Shani Jayamanne: Welcome to Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situations, circumstances or needs. 

Mark Lamonica: So, today, we are doing our long-awaited Q&A episode. So, we had lots of questions going in. We're going to answer four of them today.

Jayamanne: And one of the exciting things about this episode is, we will have our first guest.

Lamonica: Oh, so we're doing that?

Jayamanne: Yeah.

Lamonica: Okay. Have you told Will about this?

Jayamanne: No. Will, we're going to have our first guest on the podcast.

Lamonica: Because we asked people to dial in – there's like a link that you could leave a voice message and guess how many people did it.

Jayamanne: One.

Lamonica: One person. One person did it.

Jayamanne: So, we thought we have to do his question.

Lamonica: We do.

Jayamanne: He went to the effort of leaving us a voicemail.

Lamonica: We do. But what question should we start with?

Jayamanne: All right. Let's start with Brian, who had a question about hybrids.

Lamonica: Okay. And Shani wants to start with Brian because Brian also put in his email that he has been married to a Shani for 37 years.

Jayamanne: And I feel like that's a pretty good reason.

Lamonica: Yeah. Are you that Shani?

Jayamanne: No.

Lamonica: Okay. Just making sure. Okay. So, Brian it is. So, Brian asked to talk a bit about hybrids and how they would perform or should perform in the current investing climate. So, let's start with a very simple question, Shani. What is a hybrid?

Jayamanne: A hybrid is a security that has both debt-like and equity-like characteristics.

Lamonica: Okay. Well, that's really clear, right?

Jayamanne: Yeah.

Lamonica: So, all right. Let's dig a little bit deeper into some specifics. So, the first thing that makes them a bit more like equities than debt is subordination in the capital structure. Now, people might be confused by that term. I'm confused by that term. But it basically just refers to the pecking order if a company goes bankrupt. So, generally, a bankrupt company will still have some assets, so perhaps some buildings to sell off or even part of the company that someone else wants to buy. And in general, debt holders are higher in the pecking order than shareholders, meaning that only if everyone else is paid back will shareholders get any claim to the assets of a company. So, hybrid holder has less claim to the assets of a company than a debt holder, which makes it less secure than a regular bond.

Jayamanne: Many investors buy hybrids because of income, and a hybrid pays out a predetermined rate of income, which is more like a bond that can either be a fixed interest rate or a floating interest rate. But even though there is a set amount, those distributions can be deferred at the issuer's discretion or if certain debt covenants or rules are violated.

Lamonica: And hybrids are also a little different when it comes to maturity, not like lack of maturity like me, right? That's what people keep saying about me. But we're talking about, of course, when they "expire", so when a bond matures versus the end of its life. So, many hybrids are either perpetual securities, which means they have no maturity date, or they have really long dated maturity dates. But they also generally have one or more call options, which means that the issuer of the hybrid has the right, but not the obligation, to redeem the security if they see fit.

Jayamanne: Now, there are many types of hybrid securities, and we aren't going to explain them all right now. What we will say is that since there are different types and the terms can be very different, it's very important to study the exact security you're buying. But today, we'll do some generalizations. So, Mark, why would an investor buy a hybrid?

Lamonica: Well, hybrids are primarily purchased by individual investors and are very popular with self-managed super fund holders. And there are several reasons for this popularity. First off, hybrids generally have higher yields than other types of investments, which makes them very popular with people looking for income. They are also primarily issued by banks, which clearly have a good reputation and brand recognition with retail investors. And guess what, Shani, you also get franking credits.

Jayamanne: Everybody loves franking credits.

Lamonica: Everybody does love franking credits.

Jayamanne: The question, of course, is what to think of hybrids right now. One of the key advantages to hybrids over a fixed income security is that most hybrids are floating rate and most fixed interest securities are fixed. When the interest rates go up, bond prices go down. But with floating rate hybrids, you're protected from those rises in interest rates.

Lamonica: And the concern with a hybrid is, of course, credit risk. So, an environment that might involve a recession, you do need to be careful that this isn't a situation that hybrid would not be able to pay the distributions or that the market would start to worry they wouldn't be able to pay the distributions and then you'd have a fall in price. And remember, where hybrids fit in a portfolio, so they are less volatile than shares and should have lower long-term expected returns, and they are more volatile than a bond and should have higher long-term expected returns when compared to a bond. And from an income perspective, they should have more than both bond and equities, so more income – you should be able to generate more income than both bond and equities initially, but they don't have the upside of a growing dividend like a share may have.

Jayamanne: All right. So, I think, it's time for question number two. This one is from Lisa, and it's a term that has been thrown around a lot these days. She wants to know what a bear trap is. As an Australian, I've had less experiences with bears than someone who grew up in the U.S. So, why don't you give this a shot, Mark?

Lamonica: You know, I grew up – I know you've never been to the U.S. – but I grew up outside of New York. So, there's not a lot of bears around. And we're in Australia – there are koala bears and drop bears, Shani.

Jayamanne: And some bears on Oxford Street. So, I think it's safe to say that we've exhausted all of our bear knowledge.

Lamonica: Well, you know, Shani, to paraphrase John Paul Jones, a famous American hero, I have not yet begun to exhaust my bear knowledge. I know lots about bears, not as much as Dwight from The Office.

Jayamanne: That's true.

Lamonica: But I do know stuff about bears. All right. So, let's stick to the bear trap. So, a bear trap is a term that refers to technical analysis where there is a false indicator that a downward trend is reversing. So, this indicator, of course, because it's false, it will sucker investors into buying, which, of course, will be the wrong time to do it because the market fall will resume. So, let's start with technical analysis. What is that, Shani?

Jayamanne: All right. So, technical analysis is a technique used to identify trading opportunities using price trends and patterns on charts. And I feel like there's a rant coming.

Lamonica: I mean, no rant from me, Shani. I think you can give a good overview of this topic. So, perhaps your description can include another animal that starts with a B that is associated with investing.

Jayamanne: Well, that animal is a bull, which I think all our listeners know is not something associated with this podcast.

Lamonica: Well, touché, Shani.

Jayamanne: We are clearly not fans of technical analysis. First off, because it's a trading strategy, and we don't believe in trading. Secondly, we believe in fundamental analysis, which is the opposite of drawing lines on a chart.

Lamonica: But the bigger point is that the concept of a bear trap is something that is wider application. It also equates to buying at the dip or jumping in too early because you think a bear market or any drop is over. So, how should we think about this, Shani?

Jayamanne: Well, there are a couple of points we can make here. The first is something we've been saying a lot on here – finding the market bottom is almost impossible to do. Whether you're using technical analysis or any other analysis will not help you identify the market bottom. The point of doing fundamental analysis of a share is to identify fair value and then allow for an adequate margin of safety to protect you against the imprecision of that analysis. That does not mean that the share will not continue to fall over the short term, but the protection will come into play over the long term.

Lamonica: That's right, Shani. So, I would not be too worried about if we are currently in a bear trap or not. Nobody knows if the bounce we've had during July is the start of the next bull market, or just a brief interlude on a trip downward. The concern you should have as an investor is if the present conditions are a good time to buy in order to achieve your long-term goals.

Jayamanne: And my answer is yes, I'll continue dollar cost averaging because I have a long time before my goals.

Lamonica: And my answer is that I think I can still achieve my goals without continuing to put more money into the market just because I don't think the risk-reward balance is to my liking right now.

Jayamanne: Okay. So, I hope that helped to answer your question, Lisa.

Lamonica: All right. Moving on to our next question. So, Graham asked what is a reasonable rate of return to expect for a portfolio?

Jayamanne: And Graham actually sent us a really nice email outlining how he was inspired by our podcast to start playing around with different retirement calculators.

Lamonica: Yeah. It was a really nice email.

Jayamanne: Yeah.

Lamonica: Can we say it's our favorite email from the investing Q&A ones, or is that mean to Brian and Lisa?

Jayamanne: And also, to David from Perth who left his voicemail.

Lamonica: I said email.

Jayamanne: Yeah, sure.

Lamonica: Okay. So, anyway, let's start with some basics for Graham about rates of return. So, the reason we want a realistic rate of return is to determine if our goals are realistic. If they aren't realistic, it is important to know as soon as possible, because it means you can make adjustments while you still have time. Because, of course, as you approach your goal, it becomes harder to make up for shortfalls with extra savings.

Jayamanne: The other thing that is important to note is that when we look at realistic rates of return, we need to look at after-tax and after-fee rates of return. And when the financial services industry quotes returns, they're always talking about the index, which, of course, does not take into account fees or taxes.

Lamonica: All right. So, Shani, we're going to use a practical example here. What were you doing on July 20th, 2017?

Jayamanne: That's a really good question. I was probably working.

Lamonica: Okay. Well, if what you would have done is you put $10,000 into the S&P 500 on that day – maybe you did do that. I don't know what you were doing – over those five years, Shani, that $10,000 would have turned into $17,400, which I think is pretty good, especially considering the recent drop in the market.

Jayamanne: Yeah. The problem, of course, is if you sold the investment right now. Let's say you had this in a taxable account and made $100,000 a year. According to the capital gains tax calculator, you would owe $1,203. So, now, your gain goes from $7,400 to $6,197. Your total return has now dropped from 74% to 62%. If we annualize that, it changes from 11.71% return to a 10.13% return.

Lamonica: Yeah. And obviously, everyone's tax situation is different, and taxes, of course, would be lower within super. But don't lose sight of taxes and fees. They can make a real difference. So, let's look at realistic returns. We recently released a new investment policy statement feature on Morningstar Investor that includes Morningstar's projected asset class returns over the next 20 years. So, these projections are based on economic and corporate conditions, which, of course, includes as we always talk about valuation levels. So, the higher the valuation level, the lower those future expected returns are.

So, Shani, without that big introduction, what are Morningstar's projected returns?

Jayamanne: Yeah. So, for Aussie equities, we have a 7.9% return. For global equities, we have a 6.75% return. Aussie listed property is at 6.85% and global listed property at 7%. Infrastructure is at 7% as well.

Lamonica: All right. And I'll handle the defensive assets because that fits into my personality, right? So, Aussie fixed interest 2%, global fixed interest 2.25% and cash at 1.75%.

Jayamanne: And when we look at your portfolio, we need to, of course, remember your asset allocation and how you have distributed your funds among those various asset classes. This is why asset allocation is such a big deal. So, our view is very much that if you are looking at after-tax and after-fee returns that go into the 8% and up range, you should be wary.

Lamonica: And if we are wrong and returns are higher, guess what, Shani? You have more money, which is a good thing, right? And I will say this brings up a little bit of a pet peeve of mine. So, there is a lot of talk right now, and a lot of it's political talk, which I know you're into Shani – but there is a lot of talk about what retirees need to save for retirement and that the superannuation industry is deliberately getting people to save more money than they need because they want to collect the extra fees on those assets. And come on, Shani, like, what is the worst thing that happened if you over-save?

Jayamanne: You have more money to spend.

Lamonica: You have more money to spend later on. So, if you were young, saving more money is just insurance. It's insurance that you don't lose your job for extended periods of time. It's the ability to maybe change jobs to something lower paying later on. So, anyway, you want to assume that you're getting double-digit returns, and it doesn't happen, that means you won't achieve your goal. You're more realistic and follow what Morningstar's guidance is, it means that you have a better chance of achieving your goal.

Jayamanne: The other thing we would stress is that you can project a range of outcomes and consider the different impacts that each end of the range would have on your life. Also, spend some time estimating how much you need for retirement. Don't go with some average number from the superannuation industry body. Being independent means taking control of your life.

Lamonica: Yeah. And who wants an average retirement?

Jayamanne: Nobody.

Lamonica: I don't want an average retirement. Anyway, Graham, actually, he sent through a follow-up question as well. So, he asked how to estimate inflation. So, we will quickly do this. Inflation is another key input into trying to achieve your goals, of course, and this one is a little bit trickier given the environment we're currently in. So, if we go back to 1983, the average Australian annual inflation rate was 3.77%. And it was an interesting time because that was a time where it was very high inflation, so over 10% in 1983 to really low inflation that we've seen recently. And then, of course, it surged again in the past year.

Jayamanne: Yeah. And this is another case where it pays to build in a bit of a buffer, and it pays to look at personal inflation rates. CPI is a basket of goods that is supposed to represent the average Australian, but each of us live unique lives. Think about the drivers of your own inflation, especially around the biggest categories like housing at 23%, food at 17% and transport at 11%.

Lamonica: All right. So, Shani, now we introduce the guest. I don't know how this works.

Jayamanne: I know because we haven't planned this.

Lamonica: Yeah. Will has to work his magic. But anyway.

Jayamanne: Okay. Should we just say here is the voicemail?

Unidentified Speaker: Good morning. And my question is this. I've examined my portfolio and broken it into five general categories – utilities, pharmaceuticals, consumer staples, financials and materials, including building materials. Can we, as an exercise at Morningstar Investing Compass rank these categories in which we can buy with the upcoming dip in the market? Thank you.

Jayamanne: All right.

Lamonica: All right. So, now the voicemail played, and that, of course, is David from Perth.

Jayamanne: That's David from Perth. So, yeah, thank you, David from Perth for the message because we didn't really get a good turnout on that, of course.

Lamonica: Yeah, but you can still leave us messages.

Jayamanne: Yeah, you can. It's still on there.

Lamonica: Anything you want. Maybe if there is anyone out there that's a dog trainer and can figure out a way that (Priscilla) will stop peeing on me, that would be great.

Jayamanne: Let us know, yeah.

Lamonica: All right. So, David, as you said – as you heard, divides his portfolio into different sector categories. So, he said utilities, pharma, consumer staples, financials and materials and now wants to know what do we think of the approach. So, Shani, what do we think of that approach?

Jayamanne: Well, those are all sectors, even if he is using slightly different names than the official names of the sectors, and with sectors, the big thing is cyclicality and how much the businesses in that sector are impacted by the economic cycle.

Lamonica: That's right, Shani. So, very cyclical sectors will be very much impacted by the business cycle. And then, of course – and there is nothing wrong with that, but those sectors are likely to be more volatile than something that is non-cyclical. So, those non-cyclical sectors will perform no matter what is happening with the economy. So, those sectors are healthcare, consumer staples and utilities.

Jayamanne: So, the only advice we would have for David is to spend some time thinking about what type of investor he is and how he would respond to volatility and how volatility may impact his ability to achieve his goals. For instance, if he is transitioning to retirement, he would be faced with sequencing risk and may want to be overweight in less volatile sectors.

Lamonica: Okay. Exactly. So, we've done it.

Jayamanne: We've done it.

Lamonica: We've answered some questions.

Jayamanne: Our first Q&A, I have to say.

Lamonica: I know. There is one more question, but it was about multi-sector funds, and we thought, that's a really good question. We should do a whole episode on that.

Jayamanne: Yeah. So, stay tuned.

Lamonica: Yeah, exactly. So, there is one more that we will do. But if you ever have any questions and just want us to respond to it over email, send them to my email address, which is in the show notes, and you can also email suggestions. They don't have to be voicemail – email suggestions about how (Priscilla) can stop peeing on me. So, thank you guys very much for joining. Once again, we'd love any comments you have or ratings in your podcast app. And yeah, we'd love to hear from you. So, thanks very much for listening.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Pty Ltd and/or Morningstar Research Ltd without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact the financial advisor.)