International exposure can bring big benefits, says Morningstar

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Glenn Freeman: In this edition of 'Ask The Expert'. I'm speaking to Tim Murphy from Morningstar Manager Research.

Tim, thanks for joining us today.

Tim Murphy: Thanks Glenn.

Freeman: Now today we are talking about managed funds and you are going to speak to some of the asset trends that you observed in 2018.

Murphy: Sure. So it was an interesting year in markets, obviously the first 8 or 9 months of the year characterised continued strengths, particularly across risk assets. But then we, obviously, saw a high degree of weakness in the backend of the year in the fourth quarter, which led to some negative returns across the board in most major equity markets around the world. The first time that had happened for several years.

What it's really saying is big dispersion breakout in portfolios has been quite interesting. So over the course of the year, the best performing asset class as it turned out was good old fashioned Aussie bonds.

So most people or many market participants certainly have been talking in recent years about questioning the role of why you would ever have bonds in a portfolio, given interest rates are so low. But I think 2018 evidenced why you would have that, because you've seen Aussie bonds add material value last year in protection returning over 4 per cent for the year on the main Australian Composite Bond Index. While we also saw global bonds and cash deliver positive returns as well. So, it's really highlighting why you have those defensive assets in a portfolio, to provide some strength in times of broader weakness.

Freeman: In terms of markets, one of the standout areas that you mentioned earlier was the United States, that actually had done reasonably well over the course of the year.

Murphy: So, we saw some wide dispersion in equity market returns over the course of the year. There was continued weakness throughout the year in emerging markets, in particular in China. But in areas like the U.S. were certainly the strongest performing market over the course of the year and sectors like technology, when we are looking over the whole year certainly with the stronger performers albeit that did pull back some way in the fourth quarter of the year, but still as we look over the whole of 2018 any of the global funds or ETFs exposed to technology or U.S. tended to be the better performers over the course of the year. Anything more focused on emerging markets certainly, China in particular we saw some big negative drawdowns there.

Freeman: And what does this mean for Australian investors in terms of how they think about their portfolio construction for this year.

Murphy: Well, most Australian investors tend to be domestically biased. So, if we think about the Australian equity market for last year, it did perform better than many of the major developed markets in local currency terms. But when you factor in the falling Aussie dollar. I mean global equities on a hedge basis actually did lot better than Australian equities domestically.

So, one of the things we encourage clients to consider is having unhedged currency exposure which has tended to provide a buffer in times of weakness. Historically given the procyclical nature of the Australian dollar and that proved to be true again in 2018. So there are certainly, some big benefits to having new international exposure in your portfolios in that regard.

If we focus on the local markets specifically, maybe another thing to keep in mind is most people's portfolios tend to be heavily focused on dividend paying stocks, banks in particular - they are one of the weakest areas of performance in 2018, obviously we saw the Royal Commission and slowdown in the property market have quite effect on share prices of many of the major financial stocks here that tend to make big parts of portfolio.

So I think the big takeout and the big thing to think about first structuring your portfolio going forward is really thinking about not having all of your portfolio and particularly if you are trying to deliver an income stream, not have all of that tied to one particular sector or one area which we know that many investors have particularly done that relative to the bank and their exposure to banking stocks for the dividends.

Freeman: Following on from the interest rate movements and in currency - what are some of the pockets of opportunity that you've seen? I think real estate investment trust is one that sort of showed up?

Murphy: Interestingly there is big divergence in listed property, infrastructure stocks over the course of last year. So as we saw material rises in interest rates in the U.S., for instance. Some of those sectors that are viewed as being interest rate sensitive like infrastructure and property perform quite weakly overseas whereas domestically obviously we haven't seen a movement in any interest rates from the RBA for some time now and Australian listed property trusts or AREITS one of the better performing sectors on the local market. So, again highlighting that maintaining some diverse exposure to different sectors really helps build better, more robust portfolio through time.

Freeman: And were there any areas that really stood out as being, so what were kind of poor performers across 2018?

Murphy: So on domestically it's definitely anything exposed to the banks at a local level in a meaningful way. Certainly weaker areas there and as I alluded to for overseas exposure anything tied to China or emerging markets were certainly some of the weaker performers for 2018. But I guess as we roll forward the question then becomes where the opportunities lie going forward and certainly when we look at the world. Places like emerging markets and places like Europe certainly look like better value from a go forward investment perspective now than other areas might have been performers in the past.

This report appeared on 2019 Morningstar Australasia Pty Limited

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