1 Oct 2009
Positives and Pointers
By Money Marketing
In today’s newsletter we take a look at some positives in the economic environment and we share some thoughts from Anne Cabot-Alletzhauser on investing for retirement. There has definitely been some good news on the economic front – some bad too – but again the question that raises itself is - is this good good news or good news amidst the bad? Today we focus on the good news.PositivesPMI takes a turn for the betterThe Kagiso PMI was released earlier today. It has risen from 39.3 in August to 48.0 in September. The Kagiso PMI is a leading indicator and is seasonally adjusted. This increase is the second largest increase recorded since the survey commenced (September 1999).
“September’s results are showing signs of life in the domestic manufacturing sector for the first time since the collapse of US investment bank Lehman Brothers in September 2008,” says André Coetzee, head of Fixed Income at Kagiso Securities.“Although we would like to see confirmation in the 2009Q4 PMI data, the latest results seem to confirm the analysis presented in the July PMI report, ie that SA’s manufacturing recovery will probably be similar to countries such as the US and UK who, after an initial muted rise in their respective PMIs, experienced accelerated gains during the following months.” Is it a sustainable trend? Coetzee is cautious here – and says that it is also important to look at what is happening globally with PMIs- “we saw a good recovery here but yesterday the Chicago PMI came out below 50 again and below expectations.” PMI is still not above 50 so that indicates we are still contracting but at a much slower pace than before. The Index has 9 components and some of these have scored over 50 – notably expected business conditions. “With the exception of February 2009, purchasing managers’ optimism regarding medium-term business conditions has been rising steadily since November 2008: September’s results saw this index increasing to 70.3 points - the highest since early 2007,” Coetzee says.Three reasons a W will be avoidedStimulus has a long way to runEarlier in the week at an Absa Capital presentation, head of Absa Capital Research Jeff Gable, said that there has been an argument raised that much of the recovery has been due to the stimulus packages and this raises the question of what will happen when the stimulus ends. “Don’t misunderstand the nature of the stimulus.”The positive here, Gable says, is that the stimulus is far from over. Much of the stimulus already agreed has yet to be implemented. For example – in China 60% of the agreed stimulus has yet to hit the ground and in the OECD countries nearly 40% of the stimulus will only hit next year. “Even if there is nothing more – there is still a lot coming.”And while South Africa may not have had an officially named stimulus package, Gable says economic policy has been far from normal. Gable says a lot has been done in South Africa – just not under the guise of a package. 18 Months ago South Africa had a fiscal surplus and that is now likely to move into a deficit around 8% of GDP. This is not “policy as usual.” Gable says the tone of the stimulus projects around the world has been to focus on what is needed for example in terms of infrastructure – and South Africa was already doing this and had the “right policies at the right time.”Can we do more? The deficit is very large and signals are that there is not much more money in the kitty, said Gable. Gross revenue collections remain below target, VAT collections are improving – but of the main revenue sources, VAT shows the largest deviation from budget. Interest ratesGable says that double dip recessions tend to be caused by early tightening – and signals are that this is unlikely. “The language from policy makers couldn’t be clearer.” Gable says policy makers are going out of their way “telling us they are willing to risk interest rates being too low for too long” rather than pulling the rug out from a fragile recovery. The consumer’s balance sheetWhile Gable says his sense is that credit won’t be easy going forward and there is a need to normalise their balance sheets, “to bet against the consumer you need to believe things will get significantly worse.”Without doubt there is a lot of debt, and while consumers may have felt okay taking on debt in boom times, when the boom turned into the bust it was an unpleasant experience. The wealth effect of decreasing asset prices – notably house and equity assets – saw the net wealth of consumers decline. But with US and UK house prices down 30 – 40% from their peak, Gable says the real serious impact to wealth seems to be behind us. Based on 50 years of research, Gable says a lot of the savings behaviour can be explained by changes in wealth, rather than leverage. In the presentation Gable said that savings have already adjusted much higher and may not have further to go. If wealth does not fall further savings rates may be unlikely to increase.But that does not mean spending will return. Sentiment clearly favours the out of the woods but not too far from the trees. Good and bad news make for a difficult investment environment. Getting the solution right
Anne Cabot-Alletzhauser, chief investment officer, Advantage Asset Managers, discusses developing a better framework for decision-making around investment options, for individuals and retirement funds.
So how should advisers and investors think about the investment decision-making process? Simple. There are two pillars for making efficient investment decisions: understand what goal you are trying to achieve (Goals Based Investing) and what risks you are prepared to take in order to achieve your goal (Risk Budgeting).
In developing a framework for decision making that incorporates these two pillars, you need to understand some of the dynamics of decision-making that a typical investor goes through when faced with the problem of how and what to invest in.
Goals Based Investing and Risk Budgeting
Goals Based Investing is the discipline of explicitly defining what an investor is trying to achieve. The “goals” could be, for example, a specified rand amount or a rate of return that would lead to an acceptable pension at retirement.
The key issue about Goals Based Investing is that it considers the particular needs of an investor and what the investment needs to achieve in order to allow the investor to meet those needs. It isn’t a process of identifying with a particular peer group for instance, as this does not target the specific needs of the investor.
In order to achieve a particular goal, the investor needs to take on some investment risk. Risk budgeting is the process where the various risk/return trade-offs needed to achieve a particular goal are identified and explicitly stated.
Unfortunately investment risk and investment return are opposing forces. You simply can’t expect to get high investment returns without taking on investment risk. The Risk Budgeting approach will allow you to assess what is possible and what isn’t.
As an example, if an investor wants a relatively high return and isn’t prepared to accept risk in terms of a negative return, the risk budgeting approach will allow you to express that a) either you need to reduce your required return or b) you need to accept a higher level of risk.
Insights from Behavioural Finance
One of the key insights of behavioural finance is that investors don’t necessarily evaluate investments from a pure risk / return trade-off perspective. Investors are governed by fear, greed and unrealistic expectations, which may cause them to act in a way that from a purely objective point of view may seem irrational.
Investors will exit the market after equity markets have fallen, fearful of more losses and not considering that after equity markets have fallen, they should offer a myriad of profitable investment opportunities.
It now appears that risk based questionnaires are not seen as being an effective way to assess an investor’s risk appetite. This because of the way in which an investor answers the risk questionnaire, may have more to do with the way that the investor is feeling on a particular day, rather than be based on an objective measure of the investor’s risk tolerance.
Investors also tend to invest in such a way as to maximize their utility function. An investor wants to invest in such a way so as to maximize their satisfaction, which has nothing to do with risk and return because this measure is so personal.
All of this means that an independent third party may be able to make better investment decisions than the investor themselves, as emotional aspects of the investor’s decision are stripped away. This is especially true when the investor has very little direct investment knowledge.
In addition, where an investment strategy is defined it would be useful to set out the best and worst case scenarios upfront and how an investor should react, if at all. This may assist in allowing the investor to be more objective when, over the short term, the investor’s portfolios don’t perform as expected.
A framework for investment decision-making
The starting point of any investment decision-making process is to understand the investors’ characteristics. These characteristics include, but aren’t limited to; how old each investor is, how much they are willing to save, what the investor is trying to achieve, how much and what types of risks can the investor tolerate.
So let’s look at a retirement fund as the investor.
Once you understand the needs of the fund, it is appropriate to come up with a default investment portfolio that will meet most of the needs of the members, which balances the goals of the majority of the members with the risks that they are willing to take.
The default approach is prudent as it will help mitigate any tendency for members to chop and change their investment approach which could be detrimental to their long term savings if they make bad decisions, like investing in cash after markets have fallen and then missing out on any recovery in the equity market when it happens.
A prudent investment approach for a retirement fund should take into account that the members’ needs change as they come closer to retirement. Again in line with the default option proposed above, it is prudent to build investment strategies that take these changed circumstances into account and as far as possible automatically move members into portfolios that are most appropriate for their needs.
In the simplest form this may be offering members a pre-retirement switch to more sophisticated models, such as life staging, that move members into portfolios that are more in line with their needs.
To digress quickly, when defining a default portfolio, you should bear in mind that you are trying to address the needs of the majority of members. You will never be able to cater for every member’s particular needs. There are mechanisms, such as member choice, that can be set up to cater for these member’s needs.
From an investment portfolio construction approach, once you have established what the members goals are, it is relatively straight-forward to identify the type of investment product and the basic mix of equities, bonds and cash that would be needed. So for example, if the members require long term growth that would reasonably achieve a return of CPI+5% pa, a portfolio that maintains an asset allocation not too different from 65% in equities, 25% in bonds and 10% in cash should be able to achieve this goal.
Obviously when you do select a portfolio, you need to understand the philosophy and approach of the portfolio and how it is managed in order to meet the objectives that you have established.
Finally, it is crucial to measure the performance of the selected portfolios against the required objectives. In measuring this performance you need to keep in mind what the market circumstances were, what the performance potential was and how the portfolio performed.
It is important to stress that for retirement funds in general, investments is a fairly long term game, so performance should be measured over a reasonable period. Focusing on monthly, quarterly or even annual performance may not be an effective way of evaluating whether the portfolio is meeting the longer term objectives. The opinion and comment in this newsletter is opinion and comment only and does not in any way constitute financial advice. Please seek professional advice from a registered financial adviser for all investment decisions.