Planners constructing portfolios in the new market environment should go back to basics, as Kristen Paech reports.
In a down market, it is common to hear that cash is king. And with banks and institutions offering rates of up to 9 per cent on term deposits, it is little wonder. There are times when investing in cash makes sense, but the flood of money into such vehicles over the past six months has prompted concern that planners may not be making the most of the opportunities that are available to clients in a bear market.
Tim Farrelly, principal of farrelly’s Investment Strategy, says planners should have been more cautious last year, and much more aggressive this year, but in fact the reverse is occurring. Asgard Wealth Solutions, which added term deposits to its eWrap platform in May, has seen about $575 million invested in cash and term deposits since January – an 18 per cent increase over the same time last year.
Macquarie has also responded to demand for cash products from advisers by adding Macquarie Cash XL and term deposits to Macquarie Wrap.
“My perception is far too many [planners] are sitting on their hands at the moment and saying, ‘in a down market cash is king, we should be increasing our levels of cash and looking for opportunities’,” Farrelly says.
“The opportunities are out there, and to the extent that you’ve got cash at the moment you should be buying [assets] that are cheap. Cash is not king until it’s spent.
“[Planners] ought to have been standing back, raising cash and getting ready for a downturn of some nature. This year we’ve had the downturn; now is the time to be stepping up to the plate and investing the cash that hopefully you’ve raised, and certainly staying with the allocations you’ve got. It’s not the time to say, ‘[markets] are down, I should be switching [my asset allocation]’.”
Nevertheless, it is a good time for planners to take a step back from the daily bad news and consider whether the portfolios they have constructed for clients, especially those that were put together in the height of the bull market, are still appropriate.
“I would be asking, given the expected risk [and] return from a particular portfolio, is that still in line to meet the client’s needs?” Farrelly says.
“Things really have moved around and it’s time to have another look at it, particularly if you’ve set the portfolio based on very different conditions, [like those] that existed a year-and-a-half ago.”
Brian Parker, investment strategist at MLC, describes this as performing a “health check” on the financial plan. He says now is a great time for financial planners to be really proactive, and stress to clients that good plans are built for good times, bad times, and all times in between.
Furthermore, they are built with the idea that market downturns happen, but at the same time that they never last.
“Don’t wait for the phone call, ring all your clients, send out letters and emails,” Parker says.
“It’s about sticking to the financial plan and reiterating why we put the plan in place, running a bit of a health check: Is the plan still valid? Have [the client’s] circumstances changed? Is the client not as risk-seeking as we thought initially? Hopefully that’s not the case, but if so, the plan needs to be adjusted.”
Identifying which clients are in most need of a health check is the tricky part, but in this environment, Farrelly says most people would welcome a call.
The conversation may lead to a review of the client’s asset allocation, or even just help to allay concerns and answer any questions they might have about the state of financial markets and how their portfolio could be affected. It’s also a good time to talk to clients about the range of opportunities that are available to them, particularly if they have some spare cash lying around.
“Right now [planners] should be talking to all their clients because a lot of them will be nervous and wanting to know what’s [happening] out there, and [wondering] should they be concerned,” Farrelly says.
“It is a hand-holding exercise, but it’s a useful one.”
Paul Resnik, the co-founder and director of risk-profiling firm FinaMetrica, believes the starting point for planners reviewing portfolios should be a thorough assessment of the client’s risk profile. He argues planners that use a traditional risk profile questionnaire, or none at all, often get their clients’ risk tolerance wrong.
Such questionnaires usually ask only a handful of questions, and confuse risk “needed”, risk “capacity” and risk “appetite”, he says.
“Risk needed” is the level of risk required to meet the client’s financial goals; “risk capacity” is the amount they can afford to lose; and “risk appetite” is the amount of volatility they can stomach along the way. An empirical test by FinaMetrica of 20 advisers from four dealer groups, each with 10 clients they knew well, revealed advisers got their clients’ risk tolerance wrong one in six times by more than two standard deviations.
In other words, one in six financial plans, if based on the planner’s estimation of the client’s risk tolerance, was mismatched. To put this in perspective, Resnik says two standard deviations could vary the exposure to growth assets by 30 or 40 per cent.
“If I was a planner, I’d be saying, ‘I need to invite my customers in to review where they are’,” he says.
“Most people constructed a portfolio in a different environment than today, with different drivers. It’s entirely legitimate to review every portfolio and look to see whether it’s appropriately positioned going forward. As part of that, it’s a reasonable time to expose clients to a robust risk tolerance assessment, if for no other reason [than] just to figure out which of your clients are the one in six [whose risk profiles] you’ve got wrong.”
According to Resnik, the easiest way to measure a client’s risk appetite is to use a psychometric tool. Working out “risk needed” is where the “genius of the planner comes in”, he adds.
“The risk needed might be five per cent real after inflation, fees and taxes to achieve my goal, but my sleep at night might be two per cent,” Resnik says.
“What you’re doing as a planner is trying to minimise the [likelihood] of the client being miserable and unhappy; one, because they don’t achieve their goals, or two, because when their portfolio behaves badly they withdraw, sell-down, hate you and decide to sue you because you didn’t give advice that was appropriate to their needs.”
Despite the massive stockmarket fluctuations over recent months, Resnik says a client’s risk tolerance is unlikely to have changed.
But while risk tolerance is a “relatively enduring personal trait”, perception of risk can change during turbulent times.
Behavioural science research shows that clients have less tolerance for downside risk than they do for upside risk. For example, a client with a low risk tolerance would be better off gaining their equity exposure through a fund-of-funds, rather than an individual portfolio of shares, where the volatility of each individual stock is more visible and could cause unnecessary pain in a downturn.
“Recognising that [a client] has a low risk tolerance but has still decided to take additional risk, you would look to see how to shelter them from negative experiences,” Resnik explains.
“So you’re not actually changing the riskiness of their recommendation, you’re just recognising how they’re going to feel.”
But it is not just client risk profiles that should be reappraised in light of the new market environment.
William Tomac, business manager at specialist international equities fund manager Global Value Investors (GVI), says the market generally has been rather complacent in its attitude towards risk.
“That’s come home to roost in the last 12 months with the major correction across all sectors, brought about by the collapse of the credit markets due to the sub-prime [crisis],” he says.
“In that respect, advisers are probably reap-praising once again their attitude towards risk and to what extent should they be actively involved in moving assets from various asset classes in order to defend better the wealth they’ve created, particularly over the last four years since March 2003.”
The use of excessive leverage by some companies and banks has led to increased scrutiny of gearing by both regulators and investors.
And with the credit crunch pushing up the cost of borrowing, highly geared investments have become more expensive and less desirable than in recent years.
Annette Vlismas, client portfolio manager at Russell Investments, says this is having an impact on the way planners are structuring portfolios.
“A lot of the higher levels of borrowing that were part of [market] conditions a year ago and in the run-up to the market correction meant a lot of highly geared types of investments,” she says.
“They’re more costly now, because the cost of borrowing has gone up, and that’s a big influence in the way planners are shaping portfolios. The positive side is that with all of the gearing coming out of the system you’re getting back to the basics of seeing the real value of the companies, so the prospect for good returns from good quality companies has improved.”
Parker says the new market environment has also honed the focus on the true role of the financial adviser – to build and protect clients’ wealth so they can meet their long- term financial goals.
“That should be simple; my concern is that too many people have tried to make the business of building wealth too messy, structured and layered and it doesn’t need to be any of those things,” he says.
“Some of the sexier products and strategies that have been marketed to investors in recent years have been shown to be wanting in this environment. It’s going to be a back-to-basics market in the next few years.”
The old rules of thumb for portfolio construction have not changed; planners should ensure diversification among assets, sectors and countries, pick quality funds management houses to implement the asset allocation, and stay focused on the needs of each individual client, Parker says.
International equity investment is important due to the small size of the Australian sharemarket relative to other countries globally.
According to Parker, about 60 per cent of the market is concentrated in financials and resources.
“Australia is only two or three per cent of a global portfolio; the reality is 97 per cent or more of the equity opportunities are somewhere else,” he says.
“If you want a more diversified portfolio, you have to look overseas.”
Vlismas says Russell is advocating overseas in- vestment to planners to capitalise on the globalisation of world economies, and the opportunities the new market environment presents.
“We have been suggesting to planners that they look to take a global approach to investing, to get away from the bias of having a lot of domestic assets,” she says.
“It could well be that coming out of these unsettled economic conditions there’s more scope for recovery overseas than in Australia. That’s probably because the US economy has had a lot of stimulus whereas in the Australian economy the brakes are being put on. There’s the chance that sharemarkets will start to anticipate a recovery overseas well ahead of any sign of the Australian economy picking up again.”
However, Maggie Callinan, head of research at Financial Facts, says it’s important for planners investing overseas to put a hedging strategy in place to counter any adverse movements in currency markets.
“Where the Aussie dollar is appreciating, that can reduce returns from the international sector, so we would advocate investing in international shares on at least a partially currency-hedged basis,” she says.
Whether investing at home or abroad, it is important to focus on the client’s objectives and match the products available to their long-term strategy and objectives.
Tomac says that far too often, there’s a major disconnect between the way that products are managed by fund managers, and their objectives, and the objectives of the client.
“One needs to look at the income requirements of a client; the short-, medium- and long-term outcomes for the client, and construct a portfolio accordingly,” he says.
“So advisers, I would argue, have a keener interest at this particular point in time to construct portfolios that are more client-outcome focused rather than market-outcome focused.”
A survey in May this year by GVI of more than 300 financial advisers found that with the current market outlook for slower earnings growth from equities, planners are focusing their attention on income and dividend yield.
Some 83 per cent of respondents said the income component of total returns would “definitely” (54 per cent) or “possibly” (29 per cent) play a more important role when shaping clients’ portfolios. Almost 90 per cent had made some adjustments to their clients’ asset allocation in the past six months because of the changes in economic conditions.
“In order to smooth the returns and provide a quality income from equities, receiving a dividend is vital in terms of ensuring good defensive qualities in the portfolio, and it’s also quite a comforting experience to receive physical income from an investment, despite the fact that in the short term, the price of the asset may have fallen,” Tomac says.
“It helps to soften the impact of the market falls.”
Paul Taylor, head of Australian equities at Fidelity, says individual stock selection is critical in a bear market.
At Fidelity’s recent Investment Forum in Sydney, he said investors should look for strong balance sheets; quality management teams; prudent business models, pricing power; good marginal re-investment opportunities; and structural growth from the companies in which they invest. However, Parker says fluctuations in portfolio values across the board have shown up those planners whose value proposition was based on stock picking.
He argues planners face a conflict in trying to manage client portfolios day-to-day, and yet at the same time build and manage their businesses, and so should outsource the capability to professionals.
“It’s very hard for a financial adviser to keep people’s asset allocations on target, to keep portfolios rebalanced on a daily basis, and at the same time run their business, and time’s shown that to be the case,” he says.
“What financial advisers need to ask themselves is: Am I a fund manager or an adviser? What do my clients really need from me? My clients need advice, behaviour management, education; they don’t need me to be the world’s best stock picker, because there are other people who can do that.”
