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2 investment anchors amid a sea of volatility

Glenn Freeman  |  29 Jul 2016Text size  Decrease  Increase  |  

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Near-unprecedented levels of global market volatility highlight the need for individual investors to be smarter in diversifying across asset classes, says Scott Fletcher, director of client investment strategies, Russell Investments.

"There really isn't a playbook for the current period. Economic and monetary policy is making up the playbook as we go, because we have no precedent. But diversification and discipline--those are things that do stand the test of time," Fletcher says.

It's well known that self-managed super funds suffer from a lack of diversification. SMSFs allocate more than one-third of their share portfolio to domestic bank or financial stocks, and another 21 per cent to resources and material stocks, according to a 2015 Investment Trends survey of more than 4,000 SMSF trustees and 500 advisers.

The increased exposure managed funds provide to international markets versus direct investing is one of their key benefits.

"But it's about a lot more than just providing access to international equities. In a low-return environment, it's about how you diversify," Fletcher says.

"One of the limitations SMSFs [invested only in direct assets] have over a more pooled arrangement or managed fund is the nature of the diversifying assets.

"Funds will typically invest across a broad range of asset classes, from unlisted property and alternative assets, through to everything you can't get an exposure to in a direct sense."

What's in a name?

Fletcher believes the traditional asset allocation identifiers--such as equities, bonds and property--are now less clear-cut.

"These days, you cannot asset allocate by name, but you can by nature. For example, just because something is called a bond, doesn't mean it's not behaving like an equity," he says.

"You've got to be smarter in the way you diversify across asset classes ... you need to really understand the key drivers of an asset class, how they will react with other things in your portfolio, and how they will respond to the big drivers of markets and to policies."

As an example, he refers to a common portfolio construction process for an SMSF.

"For an SMSF portfolio, you might look at hybrids as a replacement for the defensive part of their exposure, but in actual fact, it behaves a lot more like an equity," Fletcher says.

Many financial advisers would traditionally use a hybrid as a defensive asset, while a stock is viewed as a growth asset, though he argues this is often no longer the case.

Some bonds or hybrid investments behave more like equities, and some equities also behave more like bonds than other types of shares.

"It's now more nuanced--you can split it up further than just the traditional asset classes, for example, using defensive equities and specific style and factor exposures," Fletcher says.

Similarly, he says investment-grade credit assets can also be utilised in gaining different types of fixed-income and defensive exposure, "beyond just plain vanilla bonds and cash".

"If you've got a view that bonds are very expensive--even if interest rates go up, you're looking for things with high yield, and lower interest-rate risk. That pushes you out into things like investment-grade credit, mortgage-backed securities, emerging market debt--and then absolute-return-type strategies on equities and bonds," Fletcher says.

What to look out for

In selecting managed funds for an SMSF portfolio, he warns investors need to adopt an outcome-driven approach rather than simply choosing the lowest cost option.

"Everybody wants higher returns, no downside, and as cheap as possible--the free call option--but it doesn't exist in the real world," Fletcher says.

"It becomes a trade-off. They want as much certainty as they can get, but they can only get as much certainty as they can pay for. If you focus on cost alone, you get what you pay for, and that will force you into passive outcomes, indexes et cetera."

While these represent a viable solution for many, he believes the cost saving on fees can be something of a false economy.

"If you look at them as exposures, index investments will be more heavily invested in the more expensive parts of the market--that's the same for equities and bonds. So even if you buy a credit index, it's going to be quite undiversified," Fletcher says.

"You just can't get as diversified by investing directly. If a retail investor wants to try and match [a managed fund] ... they can't get access to everything we can get access to, and if they tried, they'd be paying through the nose."

The cost of using managed funds is one argument often used against their inclusion in an SMSF portfolio, and loss of control is another.

"The control thing is a real issue, as are the tax-specific effective outcomes. But that's not to say that where control and transparency and tax management issues are at the centre [for the individual investor], that you can't combine the two to get the best of both worlds," Fletcher says.

"Strategic asset allocation is not just an investment issue, it's a client discipline issue ... that investors have an anchor that they're working from."

More from Morningstar

How managed funds can smooth your SMSF risk exposure

Why adopt an unconstrained approach to fixed income?


Glenn Freeman is Morningstar's senior editor.

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