Christine St Anne: Ian, can I just ask you about the banks? There's been a lot of discussion that the cost of funding could increase in Europe, which clouds the outlook for 2012. What's your view?

Ian Huntley: For the Australia banks, they are dependent on offshore wholesale funding, let's say roughly 25% of their book. Now there's some - there's obviously some issues there with continuing with money coming out of Europe, but on the other side of it, you've got to realize that the big four Australian banks are among the most highly rated in the world, and you've got a period where money is flying around the world and it's becoming increasingly frightened that lending money to European banks.

So of course, there's going to be some money looking to come to Australian banks because they are extremely highly rated and there seems to be increasing the U.S. money market funds have been for quite a while lending into Europe, now some of them are lending into the Australian banks. So, I am certainly not wishing to jump out of any window. I own Australian bank shares, and I can assure you, I sleep very well at night, and bank the dividends with the greatest of glee. If some silly idiot offshore or the panicked merchant there wants to sell them at a lower price, I'll buy some more.

St Anne: Daniel, are you sleeping well at night with your bank portfolio?

Daniel Needham: I have a slightly different view on the Australian banks. I mean, I think that the funding situation - I agree with what Ian was saying. I think that they've significantly improved their funding situation relative to say 2008, where a much larger portion was from the foreign capital markets, and you know, the level of credit growth is much more sustainable for the banks at the moment. I don't think we're seeing significant expansions of balance sheets. My concern-

Huntley: It's lousy.

Needham: My concern is that there was a lot of credit growth, and this is kind of where you'll probably see the differences between Ian and myself. I see residential property prices in Australia as being relatively high, and the banks themselves have a significant exposure to that asset. Whilst the asset quality is good now, a deterioration in that asset quality I think could create some pressure for the banks, and so I think, there's a reason why the banks are trading on high dividend yields and lower valuations. I think, you're being - because there is a risk on the credit quality of the bank balance sheets and so I think you should be getting a higher reward for that risk.

So, my concern is that there is significant credit growth in Australia, property prices went up significantly on the back of that, and there was additional credit growth on the back of the First Home Buyers Grant, which gave it another spurt up, and if we do have an environment where growth in Australia slows and unemployment moves up, I think that the banks could be under pressure in that situation with credit quality deteriorating. But I don't think it's a 2012 problem, I think, this is a longer term challenge for the banks.

Huntley: By the way, I do not agree with my friend there too. I think, he's got this crystal ball, he looks at it for China - the other one looks at an Australian residential market, and I think they're out there somewhere. Look, you've got to remember that Ian Macfarlane, when he was Head of the Reserve Bank in Australia in 2003, put in a hell of a credit squeeze on our home lending, because there was a bubble, there was a developing bubble, and unlike our American friends, Mr. Macfarlane - and he even held a seminar about it, and it was discussed and reported in the press - he decided to hit the developing bubble before it became a catastrophe.

Mr. Greenspan believed that, you did it after the catastrophe. It was easier to mop up than stop, and America is paying for it, right? But that was the broad Australian market that he stopped and slowed down, and if you look at the credit aggregates as to lending to Australian housing since then have come down ever since. They are actually very low now, about 5%, very low. It should be higher.

Now since 2003 with the - for want of a better word, the financial bubble, the upper market in the city, in the CBDs and the financial districts of Australia, they ran very strongly, and that actually was a global situation. Now, that's coming off now, and certainly you can get your 25% falls and 30% falls in areas like Mosman, mainly Toorak in Melbourne right? That's still - it's a limited effect. The broad Australian market, it's fine, and that's where people like Jeremy Grantham and my friend here completely miss it. The one other huge major thing these guys are totally missing is that part of the problem in the U.S. and the U.S. people, a lot of U.S. commentators say. 'Oh, because we stuffed it up, everyone else must too. We are the cleverest, we are the Americans.' By the way, I love America.

Now, a long time ago, possibly in the '30s, American credit standards were changed from full recourse on home lending to nonrecourse. That meant that when you borrowed money for a home, if you could no longer keep up your payments, all you did was to loose your home, okay. It's a very major difference.

In Australia, if you default you'll lose everything including your wife's jewelry, the whole works, the car, the lot. You are tied up and your credit rating is horrific ever after. There is tremendous pressure on you. Our credit lending standards are never exploded like the U.S. That is why our banking system remained in good shape all through the GFC and continues to. Our housing defaults are extraordinarily low. They are pinpricks, right since the GFC, and they're going to continue that way, because what happened in America, they had a massive weakening in credit standards, and then half of their lending market crashed, it collapsed. That was the size of their shadow banking market, which was a serious mess with absolutely no concept of a holding of security on behalf of the lenders. We didn't have it, because we have less than 1% shadow banking type lending in Australia. That's why we are in good shape. You got to understand the credit market and what went wrong to relate to the future of housing crisis in Australia.

Then compared to the United States, broadly we are a middle-class country. We don�t have the same extraordinary lows and heights in incomes. That�s enough on that one. One could go into more detail, but I have spent a lot of time on that and I have lived through many, many housing crashes in Australia, 1974. All the things that have molded the minds of Mr. Macfarlane and also the current Governor of the Reserve Bank and also the banking culture and the leaders of our banking system.

Needham: I agree with the comments about the United States, but I think within Australia, I agree that the supplies - and there wasn't an excess amount of development in Australia. I think that the types of credit vehicles in the expansion of the shadow banking system effectively didn't happen in Australia, certainly not to the same levels in United States. I think that the supply-demand picture for residential property in Australia is much, much more positive than the United States. But I think that - I guess my view is that the affordability and the fact that property is an asset that is handed from an inter generational perspective, and right now there is a lot of property that's owned by the baby boomers and a lot of that's owned outright, and a lot of the mortgages in Australia actually interest only investment properties because there is a significant tax incentive to own investment property. I think that creates risk, investment property creates that risk. At the same time-

Huntley: Yeah, if it was overblown, yeah.

Needham: -and there's also large amounts of unfunded future pension liabilities for retirees.

Huntley: What? Compared to the United States, you've got to the joking. We�ve got this extraordinary superannuation system. We are so far ahead of just about every other country in the world. It's a joke.

Needham: Yeah, but the consumption level for people to even maintain two-thirds of their pre-retirement income, they're going to have to downsize their properties.

Huntley: Oh, sure.

Needham: So, they're going to consume their property, and I think that they will be able to maintain. I agree, like the pension system is much better. So, I think we could see some more supply of housing come on to market.

Huntley: Well, that's been going on for years.

Needham: Yeah, and I think it's going to increase, because the baby boomers are going to start to consume their property more and more. I think that the difference between - say what, it's a very different property situation in the U.S., but I still think that supply is going to cause a re-pricing of property, as younger people who need to access credit; they need to borrow relative to their income. I think that we could see some downward - either in real terms, I think we could see property prices, sort of trend across for quite a long period of time.

The potential that we get hit as much as Ian, sort of thinks, we could have a big issue in China, should that happen property could correct significantly. But I think, it's going to be - I don't think we are going to see the same type of real share price increases - sorry, property price increases that we have seen previously.

Huntley: I'm not looking for any particular residential property prices, but we go to - broadly, for sometime even though people are a lot smarter than me about it, do see over next few years high single-digit, low double-digit growth. They certainly know the markets better than I do, but I have been following property for longer time. But you got to understand that the Australian markets have lots of different sectors in it. The market probably up to about $1.5 million in Sydney is probably showing slight increases in prices, while the up market $2 million and above, probably coming off.

It's not one simple situation. Various areas do better than others, and other areas, they are worse. So, it depends a lot where you are looking. Queensland, for instance, this year has been the worst hit of all. But next year as the various flood relief programs start pumping through and all those major gas developments start being - employing people and the rest of it. It's a massive driver of the Queensland economy. I think, you will see some - over the next three years, I would argue that you would see some decent increases in your basic residential prices in Queensland. It's pretty simple - it's come off such a low base, and there is going to be fair revival there. But you've go to look at it - you got to get into the detail on this one, because you don't have the massive shock across the boards that you've had in the United States.

St. Anne: Gentlemen, thank you both for your time.

Needham: Thank you very much.

Huntley: Thank you.

Christine St Anne: Market volatility will no doubt continue in 2012, and with that investors could be making some of the common mistakes of last year. To avoid these pitfalls, I'm joined by Westpac's David Simon.

David, welcome.

David Simon: Thank you.

St Anne: David, one of the common mistakes is staying out of market. What kind of investment opportunities are investors missing out on by doing that?

Simon: Yeah, sure. I mean, investors are naturally pessimistic and scared due to the current economic and political turmoil that is currently being witnessed in markets. Obviously, many investors tend to put off their decisions to invest days, months, and sometimes even years. Now this procrastination is one of investments - investors' most common mistakes, and it's obviously driven by fear of failure.

Now interestingly, there's some evidence to show that deferring or delaying investment decisions actually cause quite a significant opportunity cost, and one example, and the example is quite a significant one: if an investor choose to invest in the S&P 500 in March 2009, by the middle of November that year, they could have actually received a 51% return. Now, if the investor actually only deferred or procrastinated their decision by a period of only two months, that return would only be approximately half at 26% for that period.

St Anne: Investors are also continuing to favor cash. Are there any mistakes regarding diversification?

Simon: Yeah, diversification is a risk management technique that investors use to effectively ensure that their assets are, a range of asset classes and their investments, are not just in only one particular class, effectively not having all your eggs in one basket. Now cash is a certain and secure asset class. However, for an investor that only chooses to invest for a period for up to 3 years, that investment class may actually be the correct one. Nonetheless, cash has never been the best performer after inflation and tax for a period of 5 years or more. So, diversifying across a range of investment asset classes such as growth assets, as well as income assets may offer the opportunity for capital growth, and a better return than cash.

St Anne: David, with this market volatility, investors are also tempted to time the market. What are key pitfalls behind that?

Simon: Yeah. That's an interesting one. Certainly, some people that sold their shares before the global financial crisis have done very, very well, and considering that markets are still well below their pre-GFC levels, those investors are still smiling pretty. However, it's not often where investors that try to time the market actually get it right, and indeed investors that choose to time the market based on gut feel, speculation, and indeed without a strategy often fail.

Interestingly, recent data shows that if an investor invested in the Australian share market over the past 20 years, they'll have returned an average of around 7% per annum. However, if that same investor tried to time the market over that 20 year period, and missed out on the 20 best days during that period, their investment return would have reduced down to about 2.5% per year.

St Anne: David, investors tend to also chase numbers. What are the issues behind that especially in periods of market volatility?

Simon: Yeah, sure. Look, history has taught us that the normal and traditional asset classes such as shares, property, cash and bonds don't follow a normal or regular pattern. In fact, last year's best performer often becomes the following year's worst. Indeed over the last 20 years, for six out of the last 20 years, the previous best performing asset class actually did become the worst performing asset class a year thereafter. In fact, no single asset class has enjoyed any more than three consecutive years of being the best performing asset class over the last 20 years.

St Anne: David, thanks so much for your insights today.

Simon: Thank you.

Christine St Anne: With the continued market volatility, gold has emerged as one of the few safe investments havens, but there are other precious metals that investors can consider. Today, I speak with CMC Markets' Ric Spooner about what other metals can add spark into your portfolio. Ric welcome.

Ric Spooner: Thanks Christine.

St Anne: Rick, besides gold, what other precious metals can investors look at?

Spooner: Well, people tend to think gold when they think precious metals, but there are other significant metals. The biggest traded ones are silver, platinum and palladium. But for most investors probably silver and platinum are the ones that are large enough, with big enough markets to operate in.

St Anne: So, what are the key characteristics behind these metals?

Spooner: Well, like gold they share the characteristics of precious metals, that is, they don't rust, they're basically indestructible and they're beautiful. So, they are metals that have traditionally been treasured and also used in jewelry. The key difference though with those other two metals is that they have a much higher industrial usage than gold. So, their pricing and demand is much more impacted by the world industrial production. Platinum in particular is used extensively in the motor vehicle industry and silver is used in electronic switching.

St Anne: You mentioned that these metals differ from gold. Does that have implications to the way they behave in an investor's portfolio?

Spooner: They both can be, and traditionally have been used as precious metals. So, like gold, from an investor's point of view, they are something that retains their value, is traditionally used as a hedge against weakening currencies, particularly weakening U.S. dollar and inflation. But the difference is that they will tend to outperform gold when you also have a situation where industrial demand for them is strong. So, investors are often well served to think about, not just if they believe that precious metals is appropriate for them, to think about which of the metals at the current moment might be the best.

St Anne: Ric, so how have these metals performed?

Spooner: Well, there has been quite a bit of a change over the last two years in the relationship between these metals. In the year running up to 2011, silver and platinum significantly outperformed gold. Really, throughout the rest of 2011 though or from April 2011 onwards, gold outperformed silver and platinum fill more heavily and that was because industrial production fell, as the world becoming increasingly concerned about the European situation.

St Anne: As these metals are available globally, do they have currency implications for investors?

Spooner: Yes they do, especially investors outside the U.S. or all the - most commodities and certainly these three metals are all quoted in U.S. dollars. And the implication of that is that for investors outside the U.S. the prices will underperform in their own currency if their currency outperforms. And certainly for Australian investors this has been something that has tarnished the performance of precious metals to some extent. Generally speaking in recent years, because the currency has been so strong and that had reduced the U.S. dollar gain.

St Anne: Ric, so how can investors minimize these currency implications? Can they, for example, look at hedging strategies?

Spooner: Yes. Well, when you're considering an investment in previous metals, it is a good idea to think about the currency implications and to also have a view about your local currency. A couple of things you can do there: one is, as you say, is to consider hedging the currency of your investment if it's large enough. Another alternative though is to look at CFDs as an investment tool because they're your currency exposure is limited only to the profit or loss that you make and not to the whole face value of the gold or silver. So, if you are concerned then about a strengthening in your own domestic currency, then you can use a leverage product like CFDs as a way of getting around that largely.

St Anne: Ric, thanks so much for your insights today.

Spooner: That's a pleasure, Christine.

Transcript to follow.

Christine St. Anne: Morningstar's Tim Murphy has been busy with the upcoming Morningstar Awards 2012. We've managed to grab some time with him to discuss the reasons behind the awards and what makes a good manager. Tim, welcome.

Tim Murphy: Thanks, Christine.

St. Anne: Firstly Tim, can you give us a reason behind the awards?

Murphy: Sure. So, we have these awards on an annual basis. The idea being that we recognize fund managers that have delivered solid returns for the unit-holders and investors in their funds, not only last year but over the long term. So, it's a recognition from us of the achievements of particular fund managers within each asset class, and then of course, overall for our overall fund manager of the year as well, which represents excellence in multiple categories or asset classes across the board.

St. Anne: So, what makes a good fund manager?

Murphy: So, in determining awards there's three broad criteria that we use. They're an annual award, so clearly one of the criteria is you have to have performed well last year, and that I think goes without saying. But, I think where our awards are somewhat different to many others out there is the fact that there is much more behind that. We don't just pick the best performer last year and give them an award. Anyone can do that. But rather to make these more robust on a forward-looking basis, we look at not only last year but also how is the longer term performance of those fund managers been and certainly looking at that not only in absolute terms, but on a risk-adjusted basis. We all know that investors out there suffer much more pain from draw downs than they do from equivalent drops. So, we penalize funds with downside volatility over the long-term as well on that.

Thirdly too, is the qualitative overlay of our research team. So, I have 10 researches in my team that are analyzing these funds day-in, day-out. So, combining those who are funds that performed well last year, who are funds that have performed well over long-term on a risk-adjusted basis, and who are funds that we think are going to be good long-term investments into the future for people. So, combining those three criteria within each award category is how we narrow those down to the finalist, and of course being a winner.

St. Anne: Tim, are you picking up any trends from this year's awards?

Murphy: It's interesting. It very much varies across asset classes. Clearly last year was a fairly challenging environment for most markets and asset classes. So certainly in equities, managers that had more quality-driven processes, alternative fund, their portfolios invested in some less speculative lower beta type names have tended to do well last year. So, certainly there is a consistent element of the contenders with those sorts of characteristics in equities.

On the fixed interest side, certainly, any managers that were long duration last year, which they weren't many, was certainly a common theme that stood out, where as most managers tended to be shorter duration, i.e. had less interest rate exposure. So, as interest rates fell sharper than people were predicting at the start of the year, if you were short duration, then you didn't perform as well as the broader benchmark. So, that's where some of the index funds looked quite good in the relative context last year.

St. Anne: Tim, finally, big and small managers, did either dominate the awards this year?

Murphy: They're all in the mix, as we've said many times before. We certainly don't have any particular preference of one model versus the other. Each have their pros and each have their cons. If you're looking through the contenders this year, there's a more than adequate mix of both institutional managers and boutique managers. So, both would be well represented on the awards nights at the end of February.

St. Anne: Tim, thanks for much for your time, today.

Murphy: Thanks, Christine.

Christine St. Anne: Last year the Australian dollar enjoyed some record highs, but will it continue to appreciate this year? Today I am joined by City Index's Kara Ordway to give us her view on the outlook of the Australian dollar and some of the major currencies.

Kara, welcome.

Kara Ordway: Thank you.

St. Anne: Kara, what's your outlook for the Australian Dollar? Do you think it will continue to appreciate?

Ordway: Yes, certainly. We've seen a very big rise for the Australian dollar over the first half of 2012. We have seen a high of 1.0573, which is quite a significant move for such a short period of time. What this has really come from, is more of acceptance of what is going on in the Eurozone. We are seeing a bit more risk appetite. Really, those equity markets from six-month highs has meant that people are more willing to buy into these high yielding currencies like the Australian dollar, and that's what has really pushed it higher at the moment. Now, we have seen all-time highs against the Euro, and these highs of 1.05 against the U.S. dollar, so it has really done quite well in the beginning part of this year.

Now, with the lower volatility that we are seeing at the moment, the high commodity prices, this has tended to keep it above these levels and consolidate around the 1.04, 1.05, that we are seeing at the moment. Now, what we also have to consider, is that the Australian dollar is a very high yielding currency, which means it's very expensive for traders to actually short that currency, and that's what's also kept it afloat over the first part of this year. So certainly, a very resilient Australian dollar, compared to what's going on in the Eurozone at the moment.

St. Anne: There has also been some talk about domestic interest rates easing. What implications would that have for the Australian dollar?

Ordway: Yes certainly, alongside all this resilience that we are seeing in these high numbers traded, actually what a lot of traders are saying now, is the Australian dollar is largely overpriced, and we are seeing a lot of technical levels now that are actually indicating that it has been over bought at these levels. One of the key factors in bringing it down would certainly be the RBA rate decisions over the first half of this year.

Now CPI numbers will be a large indicator of whether they have got room to bring those rates down. If inflation is eased then certainly, we will be looking for a rate cut in February, and certainly going on to into the second half of the year. So that's one of the reasons that we could see the Australian dollar actually trade lower, despite it trading so high at the moment. So, we'd be looking forward to that. And actually, saying that it's overbought, we're actually in a very fragile state for the Australian dollar at the moment, sitting on the edge of what's going on in Europe, and it wouldn't actually take a very large catalyst to bring it off those highs, at these overbought level.

St. Anne: Kara, you've mentioned the European situation, what about the euro, would that continue to be resilient?

Ordway: Well, we've seen a very resilient euro over the past couple of weeks, and actually throughout 2011 as well. So, we're trading around the 1.29, 1.30 levels, and despite going down to the 1.26 levels against the U.S. dollar at the first part of 2012, it's actually showing a further bit more of optimism going into the end of January. So, really though looking at the fundamentals, I see no real argument for the euro to trade higher than this 1.30 level.

I think, what we're seeing is these pockets of optimism where people are really desensitized at the moment of what is going on in Europe, and they're managing to push this euro higher at the moment. What's also a factor is that we're seeing record number of shorts in the euro market at the moment. So, that short side of the euro is really largely saturated at the moment. So, any movements upwards creating stops in the market, people having to come out of their short positions, and really when we're seeing these large amount of shorts, it's really indicating that the market is largely exhausted and it's not hard to facilitate a bounce at that time, when we're seeing so many shorts in the market, so that's why it's been so resilient.

Certainly, I don't know whether it will,  this will be able to continue into 2012. For me, as I said, there's no real meaningful reason for it to be trading this high. It's still above the average that it's... from when it opened in 1999. So, we're still on relatively safe levels, but certainly going into 2012, despite some probably capital flight and repatriation of funds back to the Eurozone, no one really knows what the exposure of Europe has to the rest of the world.

So, certainly for me, I'm still bearish on the euro going into 2012, and I think at the moment, the more realistic number we should be looking at is around the 1.20 level, rather than the 1.30 at the moment.

St. Anne: Kara, China's latest numbers indicated some easing in growth, what are the implications for the renminbi on the back of this slow growth?

Ordway: Exactly. Well, we've seen those growth numbers in China actually decline - they were released last week. Where growth was coming in around 10% we're now seeing it more around the 8% mark. So, certainly there is a definitely a slowdown in China occurring that is set to continue into 2012.

Now, what that implication has on the Yuan or the renminbi is likely not appreciate as much as it would first be thought. So, certainly the market expectations of appreciating have declined. China will be more reluctant to let it appreciate in these type of conditions and certainly what we'll see, whether the global conditions improve or decline, it's certainly going to be up to China as to how they appreciate it and when they appreciate it, and I doubt they will take any pressure from the U.S. despite all these factors.

St. Anne: Kara, finally what currencies are you bullish on?

Ordway: The currencies that we are looking at this year, definitely the Canadian dollar. They've got a strong fiscal start, so certainly looking to the Canadian economy for some support. It's not as overbought as other commodity currencies like the Australian dollar and the New Zealand dollar. So, certainly there the Canadian dollar is one to buy.

Also, actually the Norwegian krone. We've seen a lot more activity in the Nordic crosses over the past couple of months as traders try to get exposure within Europe not using the euro. They also have a large fiscal surplus, and so definitely the Norwegian korne is looking good over 2012.

But I definitely think this year will be characterized by a different dynamic in the FX markets, particularly driven by the euro. We are not going to see those traditional risk-on, risk-off trades. The correlation between the euro and the S&P has declined quite significantly. So, we are no longer seeing in terms of risk-on people, buying into the euro and that is really going to create a different dynamic throughout 2012 for the FX market. So, it will be an interesting one to look out for.

St. Anne: Kara thanks for your insights today.

Ordway: Thank you.

Christine St Anne: For our year-end review, we thought we'd speak with our very own Ian Huntley and Daniel Needham to give us their views of the key events this year and their forecasts for 2012. Gentlemen, welcome.

Daniel Needham: Thank you.

St Anne: Ian if I can begin with you, you've been relatively optimistic about the share markets. Can we expect some sort of miracle rally for next year?

Ian Huntley: I don�t know if you are correct in saying I'm usually optimistic. Sometimes I'm very -- quite pessimistic but I do make mistakes; I don't necessarily get it right all the time. Look, since 2009, I have looked for the market to see-saw broadly between 4,000 and 5,000 on the Australian All Ordinaries Index.

Now, take it which way you will, whether that's optimistic or pessimistic, some people had it going to 7,000, I certainly didn't, and I really haven't changed my mind a great deal this year. I looked for a Christmas rally from October, and certainly we have had an up-tick. That could easily go further, but I still think that it will then go back down into the middle of next year, and there will be a quite a bit of gloom around, but the stocks will be excellent buying. I basically think there is lot of fear around but Australian businesses are doing pretty well.

St Anne: Daniel, you've mentioned a black swan in your reports. Do you expect this swan to reemerge next year?

Needham: I mean, I think that one of the things that I talked about was not necessarily that an extreme event would happen, but the fact that Australia is very dependent on China, specifically metallurgical coal and iron ore, and effectively the bottleneck in the seaborne iron ore market caused significant increases in prices and that increased their terms of trade. That filtered through to profit margins, both in the mining sector as well as in the mining services sector, and that's meant that we have had an extreme expansion in profit margins in Australia over the last, probably seven years.

Now, should something happen in China, should the investment led boom stumble or should there be some type of unforeseen event in China, Australia could become significantly negatively affected from that, so we could see profit margins collapse in Australia, and so in that situation -- and I'm not saying it's going to happen -- but that�s a potential event, this Australian share market could trade on, you know, 4% profit margins with P/Es of 6 or 7. In that event, you could see the S&P 200 below 2,000.

Now, I'm not saying that's a base case. I'm saying that's an extreme event, but at the same time I think that, you know, on trailing valuation measures, the market looks inexpensive, but from a trend fundamentals perspective, which is what we look at, if you normalize earnings in Australia, it's still heavily overvalued in our view, but again, I take what Ian has said that there is a lot of fear around, a lot of investors are underweight equities, and that makes a potential buying environment for equities and probably supports them in the shorter term. I mean, I think that there is a lot of pessimism out there about the global economy at the moment, and in those types of environments, it doesn't take much to surprise investors to the upside and cause a short covering type of rally. So, on a medium to long-term basis, we still think Australia isn't an attractive equity market. We think that the China led investment boom is simply a credit bubble but has lots of stories around it.

St Anne: Finally, investors have faced an unprecedented level of volatility, what�s your tips for keeping their faith in the share markets?

Needham: The framework that we use is a evaluation driven framework and we focus on capital preservation and we're going to miss out on the big booms and the big rallies, the latter parts of them, but at the end of the day we�

Huntley: That�s nice.

Needham: But we think we can pick assets up that are very cheap when most other people are writing them off and that's where we make most of our money through the cycle, and from that perspective, I think focusing on capital preservation first is important.

I think that assessing assets based off of what kind of income you can get, having conservative assumptions about the capital appreciation, I think that framework is going to lead you towards having a reasonable amount in banks, property trust in Australia. You know, the term deposit rates are pretty appealing for Australian investors. I think relative to other parts of the world, you can get a decent return without taking too much risk.

So, I think that a diversified portfolio for an Australian investor is looking pretty good, and so I think making sure you've got a framework to assess markets that you don't get sucked into the emotion and the mania and the headlines, and you try to avoid making those bad decisions. I think this is the environment where investors need to have a framework.

Huntley: There are parts of that that I would question. Now, people think that putting their money on bank deposits has this wonderful security about it, I'm not bothered. I certainly think the banks are stable, I have no troubles with that, but I think interest rates can fall.

Now, if one takes -- looks at the interest rates in Europe and United States and says, well the worst case could happen if, my friend here says, the rest of world is going to end up in a deep hole down there and well, we could have our interests rates pretty low okay, if you just take, you know, our friend�s view of the world. But in Australia, if you carefully look through, just as in the United States, you can find first class defensive income stocks that are quite happy to own, right through all that, and that's what we've been recommending for quite some time.

Needham: So, is that U.S. based?

Huntley: No, Australian.

Needham: Australian.

Huntley: Well, I'm not working on U.S. stocks, but I do realize that � I am sufficiently interested in the U.S. market to realize that they are there as well, and I'm sure if you looked at a quality, reasonable dividend paying, defensive stock portfolio in the United States over the last couple of years that would have outperformed indices, taking out Apple, that would have outperformed the indices pretty well. I think you got the odd skyrocket over there like Apple, but in Australia these things are just wonderful and you got security of capital and security of income. You don't have security of income in your deposits, but do have security of capital. And that's where retirees get really hammered, and I have seen it a number of times. For instance, when deposit rates came down from 17% to about 5%, retirees were screaming, where is my income? It's bloody sad and it's one reason I hope that our Australian interest rates don�t fall much further.

Needham: I think that, you know, a diversified portfolio in my mind is a portfolio with some good companies in there and that have got good yields and they are inexpensive. If you can find some good property trusts that have got good yields, inexpensive. I think having some � I agree that when the reinvestment risk for term deposits is probably � it's not accounted for by many investors.

Huntley: That�s what I am saying.

Needham: Yeah, exactly. I agree with that, but the good thing I guess in some ways is that when � if rates do come down, it's normally associated with a difficult economic environment, and so you tend to find that stocks are probably cheaper. So, the cash frees up at the time when you can actually deploy it into more attractive. So yeah, I think the idea that you're going to be able to get these levels of interest rates term deposits forever I think is certainly not a � is not a good assumption to make.

Huntley: That's where the risk is.

Needham: Yeah.

Huntley: People thinking, you know, the explosion and people putting money into bank deposits has been a wonderful thing for the banks.

Needham: Absolutely.

Huntley: It's halved their reliance in offshore money.

Needham: Yep, yep.

Tim Murphy: Hi, I'm Tim Murphy, the Co-Head of Fund Research here at Morningstar. At the end of January, we're going to be transitioning to a new global analyst rating scale for our fund research. Many of you will be familiar with our existing Morningstar recommendations for funds, where every fund that our analyst team goes and visits and assesses, we give a rating of either highly recommended, recommended, investment grade, hold or avoid.

At the end of the January we're going to be transitioning to a new scale, where the scale will read gold, silver, bronze, neutral and negative. So, there is a couple of different reasons why we've done that and some important implications for you, as users of our research and our ratings.

Firstly, looking at why we've done this. There has been some feedback over the years that people would like to see an extra level of granularity among the positive funds that we rate, i.e. the funds that we recommend and that we like. So, to-date we've had two positive rating scales being recommended and highly-recommended. Going forward from the end of January we're going to have three what we'll collectively refer to as the Morningstar medalists.

So we'll have funds that are rated gold, silver or bronze. What that means is compared to the existing scale, funds that are highly recommended today will become gold rated funds at the end of January, while the extra level of granularity around funds that are currently recommended, will mean that some of those will become silver and some of those will become bronze. So therefore users of our research, you have an extra level of granularity to see where our conviction lies at different levels among the funds that we like.

As I said, collectively we'll be referring to these as the Morningstar medalists. So gold will represent funds that we have the absolutely highest conviction in their sector or asset class, but at the same time silver and bronze funds are still equally good funds that can play a valuable role in a portfolio.

So as users of our ratings, and you should ask yourself, is the funds in my portfolio Morningstar medalists and if not maybe look at other Morningstar medalist funds to consider for the portfolio.

This new rating will also bring our rating scale in line with what we're doing globally at Morningstar and Morningstar is a global business, we have more than a hundred fund analysts around the world. And so now, for those of you that are using us across different borders, you'll be able to have the same look and field through our research, whether it's in the U.S., in Europe, Asia or here in Australia.

As clients now looking forward, as I've said highly recommended will become gold, recommended funds today will be either silver or bronze. Funds that are currently rated investment grade which is the highest number of funds we rate at the moment, they will become known as neutral while on the negative side, we'll have funds that are currently rated avoid will become what we call negative.

Outside of that we'll also have terminology to use funds that are either not ratable because of lack of disclosure or under review where there has been a material change to people or process behind a fund.

So, going forward, neutral means a fund that is adequate and should do an adequate job at meeting its objectives, but the Morningstar medalists rated gold, silver and bronze are the funds that we think people should be focusing the most time and attention on and using in your client portfolios.

Christine St Anne: There has been much debate that investors are set for a low growth environment. Today, I�m joined by Extreme Money�s author Satyajit Das to give us his views on whether this phenomenon is actually going to be a reality. Das, welcome.

Satyajit Das: Nice to be here.

St Anne: Das, if we could begin with the U.S., do you think that they are going to be stuck in a very low growth environment?

Das: If you look at the United States, they�ve actually done a little bit better than most people would have thought. I always thought the growth trajectory of zero to two, which is well below peak growth for their more trend growth, is probably possible. They have some advantages. The first is, they were the first hit by the crisis. They actually did something which is very interesting. The Americans have a capacity to leave the past behind which is - they drew a line in the sand, they wrote off a lot of stuff, they recapitalized their banks. They did it quite early and aggressively. So, basically they are a little bit cleaner than say the Europeans, where the Europeans refused to admit reality and didn�t take the hard decisions, the hard write-offs, the hard recapitalization issues, with certainly the banking system.

The second issue is the U.S. people forget it�s quite a closed economy. Trade is not as bigger part of the U.S. economy and so as a result of that, they can sort of muddle along and unlike Europe, they have the advantage that they control their own currency which also happens to be a reserve currency. So what they are trying to do, the strategy seems to be, is to print money and to basically keep the economy going and printing money has a lot of side effects. But one of the effects it has for the United States anyway, is it�s keeping interest rates very, very low and the second issue, which is kind of paradoxical because you would expect printing money to push up interest rates its having the reverse effect.

The second issue is that it�s reducing the quantum of debt that they have to service in two ways: One is that they just pay it out of the printing presses. But on the other side, the devaluation of the U.S. dollar, it helps them. So overall, they are robbing their creditors to basically keep the economy going. The big problem for them is going to be if the rest of the world basically slows down and particularly, the money markets around the world seize up, again as they did in 2008. They can�t be completely immune from that. So they are actually, ironically in a little bit of space than say � for instance, I would say Europe and maybe possibly China.

St Anne: Das, what about Europe? What�s your outlook there?

Das: Well, Europe is kind of a dystopia on a large scale at the moment. But you�ve got to come back a stage and say, look we can go through the entire very convoluted history, but what should they do? What they should do is pretty straightforward. One is the peripheral economies like Greece, Ireland, Portugal, maybe Spain and even Italy, have too much debt and you are going to have restructure some of them down, because there�s no way they can continue to go. I think Spain and Italy might muddle through; the other ones are more dubious.

The second thing they should have done is the resulting losses to the banking system that would result from these write-offs; they had to recapitalize their banking system. The third, they needed to put a fairly big wall around Spain, Italy and ultimately the core which is France, Belgium, Germany and so forth. And at the same time they needed to have a mechanism for growing Europe because ultimately we know, you can�t get out of debt problem just by cutting, it�s got to be by growth.

The problem with all of that is they sort of buried their heads deep in the sand for almost two years and now they�ve come to the realization that they have to do all of this and what they are doing is too little, too late.

The joke is that in Greece, they�ve decided to cut a €100 billion off their debt. Now, of that €100 billion that they are going to cut off, firstly it only reduces their debt by less than 30% and will soon leave them debt to GDP of 120%, which nobody believes is sustainable. So you�re really not dealing with the problem aggressively enough, and then you quarantine Ireland and Portugal and say they�re off-limits.

Secondly, the recapitalization they're talking about of €106 billion, looks very light. It's got to be probably three or four times that. And finally the European Financial Stability Fund, which they put in place, I mean is becoming almost irrelevant because firstly, it hasn't enough money and it may have had enough money for Greece, Ireland and Portugal, but now that you've got Spain and Italy.

I mean Spain and Italy between them have to roll over, something like $1 trillion of debt next year and so under those circumstances, I think it's going to be very difficult for them to be bailed out by the European Financial Stability Fund and they haven't helped themselves by having half baked proposals like basically, oh well let's go and leverage the European Financial Stability Fund or let's go to the Chinese and co-invest. All of those are pretty half baked and what's now happened as a result of all of that is European Financial Stability Fund itself is finding it very, very difficult to raise money.

They had to raise €3 billion to fund the payment to Ireland and they found it pretty difficult to raise it. So they're likely irrelevant, so all the planks of the plan look pretty dodgy to me and there's no plans of how they're going to grow the economy. Their idea to everything is, let's become more austere, let's become more German if you like and basically have less debt and basically cut the budget deficit down to manageable proportions, but they are not going to grow, there're just going to shrink to oblivion.

St Anne: So Das, are investors looking at lost decades of growth like what happened in Japan?

Das: Well, everybody thinks we're turning Japanese and I think there's a element of truth in that. I mean look, when all this problem occurred, the first thing is in 2008 everybody said there was a crisis and it was, but also it was a massive warning light going blink, blink, blink, think about what you are doing.

Instead of which we sort of decided that we had a very glib answer, which is to flood the system with money, government assume all the debt and hey presto, everything would be magic or we would raise the magic wand.

So we really wasted three years not dealing with the problems and during that period we wasted a lot of money and what we've done is basically contaminated the government balance sheets. The governments aren't in a position to respond to the same degree. And what that now means is our policy options are narrowing all the time. So, I think it's probably more likely than not at what we're going to end up with is a period of long slow growth, which would be sort of Japanese experience of a couple of last decades of gradually working through these problems.

Now, in many ways investors might turn around and say that's bad. The answer is that's neither bad nor good, you're just going to have low growth. The problem with low growth is, we have a system, which is basically engineered for high growth and you are going to have low growth. So you're going to have to just adjust to that. But the other interesting thing about that entire process is that Japan had certain advantages that the world doesn't actually enjoy.

One, Japan had this massive savings pool, and that massive savings pool allowed them to gradually, sort of, ride this out.

Now, where is the savings going to come from in the world? That's the next question that you've got to answer if you say we�re turning Japanese. The second issue is, Japan has a large export industry and the rest of the world during the Japanese lost decades was doing quite okay for the most part. So, their export industries did well again cushioning some of the problems, and the last issue is Japan is a deeply conservative, homogeneous society and culturally they are very stoic, and they actually accepted a lot of the loss of living standards and a lot of the hardships and I think the problem is, the rest of the world may not cope culturally with this period of low growth and the lower living standards and the social dislocation, but look there are two other options.

The one is that somebody somewhere presses the wrong red button in terms of policies, in which case we could get a disastrous collapse, which I hope doesn't happen. The last issue is, well a space ship could arrive from Mars with little Martians who might hand out little trillions of dollars to us earthlings and everything could be fine. So it's not all bad news.

St Anne: So are these Martians China by any chance?

Das: I think it's unlikely to be China. I think it is Martian life I'm looking for. Look, China could help. These countries with large reserves could help, but they have their own internal issues. To some extent, there is a fundamental problem here.

The way the developed economies, like the United States, the U.K., Europe are going about dealing with some of their internal problems, is hugely disadvantaged to people like China. I'll give you a simple example of that. The devaluing of the currency, which forces up the Renminbi, and then basically what that happens is all their foreign exchange reserves which is their savings basically gets reduced in value.

The second thing is, because most commodities are traded in U.S. dollars, the price of that goes up, they actually import an inflation, which causes domestic pressures and huge social discontent in places like China, where food prices and energy prices are going up very sharply and same in India and other places.

The last issue is when they ask for help from China, they actually ask for it in a, sort of peculiar way. Christine Lagarde goes to Beijing to basically ask China to contribute to the efforts to rescue Europe, and basically then lectures the Chinese officials and the Chinese Bureau about how they should behave in terms of currencies and so forth.

I mean I think I would have gone there and said, you can help Taiwan, you can have Tibet, you can have the Dalai Lama, you can have probably the Eiffel Tower and the Parthenon, can we have the money please, instead sort of lecturing the people who hold the keys to the treasury.

So, I think there is a cultural issue and my fear is that the emerging nations may decide. It wouldn't be in the long-term benefit of them or of the global economy, is to circle the wagons and say, well, this is all too hard, the developed economies have more problems than we do, maybe we just focus internally and try to save ourselves. People forget that a country like China is not terribly engaged with the rest of the world. Their engagement with the rest of world, certainly economically, is only a recent phenomenon.

If you look at 4,000 years of history, the Chinese are not noted for basically being engaged with the rest of the world. Any country whose symbol is the Great Wall is hardly suggestive of somebody who believes in engagement. So, I think there is some huge geo-political tensions and unfortunately we all need to pull together to solve this problem. But at the moment, I think all the horses are pulling in opposite directions, which complicates dealing with the problem quite considerably.

St Anne: Das, so do you think that it's really the culture of risk rather than government's inability to manage budgets that has lead to this crisis?

Das: You have to down to the root cause. The root cause was we're hooked on growth. The growth that occurred in effectively the last 30 or 40 years, and maybe beyond that, was driven by three factors. One, financialization, which is really the growth of debt and the taking of risk. The second is under-pricing certain resources like, obviously, climate damage and climate change and also under-pricing certain things like nonrenewable resources.

Now the problem is, we relied on those three things to drive growth and that period is now coming to an natural end and rolled up in that, is the fact that we thought we understood the financial system in terms of its risk and we thought we could manage the system far better than we can actually do.

I always say that these days there is a very complex crisis. At one level it's economic. It's at a more fundamental level about other things: our belief in growth, our belief in our ability to manage the economy as well as we think we can, and also psychologically - people's expectations of higher living standards and how they want to live. I think it's more a crisis of that. If we could address those, perhaps the economic crisis would be a lot easier to address.

St Anne: Das, thanks so much for your time today.

Das: It's my pleasure.

Christine St Anne: 2011 is a year most people would like to forget. The rollercoaster markets continued, while the U.S. and Europe are still struggling with their economies. Against all this gloom, we spoke to a number of investment managers to get their views of a 2012.

Scott Tully, who oversees the multi-manager business for Colonial First State, says the views of his managers differ to the general outlook.

Scott Tully: Look, I think, a lot of managers are seeing that, in many ways, the global economy is actually not too bad or at least better than, perhaps, what the general view of all the headline risk is. So, there are managers, who often talk to us about the strength of corporate balance sheets, and we are seeing this in the States, some improving numbers around employment and retail sales, and that sort of thing. But obviously, overlying that is the situation in Europe, and the risks that that provides. So, they are a little bit caught there, though there is opportunity, they�re seeing companies that are quite healthy, but understanding the broad environment may turn bad at least in a market sense for a period of time.

St Anne: Andrew Pease from Russell Investments also sees opportunities.

Andrew Pease: It has been an amazing year. And certainly, I think, when you look at markets in aggregate, they are all looking cheap. We've got Japanese equities trading on price-to-book value of under 1. We've got U.S. equities on multiples of about 11 times. We've got Chinese equities on single-digit price-to-earnings multiples. So, everything looks cheap, but the problem is, it's all cheap for a reason, and it's a matter of working out where those reasons are and how likely they are to be sustained, which would tell you where the ultimate value is in the market.

St Anne: So, where are these opportunities?

Pease: Well, it depends on your time horizon, anything could happen over the next six months, unfortunately with how things are playing out in Europe. So, you really have to look beyond that when you're thinking about setting up a portfolio. So, just taking it at the very broad level and trying not to get too smart about playing particular sectors, the Australian share market with a dividend yield pushing up to 5% is very good. Historically, there have been no occasions where the dividend yield has been above 4.5% when the market hasn't delivered you very strong returns over the ensuing five and 10 years. So, there's a lot of those opportunities out there in emerging markets, and those are things that everyone talks about. But again, it's a market that looks relatively undervalued right now. So, that's going to be a place to play too. But unfortunately, all of these longer-term considerations - the market can look cheap now, but it can also look even cheaper in six months' time depending on how things play out in Europe. So, there's good long-term value, we all know that, but it's a matter of whether we have that degree of patience or not.

St Anne: For Patrick Farrell, who manages Advance Investment Solutions multi-manager team, lack of confidence is stopping many companies from tapping into these opportunities.

Patrick Farrell: Look, I think markets are exhibiting plenty of opportunities at the moment, all right. It's a situation, where you need to not necessarily buy into a lot of the situation that's going on at the moment, but companies themselves are in really, really good positions. They've got great cost of capital or access to capital. They've got a lot of cash on their balance sheets. Their balance sheets have never been healthy. What they lack at the moment is just a bit of confidence, a bit of confidence to invest in terms of what their future is going to be, and that then will translate into hiring as well. So, a lot of hiring plans have been put back, but that doesn't necessarily mean that companies are in a little trouble. It just means that they need to wait and see where some of the certainty is going to come through into the future.

Now, a good situation is opportunities that arise out of this sort of market volatility will come up all the time. It just means that we need to be a little bit more nimble, a little more flexible about how we take those opportunities on board. And our managers are certainly doing that.

St Anne: Despite the volatility, these managers also believe Australian investors should move away from their home bias.

Pease: Well, Australian shares have underperformed quite measurably over the last couple of years, and particularly against U.S. shares. So, an investor would have been much better off being in hedged U.S. equities over the last three years than being in Australian shares. So, we went through that period of strong outperformance in the period before the global financial crisis, and that's now being matched by period of underperformance. So really, I think, the lesson of that is that yes, there are some benefits in home country bias, particularly the tax benefits and imputation credits are a wonderful thing, but I think the lesson of the last decade has been, whereas home country bias was rewarded during the 2000s, it certainly hasn't been rewarded over the last few years, which again just goes back to that simple boring message that people like me go on about all the time, which is diversify, diversify, diversify because that's the best way of making sure that you are getting the best of the returns that are available out there.

St Anne: Patrick Farrell says that this could also be missing out on opportunities by maintaining a home bias.

Farrell: I would not necessarily say keeping a home bias advantage is the best thing to do at the moment. Obviously, a lot of the rest of the world has issues and it has problems, we are not necessarily going to be immune from those problems, but what I do say is that, if you start to sort of restrict the opportunity set that your portfolios are accessing, then you are missing on those opportunities. You are not being able to provide a good diversified outcome. This is where the flexibility comes into it. So, I would actually say having a more diversified portfolio, giving yourself and your investors more options about where to find these good opportunities is the best investment process to actually have.

St Anne: So, how do these managers ensure the investment managers that they oversee capture the right opportunities?

Farrell: It does require a little bit of a change to the way that they would go about their normal sort of process, because even though an investment horizon will sort of come about for one year, two years, they need to think about that. They need to think about what does the future hold, but at the same time, you can't afford to ignore the market environment that we are in. Volatility is going to stick around for the next sort of 12 months at least. So, we need to be able to take advantage of that volatility as much as we possibly can. So, it's not just about opportunities that we find, but there are plenty, it's also about how we manage the risk on the other side of things.

Tully: Yes. Actually, we think, there is two types of managers that will take advantage of the opportunities that present themselves, but they are actually quite contradictory in some ways in terms of their style. So, one end of this spectrum, you've got managers that are very nimble in what they do. So, they will see opportunities, they will take advantage of that opportunity and they will get out of it within an appropriate time frame.

The other end of the spectrum are managers that are taking possibly a macro view or top-down view on the world, but look at it in a medium-term sense. So, they will position their portfolios for that medium-term outlook, but they'll have to hold the course through what will be some testing times. They won�t be able to necessarily realise their views for a couple of years. So, there is two types of managers, the short term and essentially the medium term.

St Anne: Andrew Pease ensures a blend of managers across different styles, and the lesson for investors is to diversify across a range of asset classes.

Pease: Well, I think, it's a matter of really � again, it's a diversification story, not being too style specific. So what Russell does is, we're multi-asset, multi-styles. So, we try to pick what we think are the best investment managers across all styles, then blend them in portfolios, which hopefully will achieve consistent outperformance. So, we will have some growth managers where growth is working, we will have some value managers where value is working, we will have some quant managers wherein quant is working, but the basis of what we do is, is we can pick all of these managers, the ones that we have the highest confidence in can outperform in their style, which hopefully will give their best performance over time.

But I think, more generally for investors is that they really do need to think, not just have an equities focus but be thinking across asset classes. So, we're looking it to have global and domestic equity exposure. We are looking at emerging markets, but also be looking at infrastructure, be looking at unlisted property. We're looking at also in infrastructure, looking at unlisted infrastructure, looking at absolute return strategies, looking at fixed income, looking at credit and high-yield business and great opportunities. So, I think the message right now more than in any other time that I can recall in my time in investment markets is really make sure you have the best spread possible, because trying to pick which asset class is going to be the best one in this type of environment is going to be a really hard task to get right.

St Anne: So, we expect the volatility to continue, but opportunities do remain. As the old investment rules apply, diversify and stick to your investment strategy. Christine St Anne for Morningstar.

Christine St Anne: Volatility has spooked many peoples' approach to the investment markets. Today, I am joined by George Boubouras from UBS to talk about the importance of keeping true to an investment strategy. George, welcome.

George Boubouras: Good to be here.

St Anne: George, has market volatility changed the peoples' attitudes to investing?

Boubouras: Very much so. Broadly, the way we've been seeing it, investors are very fatigued. This market volatility with risk assets, that's equity markets predominantly. It's more elevated than the long-run average, it's very persistent and that leads to a lot of fatigue with our client base.

They need to ask the question, which they invariably do, do I have the right portfolio for my circumstance? Am I employing the right amount of risk? Is my expected return realistic? How much money do I need in retirement? And, what is this about diversification that I need to be employing in my personal portfolio? It brings up so many questions, and you need to be very rigorous in that because portfolio diversification works for most people, it helps lower the volatility, of course. But very much so getting to the point of the question, investors are very, very fatigued with the current level of volatility in the equity market due to obvious global headwinds.

St Anne: Has this caused investors to loose out on investment opportunities?

Boubouras: Very much so. This fatigue can lead to what we call a sub-optimal outcome. They may lead to do something to their portfolio that they'll regret later or they may miss out on opportunities going forward.

A case in point for example, is if you have a strategic benchmark, that's predominantly the core part of your portfolio across all the asset classes and that's cash, that is fixed income, that's bond and corporate bonds, that is equities in Australia and offshore, that's listed real estate trusts in Australia and maybe offshore, and potentially some alternatives.

If you'd surely diversify across some of those or all of those asset classes, over your life cycle, over a 10, 30, 40 year time frame and you readjust those weightings, of course, towards retirement, it does add value and it does grow that portfolio into retirement. Because, you need growth assets going forward and property is the easiest way to explain it. Everyone knows when you buy a home, an investment property, that over the longer term there is some growth there, but you trade off with lower yields, and that�s the key.

The point to make here is not to change that strategy. If that strategy was applicable 10 years ago and five years ago, what has changed from my personal circumstances that leads to changing those strategic benchmarks and effectively changing how much expected return I am targeting, which leads into the lifestyle of retiring. If you go into global or domestic equities, really look for quality and don't go into that speculative value trap scenario and that's the message to outlay.

The other one is, do I go and buy global sovereign bonds? Quite clearly, that's a very topical thing. Say, a mum and dad investor will be very shocked to be going buying an Italian bond because what they are hearing in the news. But you need to do your homework of what is reasonable out there globally, what should I be doing for my portfolio? and what are the real fundamentals?

So, there are so many questions out there to answer that, and effectively. But, the point is that it will vary by each investor. Every investor in Australia should be bespoke. The portfolio must reflect their risk appetite. The portfolio must reflect the expected return through their life cycle. They need to review that every month and every quarter with someone who is a professional and find out if they are meeting those targets, otherwise you have the wrong portfolio and something needs to be done.

St Anne: George, are investors too scared to invest in global equities. Are they having too much of a home bias?

Boubouras: This is the case in point. If my Australian portfolio has BHP, and Rio and Woodside, particularly Woodside, do I really need to have Chevron and Exxon and Royal Dutch Shell in there given Woodside in Karratha are spending so much money with Pluto train 1, 2, and 3 for LNG and Exxon, Chevron, Royal Dutch Shell are throwing effectively $43 billion into the Gorgon project.

So, we try and say, you don't need to double up that exposure in building that portfolio, you need to chase earnings in your offshore portfolio that you won't be able to reflect in Australia in the next 10 years, even though Australia has been the place to be.

Case in point, Google, effectively is a company and Apple, John Deere or eBay, PayPal; people need to understand what those companies do. For example, everyone understands eBay, understands PayPal, every time they transact. E-commerce globally is running about 7% to 8% through independent research.

We think e-commerce globally will grow to about 15% to 20% in a decade's time. That's explosive for earnings on anyone who trades on e-commerce, that's good for PayPal, it's good for Visa, it's good for MasterCard, it's good from AmEx. And they�re the things to ask yourself, because you can't buy those future earnings in this local market, but you can offshore.

Apple is another case in point. Apple with a high degree of certainty probably won't grow like it did in the last 10 years. It will grow at a lower growth profile, but nevertheless that company can't be replicated in Australia or we can't foresee a company being as large as Apple. Google likewise, they have sort of themes to be considering in their global portfolio.

St Anne: Finally George, has the market volatility changed peoples' approach to the buy and hold strategy?

Boubouras: Very much so. The buy and hold strategy is very much challenged, but we ask people to build their strategic benchmarks to their core part of their portfolio. It�s still is important to have exposure to global growth, domestic growth, future earnings, therefore equities. But they must really diversify.

The average Australian needs to have more defensive asset classes, it needs more cash and fixed income like our peers offshore, equities are important � offshore equities are important and REITS are important. You need to diversify across every asset class. You need to diversify within every asset class. You need to understand your risk appetite, your tolerance for volatility and expect a return that you are targeting, track those. If it's not happening, if you can't sleep at night, you need to have the conversation to find out what portfolio helps me meet my goals or aims and effectively build nest egg into retirement.

St Anne: George, thanks so much for your time today.

Boubouras: Good to be here.

Christine St. Anne: Term deposits have remained a favorite among investors. A recent paper by Russell Investments questions the increasing role in a portfolio. Today, I'm joined by Russell Investments' Clive Smith to discuss his views. Clive, welcome.

Clive Smith: Good to be here.

St. Anne: So, Clive will term deposits continue to remain popular given the latest rate cut?

Smith: I think with the current environment that we have and the level of uncertainty there is in markets at the moment, there will be an attraction towards the term deposits. But, I think the key thing that investors need to realize is that, term deposits were particularly attractive in 2009 as banks needed to rebuild their retail deposit bases and going forward that level of traction will start to diminish. So, it's not so much of a case of saying are term deposits not attractive? For very risk averse investors they will be, but for many investors they really now need to start considering what's the next stage of investing, especially since there is entirely possible we may be moving towards the debts of the crisis.

St. Anne: So, with increasing global risk, what are the alternatives to a safe investment like term deposits?

Smith: Well, I think the thing with the term deposits for investors to keep in mind is that term deposits are really just another part of the fixed income market and accordingly, they really should be looking at the range of fixed income investments that are available, from simple cash to high yielding type investments. More importantly, looking at those investments from the perspective of their investment objectives and determining, really going forward, are term deposits the best things for them, especially once it�s taken into account that one; there is counterparty risk, i.e. credit risk in banks and secondly, term deposits, while the returns might be looking quite attractive now, not only may those results decline going forward as the banks have less demand for retail deposits, but also there are liquidity issues associated with term deposits and should investors need their money back next day there will be penalty rights associated with those.

St. Anne: Clive, there is also increasing sovereign risk around the world. Should investors actually look at fixed income?

Smith: What investors need to do is fully understand the risks associated with what they are investing in. If we go back to pre the GFC, there is no doubt that most investors took the view that developed countries, especially sovereigns, did not entail any credit risk. We are really seeing that being reappraised right now across the spectrum. Here in Australia we're very fortunate. We have a government that has a very solid fiscal position. We're closely associated with Asia and we do have a commodities boom that is assisting. So, accordingly, Australia is in a very solid position and I think for credits here in Australia, they will continue to be quite safe investments for, but there is no doubt that, in particular if investors are looking at offshore type investments in particular sovereigns, they must very closely look at the sorts of risks they are taking on.

St. Anne: Clive, you paper also mentioned credit risk associated with term deposits. Is that actually a real risk given that our banks are amongst the safest firms in the world?

Smith: I think if we look at the Australian banks, there is absolutely no doubt that Australian banks are amongst the most secure in the world. Australia did not go through a financial crisis in 2008-2009, but investor still need to be cognizant of the fact that when buying a term deposit, they are buying into bank risk and that loss to Australia on this part of the cycle has not gone through a financial crisis. We have in the past, and we may do in the future. So, this is something that investors need to just keep in mind - in the backs of their mind - when determining how much they should be allocating to term deposits as an investment.

St. Anne: Can term deposits actually be invested alongside fixed income?

Smith: I think term deposits do have a role in fixed income portfolios. As I said earlier, they're really just another type of fixed income investment. What is important for investors is for them to be putting together a portfolio that provides them with sufficient flexibility where they can take advantage of the opportunities that will arise, either now or down the track. So, the one thing that investor doesn't want is to be in a situation where all their money is in term deposits, and then may find that as term deposit rates are declining, they are not in a position to take advantage of other investments that may be available for them. This is particularly important given the pricing dynamics for term deposits are very different from other types of fixed income investments. Whereas other investments may be driven by markets appraisal of risk and return, for term deposits it's very much bank demand.

As we move into a potential environment of slowing loan demand and increase in deposits, the level of interest that banks would be willing to pay for term deposits could continue to decline as we have seen it declining over the last 12 to 18 months.

St. Anne: Clive, thanks so much for your time today.

Smith: Great to be here. Thank you.

Tom Whitelaw: With me today is John Valtwies, Senior Researcher at Morningstar. Having just completed our sector up, it's a good time to chat to John about the key themes that we saw in global markets across the last few months.

John, can you tell me a little bit about the global equities review?

John Valtwies: Yeah, sure Tom. So, we covered approximately 49 strategies and of those 49, we ended up giving highly recommended ratings to two managers.

Whitelaw: Okay. Did you come across any key themes that investors might be interest in out there?

Valtwies: Yeah, absolutely. So, I guess there were a couple of key themes, but the biggest one that I think is in front of mind for most investors right now is probably the question of currency and what to do with currency.

Whitelaw: So, I mean what do they do? Do they go for the hedged option, the unhedged options, are there options that are in between that?

Valtwies: Yeah well, I think there is a few things that we probably need to talk about. Given the last 10 years returns in global equities have been absolutely atrocious for unhedged investors. Obviously, investors know that more than anybody else, but when looking at hedge returns they have been far superior. But while return is one element of the equation, we think that people all too often are overlooking the case of risk.

Whitelaw: Okay.

Valtwies: So, risk has been one of those attributes that we've really looked at and�

Whitelaw: So, you're telling me that hedged has been more risky or less risky than unhedged or--?

Valtwies: That's right basically, so over last 10 years, hedge returns have been far superior but the risk outcome hasn't been.

Whitelaw: Okay.

Valtwies: So, that surprises most people. Give most people think that when you're hedging currency that you're removing a risk, but because of the pro-cyclical nature of the Australian dollar, and by that I mean the Australian dollar is more or less a commodity currency and that's because of Australia's role as a play on global growth. So, whenever global growth expectations come off, like we've seen in the last couple of months, the Aussie dollar gets sold off. We also saw that into 2008. So, what that means is for hedged investors, the risk outcome is far riskier and that's what we've seen over the last 10 years. So, although the returns have been far superior being hedged, the unhedged returns have been less risky and a better risk return outcome overall.

Whitelaw: Obviously, an Australian investor looks at the performance of Australian shares over the last 10 years and might compare them to the performance of global shares. So, I wonder why they need that global allocation given how well Australia has done. So why is there a place for global equities in an investor's portfolio?

Valtwies: Yeah, definitely. I mean I think one of the biggest issues is obviously diversification. So while there is no argument, Australian shares have performed in a more superior fashion than global equities and that's obviously taking into account currency and everything else. But I guess one of the key things as to why you go offshore, is diversification. Why is that so important in equities? If we think about the drivers of returns for Australian investors in terms of Australian shares, a large amount of that is that pro-cyclical element. So our market, the Australian equities market, is dominated by materials and resources as well as financials and banks. But largely, why our economy has been so prosperous in the last 10 years or so, has been the role of China, and so you want to kind of diversify that element. And so that's why it's important, we think, that investors should be looking offshore to diversify their portfolio.

Whitelaw: So amongst the global equity managers that we're covering, there�s a trend towards - they�re moving into emerging markets. Given we hear a lot of stories about low growth environments and growth coming from emerging markets, so have you seen the global managers are kind of increasing their emerging markets exposures?

Valtwies: Yeah, absolutely. One of the key tools, as you know, that we use is the Morningstar tools, and all of that tools run off that holdings based analysis and one of the best plays that we've been out to observe that is through the use of Morningstar's Portfolio X-Ray tool. So, that way we can see more or less exactly the make-up of those portfolios and so, in this review, one of the key trends has been to see the increasing number of emerging markets stocks within portfolios.

Whitelaw: How should investors deal with that? Do you see there is a limit on how much emerging markets exposure global fund should have?

Valtwies: Well, there is a few points I think to point out there and that is, emerging market exposure can be attained in many, many different ways. So, global equity managers can go directly and hold those stocks. Our observations is that, yes, people are doing that, but there are great risk controls around that, so people shouldn't be concerned � it's getting to great.

But another way of tapping into that is indirectly. So the global equity managers will buy companies like: Unilever, Proctor & Gamble, Louis Vuitton and Moet Hennessy. These types of companies who have large exposure to emerging markets. So, therefore, they're indirectly tapping into the emerging market growth theme, but from the safety of the developed world listings is being listed in London and New York and so on. But in terms of investors that can tap into it in many different ways, but depending on their risk profile, we do also see a place for dedicated emerging market managers.

Whitelaw: So you're telling me that investors actually might have a very large exposure to emerging market revenues but without actually having been that obvious for that portfolio.

Valtwies: Exactly. One other most interesting observations was that, all of � let's say, the 49 managers that we saw, no one could conclusively say, I have X percent allocated to emerging markets. Okay, they can identify their direct emerging market holdings but they can't say how much indirect emerging market exposure they have. Now that's not because the analysts are poor or they haven't been doing enough research. It's just so difficult to actually put a thing figure � or put a number to the underlying revenue a company may have coming from an emerging market like China. While the companies themselves probably do have it, they keep it close to them. So, they don't release that type of information. So, a few funds managers have some done work on a handful of companies and they found out that some of the big companies actually generate over 50% of their revenue in sales from emerging markets. So, it s a big theme for people to be conscious of.

Whitelaw: Okay. That's great. Well, thanks a lot of your time today John.

Valtwies: Thanks, Tom.

John Valtwies: Joining me today is Scott Mather, portfolio manager of PIMCO's Global Bond Fund. Today we're going to be discussing what's going on in Europe, as well as their portfolio positioning within the Global Bond Fund, and why investors should think about using global bonds in their portfolio. Thanks for joining me today, Scott.

Scott Mather: Thanks for having me.

Valtwies: Scott, given what's going on in Europe, what's PIMCO's view on the whole situation?

Mather: Obviously all eyes in the world are focused on Europe and with good reason given that it's the largest economic zone in the world and obviously hitting into some real constraints, structural problems that are slowing growth down and problems that have taken a long time to build related to debt dynamics of individual countries. So, very important what's happening in Europe, but it's not everything. There's obviously important things happening in the rest of the world as well and so, we've had the view that the European growth is going to be slow and that's certainly not helping the global growth outlook, but it is creating some interesting opportunities in global bonds at the moment, and so we're very focused on managing our portfolios to maximize those opportunities.

Valtwies: Given all of those risks and the issues that you've pointed out, how is your portfolio positioned?

Mather: Well, it's important to remember from a fundamental perspective that low growth and low inflation are generally very good for bond prices, helps yields fall, bond prices go up, and that's true. It's happening in many parts of the world. Our forecast is that that has more room to run, but there are some important caveats, and one of them in Europe that you see happening is that some sovereign bonds are becoming riskier. They've passed the point where they really respond to low growth and low inflation in the same way that you would read in a textbook. In fact, the yields are going in the opposite direction and prices are falling, and that's because for those sovereigns, they sort of tipped into a bigger credit risk than they are a reflection of low growth and low inflation.

So in the portfolio what we're doing is emphasizing those countries that we think will continue to have falling yields and rising prices because of low growth and low inflation, and monitoring the situation carefully but not investing in a heavy way in those countries with a real problem with the debt dynamic - those countries that are shifting into riskier credit space. There will be a good opportunity at some point to move further into those countries, either because the fundamentals will begin to change or because the prices will become so reflective of that rising risk that they become very attractive from a risk-reward standpoint.

Valtwies: Scott, when we are preparing for our reviews of fund managers, we use a lot of Morningstar's holdings-based analysis, and what we've been observing is the increasing allocation to emerging markets. Given Australia's fixation with China, what's PIMCO's view on China's role in global growth?

Mather: Good question. Importantly, China is not immune to the slowdown. China itself is slowing down but our base case is not for a dramatic collapse in activity or collapse in growth. In our view there's some risk in China that individual sectors will have some problems. There are some issues with over-investment, some issues with localised real estate problems, but the other fundamentals in China are so strong, the balance sheets are so strong at the sovereign level that there is the ability to correct those things that have gone wrong and that underlying growth momentum can be maintained. That's important because it allows China to outgrow some of the problems that have developed in the past several years. So, we don't think China itself is going to be the destabilizer of the global economy. It's right to ask that question and to worry about that, to look at it carefully, but in our base case that's not very likely. We don't see conditions being in place for China to really pull down the region and world growth substantially.

So, we think there will continue to be this wedge that opens up in terms of growth. We talk about a wedge, some people call it a multi-polar world, two-speed world, different ways to describe it, but a world that's anchored by China and a lot of emerging market countries growing much more quickly than the developed world, and the difference between those two rates of growth is still going to be there. They've both dropped a bit but that differential has probably even widened. So people need to, in our view, basically investor portfolios that way realize that the better balance sheets, the better growth in many cases is coming from the emerging market world now and the developed world has a unique set of problems, largely because of the different debt dynamic and different growth trajectories, which are compounding the problems.

Valtwies: Scott, Australian investors had some pretty attractive term deposit rates to think about when allocating to the income asset class. What role then should global bonds play in investor's portfolio?

Mather: Global bonds are very interesting opportunity particularly for Australian investors because the environment that we see - there is the chance for, I will say the expectation of capital gains for many different global bonds in the world today. So, even though the headline yield level is small, if the yields fall, prices can go up, and so there's a capital gains opportunity. The other opportunity that's there and sort of unique to Australian investors is the fact that yield curves, the difference between what overnight money yields as an interest rate, and what five and 10 and 30 year bond yields are that steepness, that difference in yield is very attractive for Australian investors, if they hedge up the currency risk. It's a way to think about importing extra yield into an Australian cash holding or an Australian bond holding, and that's been true for the last several years. We think there will continue to be that opportunity. Yield curves will remain steep. So from an Australian investor's perspective, they can invest in global bonds, have a much higher yielding portfolio than if they were just to invest in Australian cash or Australian bonds, and at the same time have a more diversified portfolio, which is what you want in today's world that's a bit more uncertain.

Valtwies: Thanks for joining us today, Scott.

Mather: You are very welcome. Thank you.

Christine St Anne: In this current market volatility, there has been a lot of discussion about whether people are too exposed to the share market. Today, I'm joined by Westpac's David Simon to give us his view on building a better diversified portfolio.

David, welcome.

David Simon: Thank you, Christine.

St Anne: David, do you think investors are too exposed to growth assets such as equities?

Simon: Yeah, look Christine, most investors have a different allocation to growth assets such as equities, and indeed the allocation should be consistent and relevant to the investors' personal needs, objectives, investment time horizon, and indeed appetite toward risk. So, there's no right allocation in terms of how much money or funds investors have attributed to growth assets, such as equities. However, if an investor�s goals and aspirations, required returns that are beyond the capabilities of cash-based assets, alternative solutions such as exposure to equities maybe important as they do offer the opportunity for greater returns that of cash over the long run, even though they do exhibit volatility in the short-term.

St Anne: There has also been a lot of discussion about whether retirees are too exposed to the share market. What are your views?

Simon: Yeah, look retirees have a critical need to ensure their capital base, keeps in pace with inflation, and certainly maintains its purchasing power over time. Now, most retirees are going to live for at least 25 years, once they retire. So, it's critical that they maintain the integrity of their situation. So, importantly, having a quality financial plan that contains quality financial advice and strategies to ensure that the investors are able to maintain the integrity of their portfolio is key.

So, it contains strategies such as key diversification; so having an appropriate allocation into assets, including equities, to ensure that they are consistent, they meet their needs and objectives. Also, considerations in the Statement of Advice should include, having an appropriate ongoing management and portfolio review strategy to ensure that as the retiree's personal circumstances change and evolve, that the financial regulatory and economic environment also changes, that they're getting continued advice to ensure that their asset allocation, including their allocation to equities remains intact.

Finally, strategies should include not only appropriate allocations to equities, but indeed cash as well, ensuring the right retirees have a adequate provision to allow their income needs, liquidity requirements, to ensure that they're not in a position where they have to sell their equities untoward and unnecessarily.

St Anne: David, you mentioned cash and equities, what other asset classes should investors look at?

Simon: Yeah, sure. Look, diversification plays a very important role in the performance of a portfolio. So, diversification across traditional asset classes such as: shares, property, fixed income, and cash is vital for the overall performance of a portfolio. But indeed having access to alternative strategies, such as currency, commodities, and indeed absolute returns, ensures that by having appropriate diversification the retiree or the investor isn't in a position where they're feeling the complete volatility as if they were involved in one single asset class, and that their overall returns are smoothed out over time.

Importantly, investors can also diversify within asset classes themselves, such as Australian shares. Investors can determine to invest in different companies, industries, and sectors; and equally, property investors can diversify within that asset class as well, having exposure into industrial, commercial, and residential, and indeed global property amongst others.

St Anne: There has also been a lot of discussion about whether investors should look at alternative investments. What's your view on that?

Simon: Yeah, look, alternative strategies is quite broad. So, unlike your traditional asset classes, such as shares and cash and fixed income and property; it's quite difficult to define. But nonetheless, typical alternative strategies are not particularly correlated into share market returns. That is, the performance of an alternate strategy may not need share markets to grow in value. In fact, alternative investments can actually grow in value whilst share markets are falling.

St Anne: Can you give us a little bit more detail of what these alternative strategies are?

Simon: Yeah, sure Christine. I mean, alternative assets are very different to traditional assets, like shares and property. So, they're really difficult to define as they're so broad in a sense. So, fund managers, unlike fund managers that manage just Australian shares, they don't have a mandate when they're running an alternate strategy portfolio. So, in fact they can invest in any opportunity they see. It could be currency, it could be through a hedge fund, it could be through short-selling shares, or indeed investing in commodities. So, I suppose the fund manager or investing in alternative assets, allows fund managers the freedom to choose what asset class they desire, and it's quite often uncorrelated to share market and more traditional investments where they just need to increasing value to generate performance.

St Anne: David, thanks so much for your insights today.

Simon: My pleasure. Thank you.

Looking beyond equities and cash

Christine St. Anne: In the latest Ibbotson insights paper, Head of Alternative Investments, Michael Coop discusses what causes capital losses in investment portfolio, and how investors can protect themselves against such losses. Michael, welcome.

Michael Coop: Lovely to be here, Christine.

St. Anne: So, what are the big risks that result in capital losses?

Coop: Well, there are two factors that can cause large losses. One is if an investment is de-rated, so its valuation level drops. What I mean by this is, a valuation you can think of as how much an investor is prepared to pay for investment, in terms of its income or its asset value. So, for example maybe with something like shares, you can think of the price earnings ratio as a valuation. So, if investors decide to pay less for an investment, the valuation levels will fall. So, assets that are heavily overvalued, are more at risk of a large loss. Assets that are undervalued, the risk of a loss is much lower. So, the first thing is to check to see whether the assets you own have high valuation levels.

The second thing to look at is what we call the �fundamental risk�. Every asset you buy, you buy for a certain benefit it gives you, whether it's dividends, or whether it's interest payments or whether it's rents. If those benefits that you're paying for - the rents or the dividends - fall, that also can cause a large loss. Say, for example what we find is that for shares, a large drop in corporate earnings, usually results in a large drop in share prices. So those two things together, the valuations falling heavily, and also a large drop in what we call the �fundamental�, which is really underlying cash flows of the assets. Those two things can cause large losses, as prices fall heavily.

St. Anne: Michael, your paper also discusses that another big risk is Australia could be going into a recession. How likely is such a risk?

Coop: That's a good point Christine. We had a look at what Australian investors hold, and it's fair to say, Australian shares are the cornerstone in most portfolios. When we looked at those two factors that cause large losses, the fundamental risk for Aussie shares really comes down to the corporate earnings. Every time there is a significant recession in Australia, corporate earnings fall by at least 10%; and when that happens, share prices fall a lot. So really, the main fundamental risks that Australian investors face, is a recession, because that causes corporate earnings to drop quite heavily.

So, what that really means, is you should be looking for other types of investments to have in your portfolio, where they won't be so affected during a recession. So, their cash flows will hold up better during a recession.

St. Anne: So Michael, what are these sorts of investments?

Coop: Well, historically people have looked at international shares as one way of diversifying. Many years ago, that was a very effective diversifier, but these days, recessions tend to happen at similar times in the global economy and here. So, that becomes a bit less an effective diversifier. The other traditional form of diversification is bonds. The issue with bonds these days is that because governments have taken so much debt, there is a growing credit risk you face that you won't be repaid; and we've seen that already happening in Europe. So government bonds still play a valuable role as a diversifier, but you have to be more selective than has been the case in my last 10 to 15 years.

Outside of those conventional investments, investors have to really look at other types of assets and in our own portfolios we found three things, which have been effective diversfiers. So, in our portfolios we have exposure to those three types of investments: regulated utilities, insurance linked securities and macro and managed feature strategies.

St. Anne: Michael, you also talk about cash in the paper. Is it still such a safe asset?

Coop: Cash does do the best job of preserving capital, providing of course that whoever you have lent the money to pays you back. But what it doesn't do is hold its return during recessions, and that's because interest rates typically go down during recessions, as central banks cut interest rates trying to stimulate the economy, and so your return from cash drops. In many countries we've seen that return from cash has drops below the rate of inflation. So, actually you can end up losing the purchasing power of your capital if all of your money is in cash. We haven't seen that in Australia for a long time so, people aren't used to that happening. But we've seen that elsewhere and it could happen here. So, cash returns do move down during recessions, and therefore not a suitable asset for you to grow your wealth over time.

St. Anne: Michael, thanks for sharing your insights with us today.

Coop: My pleasure.

Christine St. Anne: It looks like investors will have to look at alternative investment strategies as the Australian share market continues to deliver single-digit returns. Today, I'm joined by MLC's Michael Karagianis to give us an insight into what sort of strategies are available.

Michael, Welcome.

Michael Karagianis: Thank you very much, Christine.

St. Anne: Michael, can investors ever expect to get double-digit returns from the share market?

Karagianis: Look, I wouldn't say that you'd never get them. There are certainly opportunities over short periods of time to get to exceedingly high returns when markets show recovery. But I think we got used to a very dangerous environment, misleading environment before the GFC, where it became the expectation that we could normally expect to get double-digit returns from Australian shares for example, and that's actually not the truth.

Over a very long period of time high single-digit returns is actually more normal, and I think we allowed into a full sense of security and I think the current environment is probably a bit of payback for that.

St. Anne: Michael, your paper mentions absolute return investing. What does that exactly mean?

Michael Karagianis: Well, I think quite often the argument at the present time is very much, should I hold on to my longer-term investment strategy often quite significantly based around Australian shares or should I capitulate, and in many cases people are actually moving back in the cash, for example, because they just can't take any more pain.

I think that there are alternative strategies that we can actually look at that really try to deliver returns above the cash rate, which I think people need to try and achieve to get enough funding for their retirement, but not necessarily taking the same amount of risk that perhaps they were prepared to do before the financial crisis.

Absolute return investing is one of those strategies that I think that actually provides that sort of middle ground, I call it a third way of investing, and that's where we really use a variety of strategies that are aimed at trying to deliver better than cash returns, but spend a lot of time within portfolios, actually trying to reduce the risks associated with many of those strategies.

So you end up with hopefully a more smoother ride, one that is more conscious of the risks, downside risks that markets often present, but can still deliver you quite reasonable returns, and I think increasingly investors in Australia will switch on to strategies like absolute return type strategies that can do that sort of thing.

St. Anne: You also mentioned defensive equity investing. What does that mean?

Karagianis: Well, in some of our portfolios now we're increasingly focusing on managers in our selection process that can do more than just pick stocks relative to an index, so that they can take a more absolute return view of stock picking in global equities, for example.

That would enable them, for example, not just to hold a stock underweight versus the benchmark. If they don't like a stock, if they don't think the stock is going to go up, maybe they exit the stock completely. Maybe, at certain points of the cycle they should hold more cash in their portfolios relative to equities or even other defensive assets.

So, there's an element I guess of greater discretion that we allow some of those portfolios, by some of our managers to implement that go into some of our portfolios at MLC. I think that's a positive thing because it intrigues another level of defensiveness when times of difficulty. What we've seen with our funds most recently over the last few months in particular with this volatility is that a lot of our equity managers have actually outperformed in that environment because they've had this ability to be a little bit more defensive.

St. Anne: Michael, you also urged investors to take a contrarian approach. How can investors have such conviction in these volatile markets?

Karagianis: Well, I think by definition, of course, the majority of investors don't and hence the nature of being contrarian is being willing to move against the pack. So, you've got to accept that the pack is often moving in a certain direction and what we tend to find is that in very difficult market environments like the current one, the pack is generally getting very nervous and quite often selling shares and moving into very defensive assets.

If you can and are prepared to go against the pack -- and it is a disciplined approach, it does take a fare bit of intestinal fortitude, but this can often be the best time to pick up good value stocks, good value assets. When everyone else is distressed, when everyone is running for the hills that's when contrarian investors can often get their best deals, and certainly we try to employ that same strategy ourselves in terms of allocating towards riskier assets in this type of environment. And as I said previously in some cases, our equity managers that we appoint to manage parts of our portfolio have also been doing that in terms of buying good quality companies at really very cheap prices because of the market uncertainty we're seeing.

St. Anne: What about structured products? That was also mentioned in the paper that came under a hammering under the GFC. Can investors now consider them?

Karagianis: I think my general comment about structured products is buyer beware. I think one of the problems ahead of the GFC is that people bought products that promised a lot, but really only worked in certainly environments. They were probably in some cases very substantial costs embedded within those structured products, and the GFC, I think, proved an ultimate test bed for many of these products and a lot of them failed frankly to deliver the goods.

So, I am not opposed to structured products. I think in many cases, structured products can be quite useful, particularly products that may have capital protection elements to them. But I think it's very much incumbent on advisors and investors, who are buying these products to really understand what they're buying, and in particular, what are the environments where that type of product might actually breakdown. Because, any structured product is going to work well in certain environments, and it's really not going to work well in other environments.

No one has ever developed a product, and it's not possible to develop a product that will work well in every environment, and I think people need to bear that in mind.

St. Anne: Michael, thanks for your insights today.

Karagianis: Thank you very much

Christine St Anne: There is a lot of volatility in the markets lately with a lot of currencies rising and falling. To give us an outlook for currencies, I'm joined by City Index's Kara Ordway. Kara welcome.

Kara Ordway: Thank you.

St Anne: Kara as a currency strategist, how are you seeing the market volatility?

Ordway: On a day-to-day basis, we're obviously looking into the markets and actively trading in them. So, during our Asian session I must say one of the most popular traded currencies is the Australian dollar. Obviously at the moment that is tended to be a barometer for risk appetite in the market so, it�s seen that the risk currency, so it quite often tracks what the equities markets are doing, if its good feeling in the market we'll see the Australian dollar rise. If we see a bit of poor outlook for the global economy, we'll see the Australian dollar fall. So, it is used as that barometer for risk appetite.

However, going forward in the next couple of months, obviously people are now looking to the RBA to what they'll do next. So, today we had the jobs data release within the Australian economy and that came out better than expected. A lot of people were and having been calling for a rate cut by the RBA for next month, for the November month, so that kind of down-pins some of their thoughts that would happen. So, really we saw some big movements today for the Austrian dollar, and we have seen some big movements over the past couple of weeks where it has been kind of the key focus in taking a front seat in this risk appetite, risk-on and risk-off trading. So, the Australian dollar has been a very active participant in the market for the past couple of weeks.

St Anne: The Australian dollar has reached parity of late after falling recently, much to the disappointment of online shoppers, do you think it's actually going to reach above parity?

Ordway: Yeah. Exactly, hopefully they did their Christmas shopping in the middle of July rather than leading up to Christmas. It has tailed off as risk appetite has tailed off as well. In general it will be driven by the outlook of the markets, so the global feeling for market participants - really the situation for the Australian dollar is largely dependent on what we seen in Europe now. So, if the sovereign debt issue continues as it has been to create bad feeling in the market then we could see a stable parity, even though it jumped up above today or over the past two days risk appetite gained once again in the market. However, unfortunately our domestic currency is largely based on what's going on in Europe at the moment.

St Anne: Kara what is your outlook on the U.S. and its dollar?

Ordway: Unfortunately, what we're seeing as well with the U.S. is similar to what we're seeing in Europe and that's why for quite a while we saw the euro-dollar peg not actually doing very much because we were getting pulled from Europe and pushed from the U.S. where there was trouble from both sides of the pond. So, there is certainly a long way to go for the U.S. as well for the Fed. They have hinted that there might be the possibility of QE3, in that instance that would cause the U.S. dollar to fall.

However in general, because although it's not seen as a traditional safe haven, its the most liquid market of all the currencies that are traded. So, traditionally the most safe haven would be the Swiss or the Yen. There is a lot of manipulation in the market by Central Banks at the moment. The Swiss has been pegged against the Euro and there is constant speculation that Bank of Japan will intervene in the Yen.

So, that has kind of moved the U.S. dollar as people's third choice for a safe haven and that's why we've seen maybe some more dollar strength than we might have done before, just because of that intervention by Central Banks at the moment and the manipulation that we're seeing going on.

So outlook, if QE3 is implemented then certainly we'll see the U.S. dollar go lower, however with all the troubles that we are seeing in Europe at the moment and throughout the global economy, it could quite easily go the other way. So, unfortunately it's so dependent on what we see with Central Banks at the moment.

St Anne: Kara, a lot of attention is now on China and how it's going to manage its growth. Given that it's got a fixed currency, does that make it difficult to manage their local policy?

Ordway: They�re pegging their currencies on their terms. So, they�ll let their currency appreciate on their terms and that's how they have managed to gain some hold in this kind of global turmoil that we've seen over the past year or so. This turmoil has been here for the past year it's going to be here for the next six months, the next year as well. So, my guess is they will continue to adjust the peg, I doubt whether they'll let it flow anytime soon and obviously their concern is over whether demand will continue throughout the global economy for their exports. I mean, I think it will, they have got a lot of local domestic demand holding them as well. In terms of whether it makes it hard for them, I think they are really working to their advantage and what suits them at the moment in terms of the reason why they are pegging their currency.

St Anne: Kara, thanks so much for your insights.

Ordway: Thanks very much.

Vishal Tekchandani: The market has had an amazing rally in the past week. Is it the start of a big bull run or will Europe sovereign debt issues crush sentiment once again? Joining me today at the Fidelity Investment Forum is Paul Taylor.

Paul, the all ords has had its best winning streak since April. What is your outlook for the market over the coming months?

Paul Taylor: In terms of the next few months, I think it's very difficult to work out. I think markets in the short-term, there is fads and fashions over 3-month, 6-month, 9-month, or even a 12-month basis, I think you get fads and fashions. So, fundamentals don't always out over a short-term basis. We think you need to invest at least on a three-year basis. We think fundamentals will out over a three-year basis, so we're always looking at, at least that sort of timeframe. I think, the way we look at the market at the moment is that you are getting really good, great quality stocks at great prices, so plenty of long-term investment opportunities, great long-term investment opportunities, as we are here today.

Tekchandani: How are valuations looking across the market?

Taylor: Market valuations, I think, are actually quite attractive. So the current P/E on the Australian market is about 10 times. So, long-term averages is closer to 15 times. Dividend yield on the Australian market is about 5.9%, so that's really attractive. That's a great � even if the market does nothing, you're picking up pretty much a 6% after-tax return. So, we think, they are really attractive levels. Over the long-term, even if you try to � well one of the other measures we look at is what's called the Graham-Dodd P/E ratio, so that looks at it through the cycle type valuation, and even at that level the Australian market is looking really, really attractive, so that means good long-term investment opportunities.

Tekchandani: One of the key themes in your presentation today was the importance of dividends. Why are dividends important and what you will say you're seeing across the market?

Taylor: We think dividends are actually very important. Studies show that over the long-term basically equity investors get paid in the dividends they receive, and the growth in those dividends, which makes sense because that's the economic rent as an equity investor that you derive from that investment. So, dividends are basically how equity investors get paid and right at the moment, as an equity investor, we are getting paid very well. So the dividend yield on the Australian market is almost 6%, 5.9%, and that's not totally, but it's close to a fully franked yield as well. So, it's close to an after-tax return of 6%, which is a very attractive level and even if you look deeper in the market, you can get much better dividend yields that 6%.

Tekchandani: How sustainable are the yields given recent downgrades to global growth forecasts?

Taylor: Yeah, I think, that is one of the key questions, and we actually think dividend yields are sustainable, so to answer that question, I think, you need to look at two factors; one is the balance sheet of Australian corporate, and the next � and the second one is the cash flows, the free cash flows of Australian corporates. On the balance sheet argument, actually Australian corporate balance sheets are in fantastic shape. So, one of the measures we look at is the gearing ratio, so basically how much debt do they have. Gearing ratios as defined is net debt over net debt plus equity. Long-term it has been averaging in Australia about 32%, while at the movement we are closer to 20%. So, Australian corporates have very strong balance sheets. They don�t have a lot of debt. They are in a really good position. Their balance sheets got repaired as we went through the GFC as they raised equity. So, balance sheet is really strong. The second question is free cash flow, and once again as we stand here today, free cash flow even after dividends is pretty much at highs. So, we've got the cash flow to payout the dividends, and we've got really strong balance sheet from the corporates. So, we think dividends are very sustainable.

Tekchandani: You have listed Rio Tinto and Wesfarmers as two of your top holdings. What do you like about those companies in particular?

Taylor: Well, I think, first of all, both are really good quality companies; they have got strong balance sheets, they have got strong management teams, but if I dig into each individual one � Rio Tinto, for example, very attractively valued, quite strong growth prospects, is probably the standout in the resources sector because of its valuation, but you are picking up a quality operator. Rio Tinto own their Tier 1 assets. They own the low cost long life mines, and that�s what you want to own through the cycle, so very attractively valued great operator.

Wesfarmers; similarly great management team, strong balance sheet, good operators, and a great business. One of the interesting things about Wesfarmers is because obviously retail has been having a pretty tough time, Wesfarmers have got a little bit more of their growth in their own hands. So, Wesfarmers through owning Coles, that business is actually turning around, and they're doing very well. All the signpost show that Coles is actually doing very well and returning to a much better position. Coles has always been a great asset, maybe just hasn�t been quite managed as it should be, and they've got a great footprint, a great asset, a great brand, and under the Wesfarmers' ownership they're getting much better returns. So, we are seeing the return on equity, return on invested capital significantly improved in Coles, and we're actually going to see much better growth in Coles going forward, because of actually what Wesfarmers are doing, they are less reliant on market conditions. So, good growth, good company, good dividend yield, 5% dividend yield on Wesfarmers, and a very good turnaround story in Coles.

Tekchandani: Paul, thank you very much for joining me today.

Taylor: You�re welcome. Good to see you.

Christine St Anne: Alternative investments came under a bit of scrutiny after the global financial crisis. A recent report from Morningstar looks at these investments, and whether they suited to the retail investor. Today I am joined by Julian Robertson, who will give us further insight into the report. Julian, welcome.

Julian Robertson: Thanks Christine.

St Anne: Julian, To begin with what exactly are alternative investments?

Robertson: Alternative investments don't come with a predefined definition. They are very wide in their scope and there are different things you can look at, in order to assess whether or not you might believe it is an alternative investment. So that would typically to do with the strategy, the types of underlying instruments, and typically using derivatives and options. Often it�ll be geared, sometimes it'll be illiquid. But also the managers of these types of strategies will be looking to deliver absolute returns that is returns -- positive returns in both falling and rising markets. So, returns would be uncorrelated to the broader market or equity market moves. They also typically have quite high performance fees or different fee structures to traditional funds. So, you could look at it in those three terms, in terms of the underlying instruments, gearing, performance fees and the actual performance characteristics that they�re trying to deliver.

St Anne: There have been some notable blowups associated with these type of strategies, are they actually suited to retail investors?

Robertson: Again, they do attract a lot of attention, either for very negative reasons or sometimes very positive reasons. Some funds can perform extremely well when the circumstances or the markets are falling significantly, but then they may not perform well for long period of time. Likewise, if there is a scandal, such as the Bernie Madoff situation, indeed there are other scandals such as Amaranth and Long-Term Capital Management going back to the late 90's. So there are a lot of concerns that people may have, but there are also lot of attractions. I think it's first very important to analize and understand each individual strategy, because they are all very different. They're all run with a different risk profile using different instruments and will often deliver different outcomes. So, you do need to be very careful as to the exact underlying profile and risk profile of the fund.

St Anne: Julian, what about the issues around lack of transparency and the liquidity associated with these types of investments?

Robertson: Again, it comes down understanding and making sure that your expectations of the fund are not misaligned in the medium to long-term as to what you expect out of the fund. Often liquidity can become an issue exactly when you want liquidity, and that's something we saw throughout the global financial crisis. And so, lot of offerings now are more liquid shall we say. All investors need to be aware that where there are liquidity restrictions, that those are acceptable to them and so some of them will not allow you to redeem for a week, a month, and sometimes three months. So whether it's acceptable or not, it depends on the circumstances and the reason for investing.

St Anne: Are there any other risks that investors need to look out for?

Robertson: Well, partly what we mentioned before in terms of the transparency and some liquidity issues - areas that the regulators are actually looking at, in terms of improving investor education. But also there's the fee issue, so a lot of the returns can be eroded by fees. For example, in fund of hedge funds, you have the management fee, you have the performance fee and then you have the underlying fees of the managers, which will also include the performance fee. So in some circumstances, you can lose 30%, 40% of your gross return just by fees.

Plus as lot of them use aggressive trading techniques in investing derivatives, the returns are subject to penal tax rates. So after tax returns, they are also likely to be significantly less than the headline rate. So those are some of the risks that retail investors should be aware of as well as the fact that despite it saying an absolute return strategy, they can lose money in short periods of time and they shouldn't be seen as always delivering positive returns. There are periods when different strategies will underperform or fall in value over periods of time, or known as draw downs, and they will happen depending on the strategy of the underlying manager.

St Anne: Julian, what type of role do alternative investments play in a portfolio?

Robertson: Typically, people invest in them to diversify away from the traditional sources of return being equities and bonds for example. Because as I mentioned earlier, they are trying to achieve uncorrelated returns, so when the market is falling say, they provide better or hold up better. So in that essence, it's regarding diversification in terms of the source of returns and that's why people would invest in them.

St Anne: Julian, what are the things that investors need to look for in an investment manager who specializes in these type of strategies?

Robertson: Well, I think it just going back to the � from our points of view - the traditional sort of P's as it were. So, the people, the process, the pricing and the parents and also the longer term performance. So we would analyze all of those, and there are additional things you'd have to be aware of as well, in terms of risk management particularly important especially, things like counterparty risk and also the risk embedded within the portfolio, how they actually manage those risks given the gearing and the derivative type instruments that they're using. So, traditionally you can analyze them but also just go the extra mile in terms of how they manage risk, which should be a key point to be on top of.

St Anne: Julian, thanks so much for your time today.

Robertson: Thanks Christine. No problem.

Christine St. Anne: Morningstar's John Valtwies recently went on a study tour to meet a number of investment managers. He joined us today to discuss what he found on that trip.

John, welcome.

John Valtwies: Thanks, Christine.

St. Anne: John, so what countries did you visit?

Valtwies: Yes, we spent two weeks on the road and we started off in Asia, so we went to Singapore and Hong Kong, and then we spent a week in Europe, so predominantly in London.

St. Anne: What kind of investment managers did you meet up with?

Valtwies: Yes, we met a mix of investment managers. So we met both fixed income and global equity managers. Within global equities that included also regional equity strategists as well.

St. Anne: John, so what about the managers based in Europe, how are they finding the current market volatility?

Valtwies: Yeah, it's really, really interesting, everyone is negative. The bond guys are negative, but that's a given, bond guys are always negative, but they are horribly negative, I mean, even for bond guys. The situation isn�t pretty, doesn't look positive at all, and yeah, certainly there wasn't � there weren�t too many positives to come out of it overall. The equity guys were a bit more optimistic, but you kind of expect that from the equity guys, but overall certainly the situation is quite grim, but I think, people are beating it up and it's turning into something more than the fundamental suggests, which is what a lot of people are saying.

St. Anne: For the Asian based investment managers, do they have a slightly optimistic view?

Valtwies: Yeah, I think, it's interesting given the location of Asia and the proximity to China, I think people's sentiment is that, yeah, things are pretty bad in Europe, but they don't see it as being a big contagion in affecting Asia overall, so their expectation was what, or we drew from what they were saying, was that Asia will slow but they should be right overall.

St. Anne: John, do Australian investors have access to these investment managers?

Valtwies: Yeah, absolutely. So whenever we go and do a trip, we're not doing a trip purely just to go and see what�s out there, we are meeting those managers that are available to Australian investors. So for instance we went and saw Aberdeen. Aberdeen has a number of different strategies, be it fixed income and global equity, as well as regional portfolios. So, we went and saw their team. So that�s an example of the type of manager that we saw in the trip.

St. Anne: Any investment managers you met up with, are they looking at entering the Australian market?

Valtwies: Well, I think investors can always expect product manufacturers to be bringing down the latest and greatest products to Australia. Certainly, there seems to be a lot of interest in Europe for emerging market debt strategies and so on, so I wouldn�t be surprised to see some offerings along those lines.

St. Anne: John, you mentioned emerging market debt, is that viable given what's been happening with the debt situation around the world?

Valtwies: Well again that was one of the most interesting themes to come out of the discussions in Europe. So, obviously there has been a big sell-off in both equities and debt, and obviously people are jumping into the safe havens like government bonds, and one of the interesting themes in the most recent sell-off was the attraction of emerging market debt now, relative to let's say 5 or 10 years ago. The view is that emerging markets are almost a safe haven relative to the developed world today purely because of what they have gone through in the last 10, 20 years in terms of they've suffered their own crisis and so their balance sheets in some cases are much stronger than the developed world. So, their debt levels are much lower so, their gearing is overall lower, and their economies are in just much stronger shape.

St. Anne: John, thanks for sharing your findings with us today.

Valtwies: Thank you, Christine.

Christine St. Anne: The volatile markets continue to worry investors. There are some strategies that investors can use to protect a portfolio. Today I am joined by Westpac's David Simon who talks to us about keeping on the upside of down markets. David welcome.

David Simon: Thank you.

St. Anne: David, these markets are spooking investors. Can they still invest in these trying times?

Simon: Yeah. Look, the market does offer opportunities for long-term investors even though quality assets still fluctuate in the short to medium term. Over the long-term, tradition has proved that long-term investors still do well in even these types of markets that are currently in the current investment cycle.

St. Anne: So David, could you give us an example of some of those opportunities you mentioned?

Simon: Well, the first option out of three is being contrarian, so ensuring that investors are actually buying what others are selling. The second is dollar cost averaging and while the investing investors having to invest a single lump sum at a single point in time, investors have the opportunity to invest smaller amounts over a regular period. That ensures that they're actually investing at an average entry point and avoiding to invest at the peak of the market. And the third is being really well diversified, so not having all your eggs in one basket. Sure, it's an old cliche, but it certainly works and this current market is actually proof to say that by avoiding having concentrated positions in any particular security or asset, ensures that other asset classes maybe performing while others are not.

St. Anne: Are there any strategies to protect capital?

Simon: Look, some of the strategies that people can use certainly in the current investment cycle is effectively to be contrarian. So effectively buy when others are selling. The second is being diversified. So rather than being concentrated and having assets all in one particular vehicle, one particular security it's always wise to diversify, not just against different asset classes, but indeed sectors within the asset classes as well.

St. Anne: David, any other capital protection strategies that may go beyond investments?

Simon: Yeah, so there's a couple more protection strategies that are not particularly the traditional ones, but = particular lessons that we've learned from the global financial crisis. The first lesson is a way to protect capital; understand what you're investing in. So be vary of structured products, but most importantly be very aware of their label. So traditionally a balanced investor is the default option for your employer superannuation fund, but typically people don't understand what the balanced label means and whether it's actually relevant to their own investment ideology and risk the personality. However, when you look at some providers that provide a balanced growth fund, they could actually have 50% of their monies exposed into the share market, where another provider of a balanced growth fund could actually have 75% of their money in the share market. So people need to be very aware of what they're investing in and not just rely on the label and interpretation of what balanced means for instance. That is a wonderful way to protect capital.

The second is particularly for people that on a superannuation based pension or indeed drawing an income from their investment. One way to protect capital is ensuring that people are not put in a position to unnecessarily sell their shares just to fund their income strength. So by having at least three years worth of cash in their portfolio that is a suitable provision to generate the necessary cash flow that allows the growth assets to fluctuate in the volatile times and ensure investors aren't in a position where they're selling at a low point.

St. Anne: David, you mentioned diversification. Are there any asset classes that perform well in down markets?

Simon: Yeah, absolutely. There are some assets that are not particularly correlated to equity markets, which means the equity markets don�t need to go up for these assets to perform. Some assets include property, cash, fixed income and other synthetic assets such as derivatives or currency or exchange traded funds. These can actually still rise or increase in value when equity markets are falling.

St. Anne: David, is it wise for investors to re-jig their portfolio in these volatile markets?

Simon: Look, we think one of the major lessons from the global financial crisis is that holding a long-term investment and just putting in a draw and leaving it for 20 years may not now be the right option. We think it's important that investors still maintain a long-term view and a long-term forecast. However, we do believe that investors should monitor and maintain their view on their investments to ensure that they remain in quality. So we don't recommend wholesale changes, but we do recommend the customers and clients monitor their investments very closely. However, markets like these all do offer the opportunity for people to continue to rebalanced. So you find that when customers or clients have their assets spread across different asset classes such as cash, fixed income, shares and property and particularly those asset classes that are not correlated to equity markets, they tend to, the equity markets tend to fall disproportionately to the other assets such as cash and fixed interest, by default and rebalancing a client's portfolio back to its original risk profile, effectively means that the clients are topping up their equities at a lower price and reducing their cash in fixed income when they are at a higher yield.

St. Anne: David, thanks so much for your time today.

Simon: Thank you.

Christine Benz: I'm Christine Benz for Morningstar.com.

I recently interviewed Christopher Philips, who is a senior investment analyst in Vanguard's Investment Strategy Group. One of the topics we discussed was whether investors are better off investing in a broadly diversified emerging-markets fund or opting for single-country emerging-markets funds.

So, Chris, you have recently done some very timely research into a category of investments that's been very hot over the past several years: emerging markets. There has been a lot of interest in investing in specific emerging markets. You have done some research that looks at the benefits and the drawbacks of doing that. Let's take a look at some of your findings.

Christopher Philips: Absolutely. So, the big thing we hear now is that, "I want to focus on China as an investment because their economy is growing so strongly. We know that they hold a bunch of U.S. debt, and there is this whole trade issue between the U.S. and China. So, I want to really focus my investment on emerging markets, but I really want to concentrate on China as a core investment."

Benz: ... Or India or whatever it might be ...

Philips: Or India, or really any emerging market out there. Latin America is another great example because of a potential relationship to commodities.

So, what we attempted to do was really show that focusing on any specific country comes with a lot more risk than benefit, and it's a little bit more synonymous with investing in a single stock. So, a single stock, you certainly have return expectations, but you have potential wild swings in volatility which can be very detrimental to the risk-adjusted returns that you get in a portfolio.

So, we went through and we did some analysis around the risk and return trade-offs, the linkages between economic growth and market returns, the idea that I can play the dollar in some type of currency bet. So, we looked at a bunch of different views for evaluating the role of single countries.

Benz: So I would like to highlight that research that you and the team here have done on whether market performance follows from economic growth. I think it's a little bit counterintuitive, but what you found is that there isn't a particularly close correlation?

Philips: Yes, and I think the counterintuitive nature is the best way to sum it up. When you think of the rationale for investing in emerging markets, it's that I want to be able to capture that long-term expected high economic output, the high economic growth...

Benz: ... Of a China or India or whatever it might be.

Philips: Exactly, of any of the high-growth countries out there. And when you think very broadly, it makes perfect sense that as an economy performs, corporate profits will be linked to that economy, and therefore the stock market should ultimately be linked to that economy.

Well, with emerging markets, and actually with developed markets as well, what we've seen is that it tends to actually breakdown in terms of correlation, so that you have, say, the U.S. that has economic performance that is in line with that of the U.K., and yet market performance has been vastly different. So, you get this dynamic where, by investing in a China that you expect 10% growth, you don't actually get the benefits from that because you don't get paid for expectations that come true, and it is the same with earnings. So, if I invest in a company that has earnings expectations of 10% growth, and they achieve that, well, that expectation is already baked into the prices. So, you're not being paid for stuff that's already being baked into prices. You need to be able to predict outperformance, outsized growth going forward. And if something is already expected to grow 10%, then you have to expect it to grow 15% or 20%, and that's just extremely difficult to do.

Benz: Right. In terms of something that actually does tend to predict market performance, valuation, you did not find that even by focusing on those countries that appear to be trading at very low valuations--so if someone is conscious of prices and opts to get in, then--you didn't find that that was necessarily predictive of good market performance in single emerging markets either?

Philips: Yep, and that's actually one of the most counterintuitive aspects here, because we all hear that valuations are the single most important metric for future performance, particularly in equities. Then when you get to broad market equities, it's even more important. The challenge with emerging-market countries is that there are so much country-specific risk, and in the analysis, we actually used an example of, say, Venezuela, where Venezuela, before the market was shutout to private investors, had a P/E ratio of around six to eight times earnings, broad earnings across all Venezuelan companies.

So, if you saw that and relative to its history and relative to global markets, Venezuela would have looked like a tremendously attractive investment; however, if you invested and then all of a sudden you got shutout, you would have had a negative 100% return. So, the idiosyncratic or country-specific risk completely overwhelms valuations, especially in emerging markets.

Benz: So, the broad takeaway from all this research, if you can't really trust low valuations to guide you to the right markets or you can't trust growth prospects to guide you to the right markets, it sounds like you would argue that you are better off buying a broad basket of emerging markets rather than trying to bet on single countries.

Philips: Absolutely, and just using the valuations example--while they don't work in individual specific countries, they actually do work when you start aggregating them up into the broad emerging-market space. So, looking at aggregate valuation, we can say, effectively, that if emerging markets have a reasonable valuation, then we should expect some returns going forward. So, we think a lot of this does work in the broad space, just not in very specific targeted spaces.

Benz: Okay. Thank you, Chris. This is very useful research, and I think really timely.

Philips: Very welcome.

Holly Cook: For Morningstar, I'm Holly Cook. I'm here today with Allan Conway, he is head of global emerging market equities at Schroders. Allan, thanks very much for joining me.

Allan Conway: It's a pleasure.

Cook: So the last time we talked was a year ago, at that time we were talking about the outlook for emerging markets. You described, at that time, developed-world equity markets as being submerging markets and questioned why investors would want to invest there when they could be putting their money into emerging markets. Has the fundamental view towards the emerging markets changed? Because they've really had rather a torrid year.

Conway: Well, actually the idea that the developed markets were submerging economies has proven to be absolutely right, and particularly in Europe. I think the thing that we got wrong was underestimating the ability of politicians to mess things up, and you're seeing that really in Europe. And the frustrating thing from an emerging perspective is that there has been a sentiment overflow into emerging. All of the things we are worried about today in the global economy emanate from those developed submerging economies, as I put it. Emerging actually themselves don't suffer from those problems, but there has been a significant sentiment impact on them.

Cook: At the time, we were talking about overheating in the emerging markets and I had asked you whether you thought there was perhaps a bubble coming up. And at that time you said that we were a long way off overheating levels, but that perhaps 2012 could be the year for a bubble. Presumably that view has been postponed?

Conway: Definitely. I think overheating is now off the agenda. We are not worried about inflation anymore. Indeed, the concerns these days are things like, �would China go for a hard landing?� and we don�t think so. So we've really moved away from that, but, yes, I think the impact on the global economy, particularly of what's been going on in Europe and weak growth in the U.S., means that we are a long way from having to worry about bubbles at the moment.

Cook: So what would you say to a potential investor who says, well, emerging markets equities haven�t really worked for me over the past year, certainly developed world markets haven't exactly either but at least I know where I stand there and the current valuations are so cheap that perhaps those potential returns have more promise in the developed world. What would be your response?

Conway: I think that�s absolutely incorrect. Firstly, let's remember that emerging stock markets have absolutely decoupled in the same way as the emerging economies have. Over the last 10 years or so emerging is up some 480%. Most of the developed markets over that period are up 30% or 40%.

So you've had huge decoupling. Going forward, we expect that to continue. This year emerging, despite having very good economic fundamentals, have underperformed because investors have generally got nervous, they have taken money off the table, and particularly, I think, retail investors have viewed emerging as being higher risk.

Now, actually that's a misconception. Emerging markets today are the low risk investment. Whether you're looking at any of the macroeconomic indicators, whether you are looking at levels of government debt, emerging are low, declining; developed are high and increasing. Fiscal situation in emerging is much better, current account much better, levels of reserves--let's remember the sight after the last EU Summit of Europeans dashing off to China to see if they can get bailout money, reserves are very high in emerging.

Today the risks are all in the developed world: not only do you have low growth, but that low growth is going to continue as these economies are served with massive debt. You could have fiscal austerity for the foreseeable future, low growth; emerging--strong growth, strong economic fundamentals, will feed through into earnings and returns. So today I think investors are faced with a choice: would you go for strong economies, strong fundamentals with strong growth;  or do you go to these tired, old developed economies?

By the way emerging evaluations are extremely attractive. We are down at around 8.5 times and if you look historically when the markets have been this cheap over the following 9 to 12 months you've had anything from a 60% to 75% return. We think that�s perfectly possibly providing you get a general improvement in sentiment and that�s all its going to take.

Cook: So I know that your team operates a strategy where you try to get approximately 50% of your returns from stock selection and 50% from country selection. Has the so called Arab Spring and some of the developments there, have they opened up more opportunities? Does a post-Gaddafi Libya, for example, present an interesting opportunity for you?

Conway: Well we must distinguish between emerging and frontier markets and of course Libya, for example, isn�t even a frontier market let alone an emerging. The key market in the region of course from an emerging perspective is Egypt. And the Egyptian situation is of course extremely volatile, there is a lot of uncertainty. Valuations are attractive and overall we are quite positive on Egypt. But I think it's one you have to be watching very, very closely because it really is dependent on the final political outcome and we think that�s going to work out, but it needs careful monitoring.

The other countries: by and large the Gulf countries are all within the frontier index rather than the emerging index. There again we are pretty positive valuations, have come down. But it does require very close monitoring because the general political environment, although it�s improving there is a high degree of uncertainty.

Cook: So, do the events that we've been talking about--both in the developed world and in the emerging and frontier markets--how would I perhaps see those manifested in your portfolio changes over the last 12 months?

Conway: For most of this year we've been running a pretty cautious portfolio. So, for example, we are running a beta below 1, around 0.96, and we�ve been running quite a bit of cash. As a result, our flagship Global Emerging Fund has outperformed so far this year by about 330 basis points. It�s been a good year. Now interestingly, what we are looking at in the short term is probably putting that cash in, because it looks as though, finally, the Germans, ECB, they get it; and it look as though we won�t have the solutions to the European problem but we at least have a plan in place that looks as though it's got the ability to make progress and as sentiment improves we think emerging markets will be one of the key beneficiaries. They�ve sold off more than you would have expected this year, therefore when there is an improvement in sentiment, we expect them to bounce back more significantly and we've already started to see that at the end of last week.

Cook: So how does perhaps your short-term outlook for emerging markets, say over the following 12 months, how does that differ perhaps from your longer term view?

Conway: I think we�ve got to get used to a global economy that�s going to look pretty weak, very anaemic growth, for the next few years actually. I think Europe, even if it comes up with some form of solution, we are going to have years of trying to resolve these high government debt situations. Obviously, fiscal austerity is going to be order of the day. That�s also going to be true in the States. U.S. growth is looking better than Europe, but it still looks very anaemic. We should have seen a much stronger picture in the U.S. than we have done, given the depth of the recession.

It�s largely been a jobless recovery in the U.S. Japan, of course, weak growth too. The developed world is going for foreseeable future--for the next three to five years minimum--to have very weak and anaemic growth while it tackles debt problems. Emerging will look very strong by contrast, but I think one�s going to have to focus on things like domestic demand in emerging and one�s going to have to focus on things like yield, yield is going to become much more important in the world of slow growth.

Cook: Allan, thanks very much for joining me. I look forward to seeing you again in a year�s time and hopefully we�ll have something slightly more positive to look forward to.

Conway: I hope so. Thanks.

Cook: Thanks again. For Morningstar I�m Holly Cook. Thanks for watching.

transcript

transcript

transcript