FINANCIAL PLANNING

Tapping into Trade Secrets

By Steve Blaker

Following on from our article regarding retirement savings in the Summer 2003 issue, I thought it pertinent to cover what we would consider a very simple form of investing…via managed funds. Remember, this method should be viewed as complementary to other forms of investing, such as direct investing i.e. listed investments on stock exchanges.

The best way to harness the power and effectiveness of managed funds is not to chase the strongest performers but to use the same strategies routinely applied by professional investors and the top advisers. There are more than 3000 managed funds available in Australia, managed by institutions from all parts of the globe.

Sophisticated strategies have been developed to help investors maximise returns at the same time as minimising the risk of capital loss. Other strategies manipulate loopholes in fund structures to produce better returns. Many of the strategies have been developed by experts who advise wealthy individuals and superannuation funds. But they can also be applied by retail investors who want not only to increase their savings but also to protect their capital.

Of course, these techniques are not a fail-safe mechanism against market turmoil. They may not have prevented the negative returns incurred by many investors over the past few years, but they can provide an extra safeguard for an investment portfolio by protecting long-term returns.

Smart Money (Financial Review weekend edition - 2001) identified four techniques that can help an investor produce better, or more sustainable, returns from a managed fund portfolio: blending, risk budgeting, arbitrage and wholesale investments. Some of these strategies appear complex but others are plain common sense to anyone with a reasonable knowledge of Australia’s fund management industry.

Blending – or diversifying an investment among different managers – can help an investor minimise their risk of capital loss to a significant degree. It is similar to diversifying an investment portfolio across different asset classes to reduce risk, but more complicated owing to depth of understanding required of each manager’s individual style.

A proper blending process seeks to identify managers with different investment philosophies or style biases i.e. growth, value, style neutral, momentum etc. The idea is that when one manager underperforms, another is more likely to outperform and so reduce the drag on an investor’s overall return.

Blending increases earnings certainty over the market cycle, thus hopefully reducing investor stress levels. Blending is a fundamental element of any investment strategy and the third principle in proper portfolio construction.

The first principle of portfolio construction is the need to diversify across asset classes, rather than invest all your money in one asset class. The second principle is the importance of diversifying holdings within an asset class rather than concentrating an investment on, say, two or three shares or an investment property. The final stage of a well-diversified portfolio is to invest across different fund managers (large as well as niche/boutique) with different style biases, with the aim of minimising investment risk, and enhancing long-term growth potential.

Another increasingly popular investment strategy involves investors giving money to active fund managers only if there is a reasonable chance of the manager’s beating a benchmark index. This process is known as risk budgeting and is based on the premise that it is extremely difficult for fund managers to outperform the market in certain asset classes. An active fund manager is one that aims to beat the return produced by a benchmark index over a given period. Passive (or index) managed funds, on the other hand, are a lower risk investment and aim only to match an index.

An investor with a risk budget might invest in passive funds in asset classes where it is difficult for fund managers to outperform i.e. fixed interest and property markets, and take bigger risks in asset classes where an active manager has a decent chance of consistently outperforming an index. Macquarie, for example, have recently designed products that are intended to replicate the index return. No management fee (that is zero!) is payable up to this return objective. Excess return belongs to Macquarie.

The aim is to decide how much investment risk you are prepared to accept across an entire portfolio, and apportion that risk to asset classes where it is most likely to produce the desired returns.

Blending and risk budgeting are two of the most widely used managed fund investment strategies, but they are not the only ones available to investors. Some people, for example, are trying to capitalise on the success of Platinum Asset Management by trading the arbitrage between its listed vehicle/investment company and its unlisted wholesale unit trust/managed fund. An arbitrage opportunity occurs when there is an anomaly in pricing between two markets.

There is often an anomaly between the prices of Platinum’s funds because the fund manager has produced high double-digit returns from global share markets at the same time as its rivals…and the indices, have struggled to produce positive returns.

But the value of its listed vehicle, Platinum Capital, has also been pushed higher by the positive sentiment towards Platinum. Like any stock that does well, the listed fund has been pushed higher by market momentum and investor emotion. In other words, it is experiencing its own mini-boom. This sentiment means that the listed vehicle often trades at a premium to Platinum’s unit trust, even though the portfolios in the two vehicles are very similar.

Investors have developed two ways of dealing with this anomaly. Long-term investors have avoided buying the listed vehicle and instead bought into the cheaper unit trust. But investors chasing short-term trading gains have sought to take advantage of the arbitrage between the two products to generate profits, buying into the listed product if it falls to a discount and selling it when it regains a premium. Investors looking for simpler strategies to improve managed fund returns can consider investing in wholesale funds instead of retail funds. Investors who choose to put their money into a wholesale fund rather than a retail fund do not incur entry or exit fees and do not pay trailing/ongoing commissions to financial advisers.

Entry or exit fees on the average retail unit trust range up to 5%, annual management fees (MER’s) up to 3% from which a trailing/ongoing commission ranging from 0.25% to 0.80% is paid. Annual management fees charged by wholesale fund managers are approximately half that of the fees charged by retail funds.

Most retail managed funds have a wholesale equivalent and it makes little sense to invest in the retail version if you have enough money to meet the minimum investment for the wholesale fund. Minimum investment requirements for wholesale funds have fallen substantially in recent years and now range from $20 000 to $500 000. Investing via Masterfunds and Wrap Platforms can reduce this range to a few thousand dollars.

As you can probably glean from this article, financial jargon is not only prevalent, but very hard to avoid. Unfortunately if you are not at least familiar with the terminology, it will make it that much harder to disseminate information and then make informed decisions. As always, we would suggest seeking qualified advice and where possible seek a referral from someone you trust.

contacts

Steve Blaker CFP, DipFP, authorised representative
Logical Financial Management Australia Pty Ltd
Member Firm of Associated Planners Financial Services Ltd
Cherrybrook office: 12 Milford Grove, Cherrybrook NSW 2126
Phone: (02) 9899 4492 Email: logical@apfs.com.au