweak is easily implemented through ETFs, tailoring an allocation more specifically, and allowing both greater diversification and the ability to make strategic tilts.

This is a sponsored article by BlackRock Investment Management

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Help secure your capital with fixed income ETFs

Thursday, August 25, 2016

By James Dunn

Australian investors have not traditionally been big users of fixed income, but the asset class is increasingly coming to the fore. Investors are becoming more aware of the need for diversification in their portfolios, the income flow, stability and certainty that bonds can provide, and how crucial these attributes can be when planning a self-funded retirement. 

Steady and reliable income

Bonds are classified as ‘income assets’ as they provide a steady and reliable stream of income. Fixed income is generally considered to be a defensive asset class, but bond values can fluctuate due to changes in interest rates. Bonds have a lower risk profile than shares, which means they don’t offer the same capital growth potential.

The spectrum of bonds available ranges from practically risk-free (if held to maturity) Commonwealth government bonds, to semi-government bonds (issued by state governments) to corporate bonds (issued by companies). This bond menu offers a wide range of yields, and therefore meets a range of investor needs and risk appetites.

Corporate bonds do not have as high a credit rating as Australia’s sovereign credit rating – or those of the states – so they are higher-yielding than government bonds, but consequently riskier. However, investing in investment-grade rated corporate bonds in both the Australian and global markets is generally safer than investing in the same companies’ shares, as they are higher up the capital structure.

Easy, cost-effective access to the broad Australian bond market can be established by buying the iShares Core Composite Bond ETF (ASX code: IAF), or the investor can target only the “sovereign” (that is, commonwealth government bond) sector using the iShares Treasury ETF (ASX code: IGB). Income-oriented investors unwilling to accept the risk of inflation eroding their returns can specify their bond allocation into the Australian inflation-linked bond sector using the iShares Government Inflation ETF (ASX code: ILB). 

Fixed income securities can give an investment portfolio an element of capital stability and a consistent flow of interest income. Moreover, bonds typically show a low correlation with shares, meaning that they can protect a portfolio against capital loss.

Simple diversification through ETFs

Historically, fixed income has been a difficult asset class for Australian retail investors to use. Most bonds were sold in prohibitively large minimum investment parcel sizes, which effectively locked retail investors out of the market, confining them to unlisted bond funds. But in 2012, the first fixed income exchange traded funds (ETFs) were listed in Australia. These gave local investors the ability to lock-in exposure in one ASX listed stock to a fixed income portfolio comprising investment-grade securities, Australian commonwealth government bonds and state government bonds. 

As has happened in the equity space, the addition of global fixed income ETFs has allowed Australian investors to gain exposure to international sovereign bonds, bonds from ‘supra-national’ issuers (for example, the World Bank) and foreign companies. The global bond ETFs also add high-yield bonds (corporate bonds that are not rated investment-grade) and emerging market bonds to the local menu.

For example, the iShares Core Global Corporate Bond (A$ Hedged) ETF (ASX code: IHCB) offers a simple, low-cost exposure to global investment-grade corporate bonds, spanning multiple countries and sectors. The iShares JP Morgan US$ Emerging Markets Bond (A$ Hedged) ETF (ASX code: IHEB) does the same for the US$-denominated global emerging markets bond market.

Some hedged international bond exposure can potentially reduce a portfolio’s overall volatility. Like shares, investors have the choice of hedging the currency exposure of global bonds back into the Australian dollar. If hedged, this allows the investor to earn foreign market income and take advantage of potential foreign bond price appreciation, without being affected by currency fluctuations. (All of the iShares international fixed income ETF range is hedged to Australian dollars, to remove the currency risk for the Australian investor).

Redressing equity bias

Historically, Australian investors have shown a strong bias towards shares, particularly domestic shares. This has been cemented over the last few decades by the strong attraction of the dividend imputation system (introduced in 1987) – stemming from the subsequent boost to returns provided by franking credits – as well as a series of government privatisations and de-mutualisations of large insurance companies that served to swell the ranks of shareowners.

This bias towards shares has extended into retirement funding portfolios. According to the Australian Association of Super Funds (ASFA)¹, Australian super funds hold 48% of their assets in listed investments, with Australian shares their single largest allocation, at 23% of assets, followed by international shares at 21%. (Real estate investment trusts, or REITs, fill out the listed portion, accounting for 4% of total assets.)

However, this predilection for shares puts Australia out of step with international practice. In most of Australia’s peer group of developed countries, bonds are by far the dominant asset class in retirement funding.

According to data from the 2015 OECD Pensions in Focus² report, the average pension fund (in a sample of 31 developed countries) holds 51.3% of its assets in bills and bonds, and 23.7% of its assets in shares. The same report puts Australian pension funds’ allocation to bills and bonds at 8.8%, while 50% of the assets are held in shares.

Australia’s growing army of self-managed super funds (SMSFs) diverges even further from the normal preponderance of bonds in pension funds. According to Australian Taxation Office (ATO)³ statistics, as at March 2016, Australian SMSFs held $6.7 billion in debt securities, or just 1.2% of the $570.6 billion in SMSF assets. In contrast, SMSFs own $172.1 billion worth of shares, or 30.2% of their assets. 

The upshot of these statistics is twofold. Firstly, the asset allocation of the Australian pension system, being much lower in bonds, is not as conservative as that of its OECD peers – that is, it is arguably more risky. This applies particularly to Australian SMSFs.

Secondly, Australian SMSFs’ minuscule collective holding in bonds means that these funds are not well-diversified as a group. Using selected domestic and global bond ETFs can redress this asset allocation anomaly by cost-effectively establishing a portfolio holding in fixed income.

¹ Source: http://www.superannuation.asn.au/resources/superannuation-statistics

² Source: http://www.oecd.org/finance/private-pensions/pensionmarketsinfocus.htm

³ Source: https://www.ato.gov.au/Super/Self-managed-super-funds/In-detail/Statistics/Quarterly-reports/Self-managed-super-fund-statistical-report-March-2016/?anchor=Assetallocation#Assetallocation 

Disclaimer: This is a sponsored article by BlackRock Investment Management

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Gold Series Part 3: income overview

Thursday, August 11, 2016

Gold is back in the limelight after a stellar year so far, and back in investor favour as a safe-haven investment, and a portfolio stabiliser, working to lower overall portfolio volatility. But the yellow metal’s traditional drawback is also more apparent in a low-rate, low-return world – it doesn’t pay an income.

And as Paul Rickard, co-founder of Switzer Super Report, points out, with Australia typically having higher interest rates than Europe, the opportunity cost of holding assets that don’t pay income is higher for Australian investors than Europe – which cannot help but come into investor thinking.

But thinking about gold in terms of income “misses the point” of the commodity, says Kris Walesby, head of ANZ ETFS (a joint venture between ANZ Banking Group and London-based ETF Securities). “I actually hate this question, because gold’s lack of income is not a weakness. Investors go into gold for reasons nothing to do with income,” he says.

“The real weakness is Australia’s obsession with income, which is fair enough given the effectiveness of franking credits. But most self-managed super fund (SMSF) investors have more than 70% in equities – which is well and truly more than enough. If they’re putting 10 per cent of their portfolio in gold, we think they’re not looking for income.”

Walesby says Australian investors are actually using gold as a hedge against the equity risk that is entailed in their large equity weightings. “A lot of SMSF investors are in equities in such weightings to try get the income, but there have been situations recently when banks are returning great dividends – but getting destroyed on the capital account. We need to understand the total return perspective – whether gold is generating income or not is totally irrelevant,” he says.

Jordan Eliseo, chief economist at precious metals bullion dealer ABC Bullion, says: “Studies consistently show that maintaining a 5 per cent–10 per cent allocation to gold plays an important role in portfolio design, most notably in lowering overall portfolio volatility.

“Obviously in periods of turbulence we usually see short-term spikes in the gold price. But over the past 15 years, gold has moved from sub $500 an ounce in Australian dollar terms to over $1,700 an ounce, so it has played a very important role for investors. More recently we’ve had a low real interest rate environment, and that’s seen a lot of our self-managed SMSFs lift their gold weighting – they most commonly have 10 per cent–20 per cent in gold – as a cash alternative in a low real rate environment, and a hedge against equities volatility.”

Historically, says Eliseo, during periods of equities volatility, gold gives the best returns of the ‘risk free’ assets. “Investors around the world are dealing with an environment where real rates of return on cash are effectively negative. The gold price tends to increase on average by more than 20 per cent when the real cash rate is less than 2 per cent, because people get worried about what the low interest rates are saying about the overall market and economy. Gold prices are entirely demand-driven so during these periods the price goes up, which is what we are seeing right now.”

More recently, an income angle to gold has arisen, in the form of greater dividends than ever before from gold mining stocks. But as an investor in gold producers, Peter Hall, founder and chief investment officer of funds management firm Hunter Hall, pines for the traditional strategy of reinvesting earnings to find more gold.

“I don’t think we can really expect gold to pay us a dividend. St Barbara, for example, is about to pay off its debt and would be in a position to pay a dividend. But as an investor, we’re looking for the gold stocks in our portfolio to create value, if we can buy those shares cheaply.

“There are a lot of gold companies that have very interesting exploration ground. There’s two sources of wealth creation in a gold stock: (1) the exploration potential, finding more gold, and (2) the increase in value of their in-ground reserves, as and if the gold price goes up. That’s the wave that we’re looking to ride,” says Hall.

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Gold Series Part 2: How to buy gold

Thursday, August 04, 2016

By James Dunn

Recently, Switzer Daily brought together experts from ABC Bullion, Hunter Hall and ANZ ETFs to discuss the themes, challenges and opportunities around investing in gold. In the second part of the series, we explore how to invest in the metal.

With gold streaking this week to its highest price since March 2014 – and to a fresh record in A$ terms – many investors are starting to look at the yellow metal through fresh eyes. 

And the good news is that it has never been more convenient to invest in gold, with three main kinds of vehicles catering to retail investment.

There is bullion itself, in a range of forms and weights, and in both ‘allocated’ (which is stored individually in the investor’s name) and ‘unallocated’ forms (where the bullion is stored in bulk, and each investor has the legal title to the amount of gold they have bought.)

The Australian Securities Exchange (ASX) hosts a range of vehicles that enable retail investors to buy gold in its own right, in both A$ and US$ denominations. These exchange-traded fund (ETF) gold products give investors exposure to gold bullion ownership, without having to hold and store the gold: the stocks simply track the gold price very closely, and may be bought and sold at any time on the ASX. There is normal brokerage on the purchase or sale, and the management expense ratio (MER) of the investment is as low as 40 basis points (0.40%) a year.

Then there are the gold stocks listed on the ASX: the likes of Newcrest Mining, Northern Star Resources, Regis Resources, Beadell Resources, Evolution Mining, St Barbara, Doray Minerals, Resolute Mining, Alkane Resources and Silver Lake Resources.

Jordan Eliseo, chief economist at precious metals bullion dealer, ABC Bullion, favours bullion as the means by which retail investors and self-managed super funds (SMSFs) should hold gold. The critical point with physical bullion, he says, is that in allocated form, it belongs to the investor, who can take physical delivery. The gold is stored in special-purpose bullion vaults, but notwithstanding this, bullion is highly liquid. 

“Physical gold can be bought 24 hours a day either online or over the phone through a recognised bullion dealer, in line with the market for physical gold itself, which trades around the clock,” says Eliseo. The investor pays a premium (or buy/sell spread) to the bullion dealer (0.9% for allocated bullion), while storage is free for allocated bullion.

Kris Walesby, head of ANZ ETFS (a joint venture between ANZ Banking Group and London-based ETF Securities) says the beauty of the exchange-traded gold investments is the simplicity and easy access. “If you want gold, the first question is how to access it and what suits your situation,” he says. His firm’s gold ETF offers access to gold exposure, custody, insurance and liquidity in one product: the gold ETF is tied to physical gold bars stored at the bank's vault in Singapore.

Walesby says the main benefit of the ETF vehicle is that you can invest any amount you like, the management fee is low (0.4% a year) and investors simply pay normal brokerage in and out – which they can get quite cheaply if they use an online broker. “It’s a safe haven, but it’s liquid,” he says.

With both bullion and gold ETFs, the investor is steering clear of any company-specific factors like mine life, resource security or hedging activity that can bedevil investing in gold stocks – but those very factors are what Peter Hall, founder and chief investment officer of funds management firm Hunter Hall, looks for.

“Our business is getting to know stocks very well, and when you do that, you can recognise that the gold miners’ share prices can actually be very cheap at times,” he says.

For an investor who believes that the gold price is going to rise, says Hall, the gold miners are a very leveraged way to participate in that. “A good example is St Barbara Limited (SBM). Gold is selling for A$1700–A$1800 an ounce, and right now you can buy St Barbara’s reserves, in the ground, for about A$468 an ounce. So roughly, you're getting about four times the leverage to the price rise by buying the gold share.”

While he is “not particularly recommending St Barbara, or any other gold producer,” Hall says the point is that there is a lot more leverage in the gold shares if you believe the gold price is going to go up. “But similarly, if the gold price goes down, if we get it wrong, then the gold shares will fall quite hard,” he adds. 

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Is gold a long-term performer?

Thursday, July 28, 2016

By James Dunn

Recently, Switzer Daily brought together experts from ABC Bullion, Hunter Hall and ANZ ETFs to discuss the themes, challenges and opportunities around investing in gold. In the first part of the series, we look at gold as a safe-haven investment. 

If ever there was a time when gold should step up to the plate, it’s now. 

Gold has a traditional role as a ‘safe-haven’ investment – that is, a real store of value – at a time when ‘financial’ assets are falling, markets are skittish and political and economic risk abounds.

At such times, gold has always appealed to investors as a real physical asset with no credit or counter-party risk.

Yet again, gold has stepped up to the plate, says Jordan Eliseo, chief economist at precious metals bullion dealer, ABC Bullion.

“The media has been saying that we are in unprecedented times, and while there is some truth to this, the reality is we have been in these kinds of situations before, where from the point of view of storing wealth, we can’t rely on financial assets and currency anymore,” says Eliseo.

“Precious metals can play a key role during these periods of turbulence.”

The historical returns of gold are the best of the so-called “risk-free” assets during periods of equities volatility, he says.

“The other reality is that real rates of return on cash are effectively negative. The central banks are saying that to keep the global economy going, we have to debase currency.

“The gold price tends to increase, on average, by more than 20% when the real cash rate is less than 2%, because at these times, people are worried about the overall market and economy. Gold prices are entirely demand-driven, so during these periods, the gold price goes up,” says Eliseo.

Peter Hall, founder and chief investment officer of funds management firm Hunter Hall, says gold has “very much justified” its reputation as a safe-haven asset.

“The classic measure of the value of gold is that an ounce of gold is worth enough money to buy a man’s suit, and that holds true today.

The amount of British pounds that it takes to buy an ounce of gold has risen by about 1.8%–1.9% a year for about 300 years, so gold is really a fantastic store of value, it has defeated all other currencies and stores of value. As a proven store of value, that makes it prudent to hold in any well-diversified portfolio, in some form,” says Hall.

Kris Walesby, head of ANZ ETFS (a joint venture between ANZ Banking Group and London-based ETF Securities) says Australian investors are one of the lowest users of gold in their portfolios compared to their overseas counterparts, which was why ANZ ETFS offered gold exposure in its ANZ ETFS Physical Gold exchange-traded fund (ETF), which trades under the ASX code of ZGOL.

“Australian investors don’t hold much gold in portfolios, but it’s important in portfolio design and we see a lot of value in providing this diversification for investors.

Historically, gold has a low correlation with equities and fixed income – which are the mainstays of most portfolios here. Gold is negatively correlated with equities in negative equity market moves. So it’s not always about growth, but also about protecting SMSFs’ (self-managed super funds’) wealth,” says Walesby.

But Eliseo says there can be too much focus on gold’s defensive attributes. He says the yellow metal is also a very sound long-term performer.

“All we ever hear is the US$ gold price, but the A$ price is most relevant for local investors. The price volatility of A$ gold is much lower than US$ gold – and for the last 40 years, A$ gold has shown a very steady return, of about 9% a year,” he says. 

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How to access global markets in one easy transaction

Friday, July 15, 2016

By James Dunn

Since their arrival on the Australian investment marketplace in 2001, Exchange Traded Funds (ETFs) have proven a hit with local investors, primarily because they offer simple access to a range of different asset classes by buying one product, which is itself a listed stock. In particular, Australian investors have seized on the opportunity to solve one of their most pressing investment problems – the need to diversify their investments outside Australia – by using international ETFs.

Establishing international diversification is vital for Australian investors for two main reasons. Firstly, Australia represents only about 2% of the global stock market by capitalisation, and secondly, the Australian stock market is highly concentrated at the top end. The top ten stocks account for almost half of the Australian market’s benchmark index, and are dominated by banking and resources stocks.

Like their overseas counterparts, Australian investors have a natural “home bias” toward companies they know well, a leaning that is strengthened in Australia by the franking ‘free kick.’

But on diversification grounds, there is a strong argument for Australians owning international shares to give themselves greater exposure to the global economy and to industries and world-scale companies, which their home market does not have. For example, IT, major pharmaceutical stocks and global food companies.

Exposure to international shares using ETFs that track broad indices such as the US S&P 500 has proven highly popular. In particular, Australia’s army of self-managed superannuation funds (SMSFs) has looked to ETFs to access international equities – US and non-US – in a broadly diversified way.

SMSF investors like the broad, diversified international coverage that buying one ETF gives them, particularly when it comes in a cost effective and transparent form compared to the alternative product, which is unlisted international share funds.

The investment management cost is often lower than wholesale managed-fund rates, and investors get diversified global exposure without paying relatively high fees for active management.

The attraction of global ETFs for Australian investors is that they can be extremely cost effective, with no entry and exit fees, and an annual management fee that can be as low as seven basis points (0.07%) a year. Investors will also only pay normal brokerage when buying and selling the ETFs.

The easiest way to establish international diversification is to buy an ETF over one of the large global indices. For example, the iShares Core IWLD ETF tracks the MSCI World Investible Market Index, while iShares IOO tracks the S&P Global 100 Index, an index of the world’s 100 largest companies.

A similar effect can be achieved by buying an ETF over the S&P 500 Index. While this is one of the major indices of the US stock market, you also gain some exposure to the world economy as many of the largest US stocks are global “mega-cap” companies that generate earnings all over the world. This group of stocks contains big consumer-goods companies that represent a play on the emerging consumers in Asia, for example Procter & Gamble, GE and Johnson & Johnson, and also houses the huge technology names, such as Facebook, Amazon and Alphabet (owner of Google). This exposure works for Australian investors on a number of levels.

From first-generation global ETFs, which give access to the recognised mainstream market-cap indices (such as the MSCI World, the S&P 500, and so on), product development has moved through second-generation ETFs, which cover single-countries in both the developed world and emerging markets, and sectors (such as healthcare and consumer staples), into third-generation ETFs. These third-generation ETFs encapsulate exposure to fundamental factor-based or ‘style-based’ strategies.

Targeting particular fundamental or “quality” factors – for example, low-volatility, high-yield, ethical investments – caters for investors who want international exposure but would like that exposure to be designed so as either to maximise, or avoid, a particular factor. For example, the iShares S&P/ASX Dividend Opportunities ETF (IHD) focuses on high dividend paying Australian companies.

Currency is also a big consideration for Australian investors, because buying most global ETFs means taking on the effects of currency movements. If the ETF is unhedged (that is, denominated in a foreign currency), the capital gains and any dividends must be brought back into Australian dollars. That means any gains can be reduced by currency effects – although the opposite is also true.

The good news is some issuers have listed hedged versions of global ETFs, where the exposure is managed and brought back to Australian dollars so that currency fluctuations do not affect the returns. For example, iShares offers both unhedged and hedged ETFs that track the US S&P 500, ASX codes IVV and IHVV respectively. While hedged versions usually attract a slightly higher management cost, it does provide some peace of mind.

Whether it is gaining exposure to the world, a region, a country, an asset class, an industry sector, a currency, or an investing style, ETFs offer Australian investors a simple and low-cost way to invest offshore. Moreover, they can form part of a diversified investment approach to help your portfolio weather the times and generate the best returns possible. Indeed, the benefits of ETFs have already been realised by many SMSF investors looking to access a world of opportunities in one simple transaction.

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The secret to building a low-cost portfolio

Thursday, June 09, 2016

by James Dunn

Sponsored Content

One of the greatest weapons that investors have at their disposal is the magic of compounding returns, or earning a return on your return, as well as on your original investment. This is the same principle as compound interest, but compound returns are not earned at the same rate. Each year, if your investments go up, they earn a rate of return which increases the investment. Next year, you earn a return on the increased amount, and so on. The rate of return may not be the same every year, but if the average return that your portfolio earns over the long term is higher than inflation, you are building ‘real’ wealth.

Over time, compound returns can produce impressive growth. An investment earning 7% a year will almost double in 10 years. If you want to speed that rate of potential wealth creation up – for example, you want your investment to double in less than ten years – you need to take more risk.

The flip side of compounding returns

Unfortunately, there is a flipside to the magic of compounding – it works on your investment cost, too.

Every investment that you own that is managed on your behalf has a cost, and over time the compounding of costs works to erode your returns.

Investment fees – the transaction fees and the annual management costs – are the silent assassins of investment returns because they can compound in exactly the same way that returns do. Over the long term, what may seem like only small differences in percentage points in terms of costs can put a significant dent in your returns.

The good thing about costs, however, is that they are entirely within your control. Keeping your investment costs low is a very important weapon for the serious investor. The long-term effect on your investments of paying lower fees is just as impressive as that of compound returns. The lower your costs, the more of an investment’s return you keep – as opposed to paying away.

The importance of being diversified

The other main weapon that investors have is diversification, which should be a basic concept of any investment strategy. Diversification is so important that it is often referred to as “the only free lunch in investment”. The idea is to spread your money among different assets in order to distribute, and hopefully contain, the risk.

Spreading invested funds across a number of different assets reduces the overall risk for your portfolio, since you’re not relying on just one asset as your investment.

Diversification is not just a protective measure; it also allows you to generate a higher rate of return for a given level of risk and open yourself up to more potential sources of return.

Low-cost exposure to the asset classes

One of the biggest recent revolutions in investment markets is the advent of exchange-traded funds (ETFs), which are low-cost, simple and passive vehicles offering exposure to a wide range of Australian and global asset classes, indices and sectors, currencies and commodities, as well as a variety of investment strategies. ETFs are much cheaper than actively managed funds and indexed funds, with no entry and exit fees. Investors only pay normal brokerage when buying and selling the ETFs. There is no commission, upfront or trailing, paid to an investment adviser.

There are two main ways in which investors use ETFs. Firstly, to build a very cost-effective ‘core’ portfolio holding in an asset class (usually less than 40 basis points, or 0.4% a year.) For example, buying just a couple of ETFs can give you effective underlying exposure to thousands of stocks in your domestic and international equities allocation.

The other major use is as a tactical tool: using a passive vehicle (that is, one that delivers index performance) to make ‘active’ investment decisions.

ETFs are simple instruments but they provide very effective diversification benefits. They represent an extremely efficient way to allocate assets with just one ASX transaction, and to get in or get out of a market rapidly with a small cost profile. The ASX now hosts ETFs over all of the main asset classes of a balanced portfolio.

Australian investors can build a global balanced portfolio of different asset classes through the local ETF menu, in ASX-listed securities, denominated (mostly) in Australian dollars. ETFs particularly suit the SMSF sector, which has consistently demonstrated that it prefers direct holdings in liquid, listed securities.

Building blocks for the heart of a portfolio: iShares Core

Some ETF providers have even started to package their ETF offerings to make it easier for investors to establish a well-diversified portfolio across a variety of markets and assets. For example, iShares’ Core suite of ETFs are designed to form a strong foundation for an investment portfolio by offering access to five key share and bond exposures, backed physically by the underlying securities. The range has been designed to address six main challenges that face investors:

  • Gaining high-quality market exposure
  • Lowering the cost of investing
  • Simplifying portfolio construction
  • Achieving instant diversification
  • Making investing more transparent
  • Accessing international opportunities while managing currency risk

The iShares Core ETF range comprises local Australian shares, international equities, and bond markets to give investors a solid foundation for their portfolio.

Interest in ETFs has sky-rocketed over the past few years and all the signs point to this growth continuing, which suggests there is plenty more to come for the ETF story.

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