dynamic asset allocation handbook€¦ · 1/6/2014 · farrelly’s asset allocation investor...

Dynamic Asset Allocation

Handbook

June 2014

Disclaimer, disclosure and copyright © 2014 Farrelly Research & Management Pty Ltd (‘farrelly’s’) ABN 63 272 849 277. All rights reserved. Reproduction in whole or in part is not allowed in any form without the prior written permission from farrelly’s. This document is for the exclusive use of the person to whom it is provided by farrelly’s and must not be used or relied upon by any other person. This document is designed for and intended for use by Australian residents whose primary business is the authorised provision of securities advice as that term is defined in Corporations Regulations and, in particular, is not intended for use by retail investors. The material is not intended to be investment advice (either personal or general), a securities recommendation, legal advice, accounting advice or tax advice. The document has been prepared for general information only and without regard to any particular individual’s investment objectives, financial situation, attitudes or needs. It is intended merely as an aid to financial advisers in the making of broad asset allocation decisions. Before making any investment decision, an investor or prospective investor needs to consider with or without the assistance of a securities adviser whether an investment is appropriate in light of the investor’s particular investment objectives, financial circumstances, attitudes and needs. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information contained in this document, which is based solely on public information that has not been verified by farrelly’s. The conclusions contained in this document are reasonably held at the time of completion but are subject to change without notice and farrelly’s assumes no obligation to update this document. Except for any liability which cannot be excluded, farrelly’s, its directors, employees and agents disclaim all liability (whether in negligence or otherwise) for any error or inaccuracy in, or omission from, the information contained in this document or any loss or damage suffered by the recipient or any other person directly or indirectly through relying upon the information.

Tim Farrelly Available exclusively throughPrincipal, farrelly’s PortfolioConstruction Forum+61 416 237 341 +61 2 9247 [email protected] [email protected]

ContentsWhat’s new in this Edition? 3Editor’s Update – Making the right call on Term Deposits 4farrelly’s Forecasts - Occam’s Razor approach to forecasting 11 - Expected 10-year returns and underlying assumptions 12 - The long-term outlook for debt 14 - farrelly’s long-term risk assumptions 20Implementation – more than one way to skin the cat 21Directed Approach – Leave it to the experts - Explanation 22 - Model Allocations 23Advised Approach – Swim between the flags - Explanation 24 - Model Allocations 25Bespoke Approach – Plot your own course - Explanation 26 - Benchmark Allocations 29Crockpot – Rates are going up, so don’t buy debt 30

farrelly’s Dynamic Asset Allocation Handbook – June 2014 | Available exclusively through PortfolioConstruction.com.au | of 30


“What’s new in this Edition?” summarises changes made to farrelly’s core assumptions or methodologies. If you’re pressed for time, this is the one section that is a must read each quarter.

Executive Summary• Following a review of the farrelly’s long-term forecasts for debt, Term Deposits (TDs)

remain the preferred way to invest in debt securities (and substantial value can be added by making good decisions around TDs and bonds).

– Long-dated TDs are preferred even though interest rates will rise eventually. – Spreads on At Risk Debt are too low to make them more attractive than TDs. – Cash rates are unlikely to rise sufficiently to beat TDs over the next five years.• Exposures to At Risk Debt have been reduced in line with narrowing spreads.• The probability of Australia entering a period of sub par growth has been increased

from 18% to 22%, partly as a result of the increased probability of a greater than expected slowing of the Chinese economy and lower confidence in both sides of Australian politics.

Lots of changes to the farrelly’s Asset Allocation Implementor and Wizard• The inputs for salary, savings and spending have been simplified. Previously, it

required after-tax earnings and spending, the difference between the two being the important number, pre-retirement savings. Now, the Implementor and Wizard just go straight to the nub of the issue – how much can you save pre-retirement? How much will you need to spend post-retirement? And, it’s all in today’s dollars.

• Changes to the eligibility dates for the aged pension – the default is age 65, but this can now be varied. Investors below the age of 55 may want to estimate a higher starting age. For many, this is an unimportant change; well resourced investors should think of the pension as a safety net only to be needed if things go particularly badly.

• Changes to the Projector charts (as a result of subscriber feedback):o You can turn off the volatility – the charts will have the smooth paths typical of

most projection software. While the real world doesn’t work like that, the charts do look a bit neater. But, smooth outcomes are normally a little more favourable in the drawdown stage, so outcomes may appear a little more favourable when volatlity is removed. Warning – this is artificial.

o You can fix the value scale. It changes every time an assumption changes. Now, you can fix the scale by capping the values that the optimistic projection and the base-case projection show post life expectancy. The lines may go flat – not because capital values have stopped increasing but because there is a cap on the increase displayed. If you don’t like the flat top, just increase the Maximum Value cell which is just below the Projector chart.

o You can remove the Optimistic scenario. Switch it off and it will disappear.• A summary of the key outcomes is displayed below the Projector.• There is a new page summarising data from the Projector.

What’s new in this Edition?

CATEGORYNAME

• There is another new page that enables you to collect client data on asset allocation where a client’s assets are spread across a number of different entities. If used, this will link to the Projector page.

• Finally, there is a new Term Deposit calculator page – see the Editorial for details.

farrelly’s Asset Allocation Investor Presentation• The Investor Presentation has some new slides showing:

o Australian TD rates vs government bond rates over time;o Low US TD rates illustration;o farrelly’s asset allocation shifts over time;o The performance of the farrelly’s asset allocations versus a standard strategic

asset allocation.


Making the right call on Term Deposits

Are Term Deposits the most boring subject in finance? Actually, they’re anything but. The Term Deposit (TD) market is something that is ripe for finding opportunities to add value for clients, and therefore something all financial planners should study closely. Unlike most markets, it is far from efficient, analysis is relatively straightforward, and free lunches abound. This is an area where it is easy to add demonstrable value for clients. Just making decisions on whether to buy TDs or government bonds is a major source of value add. Add in the ability to find the best TD rate and pick the optimal maturity, and adding 1% to 2% per annum on this part of the portfolio is more than feasible. Equity fund managers would kill for that kind of alpha.

Should I buy TDs or government bonds?

When TDs are government guaranteed, this is an easy decision to make. Simply go with the highest rate as both TDs and government bonds are exactly the same risk – the government backs both. Right now, TD rates are higher than bond rates but that may not always be the case. Figure 1 (which is also reproduced in the Investor Presentation) shows the average spread between TDs and Australian government bonds over the past twenty years, highlighting the dramatic change since the Global Financial Crisis (GFC). For many years, banks got away with offering terrible rates on TDs, instead relying on cheap wholesale funding from overseas lenders. As a result, investors were definitely better off buying government bonds, either directly or via a managed fund.

Editor’s Update


Source: RBA

Figure 1: Premium paid on three-year Australian TDs vs. three-year Government Bonds

-2.50

-2.00

-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

3.00

Jun-

92M

ar-9

3D

ec

-93

Sep

-94

Jun-

95M

ar-9

6D

ec

-96

Sep

-97

Jun-

98M

ar-9

9D

ec

-99

Sep

-00

Jun-

01M

ar-0

2D

ec

-02

Sep

-03

Jun-

04M

ar-0

5D

ec

-05

Sep

-06

Jun-

07M

ar-0

8D

ec

-08

Sep

-09

Jun-

10M

ar-1

1D

ec

-11

Sep

-12

Jun-

13M

ar-1

4

farrelly’s Investment Strategy Handbook (Australian Edition) – March 2006 of 24

EDITOR’SUPDATE

Since the GFC, that has all changed. Under the terms of the Basle III arrangements, banks get more credit from regulators for stable retail term deposits than for wholesale deposits – hence, they are prepared to pay up for retail deposits. How long this situation may last is covered in this Issue’s Forecasts in Focus, but it may not be forever.

The most important thing to note is that it is a real value-add for investors to get this first decision right – bonds or TDs? While Figure 1 showed how the average spread has looked over time, Figure 2 shows the huge difference that can be made by picking the best TD rate available today instead of buying government bonds.

What if TDs aren’t guaranteed?

farrelly’s recommends sticking to the major banks and their subsidiaries. In our view, the chance of one of them being required to be rescued over the next decade is small. The chance of one then being actually allowed to fail is tiny. In the event that a bank is rescued, even non-guaranteed deposits would be made good.

On the other hand, the chance that one of the smaller institutions gets into difficulty is much higher. As shown in Figure 3, the profitability of regional banks is much lower than that of the major banks and, therefore, the probability of failure would appear to be a good deal higher.

Source: Infochoice 23 May 2014, Investing.com

Years to maturity

1 2 3 4 5

Best rate (%pa - see Figure 4) 3.90 4.10 4.10 4.40 4.60

Government Bond rate (%pa) 2.56 2.66 2.87 2.93 3.15

Difference (%pa) 1.34 1.44 1.23 1.47 1.45

Figure 2: Best TD rates and Government Bond rates for different maturities

farrelly’s Dynamic Asset Allocation Handbook – June 2014 | Available exclusively through PortfolioConstruction.com.au | Page 6 of 30

Source: RBA

Figure 3: Profitability of major and regional Australian Banks

0%

5%

10%

15%

20%

25%

Ma

r 200

5

Ma

r 200

6

Ma

r 200

7

Ma

r 200

8

Ma

r 200

9

Ma

r 201

0

Ma

r 201

1

Ma

r 201

2

Ma

r 201

3

Major Banks Regional banks

of 24Page 7 of 24 farrelly’s Proactive Asset Allocation Handbook (Australian Edition) – December 2011

EDITOR’S UPDATE

In the event that a regional bank got into trouble, it would probably be bailed out – but probably is just not good enough for the secure part of a portfolio. A government trying to balance its budget may well take the view that the broader impact of a non-systemically important institution being allowed to fail is not so high.

New Zealand investors do not enjoy a government guarantee on TDs, even though during the GFC, most investors were bailed out as a slew of second-tier institutions went to the wall. The sense is that next time around it will be a case of buyer beware. So, for NZ investors, or Australians with more than $250,000 per institution, it is better to stick with the major banks.

Which institutions’ TDs do I buy?

The choice of institution is pretty straight forward if the deposits are government guaranteed. Simply find the best rate for any particular maturity. Credit risk is the same for all, so why not go for the highest rates? (Assuming, of course, that there is no administrative nightmare.) Figure 4 outlines a selection of rates currently on offer and how big a difference this makes.

A few obvious conclusions jump out.

Firstly – the blindingly obvious – it is worthwhile looking around. Astonishingly, while blindingly obvious in theory, it does not seem to happen in practice. CBA has not only the lowest rates of the major banks, it has the biggest market share with over 28% of all TD monies in Australia. That’s almost double the market shares of NAB and ANZ. Between them, the four majors share about 80% of the term deposit market – with, generally, the lowest rates! There is a lot of lazy money out there.

A second observation is that pricing across maturities is (from the outside) hard to fathom. CBA offers less for its two-year TDs than for its one-year TDs. It obviously has no need for funding at that sort of maturity. Similarly, Westpac is offering 0.4% per annum more to go from two to three years, but only another 0.1% per annum more to go from three to four years. If you move from four years to five years, it’s back to a 0.4% per

Source: Infochoice: 23 May 2014

Years to maturity

1 2 3 4 5

Commonwealth Bank 3.20 3.10 3.95 3.80 4.20

Me Bank 3.90 4.10 - - -

NAB 3.35 3.55 4.00 4.10 4.50

Rabo Direct 3.65 4.00 4.10 4.40 4.60

St George 3.35 3.90 4.05 4.15 4.55

Westpac 3.30 3.60 4.00 4.10 4.50

Best rate 3.90 4.10 4.10 4.40 4.60

Difference between best & CBA 0.70 1.00 0.15 0.60 0.40

Figure 4: TD rates for various providers and maturities


annum pickup. Westpac’s four-year book seems to be full. This clearly is not an efficient market.

Which maturity do I buy?

So, how do we pick the best maturity? For the sake of this analysis, assume the investor has some funds that can be locked away for up to five years. If the investor had a shorter timeframe for some or all of these funds, the analysis could be adjusted accordingly.

The idea is that if we are choosing between a one-year and two-year maturity, we can work out the rate at which we would have to roll over a one-year TD in 12 months in order to get the same return as locking away a two-year TD today.

We can then consider how likely this may be and make a decision on whether we prefer a one-year or two-year TD. The analysis can be used to compare the rates on any combination of TD strategies, as we shall see. In this example, we will work with the best rates on offer, as per Figure 4 (prior page).

To beat the rate of 4.1% per annum available on a two-year TD, a one-year TD yielding 3.9% per annum would need to get 4.3% per annum when rolled over in a year. (That is, if we earn 3.9% and then 4.3% we average 4.1% per annum) But how likely is it that we can roll over at 4.3% in one year? It implies a 0.4% upward shift in interest rates over the coming year – possible, but probably unlikely in Australia given the economy remains sluggish and the latest budget hardly seems set to fire up the economy. So, on balance, the two-year term would seem to be a better choice than the one-year term.

Next, consider a two-year versus three-year term.

Again, the question to ask is what do one-year rates need to look like in two years for us to be better off locking in the two-year term at 4.1% per annum, rather than the three year term which is also at 4.1%?

In this case, we must roll at 4.1% per annum or better (obviously!). What is the chance that one-year Australian rates will rise by 0.2% over the next two years? Given that interest rates are very low at present, that would not seem to be much of a challenge. The two-year term is therefore preferable to the three-year term.

We should also look at the two-year versus four-year terms.

The rate on a two-year TD will have to rise from 4.1% to 4.7% over the next two years for the investor to be better off locking in 4.1% per annum for the next two years, rather than 4.4% per annum for four years. How likely is that? A 0.6% lift in the rate structure is quite feasible over the next two years – but, on balance, it is probably better to lock in for four years at 4.4% per annum, as rates are unlikely to lift by much more than 0.6% over the coming two years, and they may well stay low or go lower.

Finally, let’s look at a four-year versus five-year term. What one-year rate do we need to get in four years to beat the 4.6% per annum on offer for five years?

EDITOR’SUPDATE


Five years at 4.6% per annum is a total of 23% (5 x 4.6%, ignoring compounding) whereas four years at 4.4% per annum is a total of 17.6%. In the fifth year, we would need to earn 5.4% (23% less 17.6%), which is a lift in interest rates of 1.5% above the current one-year TD rate of 3.9%. For this to occur would imply a Reserve Bank of Australia cash rate of around 4.0% in four years. This is distinctly possible – in fact, it is probable that rates will have returned to around that level. So, in this case, we are indifferent between the four-year and five-year term. Perhaps some of each is a good strategy?

One last thing we should consider is that the banks may get more – or less – generous.

The average spread between bank TDs and government bonds at present is around 1.2% but has been as high as 2.5% and as low as -2% pre-GFC (as shown in Figure 1). As discussed in this Issue’s Forecasts in Focus, farrelly’s expects that this spread will fall over coming years as banks meet their target TD volumes on their balance sheets. If that proves to be the case, the four-year versus five-year comparison would imply that cash rates would have to rise by a further 0.7% (the difference between a 1.2% and 0.5% spread). This would imply that cash rates would have to rise to 4.7% for a four-year maturity to be preferable to a five-year maturity. This is unlikely in our view, so all that tips the decision towards the five-year maturity.

Note, in all of this analysis, we are anticipating that cash rates and TD rates will rise – yet, we still want to lock in the long rates. How can this be?

The answer lies in the steepness of the yield curve. Effectively, a steep yield curve means that rates have to rise a lot before it is a bad idea to lock in a longer-dated maturity. If rates rise just a little bit then locking in long-dated fixed interest securities is the winning strategy. Crude rules of thumb such as “don’t buy fixed interest if rates are expected to rise” are just that – crude and, often, very wrong. A somewhat more sophisticated analysis, as laid out here, will give much better results.

Technical Notes

How does the government guarantee work if an entity fails?

All deposits with Australian Approved Deposit-taking Institutions, up to $250,000, are covered. The guarantee covers pretty much all types of investors – individuals, charities, trusts and corporate entities. As soon as APRA declares an institution insolvent, the Financial Claims Scheme kicks into action and all deposits – regardless of term – will be repaid as quickly as possible. APRA expects at call deposits to be repaid within a week, with other deposits taking a little longer, but the time will be measured in weeks rather than months. Thus, investors in five-year TDs would be repaid early and would not have to wait out the term of their investment.

A note on bond funds

farrelly’s uses the 10-year bond rate to forecast returns from 10-year government bonds on the grounds that if we buy a 10-year bond at 3.5% per annum and hold it for 10 years, the return will be 3.5% per annum.

EDITOR’S UPDATE


This works perfectly if 10-year Commonwealth government bonds are bought and held to maturity and no interest payments are reinvested – which obviously is not the case for most bond funds as their value is marked to market, corporate as well as government bonds are owned, duration is less than 10 years, the bonds are constantly being traded, nothing is held to maturity, and income is reinvested.

In fact, all this doesn’t matter too much in practice.

Figure 5 shows the 10-year government bond rate at the start of a period and the subsequent performance of the UBS Government Bond Index. Clearly, there is a very strong correlation between the two. And, contrary to popular opinion, long-term returns on bonds are aided by rising bond yields and hurt by falling bond yields. Yes, afraid so. This is because the return from the underlying bonds are pretty much locked in but returns on reinvested income are hurt by lower yields and helped by higher yields. It’s another twist in the crazy world of bond maths.

Secondly, we have to deal with the value added by subtracting all of the trading activity of the bond managers. Fortunately – or not – it doesn’t tend to amount to much. Bond managers are a conservative bunch and don’t like to ever be too far from their peers, and that means the index. So, if the 10-year index return looks like the rate at the start of the period and the managers look like the index, then the funds’ returns will closely resemble the yield at the start.

Running the TD calculations

The easiest way to approach the calculations to compare two different TD terms is to simply work out the total interest paid over the life of each security and, from that, the difference than needs to be earned when the shorter dated maturity matures. This difference is then averaged over the difference in years between the two maturities.

EDITOR’S UPDATE


Source: RBA, UBS

Figure 5: Bond yields predict bond returns

0

2

4

6

8

10

12

14

16

03/8

8

03/8

9

03/9

0

03/9

1

03/9

2

03/9

3

03/9

4

03/9

5

03/9

6

03/9

7

03/9

8

03/9

9

03/0

0

03/0

1

03/0

2

03/0

3

03/0

4

03/0

5

03/0

6

03/0

7

03/0

8

03/0

9

03/1

0

03/1

1

03/1

2

03/1

3

03/1

4

Subsequent 10 yr returns 10 yr bond yield at start

Of course, this method ignores compounding – but returns very similar results with far less complexity.

If you’re interested in running the calculations, Figure 6 summarises how to do so.

If you’d prefer not to have to run the calculations, both the farrelly’s Asset Allocation Implementor and Wizard (available to subscribers on the farrelly’s subscriber-only web page) now have a page that will assist you. Just enter the best TD rates you can access for each maturity, update the government bond rates, and you’ll be shown the break-even rollover rates and implied changes to interest rates to prefer one maturity over another. The page has links to sites that will give you TD rates for a range of institutions and government bond rates for all maturities.

EDITOR’S UPDATE


Source: farrelly’s

MaturityA

Rate (%pa)B

Total Earned (%pa)C = Ax B

1 year 3.9 3.9

2 years 4.1 8.2

3 years 4.1 12.3

4 years 4.4 17.6

5 years 4.6 23.0

Comparison Difference in total return (%) D =Ci - Cj

Break-even rate (%pa)(Cj-Ci)/(Aj-Ai)

1 year vs 2 years 8.2 – 3.9 = 4.3 4.3/1= 4.3

2 years vs 3 years 12.3 – 8.2 = 4.1 4.1/1= 4.1

3 years vs 4 years 17.6 – 2.3 = 5.3 5.3/1= 5.3

4 years vs 5 years 23.0 – 17.6 = 5.4 5.4/1= 5.4

1 year vs 3 years 12.3 – 3.9 = 8.4 8.4/2 = 4.2

2 years vs 4 years 17.6 – 8.2 = 9.4 9.4/2 = 4.7

3 years vs 5 years 23.0 – 12.3 =10.7 10.7/2 = 5.3

2 years vs 5 years 23.0 – 8.2 =14.8 14.8/3 = 4.9

Figure 6: Sample Calculations of Breakeven rates

Occam’s Razor Approach to market forecasting

farrelly’s forecasts

In 1991, John Bogle wrote his seminal paper “Investing in the 1990s: Remembrance of Things Past and Things Yet to Come.” (Journal of Portfolio Management, Spring 1991, pp. 5-14.) He described what he called the Occam’s Razor approach to forecasting, named after Sir William of Occam, who in the fourteenth century declared the simplest explanation is generally the best. The Occam’s Razor approach to forecasting decomposes market returns into three elements: income; growth in income; and, the effect of changing valuation ratios. This can then be used to explain past returns and, more interestingly, forecast future returns with remarkable accuracy. The three elements combine to produce the following formula: Returns = Income + Growth in income + Effect of changing valuation ratios R = Y + G + V

Where: Y is the current investment yield, a known quantity, hence no forecasting is required for this input. G is the annualised growth in income or earnings for the asset. For: • Property, it is growth in rents • Equities, it is growth in Earnings Per Share • Fixed interest, growth is zero, by definition! V is the Valuation Effect. It is the compound effect of an increase or decline in PE ratios or yields on the returns produced by an asset. For example

For equities over a one year period: V= (PE at end of period / PE now ) –1

If PEs rose from 10 to 12 then: V = 12/10 – 1 = 0.2 or +20%

For longer time periods, say 10 years, we use the compound growth rate: V (%pa) = (PE at end of period / PE now)1/10 –1

Using the previous example, over 10 years: V= (12/10)1/10 -1 = 1.0183-1= +1.83% pa Why use 10-year forecasts? They are more accurate than short-term forecasts. EPS growth is steadier over 10-year periods than one-year periods. The effect of a change in PEs is much smaller over 10 years than one year, as we have just seen.


The forecasts below are based upon the Occam’s Razor approach outlined on page 12. This approach to forecasting has many attractions – including accuracy, simplicity and transparency. By making available the underlying logic and assumptions (Figure 1 below), subscribers are able to quickly understand the rationale for the farrelly’s forecasts and determine the effect of changing the assumptions.

The long-term outlook for markets

AuEquities

Dev Mkt Equities

Em Mkt Equities

AuREITs

SecureDebt

At Risk Debt

Fund of Hedge Funds

Cash

Current Yield 5.3% 2.3% 2.9% 5.4% 4.8% 6.3% - 3.5%

+ Currency Impact - 1.6% 1.0% - - - - -

+ EPS growth (f) 4.6% 3.3% 4.7% 2.8% 0.0% -1.4% - -

+ Valuation effect -0.7% -0.4% 0.9% -0.9% 0.0% 0.5% - -

Index return (pre-tax) 9.2% 6.8% 9.4% 7.3% 4.8% 5.4% 3.5% 3.5%

+ Manager value-add 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2.3% 0.0%

Total Return (pre-tax) 9.2% 6.8% 9.4% 7.3% 4.8% 5.4% 5.8% 3.5%

Total Return (15% tax) 8.0% 5.9% 8.1% 6.4% 4.1% 4.6% 4.9% 3.0%

Total Return (46.5% tax) 5.8% 4.5% 5.7% 4.6% 2.6% 2.9% 3.1% 1.9%

PE Now 16.6 18.3 13.3 - - - - -

PE 2024(f) 15.53 17.57 14.5 - - - - -

Yield 2024(f) - - - 5.9%14 - - - -

Indicative Index All Ords S&P500 FTSE-EM ASX REITs - - - -

Index Level 5,499.2 1,923.6 569.5 1,072.3 - - - -

Worse case long-term scenarios: 10-year REAL total return (pa) is less than…

1 in 50 chance -4.2% -7.5% -7.5% -6.6% -1.6% -1.6% -5.0% -0.6%

1 in 20 chance -2.1% -5.3% -7.1% -3.7% -1.2% -1.4% -3.3% -0.6%

1 in 6 chance 1.5% -2.9% -1.8% -0.6% 2.0% 1.6% -1.3% 0.2%

Worse case short-term scenarios: 1-year NOMINAL total return is less than…

1 in 50 chance -65% -66% -74% -61% -18% -44% -21% 0%

1 in 20 chance -38% -38% -43% -35% -9% -25% -11% 1%

1 in 6 chance -15% -15% -17% -13% -2% -9% -2% 2%

Frequency of years with negative returns

1 year in... 3.0 3.0 2.9 3.1 5.9 3.2 6.0 Never

Figure 1: Expected 10-year returns and underlying assumptions - Australian-domiciled investors

farrelly’sFORECASTS


Key assumptions (as at 1 June 2014)

The Australian equities forecasts assume:1. Current dividends on ASX All Ordinaries, grossed up for franking credits.2. EPS growth of 4.6%pa vs forecast inflation of 2.5%pa and real GDP growth of 3.0%pa.3. PEs moving to 15.5, the long-run PE ratio forecast for inflation in the 2% to 4%pa range.The Developed Market Equities forecasts assume:4. Current FTSE All World Index yield.5. Currency impact will equal the difference between the Australian 10-year bond

rate and that of a FTSE World Index-weighted basket of bonds. This is the return pickup that could be achieved by fully hedging currency.

6. EPS growth for Developed Markets of 3.3%pa, compared with anticipated global inflation of 2.5%pa, and real GDP growth of 2.0%pa.

7. PE ratios at 17.5, the long-run PE forecast for inflation in the 2% to 4%pa range.The Emerging Market Equities forecasts assume:8. Current FTSE All World Emerging Market Index (LOC) yield.9. Currency impact plus 1%pa (less than developed markets because of higher

anticipated inflation in EM).10. EPS growth for Emerging Markets of 4.7%pa, compared with anticipated inflation of

4.0%pa, and real GDP growth of 6.0%pa.11. PE ratios at 14.5, a discount to developed market PEs.The Australian REITs forecasts assume:12. Current yield of ASX A-REIT index.13. Distribution growth of 2.8%pa which includes the impact of rental growth,

development activities and gearing.14. Yield in 2024 of 5.9%pa, which is farrelly’s estimate of the fair value yield for A-REITs.The Secure Debt forecasts assume:15. Yield is the expected return on the Big Four Bank term deposits over the next decade,

with five-year TDs rolling over at 5.0%pa.16. Investments are rated at least A or better.The At Risk Debt forecasts assume:17. A well diversified portfolio equal to a mix of 50%BBB, 30%BB, and 20%B issues.18. The pre-default yield pickup is 2.6%pa versus government bonds.19. The impact of defaults will be equivalent to -1.4%pa.20. Assumed impact of lower reinvestment rates.The Cash forecasts assume:21. Government bond yields plus 0.2%pa.The Fund of Hedge Funds forecasts assume:22. Cash plus a premium for fund manager value add (alpha) of 2.3%pa.For Returns we have assumed:23. Returns for Australian Equities, DM Equities, EM Equities, Au REITS, Debt and Cash

reflect index returns. No allowance has been made for the after-fee impact of active management on returns or yields as these vary by fund manager. This may be done by the subscriber using the farrelly’s Dynamic Asset Allocation Implementor software.



farrelly’s analyses a number of different interest bearing assets including cash, government bonds, both nominal and inflation-linked, term deposits (TDs), and high grade and low grade credit. Within debt securities, farrelly’s has long separately classified Secure Debt and At Risk Debt. The reason for considering these as different asset classes became obvious during the GFC. On the other hand, we don’t believe domestic and overseas fixed interest are sufficiently different to require separate examination as, once hedged back to Australian dollars, the medium-term returns from domestic and overseas fixed interest of similar credit quality are very similar.

The outlook for Secure Debt

This asset class is currently made up of Government bonds, bank TDs which are explicitly government guaranteed and, perhaps, some big four bank securities.

Estimating 10-year nominal returns for Secure Debt used to be the simplest forecasting task of all. Take the 10-year government bond rate and, well, that’s it. A 10-year government bond bought at a yield of 3.5% per annum gives a return of 3.5% per annum, if held to maturity. And, if bought via a bond fund, you get much the same effect, as discussed in the Editorial.

All this may be interesting, but not that helpful, as TDs remain a better alternative than government bonds – in fact, a much better alternative, as they are currently government guaranteed to outperform over the longer term. And, they will do so with lower apparent volatility. The only concession is that TDs do not have the apparent negative correlation with equity makets that has made bonds such a good investment over the past seven years. However, TDs only seem to be less volatile and seem not to have a low correlation to equities because they are not marked to market. If they were, they would have the same volatility and the same correlation characteristics as government bonds of the same duration.

This may well be semantic, but it is worth remembering that the cash flows coming out of a 4% per annum TD and a 4% per annum government bond are identical. Apart from liquidity and reporting, they are to all intents and purposes the same thing. Same cash flows, same credit risk. The only advantage of bonds is you can trade them to make capital gains to put back into the sharemarket. But trading bonds is a tough game – many are called but few are chosen. We believe it is better to stick with an inefficient market such as TDs where you can really add value, as described in the Editorial.

Given that government guaranteed TDs offer a premium over the returns available on government bonds, farrelly’s uses the return on five-year TDs as the risk free investment and our basis for estimating the return on Secure Debt. This is not quite as straight forward as forecasting 10-year government bond returns, as we have to estimate the TD rollover rate in five years. That will be made up of two parts: firstly, an estimate of the five-year government bond rate in five years; and, secondly, an estimate of the spread that banks will need to pay on TDs in order to attract funds from retail investors.

As seen in the Editorial (Figure 1), rates paid on TDs are now 1.2% per annum higher than

The long-term outlook for debt



of 24

those available on government bonds of similar maturities. This spread has narrowed somewhat over the past few two years as TD rates have eased while bond rates have risen somewhat. Regardless, this apparent generosity on the part of the banks is a far cry from the poor rates on offer from TDs prior to the financial crisis.

Will this generosity last? There are a number of factors at play – the new Basel III requirements; how long the banks need to pay premium rates in order to change the shape of their balance sheets; and, the relative costs of various sources of funding. Let’s look at each of the three in turn.

Under the Basel III regime, retail deposits are more highly rated for capital management purposes than wholesale deposits. Banks are currently prepared to pay a premium to access retail deposits – so much so that institutional investors have been finding that they are offered up to 1% per annum below retail deposit rates. Basle III rules mean we are unlikely to go back to the days when TDs paid lower rates than government bonds.

According to RBA data, Australian banks have improved their balance sheet weighting of domestic deposits from 40% to 58% of their overall funding. Perhaps they are getting close to their target funding levels from deposits as the spead between TDs and government bonds has narrowed from up to 2.5% per annum to 1.2% per annum at present. In recent months, the share of TDs as a percentage of total deposits has declined somewhat, but it is not clear whether this is a result of consumers reacting to the lower rates on offer or banks consciously targeting other sources of funding. We think it is the former. Investors don’t know or care about the spread between TDs and government bonds, they just react to the headline rate. Banks care about the spread but also want to achieve certain levels of funding from domestic TDs. So, as bond rates have come off over the past few months, TD rates have held firm and, as a result, the spread has widened a little.

On balance, we expect conditions for TD investors will continue to be favourable for a year or two yet. But, ultimately, as bond rates eventually move back into the 4% to 5% per annum range, the spread will close to around 0.5% per annum or perhaps even less. (As an aside, in the US and the UK, TD rates are well below bond rates, notwithstanding Basle III requirements. This is a direct consequence of QE which floods the economy with deposits in excess of banks requirements. UK and US banks have no trouble meeting their targets and therefore don’t need to pay up for deposits. In the absence of QE in Australia or NZ, there is a battle for deposits and, hence, a premum is paid.)

The bottom line is that to arrive at a 10-year forecast for TDs in the absence of a 10-year TD rate, farrelly’s takes the current rate on five-year TDs (4.55% pa) and then estimates rollover rates in five years’ time. We estimate that TDs should be able to be rolled over at 5.0% per annum in five years. This reflects an expectation that the new neutral rate for government bonds is 4.5% per annum, plus an expected TD premium of 0.5% per annum. The end result is a forecast for Secure Debt of 4.8% per annum.

The Outlook for At Risk Debt

At Risk Debt includes all those securities for which we can’t be sure of repayment, and for which we get paid a premium or spread over the risk free rate. This bucket covers an



enormous range of different types of securities from AA-rated debt all the way through to distressed debt securities of companies on the verge of bankrupcy where investors are betting on how much will be paid back to bondholders after the company is wound up. While recognising that these are very different types of assets, farrelly’s nonetheless bundles them all together for the purposes of generating risk and return forecasts.

That said, from a big picture qualitative level, At Risk Debt looks quite unattractive.

Figure 1 shows yields on BBB-rated and B-rated assets in Australian dollar terms compared to TDs. Two observations immediately jump out.

Firstly, the yield on BBB securities is only marginally higher than that which can be received on government guaranteed TDs of an equivalent maturity. Secondly, the yield on B-rated assets is at an all time low. Neither factor is very encouraging. And, a final qualitative point – globally, new issuance of Hi Yield securities is at an all time high. From the point of view of corporates, securing funding when rates are at all time lows is eminently sensible. From the point of view of investors, loading up on loans to highly leveraged entities at the low point of the interest rate cycle makes less sense. Rates will rise eventually, perhaps more quickly or more slowly than we anticipate, but when they do, we would prefer to be somewhere other than in the Hi Yield space.

Forecasting returns

Notwithstanding our lack of qualitative enthusiasm for At Risk Debt, we still need to forecast returns and risks. To forecast returns, farrelly’s estimates the current yield on a portfolio of 50% BBB securities and 50% Hi Yield securities (rated BB, B or worse), makes an allowance for likely changes in yields when rolled over and, finally, makes an assessment of likely credit losses.

Typically, corporate debt has maturities of around five years. To produce a 10-year



Source: US Federal Reserve, RBA, farrelly’s analysis

Figure 1: Yields on BBB, B and TDs

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

22.5

25.0

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

B BBB TDs

forecast, farrelly’s assumes that the credit spreads will be around long-run averages when rolled over – being 2.5% per annum for BBB and 5.0% per annum for Hi Yield.

Credit failure

High credit spreads tend to be a rather good predictor of failure rates for the next year or so. Today, spreads are reflecting current low failure rates and easy monetary policy around the world. This is a low stress environment for corporates. Stresses should remain low for the next year, but beyond that timeframe – when spreads lose their forecasting ability – surprises are possible, if not probable. Figure 2 shows the failure rates for investment grade and Hi Yield bonds both on average and during two of the worst periods on record. It also shows farrelly’s forecast failure rates for the next decade.

Assessing the outlook for failure rates over next decade is not straightforward. On the one hand, farrelly’s believes that the next decade is likely to be characterised by modest growth and recurring financial crises eminating from Europe, Japan and, perhaps, China. Furthermore, cautious lenders seem to be drifting back into some of their old bad habits – the rise in high yield lending activity is a concern. On the other hand, large corporations are well aware of the difficult economic environment that lies ahead and have learned many lessons from the GFC.

This is where the artificailly low interest rate regimes in the US and Europe may finally come home to bite. While artificially low interest rates do not seem to be generating excess investment on average, they are perhaps generating excess leverage and unproductive investment in some parts of the global economy.

The end result of all of this is that we assume that from this point forward, we will see slightly lower than average failure rates for BBB-rated entities and slightly higher than average failure rates for Hi Yield securities. Higher quality organisations should be able to navigate this environment better than those that stretch themselves.

Recovery rates

farrelly’s assumes average recovery rates of 65% and 35% for investment grade debt and Hi Yield debt, respectively. Of the two, we are more concerned about the Hi Yield assumptions, particularly given issuance rates have recently been hitting all time highs. The combination of all of these assumptions leads to an estimated impact of defaults of 0.2% per anum for BBB-rate securites and around 2.5% per annum for Hi Yield. On average, this amounts to 1.4% per annum, a bit higher than the long-term average of 1.0% per annum reported by Moody’s.


Source: Moody’s. (e) farrelly’s estimate; (f) farrelly’s forecast.

Period BBB Hi Yield

Average 1970 -2011 (%pa) 4.2% 32

1931 - 1941 (%pa) 14 to 20(e) 39

1981 - 1991 (%pa) 8.4 41

2014 – 2024 (%pa) 4.0(f) 36(f)

Figure 2: Average, worse-case and forecast 10-year failure rates


Forecast returns for At-Risk Debt

As is shown in Figure 3, this all adds up to returns that just don’t seem worth the risks. BBB-rated securities offer only a marginal pickup over farrelly’s expected TD return of 4.8% per annum, but at least they do so with little downside risk – if well diversified. Poorly diversified portfolios of BBB-rated securities carry much higher risks. Whether this is worth the additional volatility will come down to individual risk preferences. Similarly, the premia on Hi Yield securities are also small but they come with much higher long-term risk and volatility. There just is not any value there. Stay away.

Inflation-linked bonds

Notwithstanding our expectation that Australian inflation will stay low for many years, it does remain a real concern for many investors. They may wish to consider inflation-linked bonds (ILBs). ILBs are currently trading at a yield of 1.6% per annum plus inflation and, given nominal yields of 3.6% per annum, will outperform nominal government bonds in the event that inflation averages more than 2.0% per annum. This is less than our long-term forecast for inflation of 2.5% per annum, hence government ILBs offer 0.5% per annum better returns than nominal government bonds, with the ILBs offering inflation protection as a bonus. However, in order for ILBs to outperform bank TDs, inflation will have to average over 3.2% per annum over the next decade. Furthermore, in the event we do get a sustained inflation breakout above 3.0%, it is reasonable to assume that the RBA will lift cash rates and, as a result, five-year TDs will be able to be rolled over at higher rates than the 5.0% per annum rollover rate that we have assumed. The end result is that an investor would have to fear inflation rising above 4.0% per annum on average over the next decade before ILBs look attractive compared to TDs. We think this is very unlikely.

Cash

Cash has also been a very good inflation hedge over the years and, obviously, has done so without the volatility associated with ILBs or other bonds. Short-term rates in


Source: farrelly’s

Base case Pessimistic case

BBB Hi Yield BBB Hi Yield

10-year risk free rate (%pa) 3.7 3.7 3.7 3.7

Credit spreads (%pa) 1.5 3.8 1.5 3.8

Current yield to maturity (5 yr) (%pa) 5.2 7.5 5.2 7.5

Impact of rolling over in 2018 (%pa) 0.2 0.7 0.0 0.0

Average yield (10 Years) (%pa) 5.4 8.2 5.2 7.5

Annualised impact of failures on returns -0.2 -2.5 -0.5 -4.4

Forecast returns (%pa) 5.2 5.7 4.7 3.1

Assumed failure ( 10 yr cumulative) 4% 36% 8% 50%

Assumed recovery 65% 35% 30% 20%

Figure 3: Expected returns for At-Risk Debt


Australia and NZ have been highly responsive to fluctuations in inflation and, for the most part, have offered real returns of around 2.0% per annum or more (Figure 4).

Unfortunately, farrelly’s does not expect cash to be nearly as attractive an inflaton hedge in future. The neutral level for Australian interest rates will probably be 1% per annum lower than in the past. This would suggest that the likely margin above inflation will be more like 1.0% to 1.5% per annum than 2.0% to 4.0% per annum. As such, cash is not as attractive as an inflation hedge as government CPI-indexed bonds.

Furthermore, while cash should remain highly responsive to any emerging inflation, it may well disappoint in the event that the Australian economy enters a long period of sluggish growth. The end of the mining boom, slowing growth in China and successive incompetant governments (where flip-flop seems to pass as policy) means this scenario certainly would not be a surprise. In that instance, short-term real interest rates could be low or even negative as has occurred in the US, Europe, and Japan. If this occured, long-dated TDs (and, to a lesser extent, government bonds) will produce real returns higher than our forecast and, for that reason, are still excellent long-term diversifiers. By that, we mean assets that give sound long-term returns and behave differently to other assets over the long term in the event of unexpected economic or market outcomes. This concept has little relationship to short-term correlations. Long-term diversification is about putting together assets expected to give reasonable returns if our base scenario holds, but that also may protect in some, if not all, alternative economic environments.

Summary

TDs remain the most attractive of all debt securities in the current environment, both from a secure return perspective and a portfolio risk management perspective. Government bonds are expensive in their own right and even more so when compared to TDs. At Risk Debt assets are unattractive. Cash and inflation-linked bonds are generally good hedges against inflation, but farrelly’s believes that inflation is quite unlikely to get to levels that will cause these assets to outperform traditional TDs.



Source: RBA, RBNZ

Figure 4: Real Cash Rates

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

1971

1976

1981

1986

1991

1996

2001

2006

2011

Aust NZ


In forumlating the farrelly’s forecasts, a range of different economic scenarios are considered and, for each, a range of return estimates is produced for the different asset classes. The scenarios relate to economic outcomes and the Occam’s Razor formula is used to translate those outcomes into return forecasts. Clearly, it is impossible to be exact about such things and so the farrelly’s Forecasts are best thought about as the central point of a range of possible outcomes, not a precise prediction of an outcome.

farrelly’s long-term risk assumptions

Scenario Prob Description Range of 10 year returns (%pa)

75% probabilityBase case -muddle through

40% The developed world grows slowly, largely as a response to governments’ deleveraging and the accompanying fiscal tightening. Corporate profits grow more slowly than usual, inflation and interest rates remain low. Emerging markets continue strong economic growth. Australia grows somewhat slower than usual. The resources boom ends. Sometime over the decade, most economies experience a sharp V-shaped recession.

Aust EqDev Mkt EqCashInflation

6 to 125 to 93 to 52 to 3

Worldwide recession

12% Most of the developed world, including Australia, experiences little or no growth for the decade. The best example is Japan from 1990 to 2010. Inflation and interest rates are low, and profit growth is negative as companies struggle to maintain profit margins. PEs fall to low levels.

Aust EqWorld EqCashInflation

1 to 6-2 to 11 to 22 to 3

Developed world recession - not Australia

12% The world divides into two groups: those struggling under high government debt; and, those with low debt and deficits. For the developed world, the scenario is as per the Recession scenario above. For Australia and the emerging markets, it looks like the Base case/muddle through scenario.


6 to 12 -2 to 13 to 52 to 3

Wither Australia 6% The rest of the world follows the Base case/ muddle through scenario while Australia experiences little or no growth, falling EPS, and low PE ratios.


3 to 76 to 92 to 62 to 3

Worldwide depression

4% The roadmap is the Great Depression of the 1930s. Real economic growth is negative, interest rates very low, earnings collapse and PE ratios fall. This scenario strikes all economies including emerging markets.


-8 to -1-9 to -4-1 to 2-1 to 2

Stagflation 13% The benchmark is the 1970s – high inflation, very high interest rates, sluggish growth and low EPS growth. PE ratios are also low. This condition hits the majority of the developed world.


6 to 93 to 67 to 145 to 8

Hyperinflation <1% Much of the world experiences hyperinflation such as was seen in Weimar Germany in the 1930s. Property maintains value but equities and paper-based assets are essentially wiped out in real terms.


35 to 6731 to 6228 to 10127 to 102

Back to normal 8% We return to the great moderation – normal interest rates and inflation, normal growth rates and PE ratios.


10 to 158 to 124 to 53 to 3

Boom 5% Governments reject calls for austerity and engage in expansionary spending and continue QE. Confidence returns and economic growth recovers quickly enough to restore tax revenues. Budgets automatically come back into balance as expenditure slowly eases. A brief burst of higher inflation is calmed by moderate fiscal and monetary tightening. The emerging market boom accelerates. Profits grow rapidly. Resources prices remain high.


17 to 2114 to 184 to 63 to 4

Figure 1: Scenarios, probabilities and expected outcomes March 2014


of 24

Implementation

More than one way to skin a cat

Asset allocation is not an exact science. Forecast returns are approximate, risk is multi-dimensional and difficult to forecast and, most importantly, the efficient frontier is more like an efficient band or an efficient cloud rather than a line. All of which says that there are many good portfolios that can be built to achieve a particular objective – in other words, there is more than one way to skin a cat.

Dynamic asset allocation

The asset allocation approaches described in these pages come under the broad heading of Dynamic Asset Allocation (DAA). DAA is very different from both Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA). With SAA, asset allocation changes are made very infrequently and are generally small changes when they occur. Under SAA, investors must be prepared to hold and, worse still, buy assets that are manifestly overpriced. On the other hand, TAA is generally about making decisions about short-term price moves over a period that may vary from one to 18 months, which means it is crucially dependent on correctly timing both the entry and exit.

DAA is all about moving ahead of events, sometimes up to two to three years in advance of an event occurring – and as such, DAA is not dependent on correctly timing either the entry or the exit to a position. DAA is essentially a long-term strategy but unlike SAA, it is not blind to valuation excesses. DAA is all about investing in quality assets that are reasonably priced, and more importantly, avoiding investment in overpriced assets.

Different approaches suit different advice models.

farrelly’s offers three different approaches to suit three different types of advisers:

• those who want to create bespoke portfolios to suit their preferences and beliefs and those of their investors;

• those who believe asset allocation should be left to the experts and who want to follow a model allocation that is managed proactively; and,

• those who prefer to make an asset allocation change only when it is essential. Effectively, all this group wants is a quick practical check of their existing asset allocations to see if a change is needed, otherwise they prefer to leave well alone.

The farrelly’s Dynamic Asset Allocation Handbook caters to all three approaches, with three distinct sets of guidelines as outlined on the following pages.


This approach will suit those advisers who believe that allocating between asset classes is something best left to a suitably qualified third party. They should be followed exactly once a suitable level of risk has been selected for the investor. The process farrelly’s uses to create these Model allocations is:

1. Create Benchmark Allocations – to give high returns for a given, stable level of risk.

2. Reduce weights below Benchmark Allocations if assets are fully valued – Even if most risky assets are fully valued or over valued, the Benchmark allocations will have a full al-location to those risky assets because the Benchmark allocations carry a stable level of risk. (For a longer discussion, see page 20). In the event that most assets are fully valued or overvalued as they were in 2007, the overall weights to risky assets will be reduced in these Model Allocations.

3. Assign zero weights to overvalued assets – In the event an asset becomes overval-ued, that is it’s expected return is less than that of government bonds, we will assign a zero weight to that asset class.

These three steps result in Target Allocations.

4. Implement changes slowly over time – The first three steps of this process are all value based and as such, suffer from the curse of all value based approaches; they tend to buy and sell too early. To overcome the value curse, we then stagger changes over time – generally over 18 months to two years. For example, if the Target allocation of a particular asset falls from 16% to 0%, the Model allocations would generally reduce by about 2% a quarter until the Model allocation was 0%. Implicit in this is the idea that when assets become overvalued, they often go on to become extremely overvalued, and, similarly, if they become cheap, they often go on to become very, very cheap. As a result, it is normally a good idea to average in and out of positions over time.

Notes on using the directed approach

1. The Model allocations may be unsuitable as a long-term buy and hold portfolio – This is generally where an overpriced asset is in the process of being sold down over time, and the Model Allocation to that overpriced asset would be too high without a plan for selling down that asset.

2. Investor portfolios should be rebalanced either quarterly or half yearly – If the Model Allocation contains overpriced assets that are gradually being sold down, it is essential that the selling process does take place over time. As a result, it is important that those investors following the Model Allocations review them at least half yearly.

3. New money should follow the Target Allocation rather than the Model Allocation – New cash should be invested in line with the Target Allocation rather than the Model Allocation because the latter will, from time to time, hold assets that are in the process of being sold down. It would be counterproductive to buy an overpriced asset one quarter and sell it down the next. Hence, new money should be invested more in line

A directed approach – leave it to the experts

IMPLEMENTATION


with the Target Allocations rather than the Model Allocations. Similarly, when moving a portfolio from a different asset allocation approach to the Model Allocation process, the farrelly’s Asset Allocation Wizard software provides a quick guide to what moves should be made, and provides backup documentation for compliance purposes.

Figure 1: farrelly’s Model Allocations – Australian-domiciled investors – June 2014

Note: Model Allocation is for use with existing portfolios. Target Allocation is best used for new monies.

1 2 3 4 5

Model Target Model Target Model Target Model Target Model Target

Risky Assets

- Australian Equities (%) 10 8 16 12 26 23 35 32 47 43

- Developed Market Equities (%) 3 3 5 4 7 6 10 10 14 14

- Emerging Market Equities (%) 4 3 6 5 10 8 14 11 19 16

- Australian REITs (%) 1 4 2 5 4 7 5 9 6 12

- At Risk Debt (%) 4 2 4 2 4 2 3 2 2 0

- Hedge Funds (%) 0 0 0 0 0 0 0 0 0 0

Total Risky Assets (%) 22 20 33 28 51 46 67 64 88 85

Defensive Assets

- Secure Debt (%) 57 57 52 57 44 47 29 30 8 8

- Cash (%) 23 23 15 15 5 7 4 6 4 7

Total Defensive Assets (%) 78 80 67 72 49 54 33 36 12 15

Base-case long-term returns1

10-yr total return (%pa, pre-tax) 5.2 5.6 6.5 7.2 8.0

10-yr total return (%pa, 15% tax) 4.4 4.8 5.6 6.2 7.0

10-yr total return (%pa, 46.5% tax) 2.9 3.2 3.9 4.4 5.0

Yield (%pa pre-tax) 4.4 4.5 4.6 4.5 4.3

Worst-case long-term scenarios2: 10-year REAL total return (%pa) is less than…

1 in 50 chance -0.2 -0.8 -1.6 -2.4 -4.1

1 in 20 chance 0.7 0.5 -0.2 -1.0 -2.2

1 in 6 chance 1.6 1.6 1.3 0.9 0.7

Worst-case short-term scenarios3: 1-year NOMINAL total return (%) is less than…

1 in 50 chance -12 -15 -25 -35 -49

1 in 20 chance -5 -7 -13 -19 -28

1 in 6 chance 0 -1 -3 -6 -10


1 year in …. 11.8 8.4 5.2 4.1 3.4

IMPLEMENTATION


For advisers who prefer to leave portfolios alone for the most part but want a quick second opinion on how the portfolios are positioned at any point in time, the Advised approach is suggested.

Under this approach we set upper and lower ranges for the various asset classes as shown on page 19. These ranges are above and below the Model allocations which are constructed as described on page 16.

The Advised approach consists of two steps:

1. Compare the investor’s current allocation with the ranges shown in Figure 1 on page 19. If outside the range bring that allocation back within the range.

2. Add up the exposure to risky and defensive assets and if inside the ranges then all is well. If the risky allocation is higher than allowed, reduce the allocation to the least attractive risky assets and apply that allocation to the defensive assets. Similarly if the allocation to risky assets is too low, then reduce the exposure to defensive assets and apply the balance to the most attractive risky assets.

As an administrative process, this is very similar to strategic asset allocation – check the investor’s current allocation against a maximum and minimum range for each asset class and, if outside those ranges, rebalance the portfolio back inside the ranges. However, while administratively similar, the two approaches have very different outcomes.

The two main differences are, clearly, that the Model Allocation ranges vary over time as you would expect, but also that the size of the band on either side of the Model Allocations also varies. Instead of just being plus or minus 5%, farrelly’s believes it is reasonable to be much more defensive when assets are fully or over priced – it’s just not sensible to be very aggressive at such times. Similarly, when assets are cheap, the minimum weight will be close to the Model Allocation weight but there will be much more flexibility to go overweight. That is, at these times, it’s not a good idea to be ultra defensive; taking a little more risk than usual is fine.

Notes on using the Advised approach

1. Investor portfolios should be rebalanced either quarterly or half yearly – The upper limits allow investors to hold overpriced assets because these upper limits will be reduced over time causing these assets to be sold down over time. Accordingly, it is essential that the review and selling process does take place either quarterly or least half yearly.

2. The limits on exposure to risky assets should be closely followed – Because the ranges on the exposures to individual risky assets is quite broad, it would be very easy to have far too much risk in a portfolio if it were not for the limits on exposures to risky assets as a whole. This provides much of the discipline in the system and therefore should be closely followed.

An advised approach – swim between the flags

IMPLEMENTATION


Figure 1: farrelly’s Model Allocations ranges – Australian-domiciled investors – 1 June 20141 2 3 4 5

min max min max min max min max min max

Risky Assets





- At Risk Debt (%) 0 5 0 5 0 5 0 5 0 5

- Hedge Funds (%) 0 6 0 7 0 6 0 5 0 5


Defensive Assets

- Secure Debt (%) 40 71 32 59 22 49 13 33 0 12

- Cash (%) 4 33 2 27 2 19 2 11 2 8




10-yr total return (%pa, 15% tax) 4.4 4.8 5.6 6.2 7.0

10-yr total return (%pa, 46.5% tax) 2.9 3.2 3.9 4.4 5.0

Yield (%pa pre-tax) 4.4 4.5 4.6 4.5 4.3


1 in 50 chance -0.2 -0.8 -1.6 -2.4 -4.1

1 in 20 chance 0.7 0.5 -0.2 -1.0 -2.2

1 in 6 chance 1.6 1.6 1.3 0.9 0.7


1 in 50 chance -12 -15 -25 -35 -49

1 in 20 chance -5 -7 -13 -19 -28

1 in 6 chance 0 -1 -3 -6 -10


1 year in …. 11.8 8.4 5.2 4.1 3.4

IMPLEMENTATION

Notes1. Returns and yields for Australian Equities, Developed Market Equities, Emerging Market Equities, Au REITs, Debt and Cash reflect

index returns. No allowance has been made for the after-fee impact of active management on returns or yields.

2. Long-term worst-case scenarios are real (ie after Inflation) returns. If subscribers wish to get a sense of nominal worst-case scenarios they should add expected inflation, 2.0%, to these figures.

3. Short-term worst case scenarios are shown in nominal terms, given investors generally think in nominal returns during falling markets.


This approach best suits those advisers who want to take control of the asset allocation process but want to do so within a disciplined and logical framework. Long-time farrelly’s subscribers and those looking though past issues of the Handbook will note that this approach was the only one offered prior to the September 2009 issue. The principal tools to use to create bespoke asset allocations are the farrelly’s Benchmark Allocations (see Figure 1 on page 23) and the farrelly’s Investment Strategy Implementor.

The role of the farrelly’s Benchmark Allocations

The farrelly’s Benchmark Allocations are designed to indicate what sort of return you should achieve for taking on a particular level of risk – that is, they are intended to be used as benchmarks against which to assess the efficiency of investor portfolios. If a investor portfolio is delivering close to the expected returns of the equivalent Benchmark Allocation, then the investor portfolio is efficient and doesn’t need to be changed. But, if the returns of the investor portfolio are well below those of the equivalent Benchmark Allocation, then the asset allocation of the investor’s portfolio should be changed – using the farrelly’s Implementor software – until returns are close to that of the equivalent Benchmark Allocation. Quite often, the investor’s new asset allocation will be very different from the Benchmark Allocation, but nonetheless it will be an efficient portfolio.

The Benchmark Portfolios are NOT designed to be followed slavishly

Because the Benchmarks Allocations are based on current valuations, they respond quickly to changes in relative valuations in markets. As a result, they vary by more each quarter than is sensible to track because, if followed slavishly, they would generate unnecessary turnover and resulting costs and taxes.

In addition, while the Benchmark Allocations change quickly based on current valuations, markets often respond quite slowly to valuation imbalances. Once overvalued, a market can remain so for years and go from being mildly overvalued to massively overvalued over time. Similarly, when in free fall, a market can move from fair value, to cheap, to very, very cheap – as was the case in the second half of 2008 and early in 2009. As a result, the Benchmark Allocations share the curse of all value-based approaches – they tend to buy too early and sell too early. Hence, better results will normally be achieved by following the Benchmark Allocations at a lag.

Finally, in order to fulfil their benchmarking role, the Benchmark Allocations maintain a constant exposure to risk even when risk is unattractively priced. The risk is aligned to the risk level of standard industry portfolios. So Benchmark Allocation 2 will always have the same level of risk as a typical Capital Stable Fund and Benchmark Allocation 4 will always have the same level of risk as a typical Balanced Fund. This means that even if markets are all highly overvalued, Benchmark Allocation 4 will have significant exposures to risky assets (equities, property and Tier 2 fixed interest) in order to match the level of risk inherent in a typical balanced fund. This is because the Benchmark Allocations are intended to describe the return to expect for taking on a certain level of risk. They do not suggest whether it is prudent to take on that level of risk. That is the

A bespoke approach – plot your own course

IMPLEMENTATION


role of the adviser in creating the bespoke allocations. In many respects, the bespoke process should mirror that described in the Model Allocations - but with much more control in the hands of the adviser.

When building bespoke asset allocations, the following principles should be followed.

Keep transaction costs lowTransaction costs and taxes eat returns. The keys to keeping them low are pretty clear. Firstly, make as small a change as possible when bringing portfolio expected returns in line with those of the Benchmark Allocations. To do this, you need to use the farrelly’s Investment Strategy Implementor software (available to all subscribers on the private farrelly’s forum). You will find that it is generally possible to find allocations that have entirely acceptable expected returns but require much less change than implied by moving all the way to the Benchmark Allocations.

Rebalance infrequently or stagger changesIn order to avoid the value curse, either make infrequent reviews of investor asset allocations or, when making changes, stagger them over time. We suggest reviewing bespoke portfolios every one to two years. This way, when assets move into over valued territory, you will not sell out at the very first moment and miss out on any move to the very, very over valued status assets can achieve in a bubble. Or, you could choose to make more frequent changes, but implement them gradually over time. For example, a decision to increase allocations to international equities vis a vis Australian equities could be made today, but implemented in six quarterly, or three half-yearly moves over the next 18 months. How you choose to do it will depend on the nature of your practice and systems, and the attitudes of your investors.

Vary the risk level as market valuations varyBecause the risks inherent in the Benchmark Allocations are anchored on typical industry balanced and capital stable funds, they don’t reduce risk when markets become over valued. Subscribers using a Bespoke Approach need to make that decision. Generally speaking, that will mean taking a risk 4 (or balanced) type of investor down to a risk 3 or 2 level gradually over time if a bull market continues unchecked.

Don’t buy expensive assetsHolding over priced assets is a real problem if they were bought at over priced levels. It’s less of an issue if they were bought at fair value. So, one of the keys to building bespoke portfolios is to simply not buy expensive assets. Assets are considered expensive when their expected return falls below the rate of return available on government bonds. The Benchmark Allocations don’t help here. Because they always take on market risk, they may still have significant exposures to expensive assets, particularly in environments where all risky assets are expensive, as was the case in late 2007.

Dollar cost averaging can help when placing new moneyDollar Cost Averaging (DCA) is simply staggering a purchase of assets over time, typically when investing new money. Despite a lot of hype surrounding DCA, farrelly’s research suggests that DCA costs dollars on average. This is because it increases the amount of time spent invested in cash, which tends to be the lowest returning asset in the long term. Having said that, here are some guidelines about when it does and

IMPLEMENTATION


doesn’t make sense to use DCA:

1. When markets are fully priced according to the farrelly’s Tipping Point Tables (that is when they are expected to return less than 2.5% per annum above government bonds), DCA doesn’t cost much and may help ease investors’ anxieties. Quite a good idea, in other words. However, make sure that the DCA program is relatively short term – no more than six months is our suggestion.

2. When markets are overpriced (expected returns are less than government bonds) DCA is not a bad idea – but not buying at all is a much, much better one. Again, just don’t buy over priced assets

3. When markets are at fair value (returning 2.5% to 5% per annum above government bonds) DCA is very costly and unnecessary. It’s much better to invest immediately.

4. When markets are cheap and in particular, cheap and falling, then DCA comes into its own. In this circumstance, it will probably make money as well as relieving anxiety (critical at these times). Again, keep the program fairly short, ideally a six month period, but no longer than 12 months.

IMPLEMENTATION


IMPLEMENTATION

Figure 1: farrelly’s Benchmark Allocations – Australian-domiciled investors – 1 June 2014

Traditional asset class portfolios Portfolios including alternative assets1 2 3 4 5 6 7 8 9 10

Risky Assets





- At Risk Debt (%) 2 2 2 2 0 0 0 0 0 0

- Hedge Funds (%) 6 6 6 6 3


Defensive Assets

- Secure Debt (%) 57 57 47 30 8 57 55 44 26 5

- Cash (%) 22 14 4 3 3 17 11 3 3 3



10-yr total return (%pa, pre-tax) 5.2 5.6 6.5 7.2 8.0 5.3 5.7 6.5 7.2 8.1

10-yr total return (%pa, 15% tax) 4.4 4.8 5.6 6.2 7.0 4.6 4.9 5.6 6.2 7.0

10-yr total return (%pa, 46.5% tax) 2.9 3.2 3.9 4.4 5.0 3.0 3.3 3.9 4.4 5.0

Yield (%pa pre-tax) 4.4 4.5 4.6 4.5 4.3 4.2 4.2 4.3 4.2 4.2


1 in 50 chance -0.2 -0.8 -1.6 -2.4 -4.1 -0.2 -0.6 -1.5 -2.5 -4.1

1 in 20 chance 0.7 0.5 -0.2 -1.0 -2.2 0.6 0.4 -0.3 -1.3 -2.3

1 in 6 chance 1.6 1.6 1.3 0.9 0.7 1.5 1.4 1.2 0.9 0.6


1 in 50 chance -12 -15 -25 -35 -49 -12 -15 -25 -35 -49

1 in 20 chance -5 -7 -13 -19 -28 -5 -7 -13 -19 -28

1 in 6 chance 0 -1 -3 -6 -10 0 -1 -3 -6 -10


1 year in …. 11.8 8.4 5.2 4.1 3.4 12.9 8.8 5.3 4.1 3.4

Notes1. Returns and yields for Australian Equities, Developed Market Equities, Emerging Market Equities, Au REITs, Debt and Cash reflect

index returns. No allowance has been made for the after-fee impact of active management on returns or yields.

2. Long-term worst case scenarios are real (ie after Inflation) returns. If subscribers wish to get a sense of nominal worst case scenarios they should add expected inflation, 2.0%, to these figures.

3. Short-term worst case scenarios are shown in nominal terms, given investors generally think in nominal returns during falling markets.


Available exclusively through PortfolioConstruction.com.au of 24

Everyone knows bond rates are going up, so why would you buy fixed interest? Actually, there are three really good reasons:- Bond rates may not be going up; - If they do, they may not go up enough to hurt bond investors; and, - For long-term investors, rising bond rates are an opportunity cost, not a genuine loss (unless they are driven by rapidly rising inflation.)

Let’s look at the first reason not to buy debt – bond rates may not go up. An April 2014 survey of 92 US-based market economists found every single one of them expected the 10-year US Treasury yield to rise over the next six months. Every single one! What happened next? Long-term rates fell by 0.2% per annum. Most forecasters continue to believe rates have only one way to go in the short term. That should worry them. But, that is the short term – and farrelly’s certainly doesn’t profess to have a reliable short-term crystal ball.

What about medium term? Why not defer purchase of five-year TDs for two years to take advantage of higher rates that will almost certainly be around by then? For this to be a smart strategy, we’d have to beat the 4.6% per annum yield available today on five-year TDs. If we left the funds in cash for two years at, say, 2.5% per annum, then the next three years must yield 6.1% per annum on average just to breakeven. This is 1.9% per annum higher than current three-year TDs rates. Any less than a 1.9% per annum hike in TD rates and investing in the five-year maturity is the better result – despite rising interest rates. The steep yield curve penalises those who wait. Interest rates need to go up a lot to offset a steeply rising curve.

If, instead of cash, we opt for a two-year TD at 4.1% per annum, the maths (as laid out in the Editorial) shows that the rate on three-year TDs would be required to rise from 4.1% to 5.0% per annum before the deferral strategy breaks even. This is quite possible.

But, even if you believe rates will probably rise by more than that, there is still one more thing to worry about... What if rates fall, a lot?

Falling rates don’t normally keep fixed interest investors awake at night, but they should. Compare the risks of the two strategies for conservative investors with substantial secure debt holdings. Say that five-year TDs at 4.6% per annum are enough to pay the bills. If we go to cash and rates fall substantially (as has happened in the US, Japan, UK and Europe) the bills don’t get paid – disaster! It’s better to lock in 4.6% per annum and, even if rates rise substantially, the bills still get paid. Investors may not be happy having missed an opportunity, but there is food in the house. From a lifestyle investment perspective, the risks are quite asymetric. Being grumpy is not nearly as bad as being both hungry and really, really grumpy. The long maturity is the safer choice.

Don’t buy fixed interest? It’s nuts and you can clearly see it’s nuts!

Rates are going up – so don’t buy fixed interest

CROCKPOT

The forecasts shown below are based upon the Occam’s Razor approach outlined on page 12. This approach to forecasting has many attractions including accuracy, simplicity and transparency. By making available the underlying logic and assumptions (Figure 1 below), subscribers are able to quickly understand the rationale for the forecast and determine the effect of changing the assumptions

AuEquities

Dev Mkt Equities

Em Mkt Equities

AuREITs

SecureDebt

At Risk Debt

Fund of Hedge Funds

Cash

Current Yield 4.0% 2.3% 2.9% 5.4% 6.3% 6.9% 0.0% 3.7%

+ Currency Impact 0.6% 2.2% 1.6% 0.6%

+ EPS growth (f) 4.6% 3.3% 4.7% 2.8% 0.0% -1.4% 0.0% 0.0%

+ Valuation effect -0.7% -0.4% 0.9% -0.9% 0.0% 0.6% 0.0% 0.0%

Index return (pre-tax) 8.5% 7.4% 10.0% 7.9% 6.3% 6.0% 3.7% 3.7%

+ Manager value-add 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 2.3% 0.0%

Total Return (pre-tax) 8.5% 7.4% 10.0% 7.9% 6.3% 6.0% 6.0% 3.7%

Total Return (30% tax) 7.3% 5.9% 8.5% 6.4% 4.4% 4.2% 4.2% 2.6%

PE Now 16.6 18.3 13.3 - - - - -

PE 2024(f) 15.5 17.5 14.5 - - - - -

Yield 2024(f) - - - 5.9% - - - -

Indicative Index All Ords S&P500 FTSE-EM ASX REITs - - - -

Index Level 5,499.2 1,923.6 569.5 1,072.3 - - - -

Worse case long-term scenarios: 10-year REAL total return (pa) is less than…

1 in 50 chance -4.2% -7.5% -7.5% -6.6% -1.6% -1.6% -5.0% -0.6%

1 in 20 chance -2.1% -5.3% -7.1% -3.7% -1.2% -1.4% -3.3% -0.6%

Worse case short-term scenarios: 1-year NOMINAL total return is less than…

1 in 50 chance -65% -66% -74% -61% -18% -44% -21% 0%

1 in 20 chance -38% -38% -43% -35% -9% -25% -11% 1%


1 year in... 3.0 3.0 2.9 3.1 5.9 3.2 6.0 Never

Figure 1: Expected 10-year returns and underlying assumptions - NZ-domiciled Investors – 1 June 2014


NZ-domiciled investor supplement


NZ-domiciled investor supplement

farrelly’s Model Allocations – NZ-domiciled investors – 1 June 2014

1 2 3 4 5

Model Target Model Target Model Target Model Target Model Target

Risky Assets

- Australasian Equities (%) 8 5 14 10 22 15 29 22 35 24




- At Risk Debt (%) 3 0 2 0 2 0 2 0 1 0

- Hedge Funds (%) 0 1 0 2 0 2 0 2 0 1


Defensive Assets

- Secure Debt (%) 54 62 47 50 40 41 27 27 13 13

- Cash (%) 24 22 17 20 10 18 7 18 5 19




Yield (%pa pre-tax) 4.6 5.1 5.7 6.1 6.6


1 in 50 chance -0.2 -0.7 -1.6 -2.6 -4.2

1 in 20 chance 0.8 0.3 -0.3 -1.2 -2.3


1 in 50 chance -12 -18 -25 -34 -45

1 in 20 chance -6 -9 -13 -19 -25


1 year in …. 11.4 7.0 5.2 4.2 3.6


dynamic asset allocation handbook€¦ · 1/6/2014 · farrelly’s asset allocation investor...

Documents