12 September 2014

Reasoned Optimism

“a pessimist is never disappointed”

A friend of ours once remarked that finance professionals were so boring that they could not even entertain a doubt. In our view, that’s unfair. We might be boring, but finance professionals are plagued by doubts. Anyone working in investment management or advice will recognise the industry’s temptation to pessimism. Amidst all the fads and theories, this pessimism is a perennial feature of finance and in our view is sometimes overdone.

Why so pessimistic?

Of course, none of this is to deny the critical importance of proper risk identification and management. Anyone can (but probably won’t) ‘get lucky’ in the markets. But, for most, enduring investment performance relies heavily on risk management tools like diversification and sound portfolio construction principles.

So what are the causes of this bias towards pessimism?

First, it could be the nature of our industry. Working in investment management or advice involves a lot of thinking about risks. We worry incessantly about the ‘black swans’ or ‘unknown unknowns’ that could affect our investors’ portfolios. We worry about appearing naive to our clients, our peers and our industry. So if a solid dose of pessimism will avoid this appearance, we’re only too eager to adopt it.

Second, it is the nature of our sensation-driven society to seize on the negatives. A headline focussing on a disaster will always trump a good news story. After all, when was the last time that you read an in-depth analysis in our papers of an investment strategy that delivered as promised? Yet these good news stories happen every day.

Finally, and perhaps less flatteringly, there is the spectre of self-interest. Vested interests will always have an incentive to block challenges to the status quo. This means that new approaches and developments in the industry will be met by dire and frequently unfounded predictions of disaster.

Examples are close to home

One can detect this pessimism in so much of the economic and investment commentary that we hear every day. As an example, consider much of the recent commentary on self managed superannuation funds, or SMSFs. We have heard tales of reckless SMSF investors who are apparently mindlessly ‘leveraging’ up their portfolios to purchase property. We hear about allegedly unbalanced portfolios that are over-exposing investors to property, or to cash, or to equities, or to whatever is the bete noir of the writer in question.

Fortunately, when one looks at the facts, the situation is quite different. The latest statistical report from the Australian Taxation Office – the regulator of SMSFs – is the quarterly report for March 2014. This report gives interesting detail as to the membership and asset allocation of the SMSF sector and a careful reading of it exposes the mythology.

Take SMSF borrowings, for example. Contrary to the myth of a sector that is out of control, or borrowing out of all proportion to its assets, we see that ‘limited recourse borrowing arrangements’ (the technical term for SMSF loans) total $2.681 billion. This sounds like a significant number right up until one remembers that the total (net) SMSF asset pool is a massive $546.92 billion. In other words, the total exposure of the SMSF sector to limited recourse borrowing arrangements is just half of one percent. At the individual level, a specific SMSF may be unwisely using leverage, but the statistics are pretty clear that there is no systemic problem.

Then there is the asset allocation myth. It seems almost to be a weekly event that a commentator will hit the press to claim that SMSFs are over-exposed to one asset class or another. Most recently, a group of hedge funds were claiming that SMSFs were over-exposed to Australian equities. But very commonly, property is singled out. So, for example, some commentators were quick to jump on a recent headline that said that SMSF exposure to residential property rose 17.2% in the 12 months to 31 March 2014. What they didn’t reveal quite so enthusiastically was that it rose to just $20.5 billion, or a mere 3.7% of total net SMSF assets.

In fact, when one looks at SMSFs as a whole, one sees a very diversified asset allocation strategy. On average, over time, one sees SMSFs holding about 30% of their assets in Australian shares, about the same in cash, about 15% in (mainly commercial) property and the remainder in a wide diversity of other assets. One could quibble at the margins whether this sort of asset allocation is optimal. Some argue that SMSFs hold more cash than they should. Then again – given that SMSF balances tend to be much larger than those in the large superannuation funds – it is perhaps understandable that they would hold more in cash both as a defensive measure and awaiting opportunistic investments.

Overall, however, as the chart above shows there is little in the statistics that would give a balanced reader a cause for significant concern. Again, to be crystal clear, none of this is, of course, to say that the SMSF sector is without flaws. Undoubtedly – by simple application of the law of averages, given that there are over 500,000 SMSFs in Australia - there will be individual SMSFs that have been constructed with too much risk. But – again on the statistics - the sector as a whole looks extremely sound, perhaps even more conservative than our large superannuation funds.

Causes for optimism

Amidst all this negativity, it is worth remembering that there are very good reasons why SMSFs are, in principle, a very positive development for Australian society. SMSFs are set up by people who are actively engaged in preparing for their own retirement. What is more, SMSFs require that people take responsibility for their retirement outcomes, reducing or eliminating the agency risks and conflicts of interest that present where big, vertically integrated superannuation funds manage large pools of compulsory savings. Finally, Australia’s compulsory superannuation system has presented a relatively small number of decision makers with an enormous amount of money to invest on behalf of members. This pool of money has the potential to be a significant influence on Australia’s economy. The SMSF sector can play an important role as a counterweight to this money.

More broadly, and returning to our thoughts on pessimism, there continues to be a variety of very solid reasons for optimism about the future of Australia. For example:

  • Australians enjoy an extremely high standard of living. The UN human development index is a summary measure of average achievement in key dimensions of human development, including a long and healthy life, being knowledgeable and having a decent standard of living. This index currently rates Australia second only to Norway. What’s more, Australia’s ranking has remained very consistent for over two decades.

    UN HDI - 2014
    (Extract; Source:UN)

    HDI rank Country HDI Value 2013 Life Expectancy at birth (years) 2013 Mean years of schooling (years) 2012 Expected years of schooling (years) 2012 Gross National Income per capita (2011 PPP $) 2013 HDI Value 2012 Change in Rank 2012-2013
    5United States0.91478.912.916.552,3080.9120
    7New Zealand0.91081.112.519.432,5690.9080
    14United Kingdom0.89280.512.316.235,0020.8900
    15Hong Kong, China (SAR)0.89183.410.015.652,3830.8890
    15Korea (Republic of)0.89181.511.817.030,3450.8881

  • Australia is extremely well positioned for the ‘Asian century’, about which we have written so much in the past. We have geographic proximity, resources, goods and services that are increasingly in demand and an attractive, politically stable culture that gives us every opportunity to take advantage of what might be the greatest economic opportunity in human history.

  • Australians are living longer. Yes – we know that has consequences for pension systems, retirement ages, healthcare budgets and so on. But surely it beats the alternative?

Let’s count our blessings!

Granted, it’s unlikely that the finance industry will ever become the natural home of the life of the party. Economics will probably always be the ‘dismal science’. But – amidst all the risk management and preparations against the worst of all possible outcomes – we would all do well to remember that we are extraordinarily fortunate to live in this country and at this time in history.

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FY2015 Quarterly Investor Call Briefing: Tuesday, 3 February 2015 - 12:00pm  (AEDT)
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FY2015 Quarterly Investor Call Briefing: Thursday, 16 July 2015 - 12:00pm  (AEST)

Whatever market you’re in... we hope it’s profitable.

Best regards,
Randal Williams, Chief Wealth Management Officer &
Chris Andrews, Head of Funds Management
La Trobe Financial Asset Management Limited

La Trobe Financial is one of Australia's leading independent credit specialist Fund Managers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Mortgage Funds under AFSL 222213. It employs over 123 staff and has managed over AUD$10Billion covering over 100,000 investment grade assets since inception in 1952.

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Investor Call Briefing Q4 FY2014, Chris Andrews, Head of Funds Management

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