Friday Fundamentals Webinar: Portfolio Construction

-- | 21/06/2019

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Mark LaMonica, Individual Investor Product Manager, discusses the fundamentals of portfolio construction and walks you through the four important steps of building a diversified investment portfolio that meets your goals.

Detailed information on each of the steps discussed in the video, as well as the worksheets, can be found in the Morningstar Guide to Portfolio Construction. This guide is exclusive to Morningstar Premium members – sign up for a Morningstar Premium subscription on the link below to instantly download the full guide and access all other Premium benefits. 

Mark LaMonica: Thanks for joining this week's edition of Friday Fundamentals. Today, we're going to talk about the portfolio construction guide. About a year ago, we put out a portfolio construction guide. Since then, it's been one of our most popular features. So, we thought we'd spend some time today going in depth into what that is.

So, really, when we talk about portfolio construction, many investors automatically jump to asset allocation and that's certainly important and we'll get there. But really, what we've done in the guide is taking a more holistic approach. Morningstar believes in a goals-based method of portfolio construction. So, we're going to walk you through four steps today, the four steps that are in the guide and we'll show you a couple of tools in the guide and we'll show you a couple of places you can use our website to find investments.

So, starting out, we want to talk about really what the traditional approach is, and this is an approach that we disagree a little bit with. But the traditional approach to portfolio construction is you start with a risk tolerance questionnaire. What a risk tolerance questionnaire is, is it's an assessment of how much risk you would take and the way that they do that is they look through what you would do in hypothetical situations. So, the market goes down 25%, what would you do? Would you sell all of your investments and go 100% to cash? Would you stay in the market, would you buy more? So, you go through these series of questions. Generally, this is done either on a website or it can be done via an advisor. And at the end out pops out your risk tolerance. And then, immediately, what that allows you to do is go from that risk tolerance into selecting a portfolio. And that's great if you are really centered around investments. But in Morningstar we're centered around investors.

So, we really get down to what is the purpose of a portfolio. And people that professionally manage portfolios have certainly different purposes. But for individual investors the purpose of a portfolio is to achieve something. The whole point of saving and investing is delay gratification now so that you can buy something else later. And really, the difference between the two is what the rate of return is and that's what your portfolio is supposed to do.

So, first, let's walk through a couple of reasons why we don't think a risk tolerance questionnaire is a very good approach to take. So, the first reason is that people are very bad at assessing what their risk tolerance is. So, you go through these hypothetical scenarios and that's great, but as soon as there is any stress placed on you, any emotions placed on you, it turns out that what you said you were going to do is completely opposite from what you are going to do. So, if you think about times and the market is going down, every day you are logging on, looking at your account, seeing that you have less and less money; that can be a very stressful event for an investor.

So, in cases like that people generally will sell. Same thing when the market is going up. You are sitting around, you are listening to all your friends, talk about about how much the market is going up. Generally, investors take on more risk when the market is going up. They want to invest more. So, that's really the number one problem is that we assume and just have a very poor ability to assess our risk tolerance.

The second reason is, what I was mentioning before, we think that a traditional portfolio management or portfolio construction approach really doesn't think about people and doesn't think about goals. So, for example, a risk tolerance questionnaire, you could go in, it could spit out again that you have a very tolerance for risk. So, generally, what people would do is, they'd put you in a portfolio that was heavily weighted towards cash, fixed income, safer assets. Well, what if your goal needs you to earn a higher rate of return? So, we think the goal is most important, not this hypothetical risk tolerance questionnaire.

Then, finally, the last reason is that a risk tolerance questionnaire assumes that you are investing for one goal. So, this works very well if you look at retirement, for example. So, it's a goal for most people far off in the future. You are looking for a set amount of money at a certain time in your life. But that's not how any of us live our lives. We have different goals. We want to save for a house. We want to save to help fund our children's education. We want to save for retirement. So, your risk tolerance is really different with all of these different goals because the timeframes are different.

So, as I mentioned before, we really take a more holistic approach and that's really where we start out within the guide and selecting a goal. And we'll walk through with the steps that you need to go through, but I did want to acknowledge that really selecting a goal and defining a goal is a very difficult thing for people to do. And it's difficult for a couple of reasons, and we'll show you sort of what information you need to define, but it's difficult because it makes something concrete, right, defining something concrete, thinking about how much money you need for it, thinking about when you want to do it, is scary to a lot of people. So, a lot of people like to avoid this and talk in hypotheticals. When I retire, I'm going to spend three months a year traveling without ever thinking about what that's going to cost or what they need to save.

So, setting a goal, sitting down either by yourself with your partner and defining a goal really means that you have to answer four questions. So, the number one question is, how much is this going to cost, and you need to obviously take into account inflation. So, at Morningstar, we have a projected future inflation rate at 2.6% a year. So, obviously, I think everybody knows this intuitively what something costs today does not equal what it's going to cost in 30 years. So, take inflation into account, but you need to figure out an estimate for what you think your goal is going to cost, whether that's saving for a home, whether that's retirement, whether that's a trip that you are saving for.

Second thing you need to do is, you need to figure out when that's going to happen. So, when specifically do you want to retire, when specifically do you want to buy your home. It's very important to have an actual timeframe there. And the next thing you need to do is, you need to take stock of where you are financially right now. And we'll get into how the formula works in a little bit. But you need to know how much money have you already saved for this goal and then how much money can you save going forward to try to reach the goal.

So, I'm going to jump in, show you a couple of worksheets that we have that helps with this whole process. I'll go through these quickly, but these are all available in the guide. So, I wanted to start out with the goal planning worksheet that you can see here. So, basically, everything that I just mentioned; defining the goal, the dates or when is that goal going to happen, the expected cost which is really important, and the duration is how long you actually want to spend if it's a case like retirement where there is additional spending. So, define your goals, come up with when they are going to be, come up with how much they are going to cost and we have a couple of different goal planning worksheets to look at, intermediate goals, long-term goals, short-term goals.

The next thing that I talked about was net worth worksheet. So, really, what the net worth worksheet does for you is it finds what you have now. So, do you have anything saved for this goal? And many people have no idea of what their net worth is. So, this really forces you to go through looking at all the different categories of assets you may have and then also looking at all the different categories you have in debt. And that's really going to show you total assets minus total debt, gives you your net worth. So, that can show you what are the resources you have that can pay for these future goals.

Then, finally, a personal cash flow statement. So, everybody hates this, everybody hates budgets. But you do need to figure out how much money you can save for your goal because that's a really important part of the formula that we're about to go through. So, pretty simple. It's looking at your income, looking at your expenses. We're certainly not asking you to categorize every one of your expenses or look at all of them. But you need to figure out how much you make, how much you actually spend every month or how much you're willing to spend, if it's a reduction and this will give you the total monthly cash flow you have that you can actually dedicate it towards savings.

So, that's really an exercise, as I said, most people do not like going through. It is necessary for this process and we'll tell you a little bit about that now. And I'm going to talk a little bit about math, and I know everybody hates math. But the good thing is, you don't have to do any of this yourself. There are calculators, but I think conceptually it's really important to understand this.

What we're talking about is the time value of money formula. So, we talked before about how savings has really just delayed gratification. So, what you are doing is, you are sacrificing a going out to dinner now for potentially a trip in the future, right, and the difference between those two amounts of money is the return that you actually get. And the time value of money formula is what shows you what you will have in the future. It's pretty simple. There are a couple of inputs that you have and luckily enough, all of the inputs actually just came off of the three worksheets that we talked through. So, if we do complete those, you will have all the inputs.

Input number one is, you need to know how much money you have now that can be dedicated to that goal. So, whether that's zero or you've already started saving for something. You have to know the place you are going to start, and you get that off of the net worth worksheet that I showed you.

The next thing you need to know is how long do you have to save. So, that's looking at your goal, how far in the future is it. So, you'll have that number. Other thing you need to look at is your – looking at the cost of the goal in the future. So, that's very important. That's also on that workshop. And then, the final part of this – I'm sorry – and the other thing is, how much you can save. So, how much you can save every month, a year, that's another component of the formula.

And then, the final piece is that required rate of return. So, generally, if you sit there and look at a time value of money formula, what you are trying to calculate is the future value. So, you are saying that if have $1,000 now, I am going to save $1,000 a month, I am going to earn a 10% return. It will tell you what you have in the future as long as you define that timeframe. But back to the math component of things, I think as we all learned an algebra. If you rearrange all the variables, you can solve for any variable in that formula.

So, the next step of this process in the portfolio construction guide is to calculate the required rate of return. Now, the required rate of return is the thing that's going to connect all of the things we just talked about; how much money you have, what you want to save, what the timeframe is and what the future value is. It tells you what you need to earn to actually achieve your goal. So, I'm going to show you a calculator. So, once again, you don't have to do any of this yourself, but I will go on to this third-party calculator that we've shown.

It's and there is a link to this in the guide. So, I put it in a pretty simple example here. So, future value, so this is what you want to save for. So, let's say, you are saving for a down payment for a house. In this case, you've got $100,000 that you need. What is the period? So, in this case, we're using years as period. So, in 10 years, you need $100,000. What do you have now? You have $50,000. What can you save in one of these periods? So, in this case, $1,000. And it spits out what your return is. So, in this case, you need to earn a return of 5.696%. So, now, you know – and we'll get into why that's important – now you know how much you actually have to earn from your investments, from your portfolio.

Now, one thing that's important about this formula to realize is that if you start looking at the different variables in the formula, if any of them go up, that will increase the amount of money you have in the future. So, go through that one more time. If you have more money now, you'll obviously have more money in the future. This is assuming positive returns. If you save more, you will have more money in the future and if the time that you can save and invest increases, you will have more money in the future. So, that's really the important part about the time value of money formula because that's how you govern your life, right. So, if you think about people always talk about saving early. Why is it important to save early? Because you have more time to actually invest the money. And what that means in a practical sense is the earlier you start saving, the less you have to save. So, nobody likes saving money. If you don't want to save money, start saving earlier, right? So, that's really why I think it's important that conceptually people understand that formula.

So, we'll get back to this required rate of return. So, calculating the required rate of return answers a pretty fundamental question for you. In some cases, it can answer, is your goal achievable? So, in this case, I calculated 5.6%, that's pretty achievable, I think if we look at historic market returns. What if this popped out 25%? Well, unless you are some sort of investing genius, you are not going to get a 25% return over 10 years. So, I think in that case, you really need to take a step back and say, is my goal actually achievable and what can I do to make it achievable? And once again, we talked about some of the different levers you can pull. You can save longer. So, instead of buying a house in 10 years, you can buy a house in 15 years. You can save more every month, right? So, if you are able to rein in your spending a little bit more, save more, maybe you can achieve that goal. It's pretty hard to have more money than you do now. But if somehow you can figure out a way, sell some possessions, I guess, have more money now that you can start out with, then that's great too.

So, let me show you – I'm going to go back into the guide and let me show you, in a reasonable basis, where this return go. So, we have this chart in here that looks at different portfolios. So, you can see the different asset allocation we have between simple stocks and bonds, and it really looks at a 20-year period from 1996 to 2016. And we're looking at Australian investments only here, but it shows you what the different returns are. So, in all stock portfolio, return 9.4%. Obviously, there is now way to know what it will return in the future. So, let's say, your required rate of return that you calculated is below 9.4%. That means you probably have a pretty reasonable chance of achieving that. Once again, obviously, we don't know what future market returns will be and if you think about this was a pretty good period, but there is also global financial crisis you see here, so there was some turbulence around this period, but it can let you know sort of where you need to be. Now, you can see an all bond portfolio performed very well as well with 7%. So, at least it gets you to start thinking about where you need to be from an asset allocation perspective.

One of the reasons why this is really important, and we talked a little bit about a risk tolerance questionnaire before, the reason that this is important, because your risk as an investor, if you think about it, or at least the way Morningstar defines it, your risk is not meeting your goal. So, if you took a risk tolerance questionnaire that said you are incredibly conservative, you could not – and I'll talk about sort of how risk is measured in the financial services industry – you are incredibly conservative, you should keep 100% of your money in the bank. Well, that's great. So, maybe that is your willingness to take on risk. You have no willingness to take on risk. But if the return you need is 5%, or in our example about 6%, that's the return you need, and you put all of your money into the bank and we all know that obviously the RBA just lowered rates that the yields on bank accounts are going lower and lower. You have a 0% chance of meeting your goal.

So, what's really the risk. The risk is, and this is an absolute risk is it will not happen, you will not meet your goal. So, that's how we'd like to think about risk, risk of not achieving your goal. The financial services industry generally talks about risk in terms of volatility. So, volatility are the ups and downs that the market goes through. So, if you go back and look at that chart – so, we'll go back to this chart – and we think about volatility. If you look at this upper line, this is the return of stocks. You can see here in the global financial crisis, obviously, there was a lot of volatility, right? And that's the way that we measure things in a risk tolerance questionnaire, what would you do in relation to this volatility of the market going down. But in reality, obviously, if you held on the whole time, you earned a very strong return. So, we think that focusing on goals will make sure that you are not reacting in the wrong way to market volatility, because you understand that your bank account or your investment account may fluctuate up and down over time, but you are still locked into that goal that you are trying to achieve.

So, I am going to go back into the guide and show you the next step. So, we've talked about you have now a required rate of return and you can have multiple, by the way. So, if you have multiple goals, you have multiple required rates of return, and what we've added into this guide is from Morningstar Investment Management, they've defined five different portfolios here. You can, obviously, see running from conservative to aggressive. And in each one of these portfolios, there is a different mix between growth assets and defensive assets. And most importantly, at the bottom, there are investment objectives in each one of these portfolios.

So, CPI that is simply inflation. So, as I said earlier, Morningstar believes it's 2.6% or will be in the future. So, you can really see what the expected returns are just by adding that up. Now, one thing I would add is that – and we'll get into this later – valuation is very important. We do think the market is reasonably valued. So, we don't see a lot of opportunity for outsized investment returns in the future. So, you can see that we had 2.6% to 4%. We're really only expecting 6.6% in our aggressive portfolio in terms of returns going forward. So, that is something to take into account.

But, really, we're at this asset allocation step rate now, and you can see there are suggested asset allocations. You can see the different asset classes. And when we talk about asset allocation, what we're really talking about is what is the mix of different assets that are going to be in your portfolio. So, on a very simple level, what are your stocks versus bonds. As we've defined in here, we've gone a step deeper and we started looking at global shares, Aussie shares, different types of fixed income, cash, of course.

So, your asset allocation, once again, this is where most people start with portfolio construction, is pretty important. And there was a famous survey that came out. Roger Ibbotson, who is a professor at Yale and actually started Morningstar Investment Management, started Ibbotson Associates, which Morningstar then purchased. He has a famous survey out there saying 90% of the variability of returns comes from asset allocation decisions. So, this mix in your portfolio is very important. But most important, we think, is going through the whole goal definition process at the beginning.

So, those are different asset allocations. So, you go through. You can select one of those portfolios if it meets your different objectives. And we do have some more documentation on what each one of those portfolios is trying to achieve. And then the final step and the last step of constructing a portfolio is, of course, finding the investments that you are actually going to put in there. And that's really, obviously, with Morningstar Premium, our research comes into play. So, we cover, from an equity perspective, 1,500 equities from around the world, 450 managed funds, ETFs. So, I do want to show you sort of how you pick investments to actually make your portfolio.

So, I'll go back on to our website. We've got a tab called Discover Investments. From a stock perspective, we can start with some of our ratings, so 5-Star or highest-rated stocks. We also look at moats, which is an assessment of the competitive advantage. So, you can go through depending upon what your asset allocation is between Aussie shares, global shares. So, we've got North America; we've got Asia; we've got Europe. I think sort of more importantly, if you're trying to find these allocations, funds and ETFs can play a big role. We literally have all the funds and ETFs lined up in the different asset classes for you, so you can see our highest rated funds and ETFs, from our highest rated Gold down to Bronze. So, that's how you can access our research. It does line up with those different asset allocation targets that you have.

And that really completes the last of the four steps that we have in the portfolio construction guide. There's obviously a lot more information in there than I could say today, but those are really the four steps.

So, we're going to bring – I know we've had some questions that have come in. So, we're going to bring Emma out here to – she can navigate past the light pole – to see if I can answer any of these.

Emma Rapaport: Yeah. So, first up, (Cazz) wants to know – she is watching, but she maybe missed the beginning – is there a repeat of this video somewhere?

Mark LaMonica: Yeah, absolutely. So, the video – as soon as this Facebook Live ends, the video will be available on Facebook. We're also going to take the video, we will put it into the same video format that we have on our website, we'll send around an email to everybody, probably not till Monday, but we'll send that email around and you can certainly watch as many times on Facebook or on our website as well.

Emma Rapaport: Okay. So, Matthew, wants you to put some of your, I guess, the theories you've been talking about into practice. He sent a long question. He says, I'll read it all and then maybe we can break it down. He says, how should someone construct a portfolio from scratch with say $1 million. Consider transaction costs and timing, should the investor buy up all elements of the portfolio on day one or work towards a model portfolio over time? And then, lastly, how should the investor prioritize what to buy first?

So, maybe we should break that down. If you have $1 million how would you start thinking about constructing a portfolio?

Mark LaMonica: Yeah. I mean, listen, not to repeat myself, obviously, I would go back and look at what is the goal of the portfolio. So, I think, we talked about this in the beginning that a portfolio is a means to an end. The end is what you are going to spend the money on or potentially leave it for your children, but what is the actual goal for the portfolio. So, I guess, I would start there and figure out – and perfect example of this is – so, let's say, you have $1 million portfolio. You do have a relatively limited amount of time until you need to actually spend the money on your goal and the goal is pretty close to $1 million, potentially, you could just leave it in cash. That's really why it's important looking at the goal. So, I would start there, I'd go through that whole – that goal definition.

Emma Rapaport: What are some of the goals that you can identify? I mean, if somebody doesn't know what a financial goal is? Do you have some examples?

Mark LaMonica: Yeah. So, I guess, an important thing in that is, we think about financial goals, they're not financial goals, right, they're life goals. So, buying a house is a life goal; it's not a financial goal. There's obviously investment property, but presuming you want to live in your house, that is a life goal that impacts your life every day. So, I think, it's really thinking about like what do you want to achieve in your life. So, if we talk about retirement, retirement is a common one. What do you want your retirement to be? Do you want your retirement to be travelling all the time? Well, that's going to be a lot more expensive than staying at home. Do you want to buy a boat and go sailing on your boat? That's going to be a lot more expensive than staying at home. So, I think, it's really just thinking about and sitting down – if you have a partner, sitting down with your partner and defining what your life goals are.

Emma Rapaport: Can you have multiple goals?

Mark LaMonica: Absolutely. Well, we all have multiple goals. I think retirement and housing are probably two really good ones, because I think most people want to buy a house at some point in their life. So, that is generally a shorter-term goal. A longer term goal is retirement. But a goal can be going on vacation, a goal can be planning for an upcoming milestone birthday that you want to have a party for or go on a family trip for. So, a goal can be anything. You have multiple goals, you can have multiple time horizons, obviously, between your goals. They don't all happen at the same time. And because of that really the risk that you want to take on in different investments depending upon the goal can be very different.

Emma Rapaport: Okay. So, let's try and deal with (indiscernible) this question. If he has – so, he has built his portfolio, he has decided his risk tolerance, he has decided his rate of return and the goals he wants to achieve. Should he go out there on day one and just buy everything or slowly invest the money?

Mark LaMonica: Yeah, it is a good question. Well, I think there's two different ways to think about it. Maybe I'll quickly go through dollar cost averaging. Let me go through the problem. I guess, the problem with going out there and buying everything immediately. And we did have this question before, and I dug out a couple of stats. So, I looked at – and the ASX 200 is approaching it again – I looked at the ASX 200, local market indices, 200 biggest stocks trading on the ASX and it peaked in October 2007. So, we went back, we looked at State Street Global Advisors has an ETF, STW is the ticker on it. We went back and we looked at what would happen if we bought STW in October of 2007. So, it turns out the return today would have been negative 4.42%. So, that's 12 years – a little less than 12 years. Now, obviously, for people like no, right after that the market fell off a cliff because of the financial crisis but still if you would have gone in and invested your million dollars in October of 2007, you would not be very happy right now.

So, what's really important is looking at valuation. So, that's what we believe in as a firm, that's what our equity analysts are doing all day. They are trying to value companies and looking at the valuation of the overall market. So, sometimes the market is expensive, sometimes the market is cheap. Valuation is really important. There is also – we use the term margin of safety when we are looking at individual investments. But as an investor you want a little bit of margin of safety, maybe you sit there and look at the market and say, I think it is reasonably priced today. Well, I think, you do have to consider the fact that you may be wrong. So, by investing the entire amount you are making a pretty big bet on your view of if the markets are attractive today. So, the idea of dollar cost averaging is instead you slowly invest this money. The markets are obviously going to continue to fluctuate. If you make a huge mistake, the market has a terrible next six months, you will still have some money to invest. So, you are investing at higher prices, lower prices, different prices as the market goes along and it can de-risk that investment a little bit.

Emma Rapaport: So, dollar cost averaging, is there a timeframe in which you are thinking?

Mark LaMonica: You know, it's really up to you as an individual. What I would say is dollar cost averaging in this scenario if you have $1 million, I wouldn't be talking in weeks. I think people get very caught up in market movements. Oh, the market was down 2% today, it is a great buying opportunity. There is this expression, buy at the dip. That works very well when the market is going up; it works really poorly if the market is going down.

Emma Rapaport: Well, that leads into another question we've got. So, Rachel asks if she has built her portfolio, every day she should go and check the market to see what's happening.

Mark LaMonica: First of all, I'll say that I check every day. Not that that is a good advice. The problem with checking every day is that people get very caught up in movements and there is a lot of – Morningstar does a lot of behavioral research to look at how people react to this. And the problem is that people see the market moving around and they think they have to do something. So, everything is sort of pushing you into action and generally, action is bad, because action creates trading costs, action means that you are probably likely going to – maybe likely is not the right word. You are going to buy things when they are high, and you are going to sell things when they are low and that is the exact opposite of what you want to do. So, I think the best thing to do is to walk away and not look at all these fluctuations.

I mean, people talk a lot about housing prices, especially in Australia. That's the equivalent of imagining somebody came up and knocked on your door every day and told you how much your house was worth. Today, I'll give you $500,000 for your house. The next day they walk up, and they say I'll give you $450,000 for your house. That's not going to lead to good behavior, right? You're going to panic when it's going down. You're going to get really excited when it's going up. But none of that changes anything. It's still your house, you still live there. So, think of portfolio that way. Your goals in the future, check how you are periodically, check how you are moving towards achieving your goal, recalculate that required rate of return and go from there.

Emma Rapaport: Yeah. I'm curious like how often would you say that somebody should reassess their portfolio or rebalance. The things in the portfolio are going to move around, so therefore, the percentages that you have are going to change. So, how often do you have to think about that stuff and make changes?

Mark LaMonica: Yeah. I mean, listen, a lot of literature – there are different opinions about all of this. A lot of literature that I've seen says once a year. That's generally what I do. So, I'll sit down with my wife once a year in an activity that I'm sure she hates, and we'll go through this and really look at sort of are our goals still the same. So, you have to reassess your goals, people's goals can change, and then how you are tracking against those.

Emma Rapaport: Okay. We're coming up to half an hour. So, I'm just going to ask one more question. Let me have a look here.

Mark LaMonica: Just try to find one that I won't be able to answer.

Emma Rapaport: So, Angus asked how do you decide between actively-managed or index funds or do you use a combination of both?

Mark LaMonica: So, listen, I'm certainly not an expert on this. So, I'll just paraphrase what our manager research team does or what our manager research team says. So, as I mentioned before, they assess 450 different ETFs, funds in Australia, obviously run the gamut between passive, active. I think their opinion is that there are certain asset classes where it makes more sense to be in an active fund. And you can certainly go in and look at the way that they've assessed asset classes. So, you need to think about what you are doing. Like, many people say that from a bond perspective, if you want to go into fixed income, active might be more appropriate. If you're going to large-cap stocks, potentially passive might be more appropriate. But I think it's up to each individual investor. I guess, what I would do is, take a look at some of the different investments and the research that we have on them and see what our manager research team says.

Emma Rapaport: Check the website.

Mark LaMonica: Check the website. Exactly.

Emma Rapaport: Great. I think that's all.

Mark LaMonica: Okay. Great. Well, thank you guys very much. Thank you, Emma, for only stumping me a little bit. We'll see you next time on Friday Fundamentals.

This report appeared on 2022 Morningstar Australasia Pty Limited

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