Christine St Anne: Gearing strategies certainly came under pressure following the global financial crisis. However, if sensibly implemented, these strategies can boost a person’s retirement savings. To talk about some of the sensible approaches, I am joined by BT's Cathy Kovacs. Cathy, welcome.

Cathy Kovacs: Thank you.

St Anne: Cathy, what makes a sensible gearing strategy?

Kovacs: Well, really depends on the individual, and it’s a pretty broad based word or term, gearing strategy. But, generally speaking, I think a strategy that allows somebody a comfortable level of borrowing. When I mean comfortable, it’s commensurate with their risk appetite, commensurate with their ability to repay their debt, if you are thinking about the loan component. The other side of that is, what are you borrowing to invest? So, aligning your gearing strategy with your long-term investing needs, diversified portfolio that helps you make – rates your retirement savings.

St Anne: On the point of a diversified portfolio, can some of these gearing strategies apply to more speculative stocks?

Kovacs: Yes, it can. But again, I think if you take the gearing away from the investment, we all know that we don’t put all our eggs in one basket. So what you could do is, alongside a diversified investment strategy, you could add a degree of risk through a more speculative stock. But keep in mind that when you are adding leverage, you’re already adding a degree of risk. The other thing about some speculative stocks is that, they don’t offer any dividends potentially, and so if people are looking at dividend income, they need to be aware that they won’t get that from a more speculative stock.

St Anne: In terms of dividend income, is it best for investors to reinvest their dividends when it comes to gearing strategies. What is the best approach?

Kovacs: It depends on the individual and where people are in their lifestyle. So a pre-retiree or retiree, in fact, might want the dividend income as part of their lifestyle needs. Someone else may be in the earlier stages of their investing career and might elect to reinvest those dividends to get the compounding benefits. Either way, whether you’re reinvesting the dividends or you’re taking them, if the stock pays a franking credit, you’re still getting the benefit of the franking credits. But I would add to that that people shouldn’t be relying on the dividends to make their interest payments, because in the event that the stock’s stops paying a dividend, you still need to be able to pay the interest on your loan.

St Anne: Cathy, what about installment warrants? Are they still popular with investors?

Kovacs: So to answer that question you really have to think about what is the custom value proposition of an installment warrant. So installment warrants are method of borrowing to invest or gearing inside a superannuation fund. So if you think about the growth in self-managed superannuation and the amount of equities that people are holding inside the self-managed super, the amount of cash that they are holding, the fact that people are going to be underfunded in retirement, all of those things say to me that a degree of borrowing in super is going to help people get to their retirement needs, and an installment warrant is just a way of doing that.

St Anne: How do installment warrants compare with other gearing strategies, such as margin loans?

Kovacs: In installment warrant, if you like, is a packaged solution. So it is more definitive. We tell you which stocks we will offer installment warrant over, so it's not a broad universe. The other thing is that, by definition, an installment warrant is a limited recourse loan. So in the case of a margin loan, you could have a margin call event. So if the value for your equity folds, you need to top up your capital,. You don't have that in the limited recourse loan. So in the even that your value of investment folds, you just don't have to make the second payment on installment warrant, or you could sell that installment warrant on the ASX at any time. So it's very liquid.

The other thing is, which I like to think about when I am thinking about gearing in super, is that installment warrants are really easy way to get exposure and geared exposure inside your superannuation fund. So if I decided that I would like to get geared exposure to the ASX 200 tomorrow, I can do that by calling my stock broker or going to the online broker with the ASX code that allowed me buy an installment warrant over an ASX 200 ETF, for example. So it's a really simple way to get geared exposure in your side of super fund.

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

Kovacs: Thank you.

Christine St Anne: MFS Investment Management recently won the Morningstar's Fund Manager of the Year Award in global equities. It's also an investment firm that has performed during flat markets. To give us a little insight into the investment processes, I’m joined by Marian Poirier. Marian, welcome.

Marian Poirier: Thank you.

St Anne: Marian, what sort of companies does MFS like to invest in?

Poirier: The focus MFS has really is investing in quality companies, companies that quite often have been around for a long time, and we aim to make sure that they are around for quite a few years going forward, companies like a lot of leading global brands. Some of the luxury goods names like LVMH Louis Vuitton, just choosing them as an example. They are the sort of the company doesn't have to discount the prices. One of the other things with LVMH that's key is they are now starting to derive quite a significant portion of their revenue from the emerging markets. So, thinking about their product positioning going forward.

One of the other companies which was one of our large contributors last year to our significant outperformance was Heineken, another global brand and another company that’s deriving quite a bit of the revenue from emerging brands.

But it's got to be companies that are able to grow their earnings sustainably going forward and so that’s really the sort of companies that look forward to invest in.

St Anne: Our recent research report had noted that you tend to sing during benign market, can you give us some little insight into the investment processes that allow you to do that?

Poirier: Rest assured, I’m not going to start singing. We've done a lot of research actually in terms of different types of markets and how we perform accordingly. And we've done some research recently in terms of looking at the history of our global equity capabilities. So going back as far as 1992 and looking at – dividing it up into quarters, looking at periods where the market has outperformed by more than 5 per cent and markets where the time periods – apologies when the market has underperformed by more than 5 per cent and then in between, and in all quarters, all performance types of period, we outperformed. Probably the portion in the middle so between minus 5 and plus 5 is where we outperformed the most regularly.

So we delivered the most quarters of outperformance, but the magnitude of that outperformance tends to be more in the markets that you referred to, Christine, sort of the words falling quite a bit. And I think that that is really dying to our focus on quality.

Talking to a lot of our analysts internally, one of the things that they say a lot is when – and I have seen this happen. When they are pitching ideas to the investment team, the focus in that discussion is not about the potential upside and how much more this company can deliver and how that will translate into performance, 95 per cent of the discussion is on the buying side.

How can this go wrong? How can your thesis fall apart? What happens if currencies fluctuate? What happens if commodity prices fluctuate? There is no predicting where they are going to go. There is a lot of stress testing. So, we invest in those quality companies that I mentioned that are going to outperform, no matter what the market environment is like, and again it's coming back to quality. If you are investing in a quality company, quite often they will outperform in both periods.

St Anne: Marian, also, your portfolio managers have a personal stake in the business. How important is that to ensuring performance?

Poirier: I think its key. You know, if you are in charge of managing so much of the money for clients, you need to – I know the expression overused as it is, having skin in the game – having your own personal money invested alongside that of your clients, I think its key to delivering performance.

St Anne: David Mannheim is a very well-respected portfolio manager, and of course, one of your co-lead managers, what about key person risk? How do you overcome that?

Poirier: Even going back before that, I actually think one of the ways we overcome key person risk, is we hire the right people to begin with. And I will give you a couple of examples of the way it works. There is a very long and lengthy process, number of interviews that people go through before they get hired by the firm, but right from the onset it is all about being part of a team. There are no stars, and I know that you mentioned Dave Mannheim, and he is co-PM with Roger Morley. But you would never hear either of them talk about portfolio without talking about the platform and the team of people behind them. One of our co-head of Asian Equity Research, Simon Gresham, who is based here in Sydney, and he has, sort of, coined the phrase or he has used it to me quite a few times. He said that every one’s voice is heard at this firm and he likes that.

An another example is Roger Morley, when he was interviewing, he gave me few insights and he said quite often it's 30, 40 interviews before he joined the firm, and he said that one day after having met with maybe 10, 15 people from the investment team, senior management, what he loved and one of the reasons that he ended up accepting the role was because he couldn’t work out who was important, and that I think says volumes for the way that we manage the firm.

St Anne: Marian, that’s a positive note to end up on. Thank you so much for your time.

Poirier: It's nice to chat.

Christine St Anne: Morningstar recently released its global equities wrap-up, and found a number of managers that outperformed. To give us a little insight, I’m joined by Morningstar’s Kathryn Young. Kathryn, welcome.

Kathryn Young: Thanks so much for having me, Christine.

St Anne: Kathryn, so who were the top performing managers and what sort of attributes did they have?

Young: Well, we noticed a few trends that really drove performance over 2012 in global equities, and I think investors were familiar with a lot of those. So, one of those is that growth outperformed value on average. So, strategies we cover with a growth bias tended to do better than a value bias. And one of the big reasons for that is that many of those, sort of, ‘expensive defensives’ that people have heard a lot about, and these are the firms with large consumer brands, global consumer brands that people recognize. Those tended to do very well.

And a lot of people, lot of investors say that it’s because the market was putting a premium on safety and a little bit of yield in this environment. So, the managers that we cover that tend to have a quality growth strategy did very well. And among those are MFS Global Equity, Magellan Global, and Platinum International brands.

But that's not the only thing that drove performance. Another big driver was that financials was the best performing sector over the year and that really came on the back of the ECB’s comments that they would do whatever it takes to save the European Union. So, financials did really well and those strategies that were heavily invested in financials also did well. So, some of those are PM Capital Absolute Performance, that was the best performer by far, and also Templeton Global Trust that had quite a bit of financials and did as well.

St Anne: So what are the implications for investors from all of these?

Young: Well, it's really interesting to talk about these things. All right. It’s interesting to talk about what drove performance and who were the top performers, but I think the most important thing for investors to get out of that is what it reminds you about investing in general and investing in managed funds, in general. And that is that investors should remain focused on the long term. So, these things that I just talked about expensive defensives, growth outperforming value, those are short-term things. Right that happened over one year.

But we really think that that's not – what happened last year is no guarantee or even real indicator about what’s going to happen over the coming year or the coming five years. And one good way to explain that is that growth and value have really exchanged leadership a lot.

So, over the past 10 years, they've gone back and forth. Value actually outperformed growth from the early 2000s through about 2008. And so they have exchanged leadership, but they have ended up roughly about the same place in terms of cumulative returns over that period.

So what's important to remember is stay focused on the long term, maintain adequate diversification across tiles, and you should be fine.

St Anne: The Australian market has been very popular in terms of income. Do global equities offer that same level of income?

Young: Well, it's a good question. Obviously, income is very important to a lot of investors right now. In Australia, we looked at that for our global sector wrap up, and we found that really Australian strategies, Australian-focused equity strategies, do offer more income than their global counterparts, and that probably makes sense to a lot of Australian investors.

Telstra, the big banks, they offer consistent and relatively high dividends. So, it's a problem because those investors, retirees or other investors who were very dependent on the income generated by their portfolio, they still need to maintain adequate asset class diversification, even though they have a focus on income.

So, it gets to be a little bit tricky, and we think that people who are focused on income they do have a good reason to have more of a bias towards Australian equities in their portfolio. But part of the good news is that product providers, fund managers are realizing that there is this void in the market, and so there have been some products coming out. But still early days for those, so it’s a little bit tough to say how well they can really meet investor needs and we are keeping eye on that.

St Anne: Kathryn, thank you so much for your time.

Young: Absolutely happy to help.

Christine St. Anne: The focus for many retirees is income and yet many of these retirees remain focused in a conservative portfolio. Today, I'm joined by Legg Mason's Reece Birtles to talk about rethinking your income solutions. Reece, welcome. Reece Birtles: Thank you.

St. Anne: Reece, one of the findings from your survey is that many investors expect an 8 per cent return. Is that a realistic objective?

Birtles: Yeah, it's going to be very difficult for investors to achieve 8 per cent returns going forward. When you look at fixed interest markets with the strength in the government bond yield at about 3.4 per cent, if you look at term deposits with best rates around 4.2 per cent now, and even equity income portfolios with a benefit of franking credits for retirees achieving around 7.5 per cent return. It's going to be very hard to go to blended portfolio with an 8 per cent return.

St. Anne: Another key finding is that investors are concerned about inflation, but remain focused on income. What about the role of growth in a portfolio?

Birtles: Inflation is very important to retirees. With a 20 year life expectancy, 2.5 per cent inflation is going to have a significant impact on purchasing power over time. So to achieve growth in an income stream, greater than the inflation rate requires investing in either real assets like infrastructure, utilities, or property or in equity income type strategies, which have the benefit of profits growing over time and growing the dividend streams.

St. Anne: Reece, term deposits remained very popular with many retirees. What about the effectiveness of a conservative portfolio to addressing their income concerns?

Birtles: When you look at the needs in retirement, it's about a stable and growing income. The interesting thing about term deposits is whilst that capital might be stable the income is actually quite variable with the interest rate cycle. So, for example term deposits have gone from yielding 6.2 per cent to about 4.2 per cent today over the last two years, which actually represents a 30 per cent decline in retirement income if you are invested in term deposits.

St. Anne: With the need to increase growth assets what sort of companies should investors look for in order to achieve their income goals?

Birtles: We think equity income strategy is very different in terms of how they should be designed than your typical funds that you've seen to-date. Being benchmark away it doesn't make any sense in retirement. You don't want significant concentrations in one company because if something was to occur to it, it could have a significant impact on your retirement income.

We also think you should be invested in high-quality companies that have less variable earnings. So high-quality companies are going to be less susceptible to shocks from competitors or the changes in technology. We think you need to look quite broadly, it's not just about the top 20 companies, you need to get strong diversification in the income stream from dividends.

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

Birtles: Thank you.

Christine St Anne: Perennial Investment Partners recently won the Morningstar Fund Manager of the Year in the fixed income category. Today I'm joined by Noel Murphy to talk about the opportunities in the fixed income market. Noel, welcome.

Noel Murphy: Thank you.

St Anne: Noel, we're now in a low yield environment. Is there still value to be found in fixed income?

Murphy: Well, I think they can to a limited extent, but we have to be realistic. Bond yields are lot lower now than they were, say, 10 or 20 years ago. So, I think, our view is that largely the bond market has been in a long-term structural rally that's largely come to an end. So I see good value in fixed interest as a defensive investment if we were heading into recession, but that's not our expectation at this stage.

St Anne: Within the context of asset allocation, what sort of approach should investors take when it comes to managing their fixed income portfolio?

Murphy: Well, I think they've got two choices, and it's a philosophical question. Investors need to decide whether they are going to take a strategic long-term sit and forget approach, where they don't try and time the market in fixed interest and just have a permanent strategic asset allocation, or they take a more tactical approach. I think it's the second approach that we would advocate for the time being. Given how low long-term interest rates are, we believe that a tactical approach to fixed interest is more appropriate in the current environment.

St Anne: Noel, as a bond manager, what sort of value are you finding in the market?

Murphy: Well, we're not particularly keen on Commonwealth Government bonds, but by contrast we like State Government bonds. We like floating rate investment grade credit, specially the banks. We think that's a good story. We also have like listed property – the bonds issued by listed property trusts and some infrastructure investments. There is an area where we are quite concerned, and that's US high yield. We think that's probably fully priced, and if anything, may surprise people in delivering poorer returns going forward.

St Anne: Hybrid securities have also been quite popular among investors. Noel, did they have a role to play in a fixed income or defensive portfolio?

Murphy: Well, I think they have a very limited role. For the time being we think they are offering good value. So I think as a yield enhancement they are fine, but they should never be a significant part of any defensive portfolio, in our view.

St Anne: Finally, Noel, there's been a lot of discussion about interest rate cuts. What sort of impact would that have on fixed income?

Murphy: Well, ironically, I don't think further falls in the RBA cash rate will have much influence on bond yields. I think we're probably seeing the low in bond yields in Australia. So, despite the fact that the Reserve Bank may cut another 25 basis points, I don't think it's going to be a big influence on bond yields or bond returns going forward.

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

Murphy: Thank you very much.

Christine St Anne: Morningstar has wanted its coverage to include equity income funds. These funds adopt derivatives to boost the income in their portfolio and are relatively new to the Australian market. To tell us a little bit more about these strategies, I am joined by Morningstar’s Tom Whitelaw. Tom, welcome.

Tom Whitelaw: Thank you.

St Anne: Tom, can you give us an idea about how these funds work? What exactly is meant by derivative income?

Whitelaw: Okay. So as the name suggests, derivative income strategies are basically looking to support the traditional elements of equity income, such as franking credits and dividends, by supplementing a derivative overlay strategy to kind of add that extra income in there. So the most common tool used by the derivative income manager is the buy right.

St Anne: Can we delve a little bit further into these strategies? How does the buy right strategy work?

Whitelaw: What the buy right does is, kind of, as the name suggests, the manager would buy a holding in the stock, and then they would write an option over the top of that to garner some additional income. So it's probably easy to use a real world example, so let's take BHP. So this morning BHP was trading at around $36. So, say, the manager would buy the stock at $36. Then immediately write the option, say, $40, kind of giving them a 10 per cent upside. They'd probably get about 1 per cent payment for that, let's say, to keep the math simple. So that means that if the stock rises 10 per cent, they'd actually get 11 per cent, so they're doing pretty well. If the stock falls, they've kind of got that cushion of the 1 per cent. But then if the stock rises through 10 per cent and upwards, then they're kind of missing out, because as soon as that stock rises through $40, they are essentially naked BHP. So they no longer hold it in the portfolio. So that's why you’ll find a number of managers write multiple options around these strategies to avoid being called away.

St Anne: Tom, there are number of these strategies in the Australian market. Are they all the same, or do they differ?

Whitelaw: Yes. So with this derivative income approach, most managers try to do the same thing. They try to do as we said. They garner that additional income from selling options. But the way they go about that can be quite different. So take two of the most common ones in the market at the minute; you've got Colonial First State and you've got Zurich Denning Pryce.

So the Colonial First State guys, Rudi and Jason, will take what Matthew Reynolds does on the core Australia fund as their starting point. Then they look to write options, positions, call options over the top of those holdings to kind of garner that additional income. They also talk very closely with the stock analysts as well. So that's kind of more a tactical approach to doing this. They look at where they expect the stock to go, will it run through this strike price, kind of what’s good value. Then it's kind of seen more as – the income is seen more as a complement to the growth that you would be getting core.

Whereas, the Zurich Denning Pryce guys, so Michael Pryce is very much the atypical derivatives trader. He has kind of done it for a long-long time; very important in this kind of game. It's much more shorter term, kind of more technical trading around the derivatives to kind of – to get that income pickup, and he also limits himself to the ASX50.

St Anne: You mentioned a number of managers. So what sort of qualities do investors need to look for when using a manager to oversee these strategies?

Whitelaw: So, as I mentioned, experience is one of the most important things that we stress with these types of strategy. So time on the crease is imperative. It is very – it sounds quite simple, you just kind of buy a stock, write an option and away you go, but there’s kind of multiple facets that kind of operate behind this, and you kind of really need to understand the market, the market depth, kind of what price you're paying for some of this volatility and what not. Then when you've got managers using over-the-counter auctions, as some of them do – not the ones we’ve mentioned, but some guys do go over the counter, then it’s even more important, because there is no real buyer. At the end of the day, you've kind of got to sell it back to the guy you bought it from, and kind of broker relationships are very, very important there.

St Anne: From your preliminary research, Tom, have these strategies delivered for investors?

Whitelaw: Well, they've certainly delivered income, but you kind of got to take that as a whole when you look at the total return. So over the last three years, for example, the two guys we spoke about before, on a total return perspective delivered around 6 per cent and 7 per cent total return. From an income side, if you split out the income from that, they probably delivered around 9 per cent and 10 per cent income. You can kind of see the mismatch there. So that means that the actual growth has actually fallen by about 3 per cent or 4 per cent, so actually value of the investment would have fallen by about 3 per cent to 4 per cent. So investors just need to be cognizant of that fact. So, although you might be getting your income and might be taking the income, the actual value might be falling. So you invest $100,000, and the first year you get the 10 per cent; brilliant, you've got your $10,000 of income. But should that underlying investment have fallen 4 per cent, certainly the next year you get your 10 per cent again, which is great, but you are only getting $9,600. So it's just something to be aware of.

St Anne: On the point of value, can these strategies work in a bull market?

Whitelaw: Yes. I mean, that still work insomuch as they're still doing what they said they do. They’re still providing you this income, but that growth aspect becomes even more important, because, as we mentioned at the outset, you are writing away some of the potential upside of this stock above a certain point. So in a bull market, you’d expect prices to be rising more rapidly and more of these strike prices getting hit, getting called away in more of these stocks. So you will find that these strategies will lag in a bull market, yes.

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

Whitelaw: Thank you.

St Anne: Morningstar subscribers can get access to more in-depth research on these strategies by going to the Morningstar website and looking under the funds tab.

Christine St Anne: Hyperion recently won the Morningstar's Fund Manager of the Year Award in the small companies and large company category in Australian equities. To give us a little insight into their investment processes and finding value beyond banks and resources, I'm joined by Hyperion’s Tim Samway. Tim, welcome.

Tim Samway: Thank you.

St Anne: Tim, just to begin with, can you give us an insight into your investment processes, and how they’re different between the large company portfolio and the small company portfolio?

Samway: So, our investment process is focused on buying quality businesses, quality predictable businesses, and we don't really vary that process between large and small caps. We don't make much of a distinction between large and small caps in our investment process, simply because we are looking for quality small caps and we are looking for quality large caps.

St Anne: Your portfolio doesn't seem to have a big exposure to the major banks or the resource companies. Is there value to be found in the Australian market beyond those two sectors?

Samway: Well, interestingly enough, our portfolio is not very heavily weighted to banks and resources, and it hasn’t been over the last year, year and a half. We found a lot of value in the online sector. The Wotifs, the Seekss, the Carsales, the REAs, Trade Me, that business – those businesses, I should say, were somewhat unloved a couple of years ago, but we saw the opportunities in having effective little stock exchanges of a type. It's sort of an exchange effect that goes with those, sort of, businesses. They are quite protected from competition and we saw the opportunity for predictable long-term growth with them.

St Anne: Besides the online companies team, what other sorts of companies do you like?

Samway: Yes, of course. I mean, there are businesses in the various funds. I will try and split them up. Businesses like Iress, we really like that business. It's gone through a very difficult period over the last couple of years. It sells to the financial sector and the financial sector has struggled, and yet Iress has done very well. It's a quality business, and it's able to take its business model and replicate it in other countries very successfully. They’re certainly doing some good things in the UK at the moment.

St Anne: Tim, your funds run a very concentrated portfolio. How do you overcome stock-specific risk?

Samway: Well, the real risk that we are managing is buying fundamentally sound businesses, that is the risk that we buy a business that’s not a quality business. And we do the work to make sure that we are actually buying predictable, growing earning streams, and the real secret to that is being brutal in non-owning businesses that don’t pass the test, and not owning a bit of them, just owning none of them.

The second risk really that you need to manage with owning a concentrated portfolio is pricing risk, and that’s just being very disciplined about even if a company is a quality business, not overpaying for it if it’s actually – if its valuation is too stretched. So we often have periods where we have quality businesses that we really, really like, but we don’t buy them because they are too expensive. So, in that case, for example, the GFC actually provided us with some terrific opportunities to pick up quality businesses, because they were oversold during that period.

St Anne: Finally, Tim, with your portfolios not exposed to the major stocks like the banks, how do you address investor perceptions when the funds deviate from the index?

Samway: Well, they do. Our funds have lagged the benchmark at times in short-term periods. And the way that we have addressed that over a very long period of time, now 16 years, is to talk to investors in advance about the fact that it will happen that when you are running benchmark in sensitive portfolios, that is ones that aren’t constructed around the benchmark and are focused on just buying really good quality businesses, that there will be times where we will underperform. But the real focus for investors should be, firstly, capital protection, and secondly, long-term outcomes, because that’s what investors should be looking to.

And I guess it's helped that. We have had three periods over the last 16 years where we have underperformed for a short period of time, and then outperformed for a long period of time thereafter. And I think that repetitive nature of that cycle has given investors’ confidence that we can continue to deliver in the long term.

St Anne: Tim, thank you so much for your insights today.

Samway: It's my pleasure.

Christine St Anne: Perpetual Investments was named Fund Manager of the Year at this year's Morningstar awards. The award acknowledged the quality of investment processes across a number of strategies managed by Perpetual. Today, I am joined by the company's Deputy Head of Australian Equities, Charlie Lanchester, to give us an insight into some of these strategies.

What do you look for in a company?

Charlie Lanchester: At Perpetual, first and foremost we have four quality filters, which are fundamental to how we invest. So if a company doesn't pass these four quality filters, we simply won't even look at them, and those four filters around good management, conservative levels of debt, recurring earnings and a quality of business that we can understand. Once a company passes those four filters, it goes into our investable universe and then is ranked by the analysts, a strong buy down to a sell, and the portfolio managers like myself then build the fund from there.

In terms of valuing stocks we're very flexible. We look at all different valuation methodologies. There's no right or wrong way of looking at companies, and that's where really the art of investing comes in.

Do you favour particular sectors?

No, not at all, we are very much bottom-up stock pickers, so to speak. So we're always looking at all aspects of the market within those quality filters for opportunities where the market is mispricing a particular stock. So, no, we don't really invest on a macro type basis or even a sector basis. It's very much a stock-by-stock analytical call.

How do you manage the fund when it lags during some market cycles?

It's hard. Right now my – the Industrial Share Fund is lagging a little bit, its particular index. That said, investors are very happy, because the index is up more than 30 per cent so far this year. In general, Perpetual funds due tend to lag slightly in very strong markets, because we are much more focused on defending the downside, or protecting the downside in more difficult markets. So, in general, when you look back over many years, we've outperformed strongly in down markets and lagged a little bit on the upside in good markets.

How do you manage the responsibility of overseeing a number of strategies?

It's a bit of a balance. I spend most of my time, to be fair, managing the funds. Perpetual, only one of the strengths of working at a larger institution instead a lot of the stuff around managing the business is taken away from you. So we spend a lot of time just looking at stocks, visiting companies and on the road, and that's really what I love to do. At the same time, I do allocate some of my time to managing the team. We've made some good enhancements I think over the last couple of years in how we measure individual performance, which after all is the key to fund management.

How do you add value when managing a large portfolio?

There's certainly a sense of responsibility which comes with having large stakes in a number of companies. That said, we've managed a large amount of money for a long period of time. I’ve been in Perpetual now for 14 years and we've been a large fund manager really for most of that time. And I think we've proven that we can still outperform the index on a consistent basis, and I think there are some strengths of being a large fund manager in the Australian market.

Christine St Anne: Despite some optimism growing in Europe key issues remain. Today I'm joined by Vanguard’s Peter Westaway, to look at five specific challenges now facing Europe. Peter, how is Europe grappling with its peak to reduce its debts?

Peter Westaway: Well, I think the real problem for Europe is that it’s starting from a position where some of its countries have very high debt. They have very high deficits. And even though they are starting to implement physical consolidation programs, it takes a very long time for that to show up in debt ratios falling.

So, for most countries they still haven’t got themselves back into their fiscal surplus, which is one of the conditions that would help debt ratios to come down. And of course, because their growth rates are still so low, in some cases actually negative that means the denominator, effectively the ratio is still going up. So all told, debt ratios probably aren't going to start coming down convincingly until at around 2015 and 2016. But the right policies are being put in place for it to start happening.

St Anne: Do you see any light at the end of the tunnel in terms of growth in Europe?

Westaway: Well, we’ve just seen yet another quarter of negative growth in euro area and the euro area as a whole. And we’re probably not going to see positive growth for the aggregate euro area until probably the middle of this year 2013.

I think we're probably just starting to see these countries bottoming out in terms of recessions. Some of the forward-looking indicators is looking a little bit more promising, and just the very fact that some of the most aggressive physical consolidation is probably already happened.

So, arithmetically that means that growth start to become a bit less negative. Nothing more generally as Germany starts to pick up, as some other parts of the world start to get a bit stronger, that will also help Europe as well. But I mean let’s not hit ourselves. I don’t think we’re going to have anything like strong growth, more than 1.5 per cent for the next couple of years. It’s a long haul, I am afraid.

St Anne: Peter, are you starting to see any countries that are beginning to claw back their competitiveness?

Westaway: There are a few. I mean, a lot of countries lost a lot of competitiveness because they had low interest rates that they never really enjoyed before. They had a credit boom, say countries like Ireland, Spain, Greece, Portugal; all let their inflation rip, wage growth was too high.

Now the recession is really biting in these countries that then obviously act as a dampener on wage growth. So that's helping competitiveness to come back. Probably the country that’s doing best is Ireland where they’ve clawed back healthy, probably more than 50 per cent of their lost ground and that's partly because they are one of the countries that’s just inherently more flexible. They don’t have some of the problems that some of the other countries have on the structural reform side.

St Anne: Structural reform is of course another challenge in the region. Are you seeing any gaps in particular countries?

Westaway: There are a lot of big gaps, and really in some ways those challenges are the most important because until a lot of these periphery countries just start performing like a modern economy should, it is going to be very difficult for these countries to move forward. I mean the main gaps are in areas for example, wage flexibility, the ability of firms to hire and fire workers, restrictive practices in a number of industries, which means that there closed jobs, which makes it difficult for the economies to be dynamic.

And then there are just more generally, infrastructure spending, education spending, sort of being held back for a long time in these countries. And so all of these things together will help some of these periphery countries grow. But these benefits don’t come through quickly, it takes a long time.

St Anne: Peter, finally, are the European banks still vulnerable?

Westaway: Yes, banks are very much in the kind of epicenter of sovereign crisis, and it's in a way, the interrelationship between the banks and the sovereigns that makes it so difficult. You know, countries like Greece bought – the banks in Greece bought sovereign debt that brought them down and then in countries like Spain and Ireland the banks went burst, and the government had to bail them out. So banks and sovereigns are in this deadly embrace.

Gradually, we're seeing recapitalization happening. And that’s helping, but while growth is so low, there are still a lot of very impaired assets on these balance sheets, and the exposure of the banks to sovereign debt and to the bank debt of other countries means that there is an intensification of the sovereign crisis. Banks are very vulnerable and they won’t be able to lend money to firms and households and that could cause the recession to intensify again. Hopefully that won’t happen, but that’s the risk.

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

Westaway: Thank you.

Christine St Anne: Cash has been one of the favorite asset classes over the last few years. But latest analysis from Russell Investments has found that growth assets have recovered. Today I'm joined by Scott Fletcher to give us a further insight into the recovery of growth assets. Scott, welcome.

Scott Fletcher: Pleasure, and thank you.

St Anne: Scott, your analysis has found that growth assets have recovered over 2012. How does that compare with cash?

Fletcher: The recovery in growth assets, despite the volatility that we had in various parts during the year, growth assets were returning in general between 18 per cent and 20 per cent. If you look at individual stock markets, you had some stock markets that were mid-20s and so on. That compares to a cash return last year of around 4 per cent. So, what we found is that 2012 was definitely a year where it was almost like cash was returning to the old normal. People talk about the new normal and the new paradigms in the investment markets, but it was very much a return to the more traditional long-term rankings of growth assets versus cash.

St Anne: Scott, within the growth assets, what sectors performed the best?

Fletcher: Real Estate Investment Trust, Australian REITs. It was by far the standout. And REITs very much benefitted from a search for quality, yield, earning certainty, those sort of factors that were coming very much to the fore, particularly in risk off type periods like the second quarter of last year and so on. As you moved to the end of the year, you saw a broader stock market rally. So, it was initially the rally in the second half in REITs and in stocks as well was very much on earning certainty, yield, and so on, as large cap quality type focus. As we moved into December and even further into January, it sort of broadened more, and some of those value opportunities that managers and investors were seeking or getting into started to come at the fore very strongly at the end of the year. So, REITs have done very well, off a very low base, about 30 per cent return. Then there was Australian shares and international shares as well. With only international side, hedged outperforming un-hedged.

St. Anne: Scott, with growth assets recovering and as you mentioned cash going back to the old normal, are there any lessons for investors?

Fletcher: Yeah, I think the main lesson is that despite all the fear and uncertainty – and look it's understandable that people have been pretty apprehensive, retail investors apprehensive of coming back into the market, when the past fees have been so volatile and with the GFC and so on and such negative returns. But I think what it shows again is that you can't look for things to get better, you can't wait for economic dollar to turn around because typically, all the research and experience that we have at Russell, says that markets will turn 6 to 12 months ahead of any of the economic data, because markets are forward-looking.

So the best thing to do is, is to have a diversified portfolio. Its diversified across equities, bonds, cash, in a multi-asset type of approach, which can adapt to the changes in the market conditions, picking the best wining asset class is a very, very tough game and it's almost like again a Russian roulette. If you get it wrong, the consequences for your retirement funding and so on can be quite very serious.

So we think the best thing to do is to have a diversified multi-asset portfolio that can adapt and you see that in the performance differentials and in the tables that we put out where that multi-asset diversified portfolio sits probably in the upper echelon, but not as strong as the best performing asset class, but no way near as bad as the worse. So it sits in the sort of the second sort of grouping there. Which is what you want, long-term consistent performance to fund your retirement.

St. Anne: Finally, Scott, I know it's a bit difficult with volatility, but could you give us an insight into your views for 2013? Should investors remain cautious?

Fletcher: We definitely see an improving outlook, so particularly into the second half of 2013. The economic fundamentals are starting to turn the corner. You've got the prospects of the housing market pickup, improving its pace and that's more of a second half story at this point we think. The US economy will still grow about 2 per cent, 2.5 per cent thereabout; but by the end of the year, it should be growing about 3 per cent. China is stabilising in terms of the growth, softening that it had through 2012 and then it should get back up to about 8 per cent. Eurozone will still be a problem and Eurozone risk in terms of political risks and so on are definitely there. Also in the States, of course we've got the sequester of automatic climate cuts and so on, on March 1. We've got debt ceiling negotiations in congress.

So, second half is generally a broader outlook. Given the markets have rallied so hard and so fast they're more neutrally valued at this point. So that gives us a bit more caution on the next three months or so, particularly you have an Italian election, which could cause another bout of Eurozone volatility. So, I expect volatility spikes to continue through the year. We still think it will be a risk on, risk off type of year with its episodic bouts of nervousness and so on, but we think it's gradually improving. So by the time you get through to the second half, the outlook should be a lot brighter.

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

Fletcher: Great. Thank you.

Christine St Anne: Morningstar's latest managed funds survey found that fund managers ended 2012 with some healthy returns. To give us an insight into how well these funds performed, I'm joined by Morningstar's Julian Robertson. Julian, welcome.

Julian Robertson: Thank you.

St Anne: Julian, what managed funds did well in the last quarter of 2012?

Robertson: Well, it was fairly broad brush success for a lot of managed futures and the market was pretty strong so they all (wrote the coattails) of the increase in share markets around the world and domestically. One that probably sticks out the most is the value type managers. And the sectors that did particularly well were things like financials and consumer discretionary and that's a typical hunting ground for the value type managers, and that was common to both Australia and overseas or global investment managers too.

St Anne: Was the good performance a reflection of manager skill or the conditions of the market?

Robertson: Well, it's a combination of both, I guess. A lot of the managers, obviously, are positioned for the uptick in the economy in the market and those managers who added more sensitive buyers to their portfolios tended to do better and that's reflected in the outcome of the value managers, for example. So, it depends on their style and where they were positioned, with a bit of stock selection and a bit of fair wind from the market too.

St Anne: Julian, were there any funds or sectors that lagged?

Robertson: Well, one of the main areas where there was a marginal underperformance was actually in AREITs (Australian real estate investment trusts), it was only very small, but that's obviously after a very strong rise in that particular sector of the market. So, you could say they had a slightly disappointing quarter but they still delivered round about 7 per cent, and it's a notoriously difficult market to outperform any way because of the narrowness of the stocks within the universe.

St Anne: Julian, given the broad range of managers that did well, could we see a return of the market in 2013?

Robertson: Well, it's a difficult question because you are sort of looking at the future here. But certainly there is a few commentators who are of the opinion that the back drops got a lot better, and a few things have been resolved or there is a little less uncertainty regarding the fiscal cliff, for example, in the U.S. and the Chinese data has been little stronger or a little bit more upbeat. But then a lot of that's reflected already in the market with the recent rise. So, there is sort of concern about the valuations of the market at the moment and so net-net it might be difficult for the market to shoot ahead from here, but as always it's always with hindsight that these things are much easier to foretell.

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

Robertson: Thanks very much, Christine.

Christine St. Anne: When it comes to the fixed income asset class, investors are faced with a plethora of choice. To navigate the choice on offer and what fixed income means to your portfolio; I am joined by Morningstar's Kathryn Young. Kathryn, welcome.

Kathryn Young: Thanks so much for having me, Christine.

St. Anne: Kathryn, what are the main categories in fixed-income?

Young: It's a good question, Christine, actually because many people think that fixed-interest; it's all the same. It's just one big asset class, not a lot of difference there, and there actually are quite a few different sectors within fixed interest.

At Morningstar, we have six different categories that we cover in fixed-interest, but you can really talk about them in three main categories.

So, one is domestic bond, so that covers Australian Commonwealth bonds, the state government bonds, and in some credit, a lot of bank's incorporate bonds. But then there is also global bonds which cover governments from around the world – investment-grade countries around the world issued by governments. There is also some credit involved in global bonds. And then the third sector is just credit itself. And so, by credit I mean bonds that are issued by corporations. And credit bonds typically tend to have a bit higher yield than government bonds, because there are some credit risks related there. So, for example, credit risk is the risk that the corporation goes bust and doesn't repay you your money.

St. Anne: In an environment of falling interest rates, Kathryn, what role do these assets play in a portfolio?

Young: Fixed-income assets always play the same role. They also play a defensive role typically; income-generation role, and they provide diversification to balance out the equity part, the share parts of an investor's portfolio, but that role becomes especially pertinent and visible when interest rates are falling. Typically, when interest rates are falling, it's associated with economic weakness and often risk aversion among most investors.

So, when there is economic weakness and investor risk aversion, shares are typically falling, and in that case when interest rates are falling, bond prices go up. And so, what happens is the bond part of your portfolio is doing well at the time when your equity part of your portfolio isn't doing as well. So, you can see that it really – it helps balance out and cushion some of those losses.

St. Anne: With the hunt for yield, can these assets boost the income of an investor's portfolio?

Young: A lot of people are really talking about this because with yields on government bonds; really all bonds, the yields are at or near historic close, and so that means that they're not generating as a much income as people had gotten used to. So, a lot of investors are turning to credit-sensitive bonds issued by corporations for the most part at a time like this, because as I mentioned before the yield on those bonds tends to be higher to compensate investors for the credit risks.

So, many professional investors and many retail investors are looking to credit at a time like this, especially because many corporations globally are in good shape or have been in good shape since the global financial crisis, so there people feel more comfortable taking on that credit risk.

I think it's important to point out though that if investors are looking to corporate bonds to credit sensitive securities that it's -- I would advise most to consider using a mutual fund or unit trust, so that there is a professional manager and professional researchers looking at the credit risk involving those bonds, because it can be quite complicated for a person who has another job to do.

St. Anne: Finally, Kathryn, how could investors access these strategies?

Young: First and foremost, you need to decide what kind of strategy is appropriate for you. So, we talked about domestic bonds, global bonds and credit sensitive bonds. So, we always recommend that people stay well diversified. And so one simple way to do that might be to look at, Morningstar has a category called global Australia bonds and what that is, is just one fund that offers exposure to global bonds, to domestic bonds, and often will have some credit exposure as well. So, one of those strategies might be an easy place to start, because then you have a manager who is allocating across those different sectors and keeping you well diversified.

The second thing that you want to do is make sure that the security that you're looking at has a risk profile that matches what you intend to do with that money. So, for example, if you're just looking to invest money that you might need to use in the next two years, say to buy house or to fund your lifestyle, then you want to make sure that it's a very low, low risk type of security. So, in that case you might look at for at term deposit, but you might also look at a very short-term fund. And we have a category for that as well it's just called Australia short-term fixed interest. So, with that that risk profile would match up with what your goal is.

Another way to look at risk portfolio of a more diversified fund would be to look at the fund's performance since 2008. If it has a lot of credit risk, that fund probably lost money in 2008, because a lot of corporate bonds struggled during the global financial crisis the worst of it. So, that might help to give you a sense of how much credit risk is really in that fund. But you could also look to some other statistics, such as its credit quality breakdown. A lot of funds, funds that have a lot of their assets invested in non-investment grade bonds that might be -- that would indicate that it's a higher credit risk profile.

And then lastly, you want to make sure that the manager - if you choose a fund, you want to make sure that the manager has the resources to be able to do the right research effectively and you can tell that in many ways. A very simple thing to do would just look at how long the track record of the fund is. It might help to give you a little bit more confidence if the fund has a very long track record; investors have been investing with this firm for a long time. You also want to take a good look at fees. Fees are especially important within fixed interest, because the range of returns offered by fixed interest is lower. So, that means that fees necessarily take a bigger bite out of the income and the returns that the investor gets. So, you want to pay a special attention to fees.

St. Anne: Kathryn, thank you so much for your time today.

Young: Absolutely, happy to help.

Christine St Anne: It's not surprising that many investors flocked to term deposits during the global financial crisis, given their perceived safety. But how safe are these assets? Today I am joined by Ibbotson's Brad Bugg to discuss the volatility behind term deposits. Brad, welcome.

Brad Bugg: Nice to be here.

St Anne: Brad, term deposits are perceived as safe assets. Are they actually more volatile than investors think?

Bugg: Well, I think, from a risk perspective, term deposits have done a very good job of preserving your capital, and post the GFC I think that has been the number one concern of investors.

But one thing I think they have ignored is the volatility of the income, which comes from a term deposit. We are at now in an environment where the RBA is starting to cut the cash rate, and as a consequence the banks are starting to bring those term deposit rates down. The RBA has cut cash rates by 1 per cent over the last 12 months and term deposits have come down to a similar degree.

So, investors who were investing in term deposit 12 months ago, the income which they are going to get from the new term deposit could be anywhere from 20 per cent lower to a third lower. So, we think that's a big risk for pensioners who are relying on that income to survive.

St Anne: You mentioned the volatility of income, are there any other risks behind term deposits?

Bugg: I think one of the biggest risk is complacency. In 2007 investors could get term deposit rates of 7 per cent to 8 per cent, and they could lock that in for five years. So, that was an easy decision for investors because it gives you that capital preservation and the nice income going forward. But now sort of we are in a period where sort of term deposit rates are quite low and people have gone back to term deposits because they've given the outcomes that they wanted in the past, but that's meant they've ignored some good opportunities where they could have protected their capital, but still get a better return and from that you could have look to Australian or global government bonds, for instance, which gave you a return of more than 10 per cent over the last 12 months.

So, I think, there is that complacency that people go back to what they know, but there are other opportunities that they are missing out on. So, we think investors need to take a more dynamic approach where they look to vary their allocation to different assets, depending on the opportunities that are present at the time.

St Anne: So, how does the risks behind term deposits impact the retirement plans for investors?

Bugg: Well, retirees look to the income that's coming from these term deposits to pay the bills whether to pay the water bill, the utility bill. These bills are going up at some quite alarming rate in many instances. And with reinvestment of term deposits probably for the last 12 to 18 months, each time they've rolled over term deposit they've been getting lower income from that term deposit.

So, just to give you an example, Westpac offered a five-year term deposit at 8 per cent many years ago. Had you locked that in that would be fantastic, but now you are looking at rolling that term deposit over in a couple of years time at a rate which could be half that. So, if for instance you had all your money in that, you are going to see the income that you rely on to live halved, which I don't think is an outcome a pensioner would look to.

St Anne: Brad, you mentioned bonds, what other assets can investors look at besides term deposits and bonds that can give them some sense of capital protection?

Bugg: Well, I think, term deposits have been very good from that perspective in protecting investor capital. Bonds have also done a good job in a falling interest rate environment, and we don't think that's going to be the case going forward.

So, we look to just plain vanilla cash, having money in the bank account because that does preserve your capital, but it also gives you that flexibility to capitalize on opportunities should other assets fall and start to present some interesting valuation.

So, we think that sort of cash gives you a good option value which you are not getting with term deposits because your money is locked up for the life of that term deposit.

St Anne: Brad, so ultimately is there a role for term deposits?

Bugg: I think so, because term deposits do give you a certainty of income, but we wouldn't recommend that you have all your investments in term deposits. We recommend sort of having a diversified portfolio and varying those allocations over time, and having the biggest allocations to those assets which give you the best reward for your risk, and at the moment West is starting to see the reward for risk portfolio from term deposit being not as advantageous as some other asset classes out there at the moment.

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

Bugg: Not a problem.

Christine Benz: Jack, I want segue and talk a little bit about your most recent book, The Clash of the Cultures, and the clash is between a long-term investment culture and one that is based on short-term speculation. Let's talk about how that culture clash unfolded. What has driven the increasing focus on more speculative styles of investing?

Jack Bogle: Well, first of all, it comes around I think by and large, the kind of thing we had in the late 1990s - the information age and all that kind of thing - where the price of the stock became more important than the intrinsic value of a company. And when you focus on prices and pretty much disregard intrinsic values, you are just gambling.

Will people take your stock from you at a higher price than you paid for it, or you are buying and hoping to sell at a higher price. That's kind of the spirit of the thing; that's where the turnover comes from. And it's very, very dangerous. Add to that, stock prices became especially important during the '80s when we had executive-compensation options and corporations were judging themselves on the price of the stock. And the security analysts were judging the price of the stock. They wanted a short-term earnings guidance, short-term quarterly guidance, or something. And it just gradually turned bigger and bigger, inflamed - if that's the right word and I think is - by the huge boom we had in the '80s and '90s. Stocks looked like easy street. There is no easy street. And so it all kind of accumulated to the point where speculation has crowded out a lot of investment.

One example I used in the book is, how do you measure this? Well, if you call investment fulfilling the basic function of the financial system, and that is directing capital to its highest and best uses, you're talking about money gets directed in new ventures, existing companies, innovative companies, whatever it might be. And that has been running about $250 billion a year. How do you measure speculation? [You do so] by the amount of trading that goes on in the market, and that's around $33 trillion a year. So, if you want to look at it hard-nosed, 99.2 per cent of what goes on in the market is speculation and 0.8 per cent is an investment in the stockmarket.

Benz: What in your view would reverse that trend toward speculation? What are some steps that could be taken?

Bogle: Well, first of all, there's a natural tendency for it to blow itself out. If we had good market decline, for example.

Benz: And we did.

Bogle: And we see some of it now. High-frequency trading is distinctly less now and then we'd have to have a big market blowout, of course. There are a number of other factors. [One is] waking up investors - speculators lose, investors win, by definition. I mean think of this example. There are 500 stocks in the S&P 500, and let's assume that half of the number of shares outstanding of each are owned by long-term investors who never trade. The other half is owned by speculators who trade with a frenzy. The investors by definition will capture the market return, investors as a group, and the speculators by definition will capture the market return, too, but only before deducting the cost of all that speculation.

So, it's a mathematical tautology that investing wins and speculating loses. And if we could ever get investors to focus on that simple fact, as Ben Graham said - he has got more good quotes, but I think this maybe his very best - in the short run the stockmarket is a voting machine, but in the long run the stock market is a weighing machine. We have to get back to that. And he was taking this on by the way because it was starting to happen when he was still alive. He died I think in 1949. And it was starting to happen even then, and he was criticizing all the institutional trading. He was talking about these institutions are great big laundries that take in each other's laundry every day and clean it up and send it out to somebody else. He was a wise man.

Benz: If people are going through their year-end exercises with their portfolios, they might see that stocks have had a really great run; it might be time to rebalance out of stocks, which would mean moving money into bonds. What would you say to investors? Should they go ahead and do it given the meager outlook for fixed income? What's your take on that question?

Bogle: Well, I am not basically a rebalancer. In the long run, rebalancing is going to cost you because the higher-yielding, the higher-returning, asset is going to get to be a bigger and bigger part of the portfolio, and if you suppress it by rebalancing, you will almost definitely have a lower return over the long run.

In the short run, that's something else, and I think if people want to rebalance, that's fine. And I think if people think about it [not] as an annual exercise, but if your target equity ratio is at 60 per cent, think about rebalancing when it gets to 70 per cent or when it gets to 50 per cent, but not slavishly looking at, oh my god, I'm at 60.5 per cent and doing something, because there is too much other noise in the system to make that work.

So, to each his own on this. I don't myself. My personal account is about 80 per cent Vanguard municipal bond funds and 20 per cent Vanguard index funds, and in my retirement plan account, I'm about 50-50. So, I'm very comfortable there. I don't rebalance the retirement plan accounts ... for probably, let me say, 50 per cent at the beginning of the year. I don't do this with any exactitude. Maybe they are 55 per cent now. I don't see any reason to change that.

But you are correct in the implications of your question that this is a really difficult time to invest. I told a New York Times reporter on an article he wrote, [these are] the most difficult investment conditions I've ever seen. And by that I'm not talking about huge risk. I'm talking about the impossibility of getting the kind of returns we've gotten in the past. It is not going to happen, period.

That long-term return on stocks from Jeremy Siegel is around 9 per cent and nominal, and the long-term return on bonds is about 5 per cent, and I'm telling you, let's think about 7 per cent, and let's think about 2.5 per cent - half of those rates.

So, what are you supposed to do? Well, I do not think it's a good idea to take risks beyond that to increase your return, I just don't believe it. That's become an article of faith.

In our municipal bond group ... for years I was in every meeting that they ever held just to warn them, don't reach for income. So what's the first thing you are going to do? Well, most of the alternatives aren't really very palatable, from leaving the market. I do think you can maybe emphasize corporates more than Treasuries. I think that would be an intelligent thing for people to do - separate out the bond market into those two components and maybe take a little more maturity risk, which is not credit risk, just volatility risk.

But what are the other options? Well, you can cut back your standard of living - it's very hard - as my father used to say, no matter how painful. And you can also start to spend a little capital every year, but you can't do that forever. Maybe a year or two wouldn't hurt too much if the numbers weren't too large. You can, as a lot of people are talking about today, go into high-yielding stocks, but you are taking a volatility risk that you are not taking in the bond. Or you can go to high-yield bonds, junk bonds, but you are taking a credit risk. So there is a pro for every con.

Benz: Not a palatable set of decisions.

Bogle: So, I'm a "stay the course" guy. I do think importantly that we ought to be thinking more about the difference between government bonds and corporate bonds, because those spreads are very, very large compared to historical norms.

Benz: And you could see a case for overweighting the corporates.

Bogle: Yes. The corporate bond yields are pretty close to 3 per cent, and the Treasury yield is 1.6 per cent, and Treasuries are such an important part of total bond market index, the yield on that is only 1.7 per cent. And if you ... realize that that means you are going to get a 1.7 per cent return on the highest probability in the next 10 years, it just seems you shouldn't accept that. Not jumping off the deep end of the pool, but just getting a toe wet with maybe instead of 70 per cent governments and 30 per cent corporates, maybe 60 per cent corporates and 40 per cent governments or even 70/30.

Christine Benz: Hi, I'm Christine Benz for Morningstar.

I recently traveled to the annual Bogleheads event just outside of Philadelphia, where I had the opportunity to sit down with the event's namesake, Jack Bogle, who is the founder of the Vanguard Group of Funds.

Jack, thank you so much for being here.

Jack Bogle: Always glad to be here. It's been a year now. I am glad to be with you again.

Benz: So, let's start with your outlook for the market. Let's start with equities, and talk about what your expectations are and how you arrive at them?

Bogle: Well, I've been using this kind of system, if you will, ever since the early 1990s, when I forecasted returns for the 1990s, and it's very simple, and it is extremely helpful, because I divide market returns into two categories - investment return and speculative return.

Investment return is a dividend yield on the day you buy into the market, and to that is added earnings growth that follows. So, today, the dividend yield is around 2 per cent, and I think we can look forward to 5 per cent in earnings growth - nothing is guaranteed, but basically there is nominal growth, and the country is going to be growing like that rate, I think, nominally. And so that would be a 7 per cent investment return or fundamental return.

Benz: Bonds: I am guessing you are less sanguine, about the bond market.

Bogle: Wait a minute to talk about bonds, to finish the stocks, because stock returns are also affected by speculative return, and speculative return is the amount of dollars, the number of dollars, people will pay for a dollar of earnings. So, for example, in 1980, they paid $10 for a dollar of earnings, a price/earnings multiple so-called. In 1990, it doubled to $20. It had added 7 per cent to the return in the 1980s, and then that 20 times earnings in 1990 went to 40 times essentially in 1999, and added, doubling again, another 7 per cent.

So you know the investment return is going to be fairly stable. You know the initial dividend yield, exactly what it is, and so the question is, will P/Es go up or down by the end of the decade, I don't do this for shorter periods ... there just isn't many merit in shorter periods.

The fact of the matter is, at 40 times earnings the market is unsustainable. Could we double again? We'd have to repeat those 7 per cent annual returns additions, and it would have to go to 80 times, and the market can do anything ... but 80 times is pushing your luck.

Benz: So at current valuation levels ...

Bogle: My basic guess, and it's hard, very hard to guess - first, we don't even know what the current P/E is. There are so many different ways of looking at it: 10-year average, 5-year average, last year's earnings, next year's earnings. A big one is operating earnings versus reported earnings. Operating earnings are before all those charges that companies have; reported earnings after them, and I prefer reported. But something like 16 is probably the P/E that we're at today, rationally looked at.

And I would expect that's not going to go up a lot or down a lot in the next 10 years. So I'm just going to call out arbitrarily, zero. So 7 per cent would be my outlook for stocks.

Bonds is a similar system, except there is no speculative return over 10 years, because a 10-year bond matures in 10 years; you get back the par value. There is no growth in earnings or in appreciation in the value of the bond, so you rest entirely on the interest coupon.

So, today, if you look at a 10-year Treasury bond, for example, at 1.6 per cent - a hypothetic 1.6 per cent - that's going to be your return in the next 10 years. Now, I don't think many people are going to be satisfied with that, and you can increase that return by taking a little more risk - investment-grade corporates, longer maturities, this is kind of a short-intermediate maturity, today, for 10 years, and you can go out to the 12- to 15-year range without getting into real volatility of a 25- to 30-year bond.

So, if you could get a 2.5 per cent return or 3 per cent return on bonds today, that would be the return for the next 10 years. Today's yield is the 10-year return, and the correlation between those two numbers is an incredible 91 per cent, but of course, it has to be. It comports with your ideas of logic.

Benz: How about your inflation expectations? What sort of inflation should investors be baking into their assumptions?

Bogle: I'm using 2.5 per cent. I don't know, and the reason I'm a little bit different from Bill Gross in a lot of ways, but in this way, he gives you real returns, and it's always unclear with him where the return is coming from. I give you the nominal return, and then I basically say, you take your choice on the inflation rate and that will give you a real return. But I think you should be using something like 2.5 per cent, and that would take that nominal return of 7 per cent down to 4.5 per cent, and the nominal return on bonds down to almost zero. So, you'd have about a 2 per cent nominal return on the balanced portfolio, real.

Christine St Anne: Ethical investing is a top of investment strategy, but does this feel-good approach net good returns for investors? Today, I am joined by Westpac's David Simon to give us the low down on ethical investing. David, welcome.

David Simon: Thank you, Christine.

St Anne: David, what exactly is ethical investing? Does it differ from sustainable investing?

Simon: These themes are thrown across all the time. They are actually the same theme. So ethical investing and sustainable investing mean the same thing. Basically, it's the underlying fundamental values of the investor seeking to invest in assets that has sound attributes when regarding factors such as the social impact or the political impact and indeed the environment meant to impact of the underlying investment security.

St Anne: Can this investment approach result in better returns for investors?

Simon: The general view is that by scoping out certain assets that don't meet the merit of being sustainable or ethical means that they tend to underperform more mainstream investments. A recent survey that was produced in 2011 by the Australian Responsible Investing Association of Australasia actually came out with an interesting finding stating that for several periods the sustainable style investing is actually up for the mainstream investing. So that was quite an interesting report that was delivered.

St Anne: David, a lot of our investors like resource companies. Can these type of companies be included in an ethical portfolio?

Simon: That's a really interesting one, because underlying fund managers have different criteria on how they assess a company to be ethical or not. So some companies operate under a positive screening process and that means the fund manager is actually looking for positive attributes of an underlying security on how they provide positive impacts on society and also the environment, whereas some fund managers actually look for a negative screening process.

So they are really focused on some of the negative impacts that some companies can display on social and also environmental factors. So it's quite difficult to just use the resource component as an area or reason why to scope out some of the assets within a portfolio of ethical investments, but overall, depending on the fund manager, you can still access some resource companies within an ethical portfolio.

St Anne: David, you mentioned managed funds. Is this the best way for investors to access this type of investment?

Simon: Well, accessing investments through a theme of being ethical and sustainable are access to the same vehicles of what you would normally access any mainstream investment, whether they are listed or indeed via a managed fund or even held directly.

So there is no differentiation in terms of how to access these, but interestingly, a recent survey only showed that 1.6 per cent of total investment funds under management are held within ethical or sustainable style of themes. So there is still a lot of interest out there, but that's yet to materialize in actual investment holdings.

St Anne: David, finally what about diversification issues?

Simon: Yes, certainly. You'll find that if you look at a portfolio of assets that have these attributes of sustainable and ethical, there is a wide stream of assets to choose from. There are the obvious ones that you’d have to scope out. So companies that operate within – in weapons or companies that generally operate with tobacco and alcohol are somewhat screened out away from the opportunities say that deliver these types of values and attributes.

What that means is that the investor isn't going to get the same level of diversification. They would if they did go down that mainstream approach. So they need to sort of be conscious about whether they really more focus on the ethical component or their overall investment needs and diversification requirements.

St Anne: David, thanks again for your insights today.

Simon: My pleasure. Thank you.

Christine St Anne: Each quarter Morningstar puts together a report that tracks the inflows and outflows of the managed funds sector. To give us an insight into this report I'm joined by Morningstar's Darren Cunneen.

Darren welcome.

Darren Cunneen: Thank you for having me, Christine.

St Anne: Darren, so how are managed funds faring in these challenging times?

Cunneen: Well, the managed funds industry has been quite reactive to market’s whims. For example, in quarter one, risk-on environment, the managed funds industry gained just over $23 billion, whereas in contrast in quarter two, risk-off environment, the managed funds industry lost just over $15 billion. So, as you can see, it's been quite sentiment driven.

St Anne: We speak about outflows, but there are some managed funds that are getting inflows. Can you give us an insight into what sort of funds these are?

Cunneen: Sure Christine. As you can imagine, it's been a tough environment so investors have been out there looking for strongly performing funds. Now, as you know, past performance isn't a great indication of future performance so, investors shouldn't be chasing performance. However, investors have been rewarding funds such as Magellan's Global Equity Funds with inflows.

Magellan has really strong performance over the past year and has amassed, I think just over half a billion inflows. And then you also have, say, on the defensive side, you have fixed interest funds - they have been relatively flat following a surge of inflows over the past year. But we have seen investors reallocate from international strategies to domestically-focused strategies and this is perhaps with the aim of reducing exposure to the economic and political risks associated with international strategies.

St Anne: Darren, what about outflows? What managed funds are losing funds?

Cunneen: Well, at the other end of the spectrum, you have investors punishing some fund managers such as former market darling, Platinum International. Their flagship fund has received significant outflows over the past year, I think totaling just over one billion. So, you can see investors have kind of lost confidence in Platinum's ability to perform.

St Anne: Darren, investors seem to be having a love affair of cash, does the report reflect these sentiments?

Cunneen: Investors are definitely stockpiling cash. We've seen a 9.3% increase in cash under the management year-on-year. Investors are likely preferring the lowest defensive yield associated with cash. However, the Reserve Bank of Australia has cut the official cash rate by over 1% since May. So, this may lead investors to look elsewhere.

St Anne: Darren thanks so much for your insights today.

Cunneen: Thank you for having me, Christine.

Christine St Anne: With market volatility income is increasingly seen as the only positive return for investors, but there is more to investing. Today, I'm joined by Westpac's David Simon to tell us about getting income investing right.

David, welcome.

David Simon: Thanks Christine.

St Anne: David, with this market volatility, is investment returns all about just income?

Simon: Yeah. Look it's easier to fall in that trap and certainly whilst volatility is really high, share market performance tends to be very low. It underperforms. When volatility is quite low, the share markets tend to rise. So, when people who are investors are looking for returns, when they can't get them through growth, they are looking for income.

So, it's quite natural for them to seek an income-based asset. However, unfortunately, there are a lot of risks associated with this. So, I wouldn't say income investments are the right ones to use in volatile markets, but what I would say is that investors should always practice the discipline of being really well diversified. Have a combination of both income-based assets as well as those growth-based assets as well.

St Anne: Can income protect against inflation?

Simon: Yeah. Look, that's a really interesting one. In general, no. So, in general, income investments on their own, it's really difficult to protect against inflation, certainly once you've taken into consideration tax. So, once you look at tax and inflation and just an income-bearing asset such as a bank deposit or a fixed interest instrument, really difficult to protect against inflation and that's why it's really important to have a combination of income assets as well as growth assets. And indeed over time the growth assets should they be of quality characteristics should appreciate in value over a period of time whilst the income component of the diversified portfolio is really delivering the income return.

St Anne: David, you mentioned growth assets. So, what sort of investments can investors look at to get that growth?

Simon: Look, there are a combination and a variety of different assets that investors can look at when they are looking for growth. There is the traditional staples of shares and property, but there are alternatives as well. Investors can look at other assets to appreciate the capital value and look for capital growth; some such as foreign currency, commodities including gold are some of the examples of assets that have the ability to appreciating capital value and obviously, generate and deliver growth to investors. When coupled with their income style portfolio, hopefully that can also protect against inflation as well as those deliver a return beyond that.

St Anne: David, you mentioned tax. Are there tax considerations for investors to think about when investing in income?

Simon: Yeah. Look, if you're investing in just income assets on their own such as cash and fixed income, for instance, they are really taxing. So, they are fully taxed at a marginal rate or whatever rate the entity that owns the asset is paying.

There are other assets that also generate income that can provide some respite. For example, Australian shares are a great example of assets that can deliver an income and also provide some concessions to the underlying investor. So, if that Australian share that the investors are holding is fully franked then that tends to mean that the company tax rate of 30% is already paid by that company and they then pass that credit on to the underlying investor.

Other assets that provide some respite on tax include some types of property through depreciation and expenses to run that property. It sometimes comes to the investor as a tax deferral and that basically means the underlying investor isn't paying the marginal tax rate on the income they receive for the entire amount as some of it is actually reducing the cost base that the investor would ultimately pay through a capital gains tax play which actually would better off the investor - the investor would be better off by that outcome.

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

Christine St Anne: Key person risk is one of the key issues in investment management. To give us an idea about what this risk means for investors, I'm joined by Morningstar's Darren Cunneen.

Darren, welcome.

Darren Cunneen: Thank you, Christine.

St Anne: Darren, what exactly does key person risk mean?

Cunneen: Sure Christine. Key person risk stems from an over-reliance on key personnel for the idea generation, stock selection or portfolio construction. These key persons, they become integral to the fund process and they almost become part of the fund's brand and consequently the success of these funds becomes dependent on these star players.

St Anne: So, is this risk more prevalent in boutiques or the larger institutions?

Cunneen: Well it can be present in both, but it can just manifest itself in different forms. Within institutions, institutions are more process driven. They impose more systematic methods and philosophies on fund managers. They have deeper resource pools. They have say, embedded infrastructures, which kind of reduces the reliance on key personnel. It has more safety nets. Whereas boutiques are more flexible, they provide fund managers with the autonomy to flourish and then this again creates a dependence on key personnel.

St Anne: Darren, you mentioned star players, can you give us some examples?

Cunneen: Sure Christine. I can give an example of two high profile star players; one from the institutional side and one from the boutique side. In 2011, John Sevior departed from Perpetual. Sevior has spent 17 years at Perpetual, which shows you can never really predict whether if a manager is going to leave or not. As a result of Sevior's departure the shop suffered significant outflows over the year.

So, on the boutique side, we had the demise of 452 Capital. It's a quite well known story, whereby Peter Morgan's health scare caused significant outflows and the shop ultimately folded.

St Anne: Darren, finally, what can investors do to mitigate this risk?

Cunneen: Okay. Well, key person risk can be managed at the fund manager level. For example, fund managers can provide their fund managers with equity. This creates a personal and financial tie with the fund manager. It can also be managed at the fund level.

Investors can diversify across more than one fund for their sector. This diversifies out key person risk.

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

Cunneen: Thank you, Christine.

Christine St Anne: The hunt for yield continues, and infrastructure is seen as one asset class that can offer investors income. To discuss the issues to investing in this sector, I'm joined by Morningstar’s Katherine Young. Katherine, welcome.

Katherine Young: Thanks so much for having me, Christine.

St Anne: Katherine, can investors seek income in infrastructure?

Young: Well, we think it's important for investors to maintain a total return perspective in general, because focusing just on yield can cause investors to overlook some important risks. That applies here too. But, obviously, income is a very important topic these days, investors are looking for it and talking about it a lot.

So what we did is we looked at the income infrastructure - global listed infrastructure funds can offer in two ways: first, we looked at the aggregated portfolio yield, so that's the aggregated yield on the stocks in the portfolio over time and we also looked at the income distributions that these funds have paid investors over time.

So if you look at the aggregated portfolio dividend yield, income has offered reliable and relatively strong income. So about 4% to 6% over time, which is strong relative to global equities, which is a bit more on the order of 2% to 3% and also pretty competitive with listed real estate, both locally and globally which is another place investors look for income. So, on that level it does look very attractive.

St Anne: Are there any issues that investors need to be mindful of?

Young: It's important for investors to know that these funds - these listed infrastructure funds haven’t been able to turn that into reliable and consistent distributions, which is obviously what matters to investors, because that's what they are actually getting. So over time, these distributions have ranged from 0% to on the order of 15% and the reason is that the income distributions are affected by a lot more things than just the dividend payments of the stocks. So, for example, the distributions include capital gains, so if the stocks have had strong gains in the market and the manager sells that, the investor will get some of that capital gain back, but that's not reliable necessarily.

Also it's impacted by currency hedging. So a lot of these are global listed infrastructure funds and most of the funds hedge out the currency exposure and the gains and losses of the currency hedging are included in the distributions. So what happened to a lot of funds during the global financial crisis is they suffered some losses on their currency hedging when the Aussie dollar fell substantially and that had to be funded through the income distributions. So there was no income left to distribute out to investors.

So these infrastructure funds - the income can be an added bonus of holding these listed infrastructure funds, but we don't think that investors should use that as a primary part of their decision to invest in this sector, because it's not entirely reliable.

St Anne: Katherine, is infrastructure seen as a defensive asset class?

Young: Yes, that's right Christine. Defensiveness is a big attractor for a lot of people to the sector. That's how a lot of the funds are sold, for their defensiveness and it turns out they have actually been relatively defensive. So we looked at something called ‘downside capture ratio’, which measures the percentage of downside performance that the funds have experienced. So we looked at it relative to the ASX 300 and more global equity benchmarks.

Over time infrastructure funds have experienced about 65% of the downside performance at both local and global equity markets as measured by the indexes and that's pretty attractive in an absolute basis, only 65% of the downside. But it's also much better than the performance that investors have gotten from their listed real estate funds. So of the funds we cover on average, they lost about 32% in 2008, which is still substantial and certainly more than a lot of people expected from infrastructure, but it’s a lot better than the - on the order of 50% losses that people saw in their global equity funds.

An important caveat to that is that a lot of these global listed infrastructure funds are relatively young, a lot of them incepted in about 2007. So the time period that we’re looking at the data is from the beginning of 2008 through mid-2012. So that means that the data is highly impacted by the global financial crisis. There is no guarantee that infrastructure funds will act the same way in the next downturn as they did in the last one. There are few reasons to believe that infrastructure will continue being defensive and the most important one is that the demand and revenue characteristics of infrastructure assets make them fairly insulated from economic variation.

So a lot of these are essential services. They are electricity distributors, for example. So consumers will continue to pay for their electricity even if they are having rough economic times whereas that can’t be said for all other things they consume. The other thing is that the revenue streams generated by a lot of these assets are regulated. So that means that they are going to continued generating the same revenue even if the economy falls on hard times.

St Anne: Given these characteristics, Katherine, what role does infrastructure play in an investors overall portfolio?

Young: They are still stocks. So they’re still highly correlated to equity markets. So that means that if you’re looking at infrastructure, you want to make sure it comes from the growth allocation of your portfolio. The other thing to remember is that though they are kind of defensive, that defense really comes with a tradeoff in terms of growth. So infrastructure funds aren’t going to do quite as well as maybe more diversified portfolio in a sharply rising market, so it’s a tradeoff.

So you just really need to look at the trade-off between the growth and defensiveness and decide what’s most important to you and it’s also important know that these strategies aren’t all the same. So some infrastructure funds tend to be a little bit more defensive and some infrastructure funds tend to be a little bit more aggressive, little more growth-oriented. So keep that in mind when you’re thinking about that trade-off.

St Anne: Katherine, so if investors want to invest in infrastructure funds, what sort of managers should they look for?

Young: Well, we like a variety of managers. They don’t all have the same approach, the managers that we like, but in general we tend to prefer those managers with more defensive characteristics, because we think that’s what investors are looking for quite a bit when they come to this sector. So there are some managers that are having more strict definition of infrastructure and so that means that they will refuse to be exposed to industries that even have a little bit of competition in them, let’s say, or have a less monopolistic structure.

There are some that will invest in emerging markets, because there is a lot of infrastructure build out in emerging markets and there are some managers that don’t do that at all. So, in general, we tend to like the defensive ones, but what you really need to make sure is that any manager you look at has the resources to research these diverse infrastructure assets thoroughly.

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

Young: Absolutely. Thanks for having me.

Christine St Anne: Policymakers around the world have announced a number of recent initiatives. To make sense of what these decisions mean for the markets, I'm joined by PIMCO'S Saumil Parikh.

Saumil, welcome.

Saumil Parikh: Thank you very much, Christine.

St Anne: Saumil, we've seen another round of quantitative easing from the U.S. and the ECB recently announced a bond-buying program. Are these initiatives enough to restore confidence in the markets?

Parikh: Christine, the answer is still to be decided really. The ECB is in a very different stage of addressing financial conditions compared to where the Fed was. We really view quantitative easing or the whole sort of set of unconventional monetary policies that have been put in place by major central banks, in three different phases. So, the first phase is when the private sector and the financial system - the private financial system is undergoing bouts of deleveraging that threaten the very stability of the system itself. You tend to get action by central banks, which is the first phase.

So, the ECB has just put into place what we would call first phase quantitative easing in the sense that they have decided with conditionality to buy unlimited amounts of short-term government bonds. Now, that in itself is not sufficient to ease financial conditions within the Eurozone. If you compare where the ECB is today to where the Federal Reserve is today, the Federal Reserve has gone through two more iterations.

So, not only did the Federal Reserve buy mortgages in 2008, 2009 in the first phase of the Fed's quantitative easing, but the Fed has continued with quantitative easing through the last three-and-a-half years, through phase two, which is the normalization of credit conditions and the phase three, which is the easing of credit conditions well through their fair value or their average levels. So the Federal Reserve is way ahead of the game in terms of the ECB. The ECB is lagging by at least three or four years in terms of relative effectiveness.

St Anne: Saumil, there has been a lot of discussion about a fiscal cliff in the U.S. Can you give us an idea about what that means and is the U.S. government well placed to tackle this challenge?

Parikh: Sure. So, as you know, the public sector balance sheet in the U.S., including the federal, states and local, are collectively running about a 9% of GDP deficit, not cyclically adjusted, just a normal deficit. At the end of 2012, because of the expiration of a variety of longer-term as well as short-term fiscal policy initiatives, some of which go back to the Bush presidency, back to 2001, there is set to be initiation of a 4 percentage point of GDP decline of fiscal stimulus. Both from rising tax rates as well as from the sunset of a variety of spending and countercyclical fiscal policy measures that were put into place over the last two or three years.

So, if policymakers - once the new elections are announced and the new government is formed, if policymakers do not address the extension of these sunsetting fiscal stimulus programs then we are set to have about a $400 billion to $500 billion of fiscal drag being placed on the U.S. economy which would certainly shift the odds of a recession in 2013 to well above 50-50.

St Anne: Saumil, just want to get your views on China. Growth has consistently slowed for the country. Are you confident that the authorities there can manage this new challenge?

Parikh: Yeah. China is going through an interesting transition. There are secular issues that are causing China's slowdown as well as cyclical issues.

In terms of the cyclical, I think it's important to think about China as effectively the world's factory, and two of the major consumers of the world, the European consumers as well as the U.S. consumers are going through their own sort of consumption slowdown. In the U.S. it's because of uncertainty related to the fiscal cliff; in Europe it's because of imposed austerity by both the public sector balance sheet as well as the banking system on the private sector balance sheet.

But in effect, if China is viewed as a world's factory then China's customers are reducing their spending. And China is cyclically going through a large inventory destocking cycle, something that was classically observed in developed economies before globalization took off in the 1990s. So that's the cyclical story. That cyclical slowdown will be managed properly by Chinese authorities. We think China has more than enough tools, both monetary policy and fiscal policy tools, to counteract the cyclical slowdown in the Chinese economy.

The secular issue is what we find much more interesting. We think that China secularly is going to enter into a slower growth phase. So, for the last 10 years, China has averaged somewhere between 8% and 12% annual real growth in its economy and the bulk of that growth has come from rising amounts of investments and rising share of investment as a percentage of GDP.

We think that growth phase, what you would call the easy growth phase of economic development, is now coming to an end and China needs to transition its economy from a capital goods infrastructure heavy growth model towards a domestic consumption and a domestic services and then more an innovation type of economy and that transition is not an easy one. Over the last 50 years or so, there have been several countries that have tried that transition; it's called the middle-income transition, when basically a country goes from $5,000 GDP per capita to $15,000 GDP per capita. And only about five countries have managed it successfully, while maintaining a high growth rate.

So, the secular issue with China is that the growth story that was linked to infrastructure and capital spending is now changing. And China will appear to most outside observers, especially for countries like Australia, as a very different economy for the next 5 to 10 years. So, Chinese demand for commodities, for example, which has been growing at 10%, 15%, 20% a year, will probably not grow faster than 5% or 6% a year from this point forward because the composition of the economy as well as the growth rate of the economy are going to change.

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

Parikh: Sure.

Christine St Anne: Speaking at a Financial Services Council breakfast in Sydney, Federal Treasurer, Wayne Swan remained upbeat about the outlook for China despite its slowing growth rates.

Wayne Swan: Yes, it is true that Chinese growth has moderated, but this partly reflects a very deliberate move to more sustainable growth in China and of course it does in part reflect weakness in Europe and the impact of that on Chinese exports. The point is this, Chinese policymakers have got substantial policy flexibility to respond and I’ve said repeatedly in recent weeks, they will.

And when it comes to China’s growth rate, we really just need to keep things in perspective. China is now 40% bigger than it was in 2008, think about that, 40% bigger. We’re 11% bigger, they are 40% than they were in 2008. So that means the growth rate can be 20% lower, that is 8% versus 10% back then for them to make the same contribution to global growth. They are much bigger and they certainly have a very big impact.

St Anne: The Treasurer also picked up comments made by RBA Assistant Governor that we are only part of the way in the current mining boom and while commodity prices have eased, there is still scope for investment and export growth, thanks to a long-term trend growth in Asia.

Swan: But it is the industrialization and urbanization of China and the long-term trend there that is very powerful for the region and for the global economy and there is a long way to run when it comes to that story. Although it has already lifted many millions out of poverty, China’s GDP per capita today is still only one-fifth of the average of advanced economies. By 2025, it is projected to still only reach 50%. So China still has enormous capacity for deepening its capital stock through investments in productive infrastructure.

Consider this, the U.S. and China are roughly the same size when it comes to land mass, but China’s rail lines are still only just over one-third the length of those in the United States. According to Reserve Bank, there is also a long way left to run on China’s path to urbanization. Over the next two decades, China’s urban population is expected to increase by 42%, so that by 2030 around seven in ten Chinese will live in urban areas. By 2030, China still won’t have caught up to Australia with our urbanization rate of nearly 90%. And the peak steel requirement for Chinese residential construction is not expected to be reached until around 2023, that's a decade from now.

St Anne: The Treasurer said Australia’s role in Asia was not as a passenger, but as a driver. With other sectors of the Australian economy set to benefit from what he describes as the Asian Century.

Swan: It's not just about digging things up and shipping them off. Across the Asia-Pacific, the ranks of the middle class are swelling at something like 110 million people a year. By the end of the decade, there will be more middle class consumers in Asia than in the rest of the world combined. Just think of all of the enormous opportunities this will mean for Australian industry to go up the value-added chain, including in financial services. The capacity to deliver complex consumer durables, services, and so on.

St Anne: Speaking after the event, the Treasurer said his optimism should not be at odds with the perceived lack of confidence in the business community.

Swan: Well, the picture I’ve painted is consistent with the IMF and consistent with the assessment by Standard and Poor’s earlier in the week. Look, I know that there are people who will go out there like Tony Abbott and talk our economy down and behave in a Tea Party fashion. But the fact is that the fundamentals in the Australian economy are strong.

Yes, there are challenges in the global outlook and I spoke extensively about those this morning and they do flow through to the Australian economy. There is no doubt about that, but we've got to build on these strong fundamentals.

St Anne: He also acknowledged that consumers remained cautious, but this was because of events overseas rather than local pessimism in the Australian economy.

Swan: There are cautious consumers and the cautious consumer is partly a product of events overseas, particularly in Europe. But what Australians can be sure of is that our economic fundamentals are rock solid. We need to build on that as we go forward. We do have uncertainties elsewhere in the global economy, but I'm an optimist about our country and our region. We've got to see the glass as being half full, not half empty.

St Anne: Christine St Anne for Morningstar.

Christine St Anne: Behavioral biases in investing, happens when investors allow their emotions to dictate their decision making. To give us an insight into what these biases are, I'm joined by Morningstar’s Darren Cunneen.

Darren, welcome.

Darren Cunneen: Thank you, Christine.

St Anne: Darren, one of the behavioral biases is known as loss aversion. Can you give us an insight into that type of behavior?

Cunneen: Well, Christine, loss aversion is simply an unwillingness for investors to accept or recognize losses. Now, whether this is investors holding on to a struggling fund or for poorly performing stock, they aim to either recoup their losses or at the very least breakeven.

Now, unfortunately by doing so, they take on additional risk. This contradicts traditional finance theory whereby investors take on additional risk with the hope of getting additional rewards, whereas with loss aversion investors take on additional risk with little expected rewards.

St Anne: So should investors sell their funds on performance alone?

Cunneen: Of course not, Christine. We would never recommend to our investors to sell a fund based on performance alone, especially in the short term. We do, however, recommend for investors to revisit a fund's fundamentals to identify if there have been any material changes.

For example, within Morningstar’s Fund Research, we assess the fund based on the five key pillars of analyst research: that's people, parent, price, process and performance. Importantly, if there have been any material changes to any of these, then it may be time to look elsewhere.

St Anne: Darren, what about anchoring bias? Can you give us an understanding about that type of behavior?

Cunneen: Anchoring bias is basically a tendency for investors to fixate on a particular data point or target number. Now, this could be a particular stock price, it could be an index level, it could be one of the many number of data points.

For example, the S&P/ASX200 reached an all-time high of 6,800 in 2007. Investors believing that this will revert in due course and become fixated or anchored to this particular data point and may consequently overexpose themselves to Australian equities.

St Anne: Home bias is also another common behavioral trade. Can you explain a little bit about that and how can investors overcome that kind of bias?

Cunneen: Home bias is a tendency for investors to over-allocate to domestic assets. The problem here is that this leads to an inherent riskiness and a lack of diversification. We recommend establishing a global allocation and implementing accordingly. For investors fairing the unknown global markets, a passive strategy maybe the way to go. By doing so, investors remove the need to make active decisions, such as country or style specifications for particular fund managers.

St Anne: Darren, you also mentioned a form of passive investing as a behavioral bias. Can you give us an insight into that kind of bias?

Cunneen: Sure, Christine. I believe you’re referring to ‘status quo’ bias. This is a tendency for investors to take an inactive approach to investing. It's almost a ‘do-nothing’ approach. The problem here is that asset allocations can stray without intervention, leading to sub-optimal asset allocations. The risk characteristics of a portfolio can also change markedly. This can be of particular importance for, let’s say, superannulation portfolios, whereby investors should be shifting towards capital preserving and less risky assets as they age.

St Anne: Herding is also another key issue for investors. Darren, can you give us an insight into that sort of behavior and perhaps some examples?

Cunneen: Of course, well, herding is basically a tendency for investors to avoid the mental anguish of going against the crowd. As you know, people value the comfort of solidarity; they simply just don't want to be different.

So we've seen this multiple times throughout history. For example, the late ‘90s dotcom bubble, and probably more recently, the Facebook IPO, and I guess, arguably the mass exodus out of risky assets in to more defensive assets such as term deposits can also be considered another form of herding.

But overconfidence in your fund can be a positive; however, overconfidence if left unchecked can lead to an overestimation of the upside and an underestimation of risk. Overconfidence effect can be two-fold. First, investors can be overly assured of their ability to identify best-of-breed funds, and a good remedy for this is for investors to seek an opposing view or a second opinion. This is where the Morning Analysis Report can come in handy.

Secondly, investors can become over-reliant on a particular fund. To mitigate this, we recommend for investors to pay close attention to the role in the Portfolio section of the Morningstar research reports. Primary asset-class exposures should be achieved through what we call ‘core portfolios’. These are well-diversified and liquid portfolios, whereas additional returns can be achieved through satellite and supporting players, which can add additional returns but should be used in smaller allocation.

St Anne: Darren, thank so much for your insights today.

Cunneen: Thank you, Christine.

Christine St Anne: Each quarter the Financial Services Council surveys Chief Investment Officers or CIOs from a number of investment firms. Today, I'm joined by James Bond to give us an overview of the results.

James, welcome.

James Bond: Thanks, thanks for inviting me.

St Anne: James, so what are CIOs thinking from the last quarter?

Bond: Well, CIOs are much more positive this quarter, that's the September quarter, than they were in the June quarter. In the June quarter, we saw sentiment go negative for the first time since we've been running the series, but in September they are much more positive, though they are more positive in the positive territory, but still not particularly confident I’d say.

St Anne: So could the slight uptick in optimism perhaps signal some green shoots?

Bond: Well, I think it's a sign of different forces working different directions. On the positive side - some positive messages coming out of Europe about the political will to resolve the crisis over there. I think that's a positive, but on the Chinese economy, which had been - had fallen off the radar, as a risk has come back on the radar very strongly this quarter.

St Anne: James, are CIOs more optimistic of some asset classes over others?

Bond: I can say universally, they are very negative about international and domestic fixed income and the reason they give is that, as we saw last week, and this survey was taken three weeks ago, they expected more quantitative easing, more intervention by central banks buying bonds, and if the central banks are buying bonds, it's pushing prices down and really should be buying bonds if that's the case.

St Anne: James, you mentioned China, is that among the short-term concerns of CIOs?

Bond: Yeah, so whereas last year I think the risk was contagion from Europe, now I think the risk is that rather than we're seeing a short-term slowdown in Chinese economy, what we're seeing is a step down in growth, a step down to a more sustainable period of growth in China and so we're still going to see strong growth, but it's not going to be as strong as we've seen in the past few years.

St Anne: And what are the long-term concerns?

Bond: So again, the Chinese economy and then that step down to a slow rate of growth, but also the deleveraging of these huge fiscal and current account in balances that the United States and Europe has. The fact that these have to be unwound eventually, is this going to lean to a period of very slow growth like we saw in Japan, where there just was no growth at all for over a decade as their fiscal problems were unwound.

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

Bond: Thanks for inviting me on, thanks.

Jason Stipp: I'm Jason Stipp for Morningstar.

Active fund managers have had yet another rough year in beating their benchmarks. We've also seen a lot of investors moving into passive strategies.

So how should you think about implementing active or passive or both strategies in a portfolio? Here with me to offer some tips is Morningstar's Christine Benz, our director of personal finance.

Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: So this debate is very heated. We have partisans on both sides. There are some very clear lines in the strategies, but you say that, even though some people feel very strongly, you may or may not, and that's okay.

Benz: I think that's right. So, if people have firmly held views on this topic, if they are all index all the time or maybe they are comfortable holding actively managed funds or even picking their own stocks, that's fine. I'm not going to try to dissuade them from their viewpoints. In fact, I think one of the keys to being a successful investor is having a strategy that you believe in, and you're prepared to stick with it. But I do think that for a lot of investors, a successful portfolio might include components of both approaches. It may be anchored primarily in index products and use some active products or even individual stocks around the margins. I don't think that there is necessarily one single way to do it.

Stipp: So, Christine, in deciding whether you are going to be an active fund investor or a passive fund investor, or blending the two somehow, the first analysis that you really should do is a self-analysis. What kinds of things should you ask yourself about yourself in deciding active, passive, or some kind of blend?

Benz: I think you want to focus on three key things, Jason. The first is time. So, if you are a time-pressed individual, you don't have much time to devote to your portfolio on an ongoing basis or to selecting securities--for someone like that, I would say that using a portfolio that consists entirely or mainly of index funds is a good way to go. If you do have more time for that ongoing oversight and that initial selection, then maybe you can think about using some active-type investments.

The other key attribute you'd want to make sure you have is some acumen. Are you knowledgeable about how to pick investments? If you are someone whose main way of analyzing a fund is to look at how 10-year performance stacks up versus the peer group, that's not enough. You really need to be someone who is comfortable with all the data that we provide about funds. You need to make sure that you are willing to do that initial analysis and you understand the research that will go into that effort.

And last thing that I would point out that you'd want to have is the discipline to hang on through the inevitable weak periods that will accompany more active products, or if you are an individual stock-picker, your basket of stocks will inevitably underperform the market at various points in time. You need to be willing to put up with those periods of weak relative performance in exchange for the potential to outperform over the long haul. So, really those three attributes are the ones I would focus on when deciding how much of my portfolio to put in active versus passive products.

Stipp: And you mentioned as one of those points there, acumen. How can you know whether you're good at what you are attempting to do? What are some factors you can look at that might inform whether you're succeeding, for example, if you're following an active strategy?

Benz: I think that's a work in progress, Jason. So for all of us to the extent that we are incorporating active investments into our portfolio, I think it makes a lot of sense to check up on how you are actually doing, how good are your skills? And the best way I know of to do that is to set up a custom benchmark for yourself that more or less mirrors your own portfolio's asset allocation, but instead of using your actual holdings, you're using inexpensive ETFs or index funds, and just creating a very stripped-down portfolio. That way you can track, am I adding or subtracting value with my security selection? If, over a period of say five years or so, you really have not added value versus that blended benchmark, I think that's a good case for either switching to an all-index portfolio or making sure that the bulk of that portfolio is in index-type products.

Stipp: So important to keep tabs on whether you are making the right choices with the right active managers to make sure that you are adding that value you want as an active investor.

We've done some research, and we've also found that there are certain areas of the market where active managers seem to have a bit of an edge or they're able to add more value than in other areas. What should you know about that?

Benz: You're right. So some of our colleagues in Morningstar Investment Management have actually done some work in that area, and it's interesting because their research--and this research was done by John Thompson and Larry Cao, and some folks in Morningstar Investment Management--corroborates that "core and explore" approach that has gotten so popular in recent years. And essentially what their research shows is that within the large-cap, highly liquid stock space, that's a very good place to index, because when you look at the data on active fund performance, active managers really have not distinguished themselves versus market benchmarks.

Where active managers have done a little bit better is in the realm of mid- and small-caps as well as in emerging markets. So, in international large-cap developed markets, that's probably a better place to think about indexing. In emerging markets, active managers have, in fact, shown some ability to add value. So, small-caps, mid-caps, emerging markets might be spaces, if you wanted to include active products in your portfolio, it might be good to concentrate your efforts there.

Stipp: Last key concept: We know that index funds, if they track the same index, are pretty much the same. They're kind of commodity products in a way, though you want to look at expenses, obviously, which can be a big differentiator.

On the active side, though, not all active funds, even if they're following the same style box, are going to be the same kind of fund. They're not all comparable in that way. So what do you need to keep in mind as you're looking across the area that you want to invest in and you're looking at active funds, how can you distinguish them?

Benz: I think you want to look for a few key things in your active investments. First of all, you want to make sure that that fund is actually active. So we've seen lots of cases, especially with funds that have gotten very large, where they essentially just shadow their benchmark. They might make a few changes in their holdings, or underweight Microsoft versus the index. This was the case of Fidelity Magellan, for example, in earlier part of this decade, where it was a very index-conscious product.

The problem is, when you've got a fund that is doing something like that, and it also has significantly higher costs than an index fund might have, that's kind of a losing proposition from the get-go. It's very difficult for that index-shadowing product to actually add value versus a benchmark.

So you want to gauge how active it is; R-squared, which is available on Morningstar.com for individual funds, R-squared versus a relevant benchmark is a good statistic to look at. If you see a very high R-squared--say, you're looking at a large-cap stock fund with an R-squared of 95 or higher--that's a good red flag that that fund's movements are closely correlated with the index. Maybe the manager isn't doing a lot to stick his or neck out to differentiate performance. So, look for that active-type strategy.

You also want to think about whether the fund has costs that are actually surmountable. So if you are using [active] products, the last thing you want is to have them hobbled by very high costs, because that can encourage the manager to take maybe outsized risks to compensate for those very high costs. So you want to give the manager a fighting shot at being able to beat that benchmark, and the best way to do that is to use an active strategy and also have semi-reasonable costs.

Stipp: Active versus passive a very heated debate, but certainly it seems like there are ways investors can blend both, or at least be better at one or the other. Thanks for joining me today, Christine, with those tips.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

Christine St Anne: The developed economies continued to be plagued by economic woes, while the emerging markets have been growing strongly. Today, I am joined by PIMCO's Ramin Toloui to look at the case for economic rebalancing. Ramin, welcome.

Ramin Toloui: Thank you.

St Anne: Ramin, in your recent paper, you look at economic rebalancing. Can you give us an insight in to this?

Toloui: Sure. I mean the global economy is going through some very important transitions right now, highly indebted industrial countries are less able to consume and support global economic growth, and emerging market countries with lower levels of debt are bearing an increased burden of supporting the global economy.

So, about 70% of global economic growth this year will come from emerging markets. In fact, that's important for a transition in the global economy, it's one that allows industrialized countries to reduce their levels of debt over time without harming overall global economic activity or while minimizing the harm to global economic activity.

That's on, what we call, the real economy side. On the investment side, we are also seeing more and more interest by global investors in allocating to emerging markets, because their existing portfolios have very low allocations, and in particular low allocations relative to these very strong growth prospects.

St Anne: So, Ramin, in your experience investors are actually rebalancing their portfolios in favor of emerging markets?

Toloui: Yes. This is definitely something that's not just theoretical. We're seeing it happen in real time. One example of that is in the spring Norway's large government oil fund, one of the large Sovereign Wealth Funds in the world made the decision to shift its bond allocation from a market capitalization weighted allocation, which had very high investments in highly indebted industrialized countries to a GDP weighted allocation for the express purpose of increasing the weight to emerging market countries.

If we look at some Asian bond markets this year, we see that Norway is the largest purchaser of bonds in those markets. So, what Norway is doing is something that's been mirrored by other large sovereign investors and also other large institutional investors like pension funds and increasingly by retail investors who look at their portfolios and see that they are lopsided in their allocations to developed markets and inadequately or too small in allocations to emerging markets.

St Anne: Ramin, so this rebalancing led by investors could that actually lead to a better outcome for world economies?

Toloui: Well that, if you put it on the chalkboard, that's kind of the hope and that is the way in which the price signals that are sent by asset markets should shape global economic activity. That is, as investors shift from developed countries to emerging market countries that helps lower interest rates in emerging market countries, making credit more widely available to support additional household consumption to support business investment.

It also tends to cause emerging market currencies to appreciate, to go up in value and that encourages emerging market countries to export less and produce more for the domestic market. And so this is one important way in which what's happening in asset markets is related to this process of rebalancing the global economy. So as investors make decisions that are in the interests of their clients, this is actually something that helps facilitate this broader process that's necessary to rebalance the global economy.

St Anne: Ramin, as you are probably aware China is of particular importance for Australian investors. As an emerging market specialist what is your outlook for the country?

Toloui: Right. Well, China is a very interesting case. China is a country that grew at an annual rate of more than 10% in the last decade and in our view is likely to grow at a rate more like 7% over the next five years. The reason for that is that some of the drivers of China's economic growth in the last decade; exports to industrialized countries and investment, has sort of reached their natural limits. The exports, because of high debt levels among their consumers in western countries and investment, because they had a very aggressive investment program following the global financial crisis.

So, when we look at what that means in terms of the numbers and the sources of Chinese growth this likely means that the Chinese economy is going to slowdown and that the composition of growth will shift more in favor of domestic and household demand. That means that the impact that China has had on the rest of the world will change in the coming five to 10 years relative to what it was in the last 10 years, and for Australia in particular, it means that the demand that China has had for commodities to support its very aggressive infrastructure and investment program is much likely to be lower in the coming period than it has been historically.

St Anne: Ramin, thanks so much for being with us today.

Toloui: Thank you very much.

Christine St Anne: As a financial planner, David Simon is continually involved in managing people's investment portfolios. He joins us today to discuss some of the key concerns on his clients' minds.

David, welcome.

David Simon: Thanks Christine.

St Anne: David, so how could people reduce the downside risk in their portfolio while also maintaining their short-term and medium-term goals?

Simon: It's an interesting question, Christine. We believe employing a method around having two portfolios. So, having one portfolio dedicated to their individual short-term needs and one for their long-term needs. By having two separate portfolios, they're appropriately investing their short-term funds and also appropriately investing their long-term funds. We find that when investors combine their short and long-term objectives with one single portfolio, they may be inclined to sell a growth-based investment prematurely with the need of funding their cash flow requirements.

Importantly, by having two separate portfolios, to make it work really well, is adequate planning. So, we find at Westpac that we encourage our clients to spend a lot of time around researching and planning their investment needs first and foremost to ensure that both portfolios can run smoothly without being interrupted.

St Anne: David, another key concern was how to get the right mix between the defensive and growth assets.

Simon: Yeah look, there is no right or wrong mix in terms of the blend between income or defensive and growth assets and it always does come down to an individual's needs and objectives. I know it’s a foregone cliché but it really does work. And you find that once you understand - you deeply understand an individual's defensive and growth needs, you can always then construct a portfolio that's relevant for their own situation.

For instance, there are a various characteristics that investors need to consider, which will drive enough information to then build a portfolio. Some of those characteristics include; their desire for income or growth. So, that is, is the individual paid to generate cash flow now, do they need that income now to fund their lifestyle, or are they prepare to defer that cash flow to seek growth and generate cash flow later on in life.

Other things such as timing; is the investor looking to invest in the short term or are they investing for the long-term? If they are investing for the long-term, well, then they probably got a little bit more time to endure their volatility, the lows and the highs. But certainly not if they're investing for the short-term.

Other aspects, such as liquidity, is the individual investor, do they need immediate access with an imminent purchase that's upcoming or are they prepared to lock their money away into the future. Some of the other characteristics include tax. So, is the investor tax conscious or are they unaware of tax? Do they care? So, once you combine some of these characteristics amongst others, it really does help to build a quality portfolio that's teed towards whatever their needs and objectives are whether it is income or growth.

St Anne: David, it's all about income at the moment and of course, another concern is how to get that income in your portfolio.

Simon: There is a real variety of ways people can access income and certainly now that interest rates are down and may continue to slide, cash doesn't look as attractive as it once was. But indeed, if you look into particular assets, including Australian shares, whilst the Australian share market remains profitable and whilst companies continue pay out their dividends and indeed whilst prices are relatively low, the Australian share market is a very good source of income.

Indeed, historically share market performance - well, the Australian share market performance, over half of its performance has been generated through dividend yield. Other aspects or other asset classes that can create income include fixed interest assets and REITs or listed property. Fixed interest assets can generate higher income than traditional fixed asset assets like term deposits or cash. Depending on the issuer can derive the outcome in terms of the yield.

So, for instance, if the Australian government is offering a bond or an Australian corporate is offering the bond, generally speaking, the income from the Australian government may be lower than the income generated from an Australian company. But nonetheless over time that may be greater income than that of an alternate asset such as cash. And indeed listed property is also a good source of income that generates rent, but it also can generate further income through its trading profits from buying and selling property.

St Anne: David finally, the other big concern is will investors ever get to experience the market highs pre-2007?

Simon: Yeah. Wow, I mean that is an interesting question and there is continuous debate. I mean, nobody knows, nobody has got that crystal ball, so they can't see what the future is going to behold. I recently did some research on this exact question and I reflected on, I suppose the worst financial crisis man has seen, and the last one we can see that almost resonates what we're going through now would have been the Great Depression of 1929. So, the Wall Street crash occurred in 1929 and it wasn't until 1954 where the Dow Jones actually reached its peak once again which equaled the pre-1929 levels.

So, once you look at that, there is almost a quarter of a century of lost performance. Then you add in the other litany of disasters which really affected the share market, which includes the impacts of Vietnam War, the oil crisis of the 70s, the crash of the 80s and even the tech-wreck. But once you combine all these disasters including the great crash of 1929, the Dow Jones still managed to average a position return of 5.3% per year.

St Anne: David, that's certainly a positive note to leave on. Thanks so much for your insights today.

Simon: Thanks Christine.

Christine St Anne: Lack of diversification is often cited as one of the big mistakes made by many investors. Today I am joined by Westpac's David Simon, who talks to us about getting that diversification right.

David, welcome.

David Simon: Thanks, Christine.

St Anne: David, as a financial advisor do you find many people have a concentrated portfolio?

Simon: Not really. Most of the individual investors that I come across have a traditional, well diversified portfolio of assets. From time-to-time I do come across individuals that have a concentrated portfolio, but more often than not they are an executive of a company, which they held shares in, or they have a vested interest or a passion about the business that company operates within.

Interestingly, one of the world's, I suppose, most professional and successful investors Warren Buffet - he has a lot of quotes that are out there. But one that resonates quite well with this question. Buffet says, it's okay to have all your eggs in one basket as long as you watch that basket very closely. But I think that message was sent to more of the sophisticated investor that has a intimate understanding of that particular company and a real solid education about where that company is heading and what they are doing. But overall, most customers I see have a well diversified portfolio.

St Anne: So, what sort of assets should they look at to add more eggs to that basket?

Simon: Look there is a whole variety of assets that individuals can look at, but I think the underlying source of truth comes down to correlation. There is no point in diversifying across a basket of assets that are all going to be dependent on one another in terms of its own performance.

So ideally, we encourage investors to truly diversify in assets that are not particularly correlated or rely on one another. So, assets such as gold, commodities, cash, fixed interest, property, as well as shares have elements that are uncorrelated, which means they are not relying on each other increasing in value in order to generate performance. And you find that diversifying across this range of asset classes that are not particularly correlated means that if one asset performs and other one doesn't then the investor is not going to feel the brunt of the failing one. The other benefit he said it does smooth our returns by diversifying throughout the asset, and indeed you can diversify it within the asset close themselves.

So, for instance, the share market, you can diversify across a broad range of companies within different industries across different countries and you'll find that, that certainly allows access to opportunities, but also limits the risk of concentration.

St Anne: David, we are in the midst of unprecedented market volatility. What should investors do when one asset is not performing well, should they simply divest from that asset?

Simon: Yeah, look that's really interesting question. Investors need to first and foremost go back to the reasons why they made the investment in that asset in the first place and understand whether those reasons are still current and whether the fundamental characteristics of that asset are still present.

So, once they get through that then they need to understand the reasons of why they made that investment. So, did they make that investment for a short-term trading opportunity and hoping for a win or did they make that judgement on the benefit of a long-term investment objective rather than a trading opportunity. And then understand the asset deeply to work out whether or not the micro and fundamental characteristics of that asset still remains sound and that asset then still continues to have that quality component. Or indeed whether or not the reasons for underperformance are due to more macro noise-related events rather than the individual asset itself.

Once that investor understands this with these types of information, they then can determine whether it's still the right fit for their portfolio or not. But certainly panicking or making irrational decisions based on gut feel is certainly a very big risk to take.

St Anne: David, on that point of lack of diversification does this mean that many investors make the wrong decision when it comes to their life stage?

Simon: Look life stage is a very interesting one and it's very general in approach. We have clients that are well and truly in retirement, that say assets such as Australian Equities as a safe investment. We have some youthful people that have forty years before retirement, that say assets such as equities are the risky investments.

So, there is no right or wrong in terms of how individuals look at investments based on their lifestyle or life stage. But certainly generally speaking, typically a youthful investor that has years ahead of him before retirement and then generating sufficient cash flow out of their work to maintain their standard of living, typically they would forego the passive income that's attributable to investments in order to generate growth so that when they are at the point where they need income they can then draw income from their investments then. And progressively as our investors age then they move into an area where they are generating more income - passive income as the investor want on their employment to satisfy their income needs.

So, you'll find that life stage does invariably have some type of influence in terms of the assets in individual investing. And certainly in times like this where the market is particularly volatile and in distress, people are looking for more of a safe haven around defensive assets that have that ability to generate income, certainly whilst they are in retirement.

St Anne: David, thanks again for your insights.

Simon: Thanks, Christine.

Christine St Anne: We spoke with Bell Direct's Julia Lee backstage at an investor briefing. In the second part of our Market Insight Series, Julia gives us her take on the key risks for the new financial year.

I just wanted to begin with some of the macro issues, particularly of course with Europe. It's obviously been a lot of pain. What's going to be happening in the next 12 months? Do you think that there, low and behold, there might be some subsiding of this pain?

Julia Lee: I guess that's what markets are hoping for. At the moment, what we are seeing is an unsustainable situation in Spain with the 2-year yields at about 6.7%. So, really if the situation continues as it is now, then Spain will have to seek a bailout, so that means more volatility for markets and probably a greater propensity to look for those safe haven assets. They are the high yielding areas. We're seeing U.S. treasuries - a very traditional safe haven asset, seeing all time record lows in terms of the yields, so probably continue to see that.

Of course, what the market is eventually hoping for is at least a circuit breaker. That is, some sort of bailout package coming through from the European Central Bank or the Troika to help ease, not only the banking crisis in Spain now, but it's spread to be also a regional crisis. So, we do see that kicking the can down the road once again, that could give some temporary relief to markets.

But longer term, the solution is probably some sort of restructuring of the unsustainable level of debt in countries like Spain and Italy, and then the option is to either grow out of the problem, inflate out of the problems, or belt-tighten out of the problems, and in what option Europe is going to take, we've seen a bit of clash, where Germany wants to belt tighten, but a lot of the rest of Europe want to grow.

St Anne: And Julia, what about China, that's been down on investors' concerns of late, with some of the resource stocks taking a hammering. Is the growth really of a concern in the near-term?

Lee: Sure. Well, China has already stated they are looking at growing at 7.5% in 2012, and I guess, there's a lot of confusion around China because it is a time of change for China. They are becoming less dependent on their exports and more dependent on their internal economy and the service part of their economy. So, traditionally what we've thought of in terms of China is that an 8% growth rate means full employment for China, and then when we come down to a 7% rate or closer down to a 7% rate, that it actually - we actually see problems in terms of the labor force, in terms of social problems. But in natural fact, because of the shift in China's economy over the last four or five years, there is probably still fine for 7.5%, that probably still looks at full employment, especially with the demographics with an older workforce coming into play there.

But with China, I guess, two things that we are looking at, one is the import side, and one is the export side. The export side has held up relatively well and that's a positive given that Europe is China's largest export market. The import side is more of a concern and there the numbers that we've seen recently has shown that perhaps the domestic economy in China isn't as strong as what the market actually thought it would be, and the thinking behind it was that we'd see export soften off because of the European situation and global growth situation, and we would see the internal growth in China filling that hold over that gap. But now there is a bit of a question mark on whether we're going to see that. The good news is China has a lot capacity to be able to pull those interest rate levers.

St Anne: And Julia, if we can look at the local issues now, what sectors in the Australian economy do you think are best positioned in the next 12 months?

Lee: This is a big question, because the Australian share market in particular has underperformed and has had a negative 10% return over the last year. A lot of people are thinking why? Australia’s economy is supposed to be so strong, why has the share market seen a negative 10% return. And the fact of it is that over the last 18 months we have seen a downgrade cycle. That is that analysts have been readjusting their expectations in terms of FY ’12 earnings downwards. If we have a look at the expectations for earnings season at the moment this was 0.4% growth; that’s virtually flat growth for the Australian market. If we strip out resources, then it’s 4.1% growth. So a lot of that pain is because of the materials and the mining space.

We are expecting to see BHP Billiton with their profit result down 19% compared to the previous year. In the material space as a whole, the consensus is for negative 13% return. So when we start to see that the material space has underperformed the market and in fact has lost 30% over the past year, you start to see the reasons why not only have the macro concerns being a key factor on how investors and traders have allocated their portfolios, but also on the earnings side we are seeing an environment where earnings growth is slowing for big companies like BHP Billiton and Rio Tinto.

On the other hand, you look at the telecom sector and growth there is expected to be 10% for FY ’12. No wonder that the telecom sector is not only well supported by the macro environment, which is being very much a risk-off environment but also the expectations for earnings to grow in that sector. So sometimes because we focus so much on what’s happening in Europe and focusing on China, we don’t focus a lot, in terms of what’s happening here in the domestic economy and especially sectors of the share market.

But certain sectors of the share market have come under a fair bit of pressure over the last 52 weeks, and the ones that really come to mind are the material space where we’re expecting consensus earnings to fall by 13% and also if we have a look at some of the other areas the discretionary space we are expecting to see earnings fall by 24%. On the flipside, telecom is doing really well, insurance should see a strong bounce back as well.

St Anne: And any other defensive sectors, Julia, are they - like the retail that Peter mentioned, like Woolworths and Wesfarmers?

Lee: It is quite, I guess it’s a good exercise in having a look at those discretionary retailers versus the staples retailers. So they are the likes of David Jones, Myers, Harvey Normans versus the Woolworths and the Wesfarmers of the world, and in the discretionary space we have seen a lot of pain that’s the David Jones, the Harvey Normans, JB Hi-Fis of the world. We have seen that reflect in terms of the share price.
That discretionary space is expected to see earnings coming under pressure during this earnings season, negative 24% in terms of earnings growth coming out of that sector. On the flipside the staples area is expected to show growth of 6%. So, once again this is a situation where we are seeing the macro environment supporting these defensive sectors, but also earnings supporting the movements that we have seen in terms of share price performance.

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

Lee: Thanks Christine.

Christine St Anne: The resources sector continues to remain under pressure. Fund manager David Whitten has recently launched a natural resources fund. Today, he joins us to talk about some of the challenges in the sector, but also the opportunities.

David, welcome.

David Whitten: Thank you very much.

St Anne: David, we have falling commodity prices, high cost of doing business, and now a slowing China, why have you decided to launch a fund in this environment?

Whitten: Look, I think it's a very good time to launch a natural resources fund. We've seeing a strong correction in some of the prices. Last 12 months, I think, the global natural resources market has fallen about 15%, mainly led by the mining sector, but there are the soft commodities and the energy sectors that have been less so.

I think there is some corporate activity shaping up in the sector, and as I say, the valuations both on a price net present value and any other form of valuations look quite attractive again as there are in many times throughout the last 10 or 15 years in a secular bull market. I still believe that the drivers behind natural resources demand, population prosperity, and growing demand for natural resources is there throughout the world.

St Anne: David, also one of the challenges that many of these companies are facing is a delay in some of the projects. Is this a real concern for investors?

Whitten: Look a short-term concern for maybe earnings expectations, but really I think it's a prudent thing to do for companies, and perhaps it may have the beneficial effect of actually extending the natural resources bull market, if you like, to a greater extent.

The fact that these companies have the flexibility to delay projects, because of the depth of their projects and the database of their projects is a good thing, and I think it's prudent to do that at certain times. There is a slowdown going down in China, but we got to remember at 7% plus, it's probably growing faster in a total GDP sense than it was five years ago, when it was growing at double-digit GDPs.

St Anne: David, given all these challenges, what companies are you seeing that are best placed to succeed in this environment?

Whitten: Our view of natural resources includes the agricultural sector as well as the traditional mining and energy, which an Australian investor is often very familiar with. So in our portfolio that we've just launched the new fund this month, we've added a number of fertilizer names, agricultural names that will benefit from the growing demand for food and growing demand for protein.

And it's not just a China story when it comes to food. Countries like Brazil or India or even Africa, their middle class is growing very rapidly and their populations, of course, are growing rapidly, and we see strong demand from some of those sectors.

The energy sector as well is always a sector, which grows over time, and there is a lot of interest in this sector at the moment, particularly some of the North American energy companies. We like a lot some of the shale oil players, LNG in North America is great, gaining credence, and there has been quite a bit of takeover activity just in the last week or two in some of those stocks.

St Anne: A lot of investors look at Rio and BHP and Fortescue as big the resource players?

Whitten: Yes.

St Anne: David, what are the other companies in the investment horizon?

Whitten: If you look at the Australian ASX 300, for instance, about 25% of that is resource companies, and of that 300 companies about a 100 - I think, it's about 115 companies are natural resource companies really dominated by four companies; so BHP, Rio Tinto, Woodside, and Newcrest comprise about 60% of that and some of those companies, particularly BHP and Rio, have a strong weighting towards iron-ore and coal in some cases.

So, we are very focused in some of those areas, but there is a whole world out there in some of the other natural resource areas, particularly in energy and agriculture, you can't really get that sort of exposure to an Australian - if you're Australian-only investor.

St Anne: Finally, David can you give us an outlook for the commodity sector?

Whitten: Yeah, we don't predict short-term moves for commodity prices. What I can say, for instance, and you may be not so familiar with the soft commodities. The grains importing into China has grown by 45% in the last 12 months. Those stats just came out last month. Demand for food, protein used for feed as well as feeding people is growing very strongly, and we see strong rises potentially for some of those soft commodities such as we've seen that through drought and - with wheat and corn and palm oil, sugar, those types of commodities have real potential.

Over the last decade we've seen iron-ore, coking coal prices lead the charge, demand for steel infrastructure in China and other parts of the world. Those commodity prices have risen about 350% to 400% over the last decade. Compare that to some of the soft commodities, they are probably only just approaching 30-year levels in adjusted for inflation and have probably increased about 100% to 125%, 150% over the last decade. So, we think that there is potentially quite a way to go there, some of those commodities in the longer term and I stress longer term. Predicting short-term commodity moves is a very imprecise and difficult thing to do and we don't do it in our investment process.

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

Whitten: Thank you very much.

Christine St Anne: We caught up with City Index’s Peter Esho backstage at a recent investor briefing. In the first part of our Market Insight series, Peter gives us his views on the key risks for the new financial year.

Peter, thanks for your time today.

Peter Esho: Thanks for having me.

St Anne: Peter, if we could just begin with some of the macro issues. First of all, of course, Europe, how do you see that playing out now for the next financial year?

Esho: Well, the past year was very - extremely tough for the European debt situation. We really saw the conversation around solvency issues emerging. The European Central Bank was quick to enter the market and really address liquidity concerns. It's been a rough road I think in Europe and I think the outcome has been the Europeans are waking up to the fact that austerity on its own is no longer the solution. So we've seen a shift towards some more appropriate strategies around growth.

How they'll achieve that, we're unclear. But what was very decisive was the way that the European Central Bank stepped in to quarantine liquidity issues, and I think that was very important. The market still has not overcome the cost of that or fear. We continue to see Spanish yields, for example, Italian yields at elevated levels. But I think, at least there's a commitment there that the European Central Bank will be very firm to step in and quarantine liquidity issues, and I think that's going to be important for the next financial year. Investors will wake up to the fact that perhaps some of the worst news in Europe is behind us, and going forward, it's all about workable solutions.

St Anne: Well, with what's been happening with Europe, what about China, Peter, that's being playing on a lot of investors' minds, and resource companies are seen to be hit with those concerns. Is the slowdown a real issue in the next 12 months?

Esho: Not really, I think, what we've seen in China is a very well engineered slowdown in the economy. Six months ago everybody was worried about the Chinese property market collapsing, the price of iron ore collapsing, and sure, the price of iron ore has come from $190 odd per ton to around $120, $130, perhaps it can fall slightly more. But if you take recent Chinese data, we basically have a reduction in the rate of inflation well below the People's Bank of China’s official rate now 2.2% as opposed to 4%. You’ve got a trade surplus, which was $10 billion in excess of what the market was expecting, $31 billion trade surplus.

You've got the Chinese economy still managing to post double-digit export growth numbers, and you got Chinese GDP growth number that came at 7.6% year-on–year, which was in line with market expectations. So, what the Chinese have managed to achieve is fantastic. They've managed to reduce the rate of inflation from in excess of 6% to 2%, they've managed to maintain a respectable rate of growth at 7.6%.

They've managed to rein in the steel industry without the iron ore price for example collapsing for the Australian producers. It's been a very good balance, and I think what we will see in the second half of 2012 is a resumption in growth strategies in China. They've now reined in the economy to where they wanted it, and I think they have the capacity now to engineer more growth.

St Anne: Now Peter, if we could come back to local issues, what about sectors in the Australian market that are going to be best positioned in the near future. Is it still going to be all about defensive?

Esho: I don't think so. I think, the defensive stocks have been a very crowded space. There is the ability to place the market for those key significant risk exposures, so we think the riskier assets will perform better.

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

Esho: Thanks, Christine.

Christine St Anne: Listed investment company WAM Capital announced its full year results this week, posting an outperformance of 11%. Today, I’m joined by WAM Capital's Geoff Wilson to give us an insight into those results and the outlook ahead.

Geoff, welcome.

Geoff Wilson: Good to see you, Christine.

St Anne: Geoff, your portfolio outperformed the index by around 11%. Can you give us an insight into the companies you invested in that allowed you to achieve this performance?

Wilson: The companies that gave us the best performance over the 12 month period were the likes of Breville, McMillan Shakespeare, Flexigroup, Ainsworth Gaming and Signature Capital. They are the top five in terms of - that helped us deliver that performance.

St Anne: Geoff, you also announced an increase in the dividends by 10% to shareholders. How are you able to achieve that?

Wilson: The dividend increase from $0.10 for the full year period to $0.11, which on the current share price is about 7% fully franked. That was our belief that we want to payout franking credits, if we have them. And that pretty much for the 12 month period pays out the bulk of our franking credits.

Starting this year, we've got little under a couple of cents of franking credits. By the end of the year, we believe we'll have between $0.11 and $0.12 or $0.13 of franking credits and our belief is they are better off in shareholders hands than in our hands.

Now, the goal of the directors are to deliver a growing stream of fully franked dividends, so looking forward the next 12 months, and obviously these are Board decisions, but we paid $0.11 for the year just gone. The plan would be, if we could to at least pay $0.11 for the 12 months going forward, if not increase it slightly.

St Anne: The revenue for the business was also down by around 70%. Can you give us a reason behind that given that you outperformed the market?

Wilson: Yes. I mean the fortunate or unfortunate thing is how we account for our profit is that all our assets are held in current assets, so a portfolio - say, $170 million of assets are in current and any movement in that portfolio gets reflected in the profit and loss statement.

So a year ago, we were up 17% odd, so therefore we had a reasonably high profit, where this year we are up little over 4%. So therefore, that’s what it looks as though the percentage drop is significant from last year to this year, when the market was down 7% and we actually outperformed by about 11%.

So the strange thing, is it’s just unfortunately how the accounting works. Next year, say if we’re up 8%, then the profit result would look as though - would say that we are up 100% in terms of profit result. So, what you really need to do is look at how those assets have performed, not actually how they are reflected in the profit and loss statement those movements.

St Anne: Geoff, you also announced a placement issue. What was the reasons behind that issue and what are you going to do with the extra funds?

Wilson: Yes, a number of months ago we were doing our road show and seeing investors, and we came across a group of investors that were big investors in the list of investment company space. They wanted to get exposure to WAM Capital. They had little bit, but they wanted to get additional amount and they really - they wanted to put in a significant amount of money. So, they wouldn't have bought it on market because that wasn't possible, there’s not that liquidity. So, what the Board decided is to do a placement of that company. Now, we'd only do a placement if it was done at NTA, because then it’s fair to all shareholders. The problem is if you do at a discount of NTA, then you are disadvantaging current shareholders. So, we are not interested in that. That’s the reason why we are doing it.

In terms of how we are going to invest that money, it will be exactly the same as how we invest money at the moment. We look for growth companies that are underpriced and that we can see catalyst is going to change the valuation, that’s our research driven process or if we are sitting on cash a market driven process is where we get a performance. If we can get a better than cash performance and that at the moment we are rolling term deposits sort of out 5%.

So, we'll just do it - we’ll invest in it as a percentage basis. So, if we believe we want to buy a stock we tend to put 1%, 2% or 3% of the fund into that stock. So, at least our pool of capital will increase by the size of the placement and then if we buy 1% of the fund – put 1%, 2% or 3% of the fund into it then that will be how we invest the money.

St Anne: Geoff, your portfolio is also invested in cash, are you looking to move out of cash at some stage, and what is your general outlook for the market?

Geoff Wilson: Probably two questions there. One is, at the moment we've got about 43% cash, we would prefer to be a 100% invested in the market. But in terms of how we invest, we are not like the traditional equity fund manager that is always exposed to the market, our default position is cash.

And how we invest? We analyze companies and we can find growth companies and if they are not - if we can’t see a catalyst that we believe will change the valuation, we don’t buy them. If we can see a catalyst that will change the valuation, we'll buy that company, but then when it reaches that valuation we’ll sell it. So, market timing is very important for us.

I mean, when you look around the world, particularly in Europe, and you'll see negative interest rates, I think in four or five European countries, negative two-year bond rates, that really is quite scary and whether the markets over there are forecasting a really significant recession or even a depression, to me that's a concern.

One of the good things about the equity market is it’s all about what the equity market is factored in. And what I've learnt over time is, when you are the least certain about what’s happening, that’s probably the best time to buy. At the moment, everything looks terrible. So, I would say, if you are taking a medium term view - medium to long-term view, this period has to be a buying opportunity.

We are still of the belief that we are in a deleveraging cycle where that goes from a decade or so. What that means is it is going to be low growth, but the markets have already adjusted in terms of the P/Es are a lot lower than they were say 5 to 10 years ago. So, the P/Es are forecasting lower growth.

One of the good things about the market, there is always opportunities, whether it’s corporate activity, whether it’s capital raisings. There are some stocks that are doing well. We think this reporting period there will be some disappointing numbers again, and the outlook statements will be negative. But we would say, once they are all factored into the market, the markets have probably reasonable value.

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

Wilson: Thank you very much.

Christine St Anne: The Australian market is traditionally known for its good dividends and franking credits. There is one global equities fund that is offering investors higher dividends and income. Today, I'm joined by the fund's Tim McGowen to give us further insight into their strategies.

Tim, welcome.

Tim McGowen: Hi.

St Anne: Tim, Australian investors have always liked the banks and Telstra because of the higher dividends, why global equities?

McGowen: Yes, certainly. I mean, obviously, the dividend yield has been under - has underperformed or underpinned rather the performance of the Australian banks and Telstra for some time. What we're seeing offshore is actually, you're seeing some good dividend paying names in some of the pharmaceuticals, so some of big household names like Pfizer, and Glaxo, and Merck, so you're getting increased dividends from the pharmaceutical sector.

And then within the technology sector, you're also getting increased dividends. So, names like Microsoft have now got 13% of their market cap in cash. You're seeing that with Oracle, you're seeing that with Apple. So, the sustainability is, is that you will see increased dividends from technology names and that's also manifesting itself in regards to increased buybacks as well.

St Anne: So, what dividend yields are these companies giving to investors?

McGowen: Sure. You're looking at somewhere between, 3% to 5%, which is low compared to Australian standards. But if you look at the Australian equity market as a whole, you're looking at around 5% yield, if you take away Telstra and other banks, and obviously investors are congregating in those names, and that has certain risks to being congregated in individual names. Offshore you're seeing 5% yields - 3% to 5% yields, and increasing across a broader spectrum.

St Anne: Tim, can you explain how these buy right strategies boost these dividend yields?

McGowen: Yeah, sure. I mean, the buy right strategy is pretty well-known in Australia. There are some well-established funds who are selling call options over -Telstra is an example, over the banks will have a BHP, and by selling call options you're bringing in extra income. So, you're increasing the yield of your individual positions and/or your portfolio.

Now in the U.S., we are the first fund to do that globally, particularly in the U.S., we've kind of avoided Europe, somewhat for obvious reasons at the moment. But we're paying 8% income through a combination of dividend yield around 3% to 4%, and then enhancing that by selling call options against a basket of global equities. So, we're dealing in names like eBay and Google and some of the pharmaceutical names I've mentioned.

St Anne: How do you chose the companies, is it all about dividend yields?

McGowen: Yeah, sure. I mean, PM Capital has been around since 1998. We are well-established global manager, so we have a fundamental investment process that's been in place for a long time. So, we are replicating that process.

We are taking names whereby we find some yield - we're looking for dividend yield. We're looking for some volatility, so we can kind of package up that position in a name like eBay as I said, and then have a higher enhanced yield over that individual position.

St Anne: Tim, there's been much discussion about how volatile the global equities markets are, how does your fund overcome that challenge?

McGowen: Sure. Well, we capture that volatility. I mean, we capture that volatility by selling options against our equity portfolio. The higher the volatility, the higher the income we can return to investors. So, if you sell a call option over eBay, you bank that premium, you get paid to sell that call option and that call option is returned to an investor as a distribution, a quarterly distribution of 2%.

Now if the markets are more volatile that distribution may increase, so the nature of our strategy is that we buy equities over global names, we sell call options against it, and we're lowering our risk profile by doing that, and then we're putting in place further downside protection.

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

McGowen: Okay, thank you.

Christine St Anne: In Morningstar’s latest Australian equities large cap report a number of managers shared their views on Australia’s two-speed economy. To get an insight into those opinions, I'm joined by Morningstar’s Tom Whitelaw.

Tom, welcome.

Tom Whitelaw: Thank you.

St Anne: Tom, what are fund managers saying about a possible slowdown in the commodities boom and are they still exposed to resource stocks?

Whitelaw: I mean views vary, and that’s kind of what makes the market out there, but what we certainly did notice was there’s definitely more of a preference for the high quality resources names. So, you're seeing an increase in the weightings in BHP and RIO perhaps and also a reduction in some of the more speculative names out there, because managers are generally -they're not sure what’s happening in global markets. They don’t want to get caught on the wrong side of the trade.

What we also saw was an increase in weightings in the likes of Newcrest for example, so Schroder's actually just added that stock to the portfolio, which is quite rare for them to be holding gold, and that’s really just about gold's role as an insurance policy in uncertain times.

St Anne: If a slowdown is possible how are fund managers responding to this challenge?

Whitelaw: Well, Australia has had an unprecedented boom for the last 10 years, when resources have really kicked off and the level of growth that we’ve seen throughout the market thus far, it’s just not going to be sustainable into perpetuity. So, we’re seeing managers look elsewhere for that growth.

You got the likes of IML, who've done very well over the last 18 months or so, and won our Fund Manager of the Year in 2011. And they have focused on sustainable earnings, so competitive companies with sustainable earnings and strong management teams that are still reasonably priced. That process has done very, very well in markets recently. And also their kind of avoidance of some of the cyclical areas has also helped them avoid some of the more structural issues that have come in.

St Anne: Tom, your report mentioned a number of structural issues playing out particularly in the media and the retail sectors. Were the fund managers that you surveyed virtually ignoring those sectors?

Whitelaw: Again, it’s horses for courses, so you've got some managers like IML for example and Perpetual as well who have stayed clear of these areas, but then you've got other managers, and this is kind of synonymous within the value space. So, we would class Perennial and Legg Mason also in that value space with IML and Perpetual. The two approaches that they've had have been very, very different, so whereas you've got IML and Perpetual, who very much sustainable value approaches, looking for competitive long-terms drivers and sustainability through that. You’ve then got Legg Mason or Perennial Value for example, who are looking more for mean reversion. So, they have actually tried to take advantage of some of these issues we’ve seen in the retailers, the media stocks, the steel players, where valuations are at all-time lows.

They’ve looked to get in there at the bottom, but unfortunately those structural elements have really kind of come against them in the last 18 months, and they’ll tell you that at the bottom of any cyclical cycle everything looks structural. But unfortunately for them we’ve just not seen that kind of pull back just yet.

St Anne: Tom, a number of Australian companies are known for their high dividends, are a lot of these fund managers now seeing the Australian market as purely an income play?

Whitelaw: Yeah. I mean, again that’s something that we were seeing, so whereas before growth was a big driver of total returns. Now in an environment where growth is expected to be a lot lower, people are more concerned about the income component of that total return, so they're looking at those high yielding stocks, so there's been quite a lot of interest in the big four banks, where you get a yield. We've seen a pickup there.

Obviously, something like Telstra has been a very popular holding, and that’s been a big driver - some of the guys who did very well in 2011, as that was one of the strongest performing stocks, and it's really about just adding the income component to that total return, if growth is going to be a little bit smaller, so, yeah, definitely seeing a pickup in those names.

St Anne: Tom, your report also found that a number of fund managers were concerned about the growth outlook. Does this mean Australian investors need to rethink their equities exposure?

Whitelaw: I mean it’s definitely not a time to move wholesale into term deposits. We've certainly seen an increase in term deposits, but now we'd say keep your equities exposure, but maybe just look at diversifying that Australian equities exposure, because Australian’s typically have large home country bias, so there's a lot of that weighting is in Australian equities. We talked about the unprecedented boom that they've had over the 10 years. So, now is probably a good time just to look at diversifying that into a few more international names.

St Anne: Tom, thank so much for your insights today.

Whitelaw: Thanks a lot.

St Anne: Premium subscribers can access the report by going to the morningstar.com.au website and clicking on the Funds tab.

Christine St Anne: The market volatility continues to concern many investors. These concerns could lead to some common investment traps. To overcome these traps, I'm joined by Securitor's, Matt Englund.

Matt, welcome.

Matt Englund: Thanks for the chance to chat.

St Anne: Matt, as head of an advice group, what are the key concerns that are raised by your clients in this environment?

Englund: There are some things that we're seeing at the moment with our clients that are universal and always stand, and there are some things that we're seeing that are specific to the market at the moment. The issues that always stand are the issues associated with do I spend and enjoy for today or do I invest and save for tomorrow. This concept of instant gratification; do I make sure that my future is set up appropriately or do I spend today and enjoy the lifestyle that I'm looking for today. It's an issue that we face across all time and that's something that we face today, it's universal.

The issues associated with the more current investing climate are two. The first is the ability to effectively contextualize or understand what it is that's going on. So, when I read the paper, when I see what's going on in the news, what does it mean? Not what does it mean in terms of the economy of Greece or Spain or Portugal or the EU or the U.S. More broadly, what does it mean for me? What does it mean for me and for my future? What does it mean for me and my investments today? That's the first thing.

The second thing that is about the environment specifically today is this concept of confidence. People have lost confidence in the fundamentals. People have lost confidence in this concept of long-term investing. You can understand why, but what hasn't changed, what must remain at the forefront of thinking here is that long-term shares outperform. Long-term cash is not a good investment in isolation. Long-term you shouldn't be chasing just yield. Yes, there is a period of time in the cycle and that period of time is now where you do get good returns from cash or from the yield that comes off our big four banks, but long-term you need capital growth to have a sustainable future and by consequence you need to be invested in the markets and a return to confidence there will help deal with that issue.

St Anne: So, Matt, do you think that these concerns lead to some common mistakes that investors make when it comes to managing their investments?

Englund: Yeah, I think investors at the moment are making the mistake of being defensive at a point in time where opportunities are almost boundless. So when you think about volatility and the capital value of your investments, where at short-term that's not an issue. If I'm a long-term investor, why do I mind if the value of my investment goes up and down in the short-term if I know the fundamentals are there and that the business is sound that I'm investing in.

So people at the moment are reacting to short-term news. The market as a whole is reacting to short-term news. Even if there is an issue in Europe, even if there is an issue in terms of growth in the U.S. or in China, long-term we know that equity investors will seek and will find a good quality return. So people are reacting short-term to issues that they should see through and in fact should see as a buying opportunity.

St Anne: So, Matt, how can I overcome these mistakes?

Englund: Great question. There are two ways people can overcome these issues. The first one is to seek good quality financial advice. Having somebody by your side, a coach if you will, a money mentor to work with you through this process is incredibly important, and will give you the confidence that you're looking for.

The second way they can do it is be educated. Seek information from a wide range of sources to make sure that you understand fully what it is that you're seeing on the news, or that you're reading in the paper, or that you're hearing from your friends. When you start to understand the fundamentals and you think long-term about what it is that investing is there for, how you should focus on your long-term goals, a good quality financial advisor and being well educated yourself will help guide you through this period of instability.

St Anne: Matt, we're facing unprecedented volatility, is there any way investors can actually control their portfolio?

Englund: If I think about being able to control your portfolio, I take a slightly different view on it. Control the outcomes, control your future, focus less on the volatility of the value of your investments today and more on your long-term goals and a good quality of financial advisor partnering with a financial coach will help you do that.

Think not so much about what's going on in your portfolio today, but rather think much longer term about what it is that, that portfolio is designed to help you achieve. So don’t focus on today, think about today as an opportunity, use volatility as an opportunity to help you achieve the goals that you set out to achieve when you first started investing.

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

Englund: Thanks for your time.

Christine St Anne: Many investors look to good dividend paying stocks to get income, but there are also income focused bond funds. To give us an idea about how these funds work, I'm joined by PIMCO'S Michael Dale.

Michael, welcome.

Michael Dale: Thanks for having me, Christine.

St Anne: Michael, so what kind of assets are found in income-focused bond funds?

Dale: Well bond funds, especially income-oriented bond funds, really focus on two key principles; the preservation of capital, first and foremost, and then reliable sources of income, Christine.

So within an income-oriented fund, you really want to be looking for top quality sovereign or credit corporate bonds that is, that will pay you your face value at maturity, but also pay you a coupon that can be a real return, something when adjusted for inflation is very, very important in retirement and has very, very low default characteristics.

St Anne: How did these assets generate higher yield compared to, say, the more traditional fixed income funds?

Dale: Well, Christine, I mentioned before that one of the principle reasons of investing in a bond fund is to get reliable and timely income. So, we would say that a traditional fixed income fund or an income paying fixed interest fund really do have the same mandate when investing across securities.

If anything that would probably need to look at the type of credit quality associated with the fund that are investing in, and that will align with the kind of yield that they require on behalf of their client or for themselves.

St Anne: Michael, many investors are obviously invested in equities. Are these assets correlated to equities?

Dale: So what you need to think about there, Christine, is making sure you have a real diversified bond portfolio, whether it be global or Australian. Making sure you have a healthy mix of government securities, which are uncorrelated or the most uncorrelated asset to risk asset such as equities, and then also a healthy mix of strong quality corporate bonds that lie right up ahead in the capital structure and are very much uninfluenced by a fall out in the equity market or negligible fall out in the equity market. So that would mean that the default characteristics are very, very low within the income fund that you're paying will help mitigate it against any downturn in the equity market.

St Anne: So Michael, what are the risks investors need to be aware of?

Dale: When investing into a bond fund, Christine, really they need to be looking at the underlying credit quality of the bond fund. Really is there any default characteristics that can affect capital being returned to the investor at the maturity of the bond. Also the threat of timely income being eroded by inflation, but I would therefore say that active management becomes very crucial in this type of scenario, where active managers can make sure that they manage both the interest rate risk and the credit risk that I've just spoken about.

St Anne: Michael, you touched upon the bond rates, many investors have concerns about these rates, particularly the implications for yield, what is your view?

Dale: Well, we need to really think as an investor and what we're trying to get out and talk to people at the moment is, what a low bond yield is telling you about the economic environment around the world. It suggests that growth is going to be sluggish. It also suggests that central bank's policy rates are going to remain low for a long time to come.

Finally, it suggests that the consumer and the business are becoming very sluggish and very scared from a confidence point of view. So what you really need to make sure you have within your income-oriented fund or your bond fund for that matter is a very good quality portfolio that is uncorrelated to risk assets and that pays you timely income, whilst preserving your capital.

St Anne: Michael, thank you so much for your insights today.

Dale: Christine, thanks very much for having me. Appreciate it.

Christine St Anne: With economic uncertainty and falling interest rates, investors are continuing to look for alternative investments. Today, I'm joined by TCorp's Tim Hext to talk to us about the New South Wales government's new annuity bond.

Tim welcome.

Tim Hext: Thank you, Christine, and thanks for having me.

St Anne: So Tim, can you give us an insight into this new annuity bond?

Hext: Certainly. Well, the way the Annuity Bond came about is we had a discussion after the New South Wales Treasurer Mike Baird was elected; he had this vision that they wanted retail investors to play a much bigger part in financing New South Wales, and particularly infrastructure we need.

Really what the annuity bond is about, it is about saying when people reach retirement, how do they change as investors and clearly, in the pre-retirement stage everyone is concerned of wealth accumulation. Obviously, they are still contributing; plus they're looking for asset growth, but in retirement phase people change. Obviously, when they're drawing down their money, there is a much greater emphasis on safety and security, which is something as a government, clearly we provide.

They're also generally looking for high cash flow and finally, they're looking for inflation protection. How do they protect their cash flows against a rising cost of living? So we try to come up with the product. Now, the annuity bond itself is a reflection of the product we have always offered to wholesale investors, which is called an Indexed Annuity Bond. So, we decided we'll take that similar product and offer to retail investors for the first time.

St Anne: How do the interest rates compare with the popular term deposits?

Hext: Well, in our fixed rate program, we have a three and 10-year bond and currently they're about - it's 3.5% for the three-year and it's 4.25% for the 10-year. Now, clearly, in the three-year space, it's very hard to compete with bank term deposits; there's two reasons for that. Clearly, bank term deposits do enjoy a government guarantee, federal government guarantee up to $250,000; but secondly, most people when they're investing for fairly short time periods, credit concern anyway is not probably in front of their mind.

In the 10-year space, there is a lot less competition from bank term deposits and also having the government backing does provide some value. So, those rates are lower than the banks depending on where banks are at that time and that's all got to do with the banks needing to attract retail deposits.

An annuity bond, it's a different product. So the actual return is different and if I could just take a minute to explain it, because the basic concepts, you do need a little bit of understanding. With annuity bond you invest a principal upfront and you actually get back that principal along with interest for the life of the bond. So, in other words, at the end you have nothing left. You do not get a repayment of your principal.

As a result, two thinks happen; firstly, your cash flows every month are significantly higher than they are when you're only getting your interest which is important to retirees; but the second thing about them is that the rate of return we offer is an effective rate of return rather than an actual interest payment, because you get principal and interest in your payment every month.

So the way we work, is you invest a certain amount, let's say, $100,000; you get 1% of that amount back every month, every month you get 1%. So on $100,000, you get $1,000 per month and you get that for a certain number of months. Now, the return is affected by - you always get 1%, but when the returns are high, you get more payments and when the returns are lower, you get less payments. The current series we have on offer as of June gives you 111 payments. So, you get 1% back, which is the first 100 payments, plus you get an extra 11 payments. Now, that effectively equates to a 2.3% return but, and here is the important thing, you also get inflation on top of that. Our cash flows are linked to inflation. For example, if you're getting $1,000 a month and inflation in that month is 1%, you'll get $1,010 the next month because they move up with inflation. So your effective return is 2.3%, which is that extra 11 payments, plus whatever inflation is.

St Anne: Tim, as you know, they are other providers that are also providing annuities. How does this product compare to those products?

Hext: We’re actually raising debt. So, when you invest in New South Wales - the Waratah bonds, that money is being taken and been invested in infrastructure through Restart New South Wales which the government has set up. That infrastructure could be anywhere from railways to hospitals to schools et cetera, et cetera. So, the money actually is debt therefore your risk is to the New South Wales government and we’ll make that payment obviously in line with that, and we're not trying to provide a commercial return on the other side. So, it’s a different product.

The advantage the annuity plans have over us is that they are far more flexible. When you go to annuity plan provider, you choose your term, you choose whether you want your capital back at the end or not, you choose whether you want inflation protection or not. They are very bespoke products. Ours is actually a actual bond which will have a term, as I discussed previously, and a rate, said as previously. So, it’s less flexible in those terms, but it is a piece of debt as opposed to a plan. The actual return you get does change. I am not aware of the actual return you have for providers, but what I will say is as a government, our rates of return we can offer in that space are much closer to the rates commercial providers offer than we are in sort of very short-term, classic-term deposits.

St Anne: Tim, how does an annuity bond fit in a retiree's portfolio?

Hext: What we really are trying to do is come up with a product for retirees, which makes them feel more safe and secure in retirement. Really, the emphasis of the whole superannuation industry has always been on asset growth; what's going to give us the highest return. So, classically, when people are into retirement now, they got a lot of exposure to equities, plus they have a lot of exposure to term deposits.

Now, term deposits will clearly - the return will move up and down with interest rates as we've seen in recent times. Equities, as everybody is aware from the last five years, are very volatile, and both of those may not necessarily be ideally suited to invest in a retirement phase. There obviously is space for both. Our product says, it's a very simple idea. You work out what cash flow you need for your standard of living and then you invest that appropriate amount into our annuity.

To give you a very simple example, if you decide for a - I think is defined as a modest standard of living in retirement, which might be, say, $30,000 per year for a couple, you can work out that to get $30,000 a year, you need cash flows of around close to $2,400, $2,500 per month, and therefore you can work on how much you need to invest on annuity. You can then be certain that you’ll be getting that payment, and you can be certain that payment will move up with inflation.

So, effectively what you're doing is you're shutting down your exposure to investment markets and guaranteeing yourself an income for the next nine years or nine years and three months or whatever term it is. What we then suggest people to do is they take the excess funds they have left over and then they can invest them in growth assets for the following period, but they're less concerned about what's happening to those returns for the next nine years and three months. So, it's really about giving people certainty, safety and security in their retirement, which I think we can all agree is something that a lot of retirees, particularly after the experience of last five years, would highly value.

St Anne: Tim, that there are New South Wales annuity bonds, are these bonds available to investors all over Australia?

Hext: They're open to everyone in Australia. At present, you can only apply direct through Link Market Services; who is our Registry. We are hoping, as we mentioned previously, to get them on platforms, because we're aware that investors - a lot of investors choose to go through platforms. So, they're open to anyone in Australia, yeah, and the inflation that your return is based off is an Australian-wide CPI or inflation.

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

Hext: That's been a pleasure, Christine. Thank you.

Holly Cook: The latest development in the eurozone debt debacle was the recent news of EUR 100 billion bailout of Spain's troubled banks. I'm joined by Fernando Luque from Morningstar Spain to give us the initial reaction on the ground to Madrid.

Fernando, great to have you with us. So, tell me what's your assessment of this latest news?

Fernando Luque: Well, I have to admit that I have been surprised by the urgency of the decision, but I think that there is good news and bad news attached to this bailout. The good news is that finally the Spanish government is recognizing the problem of the banking sector, or at least part of the banking sector, because it's important to say that not all the Spanish banks have problems. Only 30%, according to the International Monetary Fund, need more capital. Now the good news, at least from my point of view, is that we are closer to the big solution to the eurozone debt and that means that the European Central Bank will definitely at the end act more aggressively on the bond market buying Spanish bonds directly.

The bad news is that at the end, this bailout will mean, in my opinion, more debt for Spain and more pressure on the Spanish bonds. Many people have the impression that we should have done this bailout three years ago. We have lost a lot of time, and we still don't know if EUR 100 billion will be sufficient to save the financial sector.

Cook: How have the markets responded to this?

Luque: We can't say that the bailout has been a relief for the bond market, and don't forget that that was also the objective of the bailout. In fact, our 10-year bond rate is reaching its record high. So the response from the bond market has not been very positive.

In the stock market, the initial reaction was a little surprising considering that we still don't know many of the details of this bailout. We don't know, for example, how much we will pay for it. We don't know that the maturity of these loans, and more importantly, we don't know the conditions attached to these loans. This is because one thing is to say that the money will be used exclusively to save the banking sector; that is the official message. And another very different thing is to say that the loan will not affect the public debt. Of course, it will affect the public debt because what we know certainly is that the government is ultimately responsible in paying back these loans.

Cook: So what's next for the eurozone?

Luque: Clearly the focus now is, I think, on the Greek elections, obviously, because independent of the result of this election, the Greek problem will not be solved on the short term. The Greeks don't want to leave the euro, but at the same time they don't want to accept the Eurogroup's conditions. Another danger is a possible contagion to Italy. And regarding Spain, the risk is that the bank bailout turns into a government bailout like the one we have seen in Greece, in Ireland, and in Portugal in which we have to admit very little success and very negative consequences, forcing the European Central Bank to implement more aggressive measures, but also forcing some governments, specifically Spain, to adopt stronger fiscal and stronger banking integration at the European level. That means losing some of the sovereignty, but that will be the political price to pay to save the euro.

Christine St Anne: With interest rates easing in Australia, term deposits may no longer be attractive. Other asset classes, however, could add value. Today, I am joined by Westpac's David Simon to explore the case for fixed interest. David, welcome.

David Simon: Thank you, Christine.

St Anne: David with interest rates easing, how does that impact fixed interest?

Simon: Fixed interest assets tend to have a different relationship to falling interest rates. In fact, generally speaking, fixed interest assets actually can appreciate in value when cash interest rates are actually reducing. The premise behind that is that the actual bond itself is paying a higher rate than what the market is paying in terms of cash due to the reducing interest rates, hence increasing the - potentially increasing the value of the bond itself.

St. Anne: So what kind of fixed interest assets can investors look at?

Simon: Fixed interest is an asset class that is effectively where an issuing company is looking to raise funds. Now it doesn't have to be just a company, it can be a government in all the different forms such as state, federal, commonwealth and indeed even local government. And indeed companies and financial institutions, such as even banks that are looking to raise capital can issue fixed interest notes.

So fixed interest notes come in the form of government bonds, corporate bonds as well as other types of assets such as debentures and indeed hybrid securities, which exhibits features and characteristics that mirror both equities and fixed income alike.

St. Anne: David, how can they access those bonds, perhaps, through managed funds?

Simon: Yeah, look investors have the ability to access fixed interest assets in various different forms. They can access fixed interest assets through a managed fund and a managed fund is typically a basket of a series of bonds in which the fund manager would actively purchase and sell and trade -- there is also an aspect where you can buy bonds directly.

So, you can go to a issuing company, such as even a bank that maybe offering a hybrid note and investors could access that directly either at the initial offer or indeed via the ASX as they regularly trade on a daily basis.

There are also other instruments such as direct corporate bonds and indeed even immediately had to be released with asset has really encouraged the Commonwealth to actually offer retail investors with Australian government bonds as well, so there are different, various forms and indeed even exchange-traded funds that are effectively bond as well which effectively track an index with bonds.

St. Anne: David you measured the fixed interest exchange-traded funds or ETFs. These products are relatively new. What are your views on those ETFs?

Simon: The rationale between fixed interest ETFs is effectively to track a particular index. My view is it's particularly difficult to track an index like a bond index because the bond market is significantly large and it's quite difficult for an exchange-traded fund to have access to all those individual securities alike.

So, what we're finding is there is some type of tracking error and tracking error is effectively the disparity between the actual ETF itself and the underlying benchmark they are looking to follow. So that is certainly something that investors should be aware of when moving into these exchange-traded funds.

Some of the benefits are certainly around diversification, so nonetheless even though there maybe some tracking error, it's easily purchased via the ASX where you have an underlying exposure to a series of bonds and that gives you diversification just by having that ETF.

Other things such as cost is also quite attractive, so by accessing ETFs, they are typically and relatively lower in terms of ongoing fees, meaning there is more income for the investor rather than fees that they are paying.

Other aspects such as flexibility around the fact that if an investor wants to access money from their ETF, they can quite easily trade that on the ASX and sell their holdings, it's not something that you wouldn't be able to do via a term deposit without penalties.

St. Anne:  David, a lot of people look at cash as some form of fixed interest asset, is it safe just to remain in cash?

Simon: Yeah, look, Christine, it's a really good question you ask. I mean, cash is a very important asset class, especially someone who is investing for the short term. So, it may go up maybe even two years, cash is a reliable form of investment because it's liquid and it's secure. However, beyond that you start really feeling the impacts of the after-tax and after inflationary impacts of cash. where you find that once you account for those two factors, you're actually going backwards.

So, that's why it's important for investors to, obviously based on their personal needs, objectives, investment timeframe, their appetite toward risk, their ideology around investments overall, to look at alternatives to cash around that medium-to-long term. Fixed interest could be one component that would fit nicely within a really well-diversified quality portfolio.

St. Anne: David, thanks for your views today.

Simon: Okay, thank you, Christine.

Christine St. Anne: The government recently announced a number of changes to superannuation. Today, I'm joined by Westpac's David Simon to discuss these changes and strategies to best maximize your superannuation. David, welcome.

David Simon: Thank you, Christine.

St. Anne: David, the government recently made a number of changes to the contribution caps. What are the implications of these changes?

St. Anne: Yeah Christine, there are three primary considerations that members need to consider about superannuation, and predominantly those are over the age of 50 are really going to be impacted. So there are three considerations and implications that they need to consider. Certainly, transition to retirement, strategies need to be reviewed quite immediately. Their actual contributions themselves need to be reviewed and indeed, consideration around that actual nest egg and what the end result will be need to be reviewed.

So to detail those out, the transition to retirement strategy, a lot of members that are currently over the age of 55 years of age are contributing around 50 - are up to their maximum contribution of $50,000 into superannuation. They are attracting a concessional tax rate of only 15% on those contributions. Whilst they are going into superannuation, these members who're actually subsequently drawing a concessionally assist income from their pension to supplement the actual sacrifice into super and they are affectively in a much better and advantageous tax situation by doing that. Due to the government reducing their contribution cap limit from $50,000 to $25,000 they are affectively halving the benefit for those transition to retirement strategies, so they no longer as effective as they once were.

The other consideration is obviously for people that are making those contributions of $50,000 into super at the moment that aren't event doing the transition to retirement, so indeed those people from the age of 50. So whether they're making salary sacrifice contributions, or whether they are self-employed and making personal deductible contributions, and of course, inclusive of their existing employer contributions it all wraps up to make that $50,000 before tax. For those over the age of 50, it's no longer be going to $50,000, so they need to desperately reconsider their strategies and get it down to that cap of $25,000. Indeed if they don't, they will be hit with those penalties around excess tax on contributions.

And finally, the other implication, which is the most important one I suppose is what it's all going to mean to their retirement nest egg when they need the money most. They can no longer contribute as much money as they were previously, so, are they still able to meet their retirement aspirations with that?

St. Anne: So, against all these challenges David, will we see people, perhaps doing a bit more contribution splitting?

Simon: Yeah, look that's a really good point. So in 2014, there's going to be a $500,000 threshold. So basically for those members that are over the age of 50 and have less than $500,000 invested in superannuation, they will then again be entitled to access that $50,000 cap, which includes their salary sacrifice, self-employed deductible contribution, and employer contribution. So indeed, if there is a member of a couple that has a greater amount than $500,000 and a member of a couple that has an amount that's lower than $500,000 the idea would be for that member that has less than $500,000 to stay beneath that threshold.

So, what's likely going to happen is that member would then divert 85% of their contributions to be the maximum to the member of the spouse that has a greater level than $500,000 preserving their benefit beneath, so they can access that more generous threshold and cap from 2014.

St Anne: David, we know that these announcements are only new, but are there any strategies at the moment that people can adopt to maximize their retirement?

Simon: Yeah look, it's a good question and we've only started to look at those strategies right now. Some of those strategies would be for people that are actually contributing $50,000 now that actually continue to do so and incur the actual access contribution tax. So, I think for those individuals that are on the highest marginal tax bracket at the moment, they will maintain that tax bracket if they were to exceed the $25,000 cap. The benefit there is that it then goes into a more concessionally tax environment. So, there is still a viability there. It's certainly less than what would be before the budget announcement.

Obviously, investors need to be very careful they don't exceed both there before-tax contribution and after-tax because the penalties are then significant and up to 93%. Other strategies that we're starting to look at is to some clients that have that risk appetite to actually take on more risky assets, hoping that over the long term that will fill some of the void though having less money contributed into superannuation.

Another strategy would be to make after-tax contributions into superannuation rather than relying on that before tax which indeed has its own threshold. And finally looking at non-superannuation by strategies such as investment in shares or property could be considered as other alternatives.

St Anne: David, now, we know that June 30th is on the horizon, are there any pre-tax strategies that people can adopt?

Simon: Look, certainly for those individuals that are over 50 they are at a limited time where they can still access that $50,000 contribution, so I certainly encourage them to utilize that benefit whilst it’s still here. There are a series of other benefits that individuals can review that are non-superannuation based. Some of them being the prepayment of private health insurance, certainly for individuals that are earning certainly above the average, they could actually loose their 30% rebate. So the idea is to prepay the private health insurance; indeed other aspects such as bringing forward medical expenses, the government budget that's recently announced changes in the gap threshold, as well as the rebate to individuals and families, so it’s about bringing them forward and accessing those.

Other aspects such as ‘in-specie’ transfers of assets, such as shares that may be in an individual’s name into a more concessional environment to superannuation as an after-tax contribution, seeing as the market is relatively low by moving assets from one structure to the other will ensure they go into more concessionally tax environment with reduced capital gains tax impact. But certainly there are a variety of different strategies that individuals can explore, that certainly it does - does obviously come down to their own personal needs and objectives and overall investment timeframe and philosophy, and certainly risk profile. So, we encourage they receive quality financial advice.

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

Simon: Okay. Thank you, Christine.

Christine St Anne: From spectacular highs the Australian dollar fell to its lowest in mid-May. To give us his views on the outlook for the Australian dollar, I'm joined by City Index's Peter Esho.

So, Peter, the Australian dollar started really high earlier this year, but fell to its lowest in May. Can you give us an insight into the main factors behind these movements?

Peter Esho: Our currency is very much tied to risk appetite and risk assets are very closely correlated with the way the Australian dollar moved against the U.S. dollar. Now, the Australian dollar had also run up against the euro to very high levels. It had a little bit more resilience there, but if we just take the swap against the U.S. dollar, for example, we saw a pullback in the copper price, we saw a pullback in the Chinese markets, the Shanghai Composite Index and we also saw a pullback in the Australian dollar.

So, those correlations were in play and every time there is risk aversion out there in the market, we see our currency fluctuating in line with those trends.

St Anne: Peter, do you expect further volatility to the Australian dollar? Will it get higher or remain lower?

Esho: Look, I think, one thing that was very well illustrated by the rise in the Australian dollar against the basket of all other currencies is the self-correcting mechanism that had to take place. I mean our currency appreciated very, very strongly in a short period of time and the economy started to feel the impact of a high currency. There has been a lot of talk around the carbon tax and the different types of drags on the Australian consumer, but the currency has been a huge disadvantage for Australia and we're feeling that at the moment, and that prompted the Central Bank to really move to ease - to stimulate demands.

So that self-correcting mechanism has put perhaps a ceiling, somewhat of a ceiling on the Australian dollar. The dollar can only rise so much until the economy starts to feel it and rates have to drop accordingly. So I think that $1.10 level was very important. It sent an indication that at that point the Australian economy starts to really feel the pain of the high currency, and therefore I think any test back towards those levels, we will start to see that pain really flowing back into the economy despite easing.

So I think those who call $1.20, $1.50, $1.70, really miss the point that a high currency is a huge disadvantage for the economy and really dents sentiment. So I think that's very important to watch and see how demand reverses, how the economy responds now that the currency has fallen off those highs.

St Anne: What about the impact on interest rates?

Esho: Look, the Reserve Bank held a very strong view that the Australian economy is in very strong shape and inflation was really a problem late last year. If you looked at Chinese inflation, it was running away and the Reserve held the stance that inflation really needs to move within that target range for them to respond. We actually saw inflation fall below the target range. That gave the Reserve Bank the mandate to move by 50 basis points.

So, I think inflation is very important. I think there will be inflationary pressures coming back into the economy as the currency falls, but I still think the currency can fall a little bit more and I still think the Reserve Bank is very focused on inflation. Inflation will drive where a rate policy goes and that's going to drive the currency to an extent. It's not completely an interest rate differential story with the Australian dollar.

It is also in risk aversion, risk appetite; and what we find ourselves at the moment is a currency war taking place between the Americans, the Japanese, for example, which is starting to feel the impact of a very strong yen and the Europeans, which you figured out, well, it's not in their interest for them to have a currency that's too strong. I think that's why we're seeing the euro fall back against the dollar. That's why we're seeing the Bank of Japan intervening, and I think that's why the Reserve Bank has finally woken up, come to the party and moved aggressively.

St Anne: So Peter, there has been a lot of discussion about the Australian dollar and its impact on the two-speed economy, is this impact actually just exaggerated?

Esho: Absolutely not. It's had a devastating impact. I mean you look at tourism; Australians are in a record numbers flying overseas, spending money overseas, and that's because Australia has become a very expensive tourist destination. If you look at the traffic numbers coming into Sydney Airport, for example, they're coming from places like Japan, Malaysia, China. You're not having the European travelers, the American travelers. You're having really the emerging travelers in the region coming to Australia.

Now, you need to start seeing a broader sample of people coming in for tourism, for example, and you don't get that with the cost disadvantage that Australia has with the high currency. The export sector, education is very important, and you've had a huge drop-off in Indian students, for example coming to Australia, because again it's just so expensive. That's fueled by the currency position.

So, I think the export economy has really been feeling the pressure. I think it's one thing that many commentators have missed in the Australian economy, that the Australian dollar has just risen too much and Australia has become too expensive as a destination to do business.

Manufacturing, we've been talking about it for a very long time. The car manufacturers needed a government injection. The steel manufacturers are struggling, they need government intervention. So absolutely across, particularly across the eastern seaboard, the services economy, the manufacturing economy has been hugely disadvantaged by the currency position.

St Anne: Peter, thanks for your insights.

Esho: Thanks for having me.

Jeffrey Hutton: The good news is you're going to live longer. The bad news is you're going to live longer. So, how can you be sure you're going to be able to pay for it? Well, one option is annuities and to walk us through how they work and what you need to know, here is Richard Howes from Challenger Life.

Richard thanks for joining us.

Richard Howes: Thanks, Jeff.

Hutton: So, Richard tells us about the demand for annuities?

Howes: The demand for product has increased very significantly. So, for financial year end 2009 for example, Challenger sold about $500 million worth of annuities to retail clients. This year we expect to sell nearly $2 billion. So that's a quadrupling of sales over three years, which is strong growth by anyone's estimate.

You are right to point out that a big driver of that has been uncertainty in the market. People crave certainty now in a post-GFC world and I think retirees are realizing that - and their advisors are realizing that, you need a certain level of protection and a certain level of certainty in the portfolio.

Hutton: These things aren't cheap. They can cost about $670,000 for a lifetime annuity that offers a comfortable income. Can you tell us about that?

Howes: Yes. Look, I guess what we're learning as an industry is that retirement is not cheap. People are living longer and so we have to fund a long retirement and then that costs a lot of money. To meet a comfortable living standard you need substantial savings. So it's not so much that annuities are expensive, it is that retirement is expensive. Annuities actually offer very attractive returns with certainty.

So for example, a lifetime annuity purchase by a 65-year old retiree in order to deliver a comfortable living standard as measured by, ASFA Westpac, which is around $42,000 a year. Costs less than investing - less than the amount required to invest in a balanced fund within an allocated pension to deliver the same outcome with a 90% or even 75% certainty.

Hutton: So, when talking about longevity risk we’re really talking about the risk of people’s retirement savings running out before they do?

Howes: That's a very good observation. I think implicitly what a lot of retirees are doing is denying themselves an optimal level of consumption during retirement because they need to allow for the possibility that they'll be one of the lucky ones that lives well past their life expectancy. And inside during you're denying yourself the appropriate level of consumption in order to mitigate the risk of living too long.

And again, that's where this concept of pooling and therefore lifetime annuities come into the picture. If you own lifetime annuity as part of your retirement portfolio, you don't need to deny yourself the optimal level of consumption during your retirement, because you know that the lifetime annuity covers the possibility of living past your life expectancy.

Hutton: Tell me about deferred annuities?

Howes: You can think of a deferred lifetime annuity as a pure form of longevity insurance. So, the way it might work for example, is that a 65-year old might buy a deferred life time annuity, which commences payment at his median cohort life expectancy, that is where he expects the average of he and his peers to live. If he reaches that age, then the annuity kicks in and pays him an inflation indexed income stream for the rest of his life.

So in that way, it liberates he and his planner to focus on the period between retirement and life expectancy, rather than having to deny optimal consumption during that period to cover the possibility that he or his wife lives longer.

You could take a modest percentage of your savings. Let's say you retired with $200,000, you could take $20,000 of that and purchase an income stream, which kicks in when you reach your life expectancy and pays you for the rest of your life $12,000 a year, which is a high percentage. That's nearly two-thirds of what the age pension is for a single home owner and that's indexed to inflation as well.

So, as an insurance policy, that feels like a pretty smart thing to do, because for a modest share of your savings, you're covering off longevity risk and inflation risk for that portion of your life, past your life expectancy.

Hutton: So, have we seen the death of market allocated pensions?

Howes: No, not at all. I think an account based or allocated pension is a very valuable and legitimate tool within a retirement portfolio overall. But the key point here is portfolio. The way we work with the planners that use our annuities is on the basis of a layered approach to retirement.

So, imagine if you will, the age pension, which in some senses is the perfect retirement product. It offers a life-time income stream index to inflation. The only problem is it's not enough. So what our planners - the planners who work with Challenger Annuities like to do is layer that with a private pension that sits on top of the age pension and provides that additional level of certainty.

Then on top of that, you can have an allocated pension, which contains among other things growth assets. So by ensuring that your client doesn't have to live below a minimum standard that you're setting for them, it liberates the client and the planner to build, if you like, even a more aggressive portfolio within the allocated pension to achieve more aspirational goals and to address the state planning for example.

Hutton: Last question, Richard. Do you have annuities?

Howes: Personally, yes I do, although, I like to think of myself as still quite young. I and Challenger believe obviously that high equity allocations are appropriate early in your career when you're still contributing to super. So I do have annuities in my portfolio, but I also have a high allocation to equity, because that's appropriate at my age.

Hutton: Richard Howes, thanks for joining us.

Howes: Thanks a lot, Jeff. Cheers.

Christine St Anne: At a recent lunch with the Australian Business Economists, Treasury Secretary Martin Parkinson put his case forward for a budget surplus.  In particular he responded to criticism that the budget surplus was due to a political imperative.

Martin Parkinson: The problem with this argument is that if it's not appropriate to restore the structural budget position when we have low unemployment and the economy is expected to grow at around trend, when will it be appropriate?

In other words, this argument; let’s just wait another year – well, we can always just wait another year and the argument will always be, let’s wait another year.

St Anne: Parkinson said criticisms did not take into account that the return to a fiscal surplus was taking place in a better economy compared with the rest of the world.
 
Parkinson: It is surprisingly under–appreciated in some of the commentary just how Australia’s fiscal consolidation is occurring in a set of circumstances that is dramatically different to that which you can see in almost every other advanced economy.
Many of those economies are stuck between a rock and a hard place. Monetary policy is at or close to the lower bound; fiscal positions, have been allowed to be in deficit for a long time and have been driven by the GFC in some situations to over 100 per cent of GDP. In this environment, traditional monetary policy is not working and opportunities for fiscal policy are limited.
We don’t face the same wrenching predicament. But continued discipline is important to ensure we never get into this situation.

St Anne: Parkinson said that with substantial risks still facing the global economy it was important that Australia maintained its fiscal responsibility. He also issued a warning that while we are in a better shape than other countries, this may not always be the case.

Parkinson: With substantial risks remaining in the global economic environment, in my view it is critical that we move now to recharge the fiscal batteries while circumstances remain favourable. This will give us the capacity to respond to fiscal shocks if they’re required over the period ahead. This just gives you a sense of the advantage we confront.

Across the OECD government debt ratios have been on a steady upward trend since the 1970s. While there have been periods where they have lowered their debt–to–GDP ratios, but basically not by enough in good times, to offset what happens in periods of distress.  The trend is even more concerning when you think about the vast majority of those countries, the big impact of population aging is still to come.
The good news from our perspective is that we are not in that same boat. The challenge for us is to recognise that we cannot assume this will always be the case.

St Anne: Parkinson also dismissed criticisms that some in the Australian community would be irresponsible with some of the spending initiatives.

Parkinson: I think they will do the same if they do if they got a wage increase. Those people who are at the lower end of the income distribution and have higher marginal propensity to consume, will consume it. Those who are receiving it and who are in the upper end of the income distribution will tend to save more of it.  I don’t see anything untoward that.

St Anne: Christine St Anne for Morningstar

Christine St Anne: We are at Wilson Asset Management Investor Forum and today I'm joined by the firm's Geoff Wilson to give us his insight into what sort of companies he looks for in his listed investment vehicles. Geoff, welcome.

Geoff Wilson: Thank you.

St Anne: Geoff, your listed investment vehicle has outperformed the market since inception. What sort of approach do you adopt to find those types of companies?

Wilson: We're very focused on growth companies and when we're looking for growth companies, we're actually looking for growth companies, but we're looking for growth companies that are very cheap, like on low PEs. Ideally, we are looking for a company that's growing at say 15% to 20% per annum and would be on a PE of eight to ten times.

 St Anne: In your presentation, you mentioned some good performing stocks, are you able to talk about them?

Wilson: I mean over the last 12 months, some stocks that have been very good to us are McMillan Shakespeare, that's done well for us, also Breville has done very well, also Ainsworth Gaming, that's - we've made very good money on those type of companies. Now they tend to be smaller companies - smaller industrial companies and that's where we believe we can find those growth companies, the companies that are growing well and truly in excess of the overall market.

 St Anne: And are you able to mention any detractors from the portfolio?

Wilson: There are always detractors in the portfolio. Centrepoint Alliance is a financial services business that we actually thought would do well. What happened is, as they've got new management it's just taken a lot longer than we anticipated. That's been one of bad ones. Another one, another detractor was Symex. We brought that for a trade and unfortunately they raised some capital and they had profit downgrade in the middle of that.

 St Anne: And how do you manage your portfolio along with these underperforming stocks Geoff?

Wilson: An underperforming stock - if there is profit downgrade, then we sell. What we are doing is, we're trying to find those growth companies and once we've found a growth company, we won't buy it unless we can see a catalyst that’s going to change the valuation. So we'll sit in cash, unless we can see that.

Once we've identified the catalyst and that could be an earnings surprise. Anything that we believe will move the share price higher, then we'll buy it. Now, if that company disappoints or if it reaches our target price, then we'll sell it. With profit downgrades - if you have one profit downgrade, then there's a high probability in another one. So, we really want to cut our losses and move on.

St Anne: Geoff, on the point of the good performing stocks, in terms of the small industrials, they have been under pressure of late, how do you see the outlook for that sector?

Wilson: Well, it's interesting you say that. So far this year, the small industrial sector has actually done surprisingly well, even though over the last period, it's been difficult in terms of performance versus the large-caps, but more recently this year, it's actually probably performed -it's probably up double the amount of the overall market. So, going forward, we'll always - we are always focusing on finding opportunities in that sector.

The reason we like it, it tends to be under researched. It's very important to us to meet management. We see probably 800 companies plus each year and it's really to understand how those companies make their money, to understand the management because from our perspective, management is incredibly important particularly in smaller companies.

St Anne: Finally Geoff, can you give us a good outlook for the Australian equity market in general?

Wilson: In terms of the outlook for the market, we are in a deleveraging period and that could take a decade to 15 years, and we say we are four years into it. So the next five to 10 years is going to be difficult. It's going to a real grind from my perspective. In terms of what's happening domestically in Australia, I think it's fantastic that we had the interest rate cut the other week. I'd say there's another 100 basis points on the downside, and then that will have some positive impacts on earnings in Australia.

It will actually be stimulatory to the economy and that's six to nine months down the track, we'll start seeing the benefits of that. It will also move money from term deposits to the equity market. It's also lower interest rates means higher PEs, so you will see some PE expansion. So, we are actually cautiously optimistic, obviously that's domestically. Then when you look at from international perspective, we accept there is incredible uncertainty about Europe and the euro. My view is that the euro won't last, that it will break up and that's going to be very painful. Asia seems to holding it well in terms of growth and America seems to be holding reasonably well as well.

St Anne: Geoff, thanks so much for you insights today.

Wilson: Thank you very much.

Christine St Anne: Morningstar recently completed a report on the small cap sector. To give us an idea about how these managers performed, I'm joined by Tom Whitelaw. Tom welcome.

Tom Whitelaw: Thank you.

St Anne: Tom, how did the small cap managers performed against the broader market?

Whitelaw: Yeah. I mean if you take this over the last five years for example, so when markets fell off a cliff probably in about November 2007, small caps dramatically underperformed in the rest of the market, just given the kind of flight to safety that we saw as people have moved out of small and more risky names and moved up the market cap ladder.

Then when the market bounce from March 2009, small caps dramatically outperformed at this point again as people came back to risk assets, moved back into these stocks, inflated the prices and kind of seeing a little bit of effect at the start of 2012 as well when the market is in a bit of slump in 2010 and 2011 and small caps came back much more strongly than the rest of the market as it rallied in the first quarter of this year.

St Anne: Tom, just how volatile is this sector?

Whitelaw: Yes, it's pretty volatile. I mean the average small cap manager is probably around 40% more volatile we found than the ASX 200 Index, which gives a good proxy for large account managers. Actually, the most volatile strategy that we covered in small caps was actually 80% more volatile than large.

That kind of gives you good idea of just how volatile the whole sector is and it really just shows that investors, when they're investing in this area, need to be cognizant of these risks. Our work around investor returns show that investors often use these highly volatile strategies more poorly, it's often a temptation to buy in after the markets had a good run and then sell out after it's fallen.

St Anne: So, what sort of managers are best positioned to manage this volatility?

Whitelaw: It's very difficult to say which are best position to manage the volatility, because the volatility just exists down at this level of the market, there is not really much you can do to get away from it. We actually found that 90% of the managers that we covered over the last five years have actually shown less volatility than the small ordinaries index itself. So, it just shows that the volatility is there.

So, if you're going to invest down at that level, it's really best just to be prepared to handle it. Actually, the managers that we covered all actually outperformed the small ordinaries index apart from a couple of that time period as well, so it shows you get the low volatility and the performance over the index, which is quite interesting at this level of the market.

St Anne: Tom, your report identified a number of small cap investment managers that were underweight in the resources sector. Do you need to be exposed to this sector in order to outperform the market?

Whitelaw: Not really. No, I mean the managers that we kind of highlight the names like Hyperion, Pengana whose processes do lead them to underweight or not own resources stocks at all, and those managers have consistently manage to outperform and also done so with the similar level of volatility, and also are amongst the highest rated managers.

St Anne: What about fees in this sector?

Whitelaw: Yes, fees are a little higher than they are in large caps. I mean that's again the nature of the beast down here. These managers are picking more stocks normally and have to employee more time visiting companies to really getting an understanding, and that leads to higher fees. So, you're talking 25 basis points higher than the average large cap strategy, which is quite a bit and that’s before you take into account performance fees. So, around half or so - over half the managers that we covered down at this level actually have a performance fee on top.

Performance fees aren't necessarily a bad thing, but we just like to have a fair fee structure. So, if managers are going to have a performance fee, we'd like them to have a smaller base fee alongside that which really compensates the investor for the performance fee with a lower kind of ongoing costs whatever happens. We actually found that wasn't the case in a number of strategies and it actually costs the number of managers that we rated, who would have probably get higher ratings have they had a fairer fee structure.

St Anne: Finally, Tom, how do small cap managers fit in an investment portfolio?

Whitelaw: They're definitely supporting players. So, if you're investing in these kinds of strategies, it's something that's going to be the edge of your portfolio. So, if you have well balanced portfolio of larger Australian managers and some international exposure for example, then these are really the spicy positions that are around the edge that can really add some alpha when the stock market is performing well, but again as we said, you got to be cognizant that these things are likely to fall a lot further than the rest of the market when times are tougher.

St Anne: Tom, thanks for your insights today.

Whitelaw: Thank you very much.

Christine St Anne: We’re at the Morningstar Investment Conference in Sydney today and I am joined by PIMCO’s Peter Dorrian to talk about the role of bonds against falling term deposit rates.

Peter, interest rates are set to fall further now, on the back of that how is that going to be making fixed income more attractive for investors?

Peter Dorrian: It’s an interesting time in the Australian economy. I think the Reserve Bank has finally recognized that the two-speed economy is producing good parts of the nation, but parts of the nation that are doing quite tough, and the 50 basis point cut that we have seen recently is obviously going to have an impact on longer-term rates. Already the 10-year bond rate in Australia is down around 3.5%.

Now, I think the important thing to think about is what that is telling us about the prospects for growth in the economy over the next few years. We still believe strongly that it is telling us prospects for growth in the economy remains subdued and the risk that China’s expansion will slow and thus have an impact on slowing the Australian economy remains pretty high. So we still see good value in Australian bonds at the present time.

St Anne: A lot of investors have been attracted to term deposits on the back of these high interest rates, so do you think now is the time that they should seriously be looking at bonds?

Dorrian: Well, I think it’s really interesting when you look at what’s happened to TD rates in the last few weeks. Lot of investors who might have held a 12 or 24-month term deposit are now facing this very serious reinvestment risk. People who have been earning a 6% or 7% earning rate are now coming out and facing rates in the 2%s and 3%s.

So, a very significant level of reinvestment risk, which is one of those things that we have been talking about, term deposit investors have to think about. So when you are coming out and facing 2% or 3% set return over the next one or two years, again we think a diversified portfolio of bonds looks pretty good compared to that as well.

St Anne: Then finally Peter how have you positioned to your portfolio, are you favoring Australian bonds to overseas or vice versa?

Dorrian: Well, in our diversified fixed income fund, which is the major fund that’s used by investors and advisors in Australia, which generally has a 50-50 mix between Australia and the rest of the world. We still have a favoring towards the rest of the world, because we see higher rates of return coming from some of the emerging markets, better rates of return coming from some of the offshore credit markets and of course we get, by investing offshore, that yields pickup between the Australian cash rate and the countries overseas cash rates. So, global bonds, still in our view, we are overweighed in that portfolio at the present time.

St Anne: Peter, thanks so much for your thoughts.

Dorrian: Christine, it’s my pleasure.

Christine St. Anne: We're at the Morningstar investment conference in Sydney today and I'm joined by Ibbotson's Daniel Needham to discuss the case for investing overseas.

Daniel in your presentation, you mentioned possibly a second financial crisis pertaining to the finance sector in Australia, why do you say that?

Daniel Needham: In my mind, it wouldn't be a second financial crisis in Australia, it will be a first, because I think in Australia we didn't really have a financial crisis. Certainly nowhere near as bad as what we've seen in the United States and Europe. I mean there was a huge amount of government intervention in Australia, both directly by the government guarantee on the bonds that banks were issuing in overseas markets, as well as the introduction of the deposit guarantee by the government and the secondary knock-on effects of the huge fiscal stimulus package that was brought into place.

So Australia dodge the bullet in many ways and in using different measures we actually increased our amount of indebtedness post the GFC, as opposed to deleveraging as we've seen in other markets. So when I say - I think the potential for the tailwinds that have supported the Australian economy over the last 20 years. So increasing commodity prices, asset markets moving off very depressed levels to what I consider to be high valuation levels, household balance sheets gearing up significantly and that money being funneled into residential property.

I think the potential, if we had a slowdown in China and a sequential slowdown in the domestic economy, I think the confluence of those two factors could lead us to have a significant potential financial crisis. I'm not saying that's my base case. I think the tail risks in Australia now for the next 10 years are the highest that they have been since the '70s and '80s. I mean, early '90s was obviously one of the worst recessions that we've had. I think it's been a long time since we've had one of those recessions.

The ROE of banks look great, but that ROE is being built off continually increasing debt and increasing asset values and I feel like that's probably run its course. So, the challenge for the Australian investors for the next 10 years and I also think for Australian banks is how they do with a shock from China and effectively a reversal of the virtuous circle of increasing asset prices and leverage.

St. Anne: On that basis, Daniel do you see more attractive valuations overseas compared to Australia?

Needham: I mean, I see markets overseas that are pricing in more potential downside risk. I think Europe whilst it's got some real problems and some of the financial stocks in Europe could face some real challenges, a lot of those are actually in the products. I mean obviously there is a potential that a few banks, effectively the equity gets wiped out. So maybe some of the credit segments for those banks is better to play, but in general I think European companies are trading on significantly higher discounts than Australian companies.

I think Japan also looks fairly promising. I think that we could be saying the exit of 20 years of deleveraging and contracting balance sheets of private companies or private enterprises. So I think that's a positive for the next 10 years.

I also think for an Australian investor being unhedged is critical. I think you can access those foreign markets, some of the high quality U.S. companies are fairly inexpensive, and if you consider the fact that you can buy them in Australian dollar terms they are outright cheap. So, an unhedged portfolio of global equities in the more attractively valued products in the market provide much more - I think much more potential upside over the next five to 10 years than the Australian share market. Within the Australian share market, I think there are still some pockets of opportunity.

St. Anne: What sort of opportunities do you see there?

Needham: I still think Australian REITS are inexpensive, and are giving you a reasonable return. There is some risk around the retail part of the market. I think that you don't get reasonable returns without bearing some risk. But I think that REIT markets are priced for reasonable returns. They are not priced for great returns, but I don't think they are priced for disastrous returns either.

I think outside of the banking sector and outside of the mining sector, there are some parts of the market that have been really suppressed from the tightening interest rate cycle, from the strong Australian dollar. I think that if we see Australia move into a more - a less robust external sector, so weaker export prices, weaker export volumes as well as lower interest rates.

So I think there are parts of the sort of the industrials - Australian industrial companies, they'll actually benefit significantly from that. These companies right now are not priced for a reversal of the Australian dollar or a significant drop in interest rates. They are priced for much of the same as what we’ve experienced and so that creates a medium term valuation opportunity. You want to be looking at what's priced in and you want to be buying inexpensive assets that have got pretty bad outcomes priced in. So, I think there is a subsector of the Australian market that fits our bill.

St. Anne: Daniel you mentioned Europe and Japan was offering opportunities, what about the emerging markets?

Needham: I think emerging markets - it's a very heterogeneous region, and so some regions look more attractive than others. In general, I think profit margins in emerging markets are high, which creates potential downside risk for earnings. I don't think that they are trading on enough of a discount, given the potential for a collapse in earnings in emerging markets.

So, I think emerging markets are probably slightly on the expensive side, but they are nowhere near in our mind those are unattractive as Australia equities or U.S. equities. So I think they probably have a role but they are a risky asset, and I think that their potential to loose - to fall significantly on a recession is pretty high. So, I wouldn’t be going heavily overweight those, or I'll tilting more towards developed cheaper parts of the markets.

Christine St Anne: Hybrids have become increasingly popular with investors, but what are the risks and how do they fit into a debt or equity portion of the portfolio? Today I'm joined by PIMCO's Michael Dale to give us a better insight into these securities.

Michael, welcome.

Michael Dale: Thanks for having me. Appreciate it, Christine.

St Anne: So, Michael, a lot of these hybrids have come into the market, what should investors be mindful of?

Dale: Well, I think, what we try to say at PIMCO is that investors really need to be cautious as classifying hybrids is a fixed interest alternative, because often hybrids will act like bonds in bull markets, but act like equity in bear markets, and the very reason why you invest in fixed interest is to have an asset that's appreciating in value while others are falling.

St Anne: So, can you give us some examples of the risks involved?

Dale: Absolutely. Well, like a fixed interest investment coupons are contractually paid, however hybrids which are being classified as a fixed interest investment will pay you a coupon or income like return, however, these are very much discretionary. In a risk of market, you may find that those discretionary coupon payments may be withheld by the issuer, and so when you need income at the most important times, you may find that the tap is turned off given the optionality that the issuer has with these securities.

Also in terms of capital structure, these securities lie just ahead of equity, and so in the event of a windup of a company, you're actually subordinated to all bond investors, and therefore should be paid for the risk that you're taking. Finally, the issuer has in-built into these contracts over these securities the option of extending the maturing from the call back optionality embedded into the security. So, the investor may find that they're investing for up to around 25 years, so are you being paid the return for that maturity level, I don't think so.

St Anne: Michael, is there ever a good time to invest in hybrids?

Dale: Well, investors really need to take into consideration the risks that are involved with hybrids. First and foremost, are they being paid for the risks that they've taken, the risk that we've already talked about. The fact that their coupon could be turned off in light of a bad run for the company. The fact that you're subordinated versus all issuance of debt, and just above in the capital structure than common equity, and so when they take all that into consideration, the investor that is, they need to then really ask themselves have they got an investment that fits their asset allocation in their portfolio. So, the question is, do you ever really want to invest into hybrids, and I'm not ever saying not to own a hybrid, but I think you need to say to yourself, what is this hybrid doing in my overall asset allocation?

You should look at whether you can purchase an equity, or common equity in the same company, and on a fully franked level is that dividend paying you as much as the hybrid. So, these are the kinds of things you need to ask yourself before investing into a hybrid, but all that we're trying to say is it shouldn't be classified as a fixed interest alternative that pays you income, because obviously, as I've mentioned before hybrids will act like equity in bear markets, and that's not what you invest in fixed interest for.

St Anne: Michael, but in an environment of subdued returns, shouldn't investors look to get that extra return from hybrids?

Dale: Well, Christine, no doubt the last three to six months has been a fantastic windfall for risk on investing, and no doubt the investments made into the hybrids of recent months has been a successful transition out of cash and term deposits. But we'd like to say that any bad news that was to come to the market over the next three months would leave these risk assets very, very vulnerable to a sell off, and therefore we don't think that investors should be rushing into risk assets like hybrids by looking for yields. So when you can find comparable yields, much higher up in the capital structure in the same bonds, issued by the same companies, hedged into Australian dollars, we'd say that is a much better alternative for investors given the volatility in markets we're still facing.

St Anne: So, Michael, what kind of assets can investors look for in this low return market?

Dale: Well I think, first and foremost, investors really need to ensure diversification amongst their portfolio. In Australia, we've been heavily skewed towards risk assets for so long now, at the detriment of investment returns. Bonds have been able to produce double digit returns both in global and Australian strategies for a number of years, and whilst may not be able to produce those returns going forward have definitely been seen in a better light from an investor's point of view to the fact that you can appreciate in value, unlock a term deposit for that matter, when other assets, particularly assets are falling in value. So, I think, going forward, the ultimate diversification of one's portfolio is going to be ultimately the most crucial aspect.

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

Dale: Thanks very much, Christine. Appreciate it.

Christine St Anne: Russell's Fund Manager Survey looks at a view that a number of investment managers have across a range of asset classes. To discuss the outlook, I'm joined by Russell's Greg Liddell.

Greg, welcome.

Greg Liddell: Thank you.

St Anne: Greg, in the survey fund managers are bullish on equities, why is that?

Liddell: The main feature there is valuations. I think, for the second quarter in a row, no manager in the survey said that Australian shares were overvalued, and 64% of managers said that Australian shares were undervalued. So combined with, I think, a little bit of a settling down of the global environment, certainly some pause in the sovereign debt crisis in Europe allowed more positive sentiment to come through and that's reflected in the survey results.

St Anne: So, within Australian equities what sectors were they most bullish about?

Liddell: Yeah, there's been a rotation out of the more defensive sectors like consumer staples into more cyclical sectors, so energy, industrials, telecommunications were the preferred sectors over the quarter. The other sector that was of note was that AREITs, after having been out of favor now for a very long time increased their - the bullishness on that sector increased from 21% to 47% which is quite substantial increase.

St Anne: What about the sectors that they were most bearish on?

Liddell: Again, looking - starting to look at some of those defensive sectors like - that have had a very good run last year, over the last - over the course of 2011, such as consumer staples.

St Anne: Greg, what about the fund managers views on the small cap sector, does that have a brighter outlook?

Liddell: Yes. Small cap managers are quite bullish on the small cap sector. I think about 67% of managers stated that they were bullish on small caps, and that comes back to the fact that managers believe that the Australian market should do well over 2012 and they're prepared to back higher beta positions.

St Anne: Greg, finally what about the fund managers views on China?

Liddell: Yeah, we asked managers this quarter what factor most influenced their portfolio construction decisions. Pretty much across the board they said that the China and Chinese growth was the most important factor that they took into account. It outranked even the Australian dollar, which has obviously been - the high Australian dollar has been a big issue for managers for some time now, and the issue with China is over the uncertainty of the growth outlook and whether or not there's going to be a hard or soft landing over there.

Manager opinions remain pretty divided on that. The housing situation over there is another point of contention, whether or not Chinese housing is in a bubble. Certainly, some sectors are, but we don't feel that there is risk of a collapse in the market over there in any sort of general sense, but that's what's giving managers most cause for concern.

St Anne: Greg, thanks so much for your thoughts today.

Liddell: You're welcome.

Jeffrey Hutton: Is China's boom about to fizzle, and what does it mean for Australia and its investors? We put those questions and others to Satyajit Das. He is the author of Extreme Money and a financial commentator. Das, welcome.

Satyajit Das: Thank you for asking.

Hutton: Das, is our faith in China misplaced?

Das: Look, I think it's like everything there is some truth in the story, but I think there is some exaggeration in the story. I jokingly now refer to Australia as the Great Southern Province of China, which upsets a few politicians, I suspect. But the reality is China has certainly become a dominant feature of the Australian landscape, mainly through commodities, a little bit on the property side, a little bit on the tourism side, because they are growing. But fundamentally it's a commodity story. And certainly commodity exports to China, have become very prominent in the Australia's future, but there are a couple of dynamics to that that are very important.

The first dynamic, which I think people need to focus on, is China pre 2007-2008 and post 2007-2008. Pre that, they were basically using the export engine of basically the manufacturing centre of choice for the world to drive their economy. After that when we had to synchronize recession in most of the major economies around the world, they were forced to take some stop-gap measures to avoid a collapse of growth for social stability reason as much as anything else.

So, basically what they have done is use the banking system to pump a lot of debt into the state-owned enterprises, who have then done what China always does very well, which is build the tallest building in the world, the longest building in the world, the fastest train in the world, the biggest airport in the world, and that's been very good for Australia in terms of the commodity exports and particularly on bulk ore - things like iron ore and coking coal, because steel productions and so forth has done very well.

But I think you have got to look at the commodity boom in a bigger picture way. I think China is a very important component of it, but it's really about a story which goes back to the 1990s, which is commodity prices in real terms were very low in the 1990s. There was a lack of investment, so we had a problem where basically we didn’t have enough supply, because people didn’t expect any growth, and then you have the BRIC story, China and India coming in, so suddenly you have expansion in demand, but your supply is kind of constrained. So, the demand has become exaggerated.

So, China has its own thing of exaggerating, but overall it became exaggerated because of the shortfalls in supply, but what Australia now faces is a simultaneous problem around China. One, is demand from China will gradually slow. I mean, there are different scenarios, but all of them call for a slowing down of China. All we are arguing about is whether it’s a hard landing or a slow landing. Nobody really debates whether it's going to slowdown.

Hutton: So, is it going to be a hard landing or a soft landing?

Das: Look, I think in some cases, they have in our resources to manage it, because I probably favour sort of slow, but not as sort of soft and cushioned as people think, and the talk of imminent collapse of the Chinese banking system and property markets, I think, is a bit exaggerated.

So it will be somewhere in the middle, and I think the biggest problem for Australia will be that that will coincide with the other problem, which is when the supply constraints will reveal Australian companies together with miners around the world invested very, very heavily in new mines and so forth, and they will come on stream, just about the time the demand starts to turn down. So, you will get exaggerated effect in the Australian economy.

Hutton: How much of that investment came from debt?

Das: Well fundamentally, I think, all of it. If you actually look at the statistics from the World Bank and they openly admit and they have this code word, government-influenced expenditure. There is almost all of the growth for some government-influenced expenditure, which to me is code for debt-fueled investment.

And what the Chinese did was basically use their state-owned banks, and the state-owned banks were told to go out and lend to state-owned enterprises. So that's where it came from,. So, that's all domestic and that's why I think the chance of a softer landing is much greater than a harder landing, because it's all domestic. It could be covered around, it could be managed, and it could be massaged, and as I always say it's a bit like a forest. If a tree falls in a forest, does anybody know? If anything happens in China, how do you know what's happened, because we get such filtered information?

So, I think that's the problem that Australia faces. It's not only Chinese demand slowing down, but basically the problem that we have started to invest massively in new facilities, which are likely to come on stream at precisely the wrong moment. And part of that also is a fascinating second element to it.

China will be rebalancing their economy over time and people have great expectations that they will move to more consumption than investment, which for China is the correct economic way of moving. But the problem with that is if you move to a service-based economy, which is much more domestically focused, they don't need new airports. They don't need new super-fast trains and that's not necessarily good for Australia, because our exports are in basic raw materials. They are not in other things that they might start to acquire. Let's put it this way. Australia doesn’t have Maseratis and Porsches that the upwardly mobile Chinese might want.

Hutton: But doesn't urbanisation have a long way to go?

Das: I think the answer to that is pretty straightforward, because essentially it's not about whether these facilities could be used. I mean, if you have a super-fast train, you can use it by simply making it free, but that means the project itself does not generate any cash flow or revenue and the returns on the projects are going to be low, and I look at a country like a giant investment project.

So, if you got a lot of investment, your investments have to produce high returns to get you high growth, the problem is not whether this stuff will be used up or whatever. They may be used over time, but they are never going to be economically viable, and that's the biggest problem that you're going to have and that will drag down growth, because you're tying up money on productive assets.

Hutton: Das, thanks for your time.

Das: It's nice to be with you.

Jeffrey Hutton: After slipping from record highs back in September, the price of gold may be poised for a recovery. To discuss just how far it might go, and why, we've got CMC Markets' Ric Spooner here to talk with us.

Ric, thanks for joining us.

Ric Spooner: It's a pleasure, Jeff.

Hutton: So, is gold a smart investment right now?

Spooner: I think so, I think the basic conditions supportive of gold remain in place. Few things going forward, primarily gold - investors see gold as a defence against the loss of value in paper currencies, and when it comes to the big currencies like the U.S. dollar and the Euro dollar, I think, we can look forward to them being under continued downward pressure for quite a while now.

Other factors that could support gold include the fact that I think we're going to see very low interest rates in place around the world for a long time, and of course, that's important for gold, because you don't earn any interest on owning it, so the opportunity costs will remain low. We can look forward, I think, to a continued Central Bank buying of gold supporting the market for at least a couple of years, and also I think that as an ongoing supportive factor for gold will be the emerging wealth in traditional gold owning countries like China, India, Vietnam.

Hutton: So, central banks are back into the business of buying gold?

Spooner: They are, they've flipped around. I'm talking about central banks overall, for several years leading up to around 2008 and '09, central banks were net sellers of gold, quite large amounts of gold in the early part of this decade. In the last couple of years, they've turned around, and become net buyers. Central banks in fact bought 430 tons of gold between them in 2011.

Hutton: Okay. So how do you go about buying gold?

Spooner: One of course, is the simple way, which is directly buying bars and bullion; another can be investment in exchange traded funds, and the third can be via CFDs and that can be a particularly attractive alternative for people looking for smaller investments and also for those seeking to avoid the currency risk involved in the potential for an Australian dollar appreciation, which of course can reduce the value of a gold investment.

Hutton: Those are Contracts for Difference, right? They're a bit risky, aren't they?

Spooner: Look, they just reflect the underlying asset, and they involve - they can involve leverage. You don't have to use leverage. With our CFD product, you can use no leverage at all. But to the extent you use leverage, well yes, you have to manage the risk appropriately, yeah, for a leveraged investment.

Hutton: Alright. So, by mid-year, what's your view on the price of gold?

Spooner: I see the long-term uptrend for gold being intact. Over the course of the next few months, I think that we'll probably hold a level around A$1,600 an ounce, with a scope for upside. Long-term view, Jeff, I think over a - if your point of view is to look as an investment over a year or two, I think that we've got a good chance of seeing prices over A$2,000, and always a significant potential for a spike up towards A$3,000 if we get a currency crisis of some sort, which is a possibility, I think, that you can't ignore in the current environment.

Primary investment reason for owning gold is to defend yourself against a loss of value in paper money, and generally the most direct relationship between - with gold and currencies have been between gold and U.S. dollar, and so with a lot of the big currencies, for example, the U.S., now that is involved in a competitive devaluation where currency is in a sub-trend growth environment or all chasing a limited value of export dollars and seeking through monetary policy now that means to keep their currencies lower, that's the sort of time when gold might come into its own as a protection against that sort of environment.

Hutton: Ric, who should be buying gold?

Spooner: It's difficult to generalise across all investors, of course these sort of whether you should consider something like gold is very much dependent on your circumstances and investment aims. But yes, a lot of private investors do own gold.

How should you do it? Well, various alternatives. I think, myself that your first thought I think should be about a direct investment in gold, as opposed to resource stocks. Resource stocks certainly have their place, particularly say for example for self-managed super funds, and people in their retirement phase of life, who maybe need to have income and dividends. But generally speaking unless you believe that resource stocks are particularly attractively valued compared to the underlying metal that they mine, that you're better off looking under direct investment in gold.

Hutton: Ric Spooner from CMC Markets, thank you very much for your time.

Spooner: That's a pleasure, Jeff.  

Christine St Anne: With the economic outlook so grim, it may be difficult for some investors to reenter the market. Today, I am joined by Fidelity's Kate Howitt, who says that the biggest gamble for investors is not to hold equities.

Kate, welcome.

Kate Howitt: Thank you.

St Anne: Kate, with unprecedented inflows into term deposits and a not so good economic environment, is it time for investors to buy equities?

Howitt: The Australian market in line with most global markets is cheap right now. On a forward P/E basis, it's about two standard deviations cheap. Even if you don’t believe the forward numbers, if you go on 10-year historical average earnings, it's one standard deviation cheap. The great thing when markets are at low levels is that the risk/reward has shifted in your favor.

So when we see stock markets down at these levels, it's much higher probability that they go up from here than that they go down. Now, what pays you to wait, maybe you don’t think markets will go up any time soon, but in Australia we are fortunate we have high returning businesses that throw off a lot of cash and they pay that out in the form of dividends. So you can now get a very solid 6% yield on the market, higher in some stocks and then you can add franking on top of some of those. So, your actual return that you are getting out of the banks, for example, is higher than the rate that you get from investing in the banks term deposits.

St Anne: Now, with investor behavior at extremes at the moment, what sort of stocks should bullish investors look at?

Howitt: Well again, it changes when you are in a cheap market environment. When we are back in those bull market heydays, you want to be buying the stocks that are growing and where the P/Es can go up and up. That’s not where we are right now. The interesting thing is now you can buy some beaten up companies, you can buy companies where the prospects may be aren't spectacular, but just they’re just so un-loved by the market that any sign of life in the market and these stocks really have the potential to re-rate quite strongly. Similarly, is as stocks did in 2009, it was the most unloved stocks. These stocks were the most hairs on them that actually had the strongest returns that year.

St Anne: And Kate what about the not so happy investors, the bearish ones? What kind of stock should they be looking at?

Howitt: Well, absolutely yield is the way to play that because it gives you very solid protection. If market sell off, company that’s paying a strong healthy dividend is public and they hold up more than the rest.

St Anne: Kate, our investors love the big banks. With the issues about the costs of funding overseas, could you give us an insight about your outlook to that sector?

Howitt: It is changing the business model for the banks and in a couple of different ways. Firstly, they are passing on those rates through to the mortgage book and that is going to make mortgages less attractive. It mathematically flows through to the passing of houses. A bank will look at your income and look at the interest rate that they are going to charge on the mortgage and that will determine how much they think you could pay for a house. So all other things being equal, higher wholesale funding costs are going to translate through into a cap on house prices. That by itself limits credit growth on the retail side.

On the corporate side, what's happening to the banks now is that their cost of funding is higher than their corporate customers' cost of funding. So previously, the banks' role was to intermediate a corporate needed $50 million to fund its latest project and they go to the bank, the bank resource the money and sell it on with a margin. They can't do that anymore. They're no longer competitive in that space. So now they'd to change their business model and move into the debt capital market space and assist those companies to do a debt raising in the bond markets. So, it's changing their business model and of course how that flush through the numbers is much lower credit growth on the institutional side.

Now our banks, fortunately they are very well managed. What they do have going for them is the ongoing capital for labor substitution. So, as technology gets cheaper, generically over time every business can put that into their operations. The banks have a lot of scope for that, because there are so much processing that still goes on inside the bank that they can continue to make investments in information technology that reduces their need for staff. That's unfortunate for the people who are no longer needed in those roles, but it does mean that the banks can continue to improve their profitability.

St Anne: Kate, finally, do you expect the stock market to perhaps rebound this year?

Howitt: Look, markets are so cheap, sentiment is so bearish, the world outlook is so grim, there are so much bad news priced in. As we've seen in the last couple of months, it really doesn't take much for markets to go up from here. All that needs is for the bad news to not get any worst. We don't even need particularly strong news because sentiment is so low right now.

So, there is ample opportunity for that. We could see it in the form of low quality rallies coming out of monetary loosening out of the large central banks that tends to be what happens these days. Central bank puts another half a trillion into market and then it finds its way into asset markets or it could be that we do have more sustainability in the recovery that we are seeing coming out of the U.S. or it could be just that the Europe region weathers its worse and doesn't have any more significant unexpected changes in the political and debt landscape over there, but any of these, you just need a bit of good news and markets could do quite well.

St Anne: Kate, thank so much for your insights today.

Howitt: Thank you.

Christine St Anne: HSBC has recently released a report on the mining boom. Today, I'm joined by Paul Bloxham to give us his views on the outlook for the sector and the impact of the newly installed mining tax. Paul, welcome.

Paul Bloxham: Thank you.

St Anne: Paul, just how big has the mining boom become?

Bloxham: It's enormous. There really is a massive mining boom going on in Australia right now as we speak. The share of mining investment in the Australian economy last year was around about a little under 5% of the economy. We expect that over the next two years it will become 10%, almost 10% of the economy. So, it's a very large ramp-up. It's like nothing we've ever seen before in its scale. In fact, just at 5% of the economy and mining investment is already at its highest level in history. This is a massive run-up in mining investment happening in Australia, and it's a multi-year story.

St Anne: How has the strength of this sector impacted other parts of the economy?

Bloxham: Well, it does look like the rest of the economy is slowing down to make way for the mining investment boom to happen. In fact, that's what the officials are referring to as ‘structural change’. We are seeing the structure of the Australian economy shift. We're shifting more of our resources, our labor, and our capital towards the mining industry and towards related sectors, and we're seeing less growth in other parts of the economy.

The parts that are weakest at the moment are the ones that are most sensitive to the high level of the Australian dollar. So, we're seeing the manufacturing industry is shrinking, we're seeing the retail industry is quite weak, we're seeing the tourism industry is also weak, and education exports, one of those areas that's very sensitive to the high exchange rate, is also lackluster.

St Anne: So, Paul, how best is it to manage this mining boom?

Bloxham: Well, it seems that the way it's being managed at this stage is the adjustment is being done via the exchange rate. So, the exchange rate has appreciated substantially over recent years, and the high level of the exchange rate is slowing down some parts of the economy while other parts of the economy are speeding up.

In terms of managing it through policy adjustments, we have a fairly limited set of tools to do that, and indeed, the way the Australian economy tends to operate is the market does most of the allocation. So, there really isn't a lot of influence from policy here. We see a little bit of it around the edges. The government is providing a little bit of support for some parts of the manufacturing industry, and it's a question as to whether they should be doing that, particularly if those particular areas are not necessarily sustainable in the future. We're also seeing it in the form of, of course, the Minerals Resource Rent Tax, which was just passed into legislation, but it is worth keeping in mind that that is a very small tax in the scheme of things, certainly a lot smaller than the original proposal.

St Anne: So you think that the mining tax won't have much of an impact?

Bloxham: No, I think it's a relatively small tax. In the end, the government estimate suggested they will get AUD $10.6 billion over the next three years. If you put that in the context of the economy, it's about 0.2% of GDP per annum, and as I alluded to before, we're likely to see a 5% of GDP rise in the mining investment share of the economy over the next two years. So, really it is a very small deal in comparison to what we're seeing.

St Anne: There's also been a lot of talk about having a sovereign wealth fund as a possible policy initiative to manage the boom. What's your view on that?

Bloxham: Well, my thoughts are that we really probably should have introduced a larger mining tax. I thought the Resource Super Profits Tax was actually quite a good tax. It really wasn't introduced - it was mishandled in terms of its introduction. I think we could have then had a companion sovereign wealth fund where we contributed those funds to a fund that would set aside some of the money that we're getting from the mining investment boom for the future, for future problems we might have, and for future generations as well.

I think the sovereign wealth fund is a good idea. There doesn't seem to be a great deal of political appetite for it, though. It's mostly at the moment just a discussion piece for academics and advisors rather than for decision makers.

St Anne: Paul, there's also been a lot of talk about commodity prices easing. Will this substantially slow the mining boom?

Bloxham: Well, it does look as though commodity prices have peaked. We think that commodity prices peaked in the third quarter of last year. This is very similar to the official view. Both the Treasury and the RBA seem to think the same thing. So, it does look like the continual boost each year we were getting from rising commodity prices to our domestic incomes has come to its end. It looks as though we won't continue to get that free kick every year just from rising commodity prices.

That's not to say the mining boom is over, because just the high level of commodity prices where they are at their levels at the moment motivates a whole lot of mining investment to keep going and makes those projects still profitable, but it does make it a tougher environment. It does mean that we will be getting less income boost every year. It does mean we will be more reliant on productivity growth in the economy, and we will be less able to just get a boost from those continual rises in commodity prices. So, it is fair to say that it may be a little more difficult in the future that it has been in the past, but with commodity prices staying at still fairly high levels, the outlook is still fairly positive.

St Anne: Paul, thanks so much for you insights today.

Bloxham: No problem.

Jeffrey Hutton: For months, the big four banks have been blaming the international capital markets for the higher cost of borrowing and that's pushed up mortgage rates, but have those markets turned the corner? Matthew Johnson from UBS is a Debt Strategist, and he's here to talk to us about it.

Matthew, thanks for joining us.

Matthew Johnson: Thanks very much, Jeff.

Hutton: The big banks have been blaming the cost of borrowing overseas for the higher mortgage rates. So, can you tell us what the situation is right now?

Johnson: Sure, the situation has improved quite a lot since the start of the year or indeed the end of the last year. There is undoubtedly pressure on bank cost of funds from global funding markets, and that pressure will continue because they had previously issued very cheap debt in the past and that's going to roll over, and they will replace that with more expensive debt, but the situation has much improved from the end of last year or the beginning of this year.

So, for example, the CBA covered bond yield was issued about 175 over swap and that's now rallied at about 50 basis points to about 125. So, things are definitely improving. And my assessment is that, with the economy improving those funding markets will continue to improve for banks, so the pressure on their net interest margins relative to what you thought they would have been at the start of the this year, should decline over time, but there is still some upward pressure from those markets.

Hutton: So, Matthew does that translate into lower mortgage rates?

Johnson: Well look, it probably translates into mortgage rates not having to go up much more than they have already, so banks shouldn't have too much of their independent hiking to do if capital markets continue to improve. But as I said, because they're going to be replacing some previously cheap debt with some new more expensive debt, then there may be some further upward pressure on the net interest margins, if markets don't continue to improve.

Hutton: How far do you expect the sell-off in U.S. treasuries to go?

Johnson: Yeah, I think the U.S. 10-year yields should end up or could end up somewhere between about 2.75% and 3%. So, I think that that would better reflect the general growth outlook in the United States and the general inflation outlook. So, growth seems to have improved somewhat, the unemployment rate has fallen quite a bit over the last few months, and the decline in inflation will slow down and the pulse of inflation that started in the second half of last year seems to have stopped. So, I think that a higher general level of yields between 2.75% and 3% would be appropriate.

Hutton: So, have the international debt markets turned the corner?

Johnson: We have turned a corner. The general situation has improved quite a lot. At the end of last year, the debt markets were really only open to governments as borrowers. There was very, very good demand for government issuance and indeed in some markets the very, very high quality issues, such as the German Government were issuing short-term liabilities at negative interest rates, so people were paying them to borrow their money from them.

So, that's a fact, that situation has reversed quite a lot. Those issuers are no longer getting paid to borrow money and other issuers have lower credit quality. They're finding it much easier to borrow money in the capital markets. So, it's been a very, very large improvement. The most important factor in that improvement is the ECBs Long-Term Refi Operation or LTRO.

Hutton: Can you expand on that?

Johnson: Many of the problems in the global debt markets were caused by an apprehension of what would happen when government-guaranteed liabilities of European banks matured and there was about $0.5 trillion of government-guaranteed bonds maturing this year, mostly at the start of the year.

With capital markets closed, there was a fear that these banks unable to renew their liabilities by issuing new ones, would have to reduce the supply of credit to the economy, which may have caused the recession. With the ECB setting up the LTRO and changing the collateral rules such that people can post previously uneligible collateral to the ECB.

The ECB is now the lender to the banks and this works much like the ECB taking at a large term deposit global in the European banking system and that has replaced the maturing government-guaranteed liabilities and other maturing liabilities and then those things don't need to collapse their credit provision, which means that general growth outlook has improved quite materially and that means that all borrowers - the market assessment their asset quality improves and that means they have better access to capital markets.

Hutton: Should fixed income play a larger role in investor portfolios?

Johnson: I think it's true that investors should have a larger allocation fixed income than they currently do. I think over the last few years the benefits of having some of your portfolio in fixed income markets would become I think quite clear and portfolios that have been over weight fixed income or have had higher allocations have performed better than once that have lower allocations.

With the outlook improving, I do think that the government bonds will tend to underperform riskier assets such as equity, credit and so you wouldn't necessarily want to start adding government bonds to your portfolio right now, but as they sell off and cheapen up somewhat I think there would be a good opportunity to if you are underweight to re-balance.

Hutton: Matthew Johnson, thank you very much for your time.

Johnson: Thank you very much.

Jeffrey Hutton: Parker Asset Management was named the Best Performing Fund Manager of The Year last year by Mercer. Joining us here now is Philip Parker, the founder and managing director of Parker Asset Management. We thought we'll pick his brains in these volatile times to tell us about the secrets of their success.

Phil, thanks for joining us.

Philip Parker: Thank you very much.

Hutton: So, Philip, you’re the guy to ask; what companies and sectors should people be looking at for the rest of the year and into 2013?

Parker: Okay. So, towards the end of calendar year '11 and the beginning of calendar year '12, we started to focus more - end of last year - particularly on resource support companies. We've had some stocks in the portfolio for quite a while, but then we also added to some ones that we really liked after the reporting season.

Hutton: It sounds like you're heavily leveraged to the mining services sector and infrastructure, is that fair to say?

Parker: That's very fair assessment, Jeff. It's funny, on a trip I did to Narrabri about a year ago, I was talking to one of the guys, who was a plant manager at a business that we didn't buy into, but what I learned was that win, lose or draw at the mining end, the guys supplying the parts were just making a fortune.

It got me thinking who’s supplying the valves? who’s supplying the pumps? Who’s pumping the water? Who’s building the new sites? Because, I think if you look at assessments, it is about $42 billion of spend coming in the next 18 months in the resource sector.

Now, some of the resource companies will be affected by commodity prices. That's another story, but the people supplying the infrastructure and the parts for this industry are going to make money win, lose or draw. So, it's been an ongoing theme for us, and Tim Riordan, who works with me, has been spending a lot of time looking at the companies has have I, on the road, and we found some very interesting businesses. We've found a company that just pumps water, for instance, which we are very keen on.

Hutton: How do you go about choosing the companies?

Parker: My background is a value investor. So, I am really interested in companies that have got a history of very sound earnings. If we can't see that history, we want to go and understand what the business is doing if it's a newly listed company.

Just to give you an example of that we – to answer your question, we discovered a company in December 2010, and basically they just did corporate travel. That was their business – Corporate Travel Management is the exact name. All they care about was the travel industry, and here was a business that was listing with the $70 million market cap. They had money at the bank, cash at the bank - you could buy the whole business for $50 odd million, and they are going to do $13 million in 2011 fiscal year, which they have done EBITDA. For this year '12, they are going to do $16 million. So you are buying the business on 3.5 times enterprise value to EBITDA. So, very cheap multiple when you take the value of the company, deduct the cash and then divide the earnings into it.

So, we got really interested. So, we met them at a conference in Brisbane. We then met them in the site here in Margaret Street, Sydney. We also, in those visits, those two visits we learnt that no one customer represented more than 5% of their EBITDA and that they only had 7% of the market share. They were buying cheap businesses at less than the multiple on their business, and then bringing them into their IT integrated world with motivated young sales staff and they have growth that business significantly.

So they're now about 8% to 9% of the market from 5% to 6% of the market. We think they are going to grow to probably 15% of the market. We bought them at $1 share price, but we bought – it was $50 odd million, they are now trading at $2.

Hutton: Do equities make sense anymore for retail investors?

Parker: I am positive of it, and I'll tell you why. If you - and it might be something that they would like to look up. There is a report that's done every year in February by Credit Suisse and the London School of Economics, and what it does, it's a very simple report in the sense of what it's achieving.

It looks for equities versus bonds versus bank bills, and it looks for the comparison of if you put a dollar or a euro or whatever the currency is in each of these different economies that have these things - very sophisticated markets, 100 years of data - 110 years of data, and it's shown that over 110 years, Australia - I'd give you an example Australia. A dollar invested in the All Ords, the ASX 300 or whatever they call it now, has grown to $2,800. A $1 invested in 10-year bonds just rolled over for 110 years is now worth $4.70, so you've five times your money and a dollar in bank bills about $2.70.

If you look at different economies, you look at the next best economy, funnily enough from its results across the board is South Africa. So a dollar in equities in – a rand in equities is now worth 2,100 in its own currency and then bank bills and bonds are similar to the Australian experience. Then you get countries like Canada and so on. So you get the theme.

Equities in countries that have got a natural resource where they have got a bit of an added advantage do extremely well, but the big thing is if you are in there, you get massive outperformance, 2,800 times your money on equities for maybe two generations of a family versus five times your money in a bond. That to me is the salient point.

Now, I don't believe - having said that - I don't believe in sit and forget, all right, because people fair enough get freaked out if the market falls 20%-30%. I think, Warren Buffett said if you can't hold a stock even if it falls 50%, you shouldn't be in the stock because he is taking the long view. I'd take the same view that you want to be in companies for the long run, but at the end of the day if things are cyclically expensive you've got to sell out, move to cash and wait for that to turn and then reinvest again.

Hutton: All right. Time to make a call, at the end of year, where is the ASX?

Parker: I never make predictions like that, Jeff, to be honest with you. What I would think is possibly up from here, but not by much. Volatile after June, but not too volatile into June, and that's the way we are sort of playing it. So we like volatile markets because we can take advantage of big moves in stocks. We can buy companies that are being beaten down or we can sell companies that are being rised up.

If I had to put a number on it, I probably think it might get to 4,500, but I’m not going to back the house on that. We're not about that sort of thing. We're about picking undervalued stocks and then using overvalued markets to protect the portfolio. That's all.

Hutton: Philip Parker, it's been a real pleasure. Thanks for your time.

Parker: Thanks a lot. Nice to meet you at last.

Christine St Anne: With the high Australian dollar, it could be time to look at buying some global companies. Today I'm joined by Fidelity's Amit Lodha, who puts the case for international equities. Amit, welcome.

Amit Lodha: Thank you for having me here.

St Anne: Amit, with the unprecedented risks, particularly in Europe, has it been difficult to manage a global portfolio?

Lodha: You know, the last year has been a tough year for global equity managers or equity managers in general. Central banks have taken on a unique role, which they've not done in the past. They have become the lenders of last resort . You've seen a lot of monetization in central bank balance sheets. Central bank balance sheets over the last decade are up over 14 times.

So, there is clearly a lot of money, which is flowing into the system because of what the central banks are doing, which is leading to a risk-on, risk-off environment and much higher correlations across global equity markets. Higher correlations are generally a tougher environment for fund managers to navigate, because bottom-up stock picking does not add as much value and as much alpha as you expect it to come through.

So, the year was tough, but I think it also offered a number of investment opportunities. So, you have the Japanese earthquake, which led to a huge sell-off in Japanese stocks, so it gave you an opportunity to buy a lot of companies quite cheaply. You had the floods in Thailand, which again gave you some opportunities, and these were natural disasters. You had the risk in Europe because of which emerging markets hold off quite dramatically towards the end of the year, and again that gave you tremendous opportunities to add good, long-term growth stories, which would grow irrespective of the macro environment into your portfolios.

So, yes, 2011 was tough, but from an investing perspective, it also gave you a lot of opportunities to add to your portfolios if you are disciplined on valuations, if you are disciplined on the longer-term outlook.

St Anne: So, managing that portfolio, what companies are best to navigate those sorts of risks?

Lodha: When I think about the world, if I can describe my portfolio in two words, it's really about innovation and inflation. I think the central bank money printing is going to cause a lot of inflation, and therefore I look for pricing power winners. So, I look for companies with strong pricing power, who will have the ability to pass on the higher cost of goods sold to their end customers.

So that's a very important theme for me. I look at companies like Schlumberger, on the oil services side; Johnson Matthey on the emissions side, Johnson Matthey makes autocatalysts, and I really believe that they have pricing power, which they can continue to pass on higher prices to their end customers.

The number two theme that I'm really interested in, is innovation. I really believe that from a global portfolio manager's perspective, I should be allocating my capital and my time towards companies who are really driving a positive change in our way of life, making our way of life better. Whether that could be someone like a Colgate, who comes up with new technologies on the toothpaste side, which take better dental care, or it could be companies like Apple or Microsoft or eBay, which are coming up with new technologies either on the mobile payment side, new smart phones, new iPad – I didn't know that I needed an iPad, until an iPad came through.

So, that kind of innovation is really what I am focused on, and this I think is going to drive growth in emerging markets also because my view is that if you look at markets like China the last 10 years were really about fixed asset investment and a significant growth to build the infrastructure. I think the next 10 years are going to look very, very different. The next 10 years are going to be about consumption growth, the next 10 years are going to be about what the middle class in China, which has grown dramatically wants to do. That will be a lot more about consumption, a lot more about increasing healthcare spends, a lot more about Internet usage.

For example, China has 515 million Internet users. That's more than the population of the United States. So that's clearly a big market for technology, a big nascent market for gaming, for internet retail and these are kind of themes, which will continue over a period of time and those are the kind of the companies which I want to own in my portfolio.

St Anne: There has been a lot of talk about a possible slowdown in China, what impact would that have on the consumption story?

Lodha: I think, the Premier was actually on TV yesterday. So, Wen Jiabao was on TV talking about the fact that they are a lot more comfortable with a much slower growth rate now. And I think that's positive. The fast pace of fixed asset investment in China has created some mal-investments, has created some projects which should have not been there, has led to a serious inflation in resource prices. So, you have seen the inflation in resource prices, which frankly Australia has done really well out of, because you are selling the iron ore and the coal and the coking coal, which China needs.

So all that has been very positive for Australia, but from a Chinese perspective, that's been inflationary. They want to retool their growth from fixed asset investment-intensive, from manufacturing intensive, more towards consumption. So, the communist party in its 12th five-year plan has talked about the fact that they want to rebalance the economy. I think this is really positive from a longer-term perspective.

I think the growth dynamics of emerging markets, whether you look at China, whether you look at India, whether you look at Brazil, they all can deliver between 4% to 7% economic growth, which is very, very positive from the perspective of where I see it looking at developed markets, where 1% to 3% growth would be a huge, huge outcome for all of us from a positive perspective.

St Anne: Finally, Amit, do you think that the developed markets could catch-up growth-wise with the emerging markets?

Lodha: I think longer term economies are - because of globalization economies are very linked with each other. So, they all need to kind of grow together. So, if you have a huge problem in Europe, I find it very difficult to believe that it won't have an impact on China or other markets. India to a certain extent is a very domestic story. China is a very export oriented story.

So, you got to keep those things in mind, but really - when I look at my portfolio and what I am trying to do with it, I am trying to buy companies which will see growth irrespective of how the economic environment plays out. And those could be listed in developed markets or those could be listed in emerging markets.

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

Lodha: Thank you for your time.

Christine St Anne: With the volatile market, it's understandable that investors may want to reevaluate their long-term goals. But even in these markets, investment principles still apply. Today, I am joined by Westpac's David Simon to discuss strategies to keep that focus on your long-term goals. David, welcome.

David Simon: Thank you, Christine.

St Anne: Firstly, David, what are the key objectives investors need to look at to get the asset allocation mix right?

Simon: Good question, Christine. Investors need to consider quite a range of objectives before they actually make a final investment decision. So, some of them include their investment return. So, what type of return is the investor seeking? Are they seeking income to improve their cash flow or are they prepared to defer their income in order to seek capital growth?

Other considerations investors need to think about is liquidity. Do I need access to their investments in the immediate sense or are they prepared to lock them away? Time frame is also important. Is an investor looking to invest for a short period, a medium term, or are they prepared to invest for the long-term such as for their retirement?

Other aspects such as tax is also very important. Has the investor considered the most appropriate method from a tax point of view. And one pitfall is, many investors don't think about the estate planning impacts. So, when they make an investment decision, have they considered how it impacts their immediate family, their beneficiaries, dependents, and indeed their overall estate through their future generations? Overwhelmingly, what's important is that once they consider these aspects and factors, have they assessed whether they are relevant or adequate to meet their overall personal needs and objectives?

St Anne: How do you stick to your plan even during market volatility?

Simon: Look, investors need not panic during the market volatility. Instead, they need to be methodical and effectively reevaluate their strategy, their needs, and the plan. After this assessment, if it still seems that the plan isn't working, then they may need to make some tweaking changes, but ultimately, we believe sticking to the plan is vital even though it may require some minor alternations.

It's important that investors avoid certain pitfalls, such as taking on way too much risk because they have had previous losses or continually looking back and thinking about what could have been, and indeed what's the worst thing they can do is to avoid investing completely just because they have made a bad decision in the past. It's important that investors refocus on the future making sure they stick to the plan.

St Anne: David, you mentioned tweaks and changes. Is there a time when investors can actually tweak their plans?

Simon: See, my experience is that investors' situations always change, whether it's their personal circumstances, the economic environment, market conditions, they're always changing. So, at Westpac, we generally believe that continued development and continued robust and consistent changes on a regular basis are very, very important. So, it's important that we do make tweaks rather than wholesale changes, ensuring that investors stick to their plan.

One example that's particularly relevant is the current market volatility. So, what we're recommending our class is to continue rebalance on a regular basis and effectively rebalancing is the technique where investors are taking profits from the asset classes that have disproportionately grown and then using those profits to invest in those asset classes that have become undervalued.

St Anne: David, on that point of rebalancing, wouldn't investors be a little nervous about making losses?

Simon: Yeah, sure. Look there are many approaches that we use and there's many considerations that we take upon before we recommend the rebalancing, but it's a disciplined approach we use that allows people to effectively take profits and so sell when assets are high and buy when assets are low. It's actually a natural default of that particular strategy.

So, we don't make wholesale changes. So, an example is, if an investor's risk appetite or asset allocation, the relevant one for them maybe they're comfortable with having half their money in Australian shares and only half their money in another asset class such as property. So, for instance, if the Australian share asset class outperforms property, we would then take the profits that have actually grown disproportionately to the other asset class, take them out and then reinvest them into the other sector.

St Anne: David, thanks for sharing your views with us today.

Simon: Thank you.

Christine St. Anne: With China, are you still optimistic about the country?

Ian Huntley: I have been positive in China for a long time. Ever since '93, we had a seminar and we had the then Economist for RIO explaining that China was the next Japan, which was the explosive growth story in the '60s and '70s; and then just behind it was India. Early in 2000's, we saw China take off and we looked at India and China, 38% of the global population wanting to catch up, and that's a tremendous force. It's no way a credit battle, that's sort of typical of a number of American observers looking - I could say some rude words about it, but somewhere else. You just got to focus on 1.4 billion people in China who for 200 years went through a series of civil wars and got nowhere.

Surveys of sentiment in China actually show that about 80% happy. We might not like their system, but you've got to remember, the system they have has improved the lot of their living tremendously in the last 20 years, and it's continuing to do it. That's the driving force. For god's sake, I read an offshore commentator the other day saying, look at all these vacancies, they are comparing it to Britain. What's it got, about 60 million people and this is 1.4 billion. Some people cannot get it into perspective. I‘m looking for China in 2012, my worst case would be 7% growth, I think it's more likely to be 8%. I think they've already started to ease their monetary pressure, which is bringing down pressure on the relatively high priced residential real estate market. But I'm looking for them to start dropping interest rates in about March.

I don't think Europe is an enormous major problem at all. It will carve off a bit. But you got to remember, the major driving in China is those 1.4 billion and they need from still, almost scratch, to develop their infrastructure. It's just an enormous driver and there is so much more to do, and they are doing it, and they are doing it well. And what they are doing at the present time is, stopping too much heat. But then people, they listen to all those wonderful experts throughout the world telling that the real estate market is crashing and that's the end of the world. Now these jokers can't even look at the fact that China's building 10 million affordable houses per annum as part of their current five year plan. They conveniently forget that, and that is absorbing a huge number of materials. It's not dissimilar in materials consumption to the upper market stuff. I just get lost listening to it all.

Look, sure China is going to have some speed bumps, but I would think for the next 10 years with -- maybe with something -- obviously there has got to be some downturns. But I guess this is going to be a wonderful background to Australia; and as for margins, yes they are very high and a number of our major resource groups like BHP and Rio, but alot of other companies are struggling in a two-speed economy. Now of course, if China did slump their currency would fall, and then a number of those other companies would do a lot better; and of course a major component of our index is the banks. The banks, I don't think they could be terribly affected by an easing off in China. But I think we'd actually do quite well, because interest rates would come off and the housing market would improve. There are lots of balancing acts in our economy, and I'll just leave at that, because you'll ask more questions. But I've got strong views in China and they've been very-very thoroughly researched.

Daniel Needham: So with - just some comments on that - I mean, I think that I agree that there are some very powerful fundamentals in China. I mean the population story is very clear, you know, that they are going to be increasing, like their wealth is increasing. Their share of output globally is going to increase, I agree with all that, but how assets are capitalized, you can't conjure up investment spending on infrastructure, and be almost -- ignore the price that you're paying for the assets, and effectively the price of capital in China is being heavily distorted. There's huge amounts of unproductive investments that are happening. The growth that's being in China is an investment led growth, it's not being led by sustainable investment driven by consumption - internal consumption needs. It's government controlled, government directed investment and it's being capitalized by a shadow banking system.

China doesn't have a secret sauce or a magic pudding. They are subject to the same economic principles that have dictated capital systems throughout the world, throughout history; and the credit aggregates are scary, 187% debt-to-GDP in China. The credit growth has been, extraordinary.

Huntley: What?

Needham: So, the government debt is estimated to be about 100% of debt-to-GDP. The shadow banking system, added to that, gets you near 200% debt-to-GDP. Credit growth in China is extreme, and that's what driving growth at the moment.

I agree that the increase in productive capacity from these infrastructure investments is going to add long-term growth to China, but how that's capitalized matters. How it's being financed, matters; and whether it comes out via - you can manipulate a banking system as much as you like. It's either going to come out of via inflation, it's going to come out via civil unrest, or it's going to come out via capital leaving China and moving somewhere else via capital flow. So, I think there is a potential for risk in China around how these investment spending, infrastructure spending, property spending is being financed, and they're not subject to different rules than any other economy. Japan is a good example. Japan was great. What about the '90s in Japan, after the property boom?

Huntley: Hey, that was after 30 years.

Needham: Sure. But the growth we're seeing in China, is happening at a much faster rate that happened in Japan.

Huntley: Not particularly, not in the early years. I think my friend here needs to look at American history in the 19th century. That's when America built its infrastructure. American growth then was driven by infrastructure growth, and that was - there was ups and downs right? But they sold land an all this sort of thing, railways went through across the country.

Needham: Like the 1830's in Chicago?

Huntley: Land became a lot more valuable. Sure, but that was the big picture all through that period, with ups and downs, and you had - if you look at the American economy in the early 1900s, which - there is a wonderful book 2007-1907. If you put the figures on the American economy, the growth rates, up on the board and said, who is this? Everyone would say China. No sorry, it's the United States. High single-digit growth; and that was as late as that. I'm listening to people arguing about China - I say, this is what was happening in America in the 20s. They've just left out a whole damn 120 years.

Needham: The 20s was a fuel for one of the greatest depressions, effectively finance and speculation related depressions in the world.

Huntley: I have studied the depression very closely. But as I said, they just left out 120 years, and I reckon that with China, it probably needed to go back at least 50. Now, the China banking system isn't the same size as the overall debt market, and China has probably got a lot of very good things in it. Because, what's happening there is private enterprise banks are beginning to understand what debt and recoveries are all about, and I certainly don't agree with the level of debt that our friend is talking about, nor do I look upon the Chinese banking system as the same as the Western worlds. I look at it, in some ways, as the way the central government is channeling, what we would think of subsidized capital into the economy. And I don't think the infrastructure is being overcapitalized.

St Anne: Moving on to upper parts of world. Daniel, what's your view on Europe? Do you think the situation there can be resolved?

Needham: Europe is a challenging situation, because the fact with a single currency, I mean it's been spoken about a lot. You have significant amounts of debt and in the peripheral parts of Europe, and they don't have a currency and so they can't devalue their currency and make themselves more competitive. They also can't ease financial conditions. I mean, I think we're getting closer and closer to a unified Europe, and I think that we're going to see Germany take a much stronger position in Europe, and I think that there is going to need to be some painful deleveraging depressions in the peripheral parts of Europe, and that's going to have to be subsidized by Germany and the larger European nations.

It's happening at the moment. I mean, the potential for that to just fall out of hand and one of the big European banks to go down is very high at the moment. We actually see Europe, there is some good investment opportunities in Europe. I think that there are parts of Europe that look quite attractive. I mean, people are pricing an Armageddon in many-many good companies that are not solely focused on generating profits in Europe. I think there is a lot of excessive pessimism about Europe, although there are some big challenges and there is potential for a financial crisis to occur. But, we're actually buying European companies at the moment. We think there are some good opportunities and I think that it's one of those classic areas where investors get overly pessimistic and in that environment, you are able to pick up some bargains.

St Anne: Ian, do you see the same sort of opportunities in Europe?

Huntley: I'm more an investor in Australia, but I think there will be opportunities in Europe. That's the reason why I think the markets will come back towards the middle of this year and it could be a fair bit of panic. I think that will come from Europe. Then I think there would be good buying in Europe, but you've got a sort of a German lover, an Italian financier and a French policeman trying to run Europe. Look, they don't get along; and Germany wants to keep its money to its chest.

They don't like spending money on Italians, the Spanish. They are in trouble, that's their problem, nein! nein! There is a problem there. I agree that there is too much fear about it and it's very-very interesting how that fear has driven down the multiples in Australia and in the United States. Whereas the companies underneath are doing pretty well. I think there is certainly some opportunity there.

I think there may be better still opportunities in Europe, a bit down the track, and I would be watching the Euro continue to fall. Because the period of Euro's strength, while the banks were pulling capital back into Europe, I think that's ended. And now the Euro is coming down as people see more and more strife there. Of course, it's putting the U.S. dollar up a touch. But I'd be a bit more slow with Europe, but not if I was major investor, I'd be looking for value, sure.

St Anne: What about the U.S.? The commentators have been quite pessimistic about the country. Daniel, what's your view on the U.S.?

Needham: I think the U.S. economy is actually in better shape than people were giving it credit for in 2011. I think there was some one-off effects that slowed the economy down. There was ridiculous wrangling over a debt ceiling which was ultimately always going to be approved.

I think that Europe, you can see growth has clearly being slowing in Europe, but the U.S. to me still looks fairly strong from a growth perspective. They've got bigger issues in 2012, as they see the austerity measures or the budget cuts being introduced. But as an economy, I think that the U.S. is a very diversified economy. They are very innovative and productive and they can move their technology and capital around, probably better than almost any other economy. So, I am not as bearish as some commentators are, but from a valuation perspective, the measures that we think have some type of medium term predictability about them, suggest that the U.S. isn't cheap. But I think that - there aren't any as many value opportunities in the U.S. as there are in Europe. But at the same time, I think the earnings and growth is much stronger there than people  are giving it credit for.

Huntley: I agree with my friend about the United States, but I think that it's large economy and there is a number of sectors in it which are doing very well. A number of businesses are doing fine; and I think there is actually some good value there too. It's amazing how innovative that country is. Hey, I'm not disagreeing with my friend.

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.

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.

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