With the current volatility in global markets, many investors are making nervous decisions and selling their growth investments for cash. Like others, they are retreating to the sidelines and are merely watching and taking no action. Both of these strategies can potentially be damaging financially, because a declining market may well offer investment opportunities.

The Lucky Country

On the other hand, other investors stop buying when markets climb - their concern being that they are paying too much for their investments! As always, when investors try to time the market, they risk missing its best performing cycles - even the most experienced investment fund managers cannot predict market movements.

One strategy that investors can consider is that of Dollar Cost Averaging (DCA).

DCA sees the investor making regular investments of a specific dollar amount under a specific periodical basis. These automatic investment plans continue to invest regardless of the financial market swings and gyrations. This strategy when executed correctly can drive down the average cost per unit. By staggering their investment in a disciplined way, the investor can acquire their investments at a discount to the rest of the market. Consequently, on average they will have payed less than other investors, which will result in greater future profits.

DCA can be an effective way to pursue future financial goals in that it gives investments time to grow. The example below shows how the strategy works over six months, investing the same amount of money.

Mark invests $500 per month for six months - In this example, the market declines steadily;

$3,000 invested and Mark now owns 209.52 units - the average cost is $14.32. The average unit price for the same period was $14.83!

How does Mark benefit?

DCA cannot shield against a potential loss when the market declines, however it can help reduce the loss. Assuming Mark purchased $3,000 of units in January, he would have only acquired 150 units and the value of his portfolio at the end of June would have been $1,800 or a paper loss of $1,200!

Now let us assume Mark purchases $500 per month in a rising market;

In the rising market example, Mark’s average cost is $13.77, which is less than the average unit price of $14.00 for the period. This example suggests that in both a rising and falling market, Mark has paid less on average for his units than the market average - DCA has worked!

Of course, in hindsight, Mark would have made more money had he invested the full $3,000 at the beginning of the period when the unit price was at its lowest. However, as markets are inherently volatile, Mark couldn’t have predicted that the market would rise steadily during the period to December. So the advantage of using DCA in this example is that it allows Mark to profit as the market rises while still providing some downside protection.

Is DCA right for everyone?

Many investors have used this strategy successfully, however DCA is not designed to produce sudden, dramatic profits, but to generate sustained growth over the longer term, despite the fact there may be short-term fluctuations in the market. This strategy also requires discipline, to keep investing when the market falls and then the resistance to sell when the market rises again.

Is there a more complex form of DCA?

Yes. Dollar value averaging (DVA) involves building and adding to your investment portfolio (of say direct equities or index) so that the number of shares or units held increases by a set amount each month, regardless of market price fluctuations. As a result, when the price falls, you invest more but when it rises, you invest less. For example, say you bought 10 BHP shares for $50 in 2011. In 2012, you plan to invest $500 per month for the following 12 months. Therefore, you would then lay out “value” targets throughout the year as follows.

At the end of the month, you assess the current value of the portfolio and compare it to the targets above. For example, if at the end of January, the portfolio is worth $900, you would then contribute $600 instead of $500 in order to force yourself to buy more shares when the market goes down. Then, at the end of February, the market has gone up a lot and we find that the value of the portfolio is $1,800. Given that this value is over your target, you would then invest nothing in BHP, instead place the investment money into another investment you had considered or cash / fixed income.

For some, DVA is more suited over dollar cost averaging because when a market falls and shares become more attractive at lower prices you actually buy a lot more shares. On the other hand, when share prices rise and are relatively less attractive you buy less or none at all. This method is a little more complicated than dollar cost averaging as you have to do the maths. Many investors prefer dollar cost averaging because it is an automatic pilot mechanism to invest say $1,000 a month into buying shares.

What I like about this method is that instead of investing a sum of money all at once, you allocate it over time. So, for example, if at the beginning of the year you had $50,000 you wanted to invest in stocks, you might invest $10,000 every two months over a year instead of plonking your money into the market in one go. It means if the market falls by 10 per cent, you do not see $5,000 disappear.

With DVA you work out your money goal and then you do a bit of work to make it happen. The goal might be based on a 10 per cent return a year and then you have to invest each month to achieve that goal i.e. invest a little more when the market value drops and a little less when market value rises.

In a nutshell, you might nominate a goal of $500,000 in 20 years time and using a return of say 10 per cent a year you have to increase your investment in bad years when you miss 10 per cent but you can ease up in good years.

Both DCA and DVA are good ideas for imposing a discipline into building a portfolio for your retirement.

It is also important that whichever strategy suits your needs, you must still continue to monitor your portfolio (in conjunction with your Financial Keys Adviser). It may well be that the chosen investment(s) simply are not capable of delivering the required performance, even in a strong market. Of course, your investment objectives may also change which may give rise to adjusting your investment strategy.

Mark Causer

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Many investors bemoan the progressive reduction in the amounts they can effectively contribute into their superannuation retirement savings. Many view the reduction in super “Contribution Caps” as having an irrevocable detrimental impact on their super. Taken at face-value, there can be little doubt that this will also have a negative outcome for future retirement income streams.

The unsurprising result has been that many Self Managed Super Fund (“SMSF”) owners, who may be increasing contributions to maximise their retirement savings, have not been contributing nearly as much to their funds as they wished.

Have they been caught out? Are there ways investors can increase the money flow into their super funds above the “Contribution Cap” limits? Happily, the unequivocal answer is ‘yes’.

Of the number of ways an investor might maintain, or even increase the flow of money into super; one way is for the SMSF to acquire say a business premises outright from either a related party or the market in general. This is a common strategy. Rent paid by the business operation is tax deductible and rent received by the SMSF represents funds flow from the business that is not captured by the Contribution Caps. The level of funds flow will be dependant on level of rent set and the lease terms covering such things as payment of expenses etc.

Another favoured mechanism involves the use of debt to acquire assets through an appropriately constituted and managed trust.

The strategy can deliver additional cashflow to the SMSF depending on the net ongoing yield of the chosen investments. It can also deliver additional capital growth to the fund over time. If shares are acquired, dividend franking also adds significantly to the outcome. Importantly getting the documentation right is a must and getting prior legal and financial advice is essential.

The strategy sees an SMSF acquire an investment through the “Trust” which acts as a custodian on behalf of the fund. Investments may be direct equities, real property, managed funds, ETFs to name a few. The SMSF pays for the investment and all purchase moneys must be paid to the vendor by the SMSF including any deposit.

Part or all funds may be borrowed by the SMSF. The lender can be a bank or related party. A member(s) of the SMSF may be the lender and may provide the funding from their existing assets or may in turn borrow the monies. The lender’s rights are limited to the acquired property and no other assets of the super fund can be used as security.

The SMSF receives all the rent/dividends or other returns and pays all expenses. Depending on the net ongoing yield, and franking levels if shares are acquired, this may be cash flow positive for the SMSF. At a future date, the trustees of the SMSF can choose one of the following options;

• Sell all assets held in the trust and repay 100% of the loan to the investor. All of the investment profits are then paid back to the SMSF.
• The SMSF repays the debt and all of the investments in the trust are paid into the super fund. The transfer can be timed not to attract any tax on any capital gain. A stamp duty exemption on transfer is available where key requirements are met.
• Pay out the loan, sell any assets not required in retirement and transfer the portfolio balance into the super fund to pay income for the investors retirement.
• The loan is simply forfeited (forgiven) - certain rules apply here.

Each option sets the scene for a later transition to retirement whilst the SMSF investor can take full advantage of tax breaks that the super environment presents.

The “Trust Loan” strategy won’t be the right fit for everyone. However, those that it does suit will have the possibility of receiving enhanced yields on an ongoing basis into their SMSF’s and also of receiving enhanced capital growth down the track. This achieves the aim of transferring more wealth into the concessionally taxed super environment beyond what would otherwise be possible within the confines of the regulated “Contribution Caps”

Importantly, however, it is essential that the trust and the SMSF arrangements are correctly constituted and managed in order to successfully avoid some potential pitfalls arising from inappropriately executed trust strategies.

Mark Causer

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Over the past few months, share markets continued to be impacted by the global events in both the US and Europe, recording big falls. The downgrade by Standard & Poors’ of the US from AAA to AA+ back in August intensified the focus on debt levels across the developed world, particularly Europe. While October saw strong rebounds in growth assets this was quickly eroded in November as concerns over the effectiveness of governments to deal with the debt crisis continued to be a key factor influencing markets.

Investment returns have been impacted by selling in the debt and equity markets of Europe in recent months driven by the belief that there is no quick fix for the continent’s fiscal woes, as Greece, Italy, Spain, Portugal and Ireland continue to struggle with large debts built up over many decades. For European economies and share prices this means that they may not recover quickly in the short term however, most economists believe that Europe will enact structural economic reforms and will eventually emerge healthier.

European growth continues to slow, raising the risk of a Euro-zone recession in 2012. The growth outlook for the US remains subdued, but an outright recession will most likely be avoided with growth of around 2% expected in 2012¹. In contrast Chinese efforts to reign in inflation have begun to bear fruit yet the prospect of slower growth in China continues to contribute to market jitters. Yet, even with the headwinds of tighter credit and an appreciating currency, China continues to grow strongly (9% expected in 2012² ). Unlike Europe and the US, China has the capacity to loosen monetary policy if needed.

As Governments seek to cut back spending and reduce debt this contributes to a further slowing in already weak economies. Another contributing factor stems from the fact that globally the aging demographic is now favouring savings as opposed to consumption in almost all developed nations. This in turn is impacting retail sales and will eventually lead to a slowing of economic conditions and potentially, falling interest rates.

In the US, the Federal Reserve has left interest rates unchanged with the target range for the federal funds rate remaining at 0.25%. As announced by the Federal Open Market Committee on 22 September, the Fed indicated it would provide market liquidity by buying $400 billion of Treasuries with maturities of 6 to 30 years while selling an equal amount of securities due in 3 years or less, known as operation twist. This is seen to be a quasi QEIII (Quantitative Easing 3)

According to the International Monetary Fund, Australia’s economy will expand 1.8 percent this year, accelerating to 3.3 percent in 2012. Bolstered by Asian demand for commodities, the outlook “remains favourable, despite global financial market volatility in recent months,” it said.

On Melbourne Cup day the Reserve Bank of Australia dropped its benchmark rate by 0.25% to 4.5%. RBA Governor, Glen Stevens described overall financial conditions as tighter than normal, recognising weak credit growth and falling house prices³. He also referred to a much less upbeat view of the external sector with China having slowed. The RBA has “ample scope” to cut interest rates and the government has room to deploy fiscal stimulus in the event of a re-emergence of the global financial crisis.

For Australia, the perception is that a significant amount of the downside risk to equities in particular, has been priced in. The fall in the resource sector has been sharp and to a degree an unexpected outcome as the China story according to most market strategists still has a long way to go. Lower commodity prices have put resource companies’ future earnings under pressure.

Most economists believe that the potential for Australian company earnings is better than the fears reflected in the market. Like in other markets, future prospects will depend on policy outcomes in Europe and the US, which remain uncertain. But in contrast to other countries, there is significant scope for conventional policy easing while the exchange rate has already eased by 15% from its recent highs. This should provide support to earnings across sectors alongside of resources.

With global investors shunning Europe and to a lesser degree the US, investors have been looking to emerging markets as an attractive alternative. While there is still the risk of further weakness globally, the Australian market now appears to have factored in a fairly poor earnings outlook and recessed global growth. Future market falls from here may present buying opportunities for cashed up investors.

 

1 IMF
2 Deutsche Bank
3 RBA Media release 1 Nov, 2011

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