Asset Allocation - the shift to Sectoral Funds

For many clients the recommendations they receive from financial planners today are likely to be quite different from 4 or 5 years ago. One of the major changes in thinking is the shift from “diversified funds” to “sectoral funds.”

So what is the difference and why the change? Most importantly what does it mean for investors in terms of investment performance and risk management?

The Background
There are four primary asset classes. These are shares, property, fixed interest and cash. There are many sub-sectors including international and local, large capitalisation and small cap, bonds, mortgage funds etc.

Regardless of an investor’s risk profile a well constructed portfolio will be diversified amongst the different investment sectors as diversity reduces risk. How to achieve that diversity is the subject of this article?

The Options
In the past diversified funds were widely used. These are investment funds constructed by different managers that invest across many investment sectors providing diversity in one convenient product. Such funds vary according to the investors risk profile and have such names as Conservative, Capital Stable, Balanced, Growth and High Growth. They comprise of a mix of asset classes and are typically managed entirely by the fund manager that issues them.

In this case investors look to the fund manager to have skills in all asset classes. They expect the equities team, the cash and bond team and the property team to be of a high standard. Many of the larger fund managers have strengths across all asset classes and identifying the best of these has been one of the roles of the financial planner.

In recent years the funds management market in Australia has matured a lot. There is now a much wider range of choice of international and local funds managers. There has emerged many more sector specialists and smaller boutique managers. The advantage for investors is that they can now use these specialist funds to create fully diversified portfolios.

This goal is substantially aided with the emergence of master trusts and portfolio WRAP services which provide easy access to the many funds available, consolidated reporting and easy cost effective switching.

The Advantages
As we have stated a key strategy in achieving the optimal return for a given investor is to diversify the portfolio. Specialist funds allow investors to choose sector specialists to manage their portfolios while still achieving the goal of diversity.

In choosing specialist funds investors can expect to see more consistent and better investment performances from each sector. This is because of what specialisation delivers. It is less likely that one manager is good at all things, so with diversified funds there may be areas where the performance is not optimal. With specialist funds this is less likely to be the case. However, even if it does emerge that one of the chosen funds is underperforming it is an easy matter to move to another specialist without disturbing the entire portfolio.
In short the advantages are

1. Better and more consistent investment performance across the portfolio.
2. Greater flexibility in tweaking the portfolio to enhance performance.
3. Greater flexibility in constructing the portfolio to suite individual investor’s needs.

Diversified Funds Fight Back
In recognition of the above points many funds managers now offer diversified funds that use different investment specialists. These more limited master trusts use a diversity of fund managers and investment specialists to manage their different offerings. In addition fund managers are not slow in poaching specialist teams from others to boost perceived internal areas of weakness.

With diversified funds the fund manager typically makes tactical adjustments to the portfolio in recognition of changes in market circumstances. With sectoral portfolios this advice comes from your financial adviser.

For many investors this is still the best option of achieving diversity in a simple solution that delivers the benefits previously mentioned. Your financial advisor should help to ensure that a good level of diversity of managers is achieved regardless of which option you use.

Conclusion
Sectoral funds can deliver advantages although they don’t suit all investors. It is important to be well informed when constructing diversified portfolios using sectoral funds and to monitor the portfolio regularly. For some investors the newer breed of diversified funds are often more suitable. Your financial planner has the skills and resources to identify the solution that best suits you.

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PROPERTY– Where to Invest in 2004?

Financial Keys asked David Scott, the Head of Property at Credit Suisse Asset Management, about his thoughts on residential property, other property investments and the future of listed property. David has kindly provided his views in the following article.

The property market witnessed a stellar year in 2003. Newspapers touting the latest record price, home renovation tips on the television, takeovers in the listed property market and seminar after seminar on profiting from property were features of a buoyant market. The end of the year saw the Henry Kaye Empire under pressure and anecdotal evidence of house prices stabilising and even tapering. So what’s in store for 2004?

Residential property - prices can fall.
Given the residential housing sectors strong performance (with real prices doubling in the last 10 years), many believe that house prices in Australia can’t fall. Can it happen?

It already has. Let’s use Sydney as an example. Between June 1981 and March 1987, the median house price in Sydney rose 22%. Great news, however, inflation ran at 58%. This led to a real (adjusting for inflation) loss of 22%. Real house prices then rose by 82% from March 1987 to December 1988 before falling 34% to December 1990 so for a “stable” sector, it has displayed surprising volatility. Over the entire period (1981-1990) real house prices in Sydney dropped 8%. But this was in a high inflation environment!

In a low inflation environment, recent examples include Tokyo, where real prices fell 65% between 1990 and 2002. In Hong Kong, real prices have fallen 59% since 1997.

The trigger for falling house prices has historically been a peak in the building cycle coupled with low affordability levels. This is the situation presenting us today. So will prices fall?

Recent data suggests the average Australian residential investment property has a gross yield of 3.4%. In some areas, and after accounting for management fees, net yields of 1-2% are being achieved (indicating price to earnings multiples of around 50 times).

Investment yields will only move back to the long term average yield of 4-5% average if:
1. Rents rise, or
2. Prices drop.

Rents are not expected to pick up in the short term given vacancy rates are at historical highs. This implies that investment property prices will come under downward pressure. The investors hit will be those looking for quick profits – particularly from inner-city apartments with no point of difference.

From an investment perspective, residential property offers a low yield, no diversification and high management costs.

What else is there?
There are many other forms of property investment – listed trusts, direct property investment and syndicates. The trusts and syndicates typically invest in commercial property, that is, office towers, shopping centres and industrial premises. Each is defined below:

Rather than dissect each form, the following factors outline the key items that investors should keep in mind when seeking exposure to property.

Costs
When you purchase a listed property stock you can be charged 0.3% of the value by your broker or $20 via the internet. For other forms of property your costs include stamp duty, due diligence and legals, which average around 6% of the purchase price. If purchasing a syndicated property, you may also be charged advisor fees and capital raising costs that can add a further 5%. Thus your equity could drop 10% before you take ownership of it. This is similar when it comes time to sell, although it’s mainly agent’s fees. Syndicates may charge a performance fee if the vehicle has outperformed prospectus estimates. Therefore, total costs can vary from 0.6% in listed property to 8% in other forms.

Liquidity
Listed property trusts are highly liquid and traded regularly on the Australian Stock Exchange. Direct property and syndicates are illiquid and are not easily divested. In fact most syndicates are “locked in” for periods up to 7 years. Should investors wish to upgrade their car, pay for renovations or even buy a new fridge; listed property investments allow ready access to money.

Management costs
Efficiencies are gained within listed property so management fees are generally quite low – around 0.3% of gross assets for the larger trusts. With direct investment and syndicates you need the same systems and personnel but the critical mass is seldom there.

Diversification
Listed property trusts also tend to invest in larger, quality assets and have significant diversification benefits over other forms (given the quantum of dollars involved). Ultimately, investors in listed property trusts can have $10 and enjoy the benefits of a diversified, liquid and professional sector. For example, $3.60 gives you a share in Westfield Trust providing an exposure to 50 shopping centres and over 9,500 retail outlets.

The outlook for listed property?
With uncertainty in the residential market, and syndicates faced with higher fees, higher debt and minimal liquidity, it follows that listed property should be on your radar in 2004.

Listed property is characterised by a reliable yield with steady distribution growth and has provided 10.5% pa returns in the 10 years to December 31, 2003.

Listed property should remain a solid performer because:

References
AMP Henderson, Oliver’s Insights - Housing as an Investment, May 2003.
Australian Bureau of Statistics, 6401.0 Consumer Price Index, January 2004.
Real Estate Institute of Australia, Australian Property Market Indicators, March 2003.
UBS Warburgs, Real Estate Monthly, February 2004.

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Market Commentary

Solid growth in world economies and expectation of better things to come has continued the strong performance from most international markets.

Today there is widespread optimism about the global economy and financial markets and this can be seen in the share market growth in recent times.

The US economy is showing plenty of signs of strong growth spurred on by extremely low interest rates and rising confidence in the general market. Tempering this optimism is the market reaction to President George Bush’s growing budget deficit.

In the US, the S&P 500 Index rose strongly over the past 3 months as shown on the graph below.

By contrast, the Australian market which has performed strongly during the past few years of international market poor performances, has moved little during the past 3 months.

Compared to the US, Europe appears to be slower in its recovery. “Private consumption is underwhelming in Europe” Klaus Baader, economist for Lehman Brother recently said. Business confidence however is improving with German business confidence indicators showing strong signs. Other positive news out of Europe is that European exports have to date received little disruption from the strengthening Euro.

Japan continues to show positive signs with evidence suggesting that business conditions have reached a 6 year high. Asian sharemarkets have had very strong performance during the past few months.

As can be seen in the graph below, the MSCI, a measure of the world share markets, has retreated a great deal over the past few years since its peak in late 2000. Since early in 2003, there has been growth in international markets as shown in the tail end of the graph.

The rising Australian Dollar has been spurred on by the interest rate differential with the United States, where the US Federal Reserve has kept its target interest rate at a 45 year low of 1 per cent. The interest rate rises by The Reserve Bank of Australia of 0.25% in November and December have aimed to slow borrowing and consumer spending. The Australian Dollar was strengthened further by the conclusion to the Free Trade Agreement with the United States.

Rising interest rates appear to have slowed the residential housing market however December and January are quiet months for housing sales so it will be interesting to see what the RBA will do with interest rates over the coming months.

While the appreciating Australian dollar has seen strong domestic demand attracted to cheaper imports, it has also made our exports more expensive. But the strengthening world economy appears to have had a positive effect on Australia’s exports, particularly in the resources sector.

Did You Know:
1. Consumer spending accounts for 60% of the Australian economy.
2. Australian new motor vehicle sales in 2003 – 909,811
3. Australian Unemployment is 5.6%
4. United States Military Budget for 2004/05 is US$401.7 billion.

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Whats Happening at Financial Keys

New Trainee Paraplanner – Joseph Law
Financial Keys is pleased to advise that Joseph Law has recently accepted an invitation to join our team as a trainee paraplanner as part of our graduate recruitment program.
With over 120 graduates applying for the available position, Joseph comes with good credentials.

Joseph has a Bachelor of Economics (University of Sydney), was recently employed in Fixed Interest Securities with Computershare, and was previously employed at Glebe Asset Management. Joseph has recently spent four months travelling through Asia which proved exciting and challenging.

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