ROADTEST

Hastings Yield Fund

Who runs the fund? Hastings Funds Management, a Melbourne-based specialist in infrastructure and yield investments, and since 2005 a Westpac subsidiary.

The basics: Invests in high yield securities including loans and hybrids. High yield means the payout is greater than in mainstream bonds, but with a greater credit risk too. It aims to beat the UBS Australian Bank Bill Index by 3% per year.

The process: Looks at senior, subordinated and mezzanine loans – these terms tell you in what order creditors get paid if a company runs into trouble. Subordinated ranks behind senior but pays better. Also looks at bonds and hybrids and can invest in structured products like collateralised debt obligations, though in practice it doesn’t seem to.

The bottom line: Good over the longer term: Morningstar says its 7.14% per year return over three years and 8.18% over five is among the best of all yield funds in Australia. 12.42% over the past 12 months is weaker than many peers, however.

Fees: 0.4% plus a 10% performance fee on returns above its benchmark, but retail investors will only be able to reach it through a platform, so add on the platform administration fee too. Alternatively a listed fund with similar holdings, Hastings High Yield Fund, can be bought and sold like any share.

Verdict: High yield is one of the buzzing areas of world capital markets, and Hastings has shown it can be successful in this complex area.

NEW FUND

Climate Advocacy Fund

What is it?

A new ethical fund which not only aims to deliver a decent return – similar to the overall share market – but to do so while improving corporate behaviour, performance and sustainability. It will do this by actively engaging with companies about environmental, social and governance issues related to climate change.

Is that a good investment?

In performance terms it doesn’t claim to be any more than an index fund and will use passive management to try to at least equal the S&P/ASX 200. It charges 1.1% a year (0.85% if you invest over US$50,000) which is more expensive than some ways of getting index exposure, but less than most actively managed funds. You’d really be buying it in the hope of effecting an environmental difference.

Well who’s doing the advocacy?

Australian Ethical, which has been running ethical managed funds and superannuation since 1986. Its Balanced Trust flagship fund, for example, has A$237.5 million under management.

If it’s an index fund how can it pick only ethical stocks?

Its portfolio will be built using an economic footprint weighting. But it differs from most ethical funds in that rather than selecting the best companies environmentally, it will use its clout as an investor to try to change practices at companies generally.

GIZMO

The iLuv iPhone iMM190 App Station

If you are an iPhone junkie you have probably already surrendered most of your daily functions to your gadget bar eating it. So you might as well add another: as well as using it for your email, address book, music, video, and even perhaps as a phone, why not make it your bedside alarm clock?

This so-called App station is a cross between a charger and a speaker. You attach your iPhone to it, add the alarm clock application from iTunes, and away you go: it turns into a big-display bedsides clock and you can program it to wake you up with your favourite iTunes songs, or with weather information, for example. It works equally well as a desktop speaker for an iPhone or iPod, and it charges the gadget while it plays. It can run on batteries so can be used outside too.

FUND WATCH

EQT SGH Absolute Return

The idea of an absolute return fund is to see a benchmark and plunge beneath it. Well, that’s not the theory, but a look at this fund’s returns might lead you to believe so, with comprehensive underperformance of the stock market over one, three and five years.

In fairness, it’s not meant to track stock market returns exactly: 75% of the portfolio goes into equities and 25% into absolute return strategies. This theoretically insulates investors during market declines, but it’s not showing up in the numbers.

Fancy a Mongolian mining company? No? How about a nice Lithuanian bank, or a Kazakhstan gas utility? OK, my final offer: KenGen. What do you mean you don’t know KenGen? It’s Kenya’s most successful electricity company. Durr.

Frontier markets, as stock markets like these are known, require greater savvy and experience than dealing with the most grizzled of used-car salesmen. This is, no doubt, where some of the most extraordinary gains will be made: the emerging star companies of tomorrow in the emerging star countries of tomorrow. But they take the idea of risk and reward to a whole new level – particularly on the risk side of the ledger.

You may not know it, but the countries you are exposed to are dictated more than anything by a group of people sitting in an office on Pine Street, New York. This is MSCI, and it is one of the leading providers worldwide of stock market indices. One of its most well-known ones is the MSCI Emerging Markets, and it is against this index that most emerging market fund managers – including those selling such funds in Australia – are benchmarked.

Consequently, most emerging market funds tend to mirror the geographical allocations of the MSCI index fund quite closely; when a market enters or leaves the index, a lot of capital tends to flow in or out with it as emerging market portfolio managers rebalance their holdings accordingly. The table below shows the 26 nations that make up the index today; even if you don’t hold an emerging markets fund yourself, the chances are your super fund will have at least a modest allocation to it, and it is because of MSCI’s decisions that you probably have an exposure to Brazil but not Argentina, to Hungary but not Croatia, and to Morocco but not Tunisia.

“The definitions to a large extent are given to us as fund managers by the index providers, particularly MSCI,” says Peter Taylor, investment manager for Asian equities at Aberdeen Asset Management in Singapore. (Taylor’s investment decisions affect the emerging market and Asia funds sold by Aberdeen in Australia.) “They have a process and criteria, and under those, some markets are defined as developed, some as emerging, and some as frontier.”

Frontier is actually quite an odd term, because it doesn’t always mean what you might think it means: poorer countries with no established stock markets. In fact, if you look at the table showing the constituents of the frontier markets, it includes some of the richest countries in the world, such as Kuwait, Bahrain and the United Arab Emirates; these have not been promoted to more widely tracked indices mainly because of a lack of easy access to their stock markets, or a lack of maturity or depth within those markets. Also, some frontier markets have stock exchanges almost as old as Australia’s: the Colombo Stock Exchange in Sri Lanka traces its history back to 1896.

“The term ‘frontier markets’ captures a broad universe,” says Taylor. “There are things that you might consider real frontier markets – Central Asia, Mongolia, Papua New Guinea, Pacific islands – where there is an insignificant stock market or sometimes no stock market at all, with the bigger companies listed elsewhere. Then there are what you might think of as the emerging markets of tomorrow: places like Vietnam, Sri Lanka, Bangladesh, Pakistan, and outside Asia places like Nigeria, Kenya or Romania. They may have their difficulties but are sizable countries with a decent number of listed stocks already that could potentially make the leap in the next few years.” And a third category is the wealthy Gulf states. “’Frontier markets’ is not strictly an income level cut-off. If a market has certain types of controls or access problems, it won’t meet MSCI’s criteria to be in the emerging market index. That’s why you have a country like Kuwait defined as a frontier market where it is far richer per capita than, say, India.”

Frontier funds covering all these bases do exist, but they are rare and little marketed in Australia. Franklin Templeton, for example, whose fund manager Mark Mobius has long been a standard-bearer for unloved markets, runs the Templeton Frontier Markets Fund out of Singapore and has so far garnered US$299.13 million under management tracking the MSCI Frontier Markets Index. Its biggest geographical positions are, in this order, Nigera, Qatar, the UAE, Vietnam, Saudi Arabia and Kazakhstan. Its biggest picks, while household names in their own countries, are little known outside them: MTN Group, a South African telco; Kazmunaigas Exploration Production, a Kazakhstan gas company; Saudi Basic Industries, a chemical, fertilizer, plastic and metals producer; Industries Qatar; and United Bank for Africa, which is headquartered in Lagos, Nigeria.

Other funds might pursue a specialist opportunity. In Australia, AMP Capital developed the Vietnam Real Estate Opportunity Fund, for example, investing in direct property there, although funds like this tend to limit access to sophisticated or institutional buyers rather than general retail.

Since few pure frontier funds exist, investors are more likely to get exposure to the frontiers when emerging market fund managers decide to dip their toes in the water of markets outside their benchmark, whether in expectation that those countries will eventually be promoted into true emerging markets and hence become part of their mandate, or simply because they think there are good returns there. In this respect, emerging markets fund managers are most interested in the chunk Taylor labelled the emerging markets of tomorrow, and this is perhaps where the biggest opportunities might lie for bold investors too. “We are quite bullish on prospects for both Vietnam and Sri Lanka long-term,” says Peter Sartori, founder of Treasury Asia Asset Management. “We think it will take longer than many people expect for both markets to become more mainstream or institutional – we expect it is five years away rather than one to three years – but it will likely happen.”

Managers differ on which markets they think offer the real opportunities. “There are a decent number of interesting stocks, particularly in markets like Sri Lanka and Kenya, which have a very long tradition of equity markets,” says Taylor.  “We find more interesting companies in Nigeria and Sri Lanka than we find in Vietnam. Vietnam is everybody’s favourite exotic market, but it’s not a place we find a lot of good companies, whereas places like Nigeria and Sri Lanka have had listed companies forever, with subsidiaries of multinationals listed there, and the local banks.” Aberdeen pursues these opportunities particularly through an Asian small caps fund – this holds stocks in places including Sri Lanka and Pakistan – and to a lesser extent in its broader emerging market funds too.

If you’ve noticed Sri Lanka keeps popping up in this story, that’s a useful point to consider. What’s really changed in Sri Lanka for everyone to be talking about it? It’s not that its companies, which have been around for more than a century in many cases, have become suddenly better – it’s because a crippling civil war has ended. Fund managers with a really long-term view will look at macro considerations like this in deciding whether exposure to a market might eventually make sense. “There has been a tremendous increase of interest in Sri Lanka but it’s got nothing to do with it graduating [to an emerging market definition – which, by MSCI, it still hasn’t],” says Taylor. “People were dismissive of it because of civil war, and suddenly it’s become exciting. We’ve been invested in Sri Lanka forever and that was not a set of investments that have performed very well for many years but suddenly it’s come good: all our stocks have been two or three baggers in the last 18 months.” That is, they’ve doubled or trebled.

Correctly calling the end of a civil war with any accuracy is clearly beyond most of us, but there are other similar factors that are easier to see coming: the world is getting more interested in Mongolia as transformative mining deals (including a vast mine backed by Rio Tinto) get closer to completion, which should lead to greater foreign involvement, faster economic growth and a more developed stock market, for example.

Still, in unpredictable places, these transformative economic moments can go both ways. “People think of emerging markets as a one way bet, but that’s not the case: you do have some emerging markets that go in the wrong direction.” The two key examples at the moment are Pakistan and Argentina, both of which in the recent past have been investment darlings – Pakistan in particular, which for a brief time was a poster child of foreign investment and privatisation before the political and security situation worsened. Both those markets now languish in the frontier indices rather than the emerging market ones, with a consequent loss of interest from international capital. Similarly Kazakhstan was for several years considered a barometer for the emergence of Central Asia, and attracted a lot of attention as it liberalised its banking sector – which pretty much went broke in the financial crisis, taking a lot of foreign money with it.

No Australia-based investor in their right mind would seek to buy a stock listed in Ulaanbaatar or Lagos without a great deal of prior knowledge, but there are other ways of getting exposure to odd parts of the world through a single stock. To stick with the Mongolia example, more and more of the world’s most powerful investors – such as Temasek, Singapore’s sovereign wealth fund, and China Investment Corporation, its equivalent in Beijing – are trying to get a foothold in companies and mining interests there in expectation of growth. One of the companies that sovereign funds have bought into, South Gobi Resources, has since been listed in Hong Kong, which can be easily reached by Australian investors and is a well-governed exchange. (It’s worth noting, though, that the stock has crashed 30% since listing, although the rest of the market is well down too.) You don’t even have to go that far to get exposure to some frontier markets: here in Australia, Lihir Gold gets most of its revenue from a gold mine in Papua New Guinea, and much of the remainder from Cote d’Ivoire. A great many mining companies, BHP Billiton and Rio Tinto included, have some exposure to the frontier mining idea.

It’s also very easy for Australian investors to invest in the USA, and doing so gives you access to the greatest range of exchange-traded funds (ETFs). These behave like buying a single share, but they reflect the performance of an entire index. Providers in the US such as Vectors, PowerShares and Claymores offer frontier ETFs, or ETFs tracking particular areas such as the MENA area, which means Middle East and North Africa. Examples are the Claymore Frontier Markets ETF (whose New York Stock Exchange symbol is FRN), PowerShares MENA Frontier Countries ETF (on Nasdaq, code PMNA) or Market Vectors Africa ETF (NYSE, NFK). Be aware that an ETF gets you exposure to the dross as well as any diamonds that might be found, and also that buying an ETF in America from Australia also exposes you to currency movements. iShares, the biggest provider of international ETFs sold in Australia, covers several individual Asian emerging markets in its Australia-listed products (Taiwan and Korea, for example), but for more far-flung stuff you have to go to their New York-listed products too: they have ETFs for Peru, Chile and South Africa, for example.

Otherwise, real frontier investing tends to be the preserve of private equity players who bring chunks of daring institutional money together to put into very new markets with a long-term timeframe. Examples are Altima Partners, the former Deutsche bank equity special situations group which peeled off from the bank in 2004 and has since launched funds including the Central Asia Fund, covering Armenia, Azerbaijan, Georgia, the Kyrgyz Republic, Tajikistan, Turkmenistan and Kazakhstan; the Dubai-based private equity specialists Abraaj Capital, which runs the Abraaj/BMA Pakistan Buyout Fund alongside a local Pakistan bank; and a group called Acap Partners, run by a former McKinsey staffer called Pierre van Hoeylandt, who runs a truly frontier-spirited entity, the Afghanistan Reconstruction Fund. It takes big money and immeasurable patience and risk appetite to participate in these sorts of ventures.

Generally, though, the idea of wanting to get in early to markets that will grow in importance, liquidity and influence is sound enough, and allied to the broader trend of Asian or emerging market growth. “Asia ex-Japan has only been on the radar for most Australian institutions for the last five years,” says Sartori. “It will definitely remain on the radar and will continue to grow in importance as the region continues to grow relatively stronger than elsewhere in the world and Asia gets larger in global indices. The frontier markets will contribute to this, but are a few years away from being more meaningful.”

BOX: The Middle East

The Middle East, which for investors is chiefly the big oil-rich markets of the Gulf Cooperation Council (GCC), is an odd case. Massively wealthy, their stock markets do not appear in global indices because by and large their markets either lack suitable access for foreign money, or because they are too small or immature. Saudi Arabia’s market doesn’t even make it into the frontier index because foreigners cannot buy Saudi shares (although they can create the effect of doing so synthetically with new investment structures).

There are funds that do invest exclusively in these markets: one of the biggest is the Schroder Middle East Fund, sold within its International Selection range, whose biggest positions are in Turkey, Saudi Arabia, Kuwait, the UAE and Qatar. “The long-term case for investing in the region remains strong,” says Rami Sidani, fund manager at Schroders in Dubai. “Middle Eastern countries are at a relatively early stage in their development and have strong growth potential. While many of these countries continue to benefit from oil and gas riches, they are investing in new products and skills to diversify away from reliance on energy exports. The region has a young, fast-growing population which should also contribute to a more rapid economic development.”

But emerging markets managers often consider the Gulf’s position in frontier indices an anomaly given that, as highly wealthy states, their future growth profile is likely to be quite different to a Vietnam or Sri Lanka.

In any event, MSCI has been talking for some years about adding some Gulf markets to the emerging markets index; Kuwait, the UAE and Bahrain are the ones that are most frequently mentioned, even though Saudi Arabia has much the biggest market in the region by market capitalization. It will be an interesting day when it happens, because calling Kuwait an emerging market – with its high performance luxury cars, bounteous oil revenue and soaring per capita income – seems just as odd as calling it a frontier.

 You will have read about the boom in contracts for difference, or CFDs. But if you join the crowd, what exactly should you do with these versatile and powerful investment tools? It’s all very well having the ability to leverage, to go long and short, and to take positions not just on stocks but indices, currencies and a host of other assets – but without a trading plan, you’re unlikely to get too far.

 “After 17 years trading financial markets I have learned that the one thing all consistently winning traders have in common is a strategy,” says Andy Richardson, founder of www.contracts-for-difference.com, a UK financial trading site that offers free advice on CFD trading. “They all stick to a strict set of rules, taking the emotion out of their decision-making.”

 LONG AND SHORT

In its simplest form, you can just use a CFD in the same way you would buy a share – by going long. Doing so means you benefit if the price of that share, or whatever other asset you have invested in, goes up.

 But one of the main reasons people choose to set up CFD accounts is they make it easy to do something that is otherwise quite tricky: going short. This means you benefit from a fall in the share price.

 This brings us to our first real trading strategy: how you use a short. Most obviously, you can use a short position to express a view that there is a fall coming in something’s value. If you were one of those bright people who took short positions on US bank stocks in 2008, or on an index representing them, then you are probably wealthy enough not to need to read on. In circumstances like that, there is just as much return to be made from something falling in value as rising.

 Many professional fund managers find the ability to go short enormously useful, and argue that being constrained to long-only positions is an illogical limitation of their skills. If they have a view on stocks that are going to go up, surely they should also have a view on stocks that are going to go down? And why shouldn’t they be able to take a position that reflects those views and make money if they’re right? CFDs allow you to do exactly that.

 But there are other uses for shorts too. The main one is hedging. This means you offset one position with an opposite one in order to reduce the risk you have. You can do this in varying degrees: you might take a modest short position that doesn’t complete balance out a long position but does provide a bit of insurance to dampen the blow if the share price falls. Or, in some circumstances, you might choose to negate your positions entirely – if, for example, you have acquired a lot of stock that you can’t sell (most commonly through a share option plan with your employer which requires you to hold the stock for a certain period of time), you could take a short position which means that no matter what happens to the share price you will not have lost or made money.

 “Recently, when we’ve seen activity in our market driven by what’s happening in Europe, clients have been adjusting their strategy a bit,” says James Leplaw at Macquarie. “We are seeing more people use CFDs to hedge their portfolios. If you’ve got 10,000 BHP and you don’t want to be exposed to potentially losing the stock, and what you really want to do is protect your investment, you can short or sell a CFD for the same number of units. You’re then not getting any downside risk, but are also losing any upside exposure to what BHP might do in the short term.”

 RULES TO LIVE BY

 But a trading strategy doesn’t just mean following a theme like this. When many traders talk about strategies, they mean a hard and fast set of rules they apply to themselves when trading as a form of risk management. This might include when to sell out of a losing position; when to sell out of a winning one; and how much leverage they are comfortable with.

 Vital in implementing these strategies are instruments like the stop loss.

 There are all sorts of variations of these conditional order tools, but the principle is simple. A stop loss defines a level at which your broker will sell out of your position if the market moves against you.

 The most obvious example of a stop loss is in a long position, when you’ve bought something in the hope that it will go up in value. If you set a stop loss sell order at, say, 10% below the market price when you place the order, then your broker will bail you out after your position has lost 10% of its value. Deciding exactly where to put the order is tricky: too close to the share price and you’re likely to trigger it in everyday volatility, too far below and you’re exposing yourself to a lot of risk.

 A variation on this theme is the stop entry: that means you’d like to buy a stock, but only if it falls a bit. By buying a stop entry position, your broker will automatically buy in if the stock falls to that level.

 With some providers you can also put a stop loss on a short position, meaning you get out of it if the share price rises too far.

 It’s important to understand a distinction between different stop loss products. “The mechanism for how it is triggered is important,” says Leplaw. “With a stop loss, if a stock trades at a certain price, the order will be executed – but in order for that to happen it has to trade at that exact price. What can happen is, in a falling market, a price step can be jumped” – going straight from $19.05 to $18.95 without hitting your stop loss level of $19, for example – “and with a normal stop loss that will mean the order is not triggered.”

 This is called gapping, and is particularly dangerous in the gap between the market closing and opening again, when the behaviour of other markets around the world will have a big impact on the share price in the meantime. It is quite common for a stock to close at one price and then open the next day much lower or higher.

 To get around gapping, many providers offer a guaranteed stop loss, meaning that even if the share price jumps over your stop loss level without hitting it, the broker takes on that risk and guarantees to get you out at that level. “Think of it as an insurance policy,” says Leplaw. Stop losses cost money and guaranteed stop losses cost more, but many traders swear by them for peace of mind.

 KNOWING YOUR LIMITS

 Another vital part of a trading strategy is to make sure you absolutely understand how leveraged you are, how much you can lose, and whether you are comfortable with that. If you are too highly leveraged, you can sell some of your position, or commit more money as margin against share price movements. But it is impossible to overstate the importance of understanding this simple fact: leverage allows you to make a lot of money, but it potentially loses you a lot too – perhaps more than you actually have. You must understand how to mitigate this risk, and be comfortable with it, before trading with CFDs.

 What do we know about how people really behave when it comes to these risk systems?

 A useful study is the 2009 CFD report by the consultants and researchers Investment Trends in Sydney. They got responses from 7,500 investors, including 2,000 current CFD traders, so their findings are quite representative.

 “Risk management plays an important role in current traders’ strategies, but they are unlikely to switch providers for improved risk management tools,” explains Pawel Rokicki, analyst at Investment Trends.

 58% of current traders in the survey said that contingent or stop loss orders would be important if they were choosing a CFD provider today, and of those respondents who aren’t yet traders but plan to do so, 42% said the availability of guaranteed stop losses was the single most important catalyst to prompt them to start using CFDs.

 More than anything the key with CFDs is to know what you can do and understand what tools you have at your disposal. “Traders should stack the odds in their favour before making a trade,” notes Richardson. “That means spending some time analysing their trading style and mindset, as well as the markets. Some CFD firms offer investors a free suite of tools and seminars designed to assist. Only once these crucial elements are conquered is an investor ready to trade.”

 BREAKOUT: STRATEGIES THE PROFESSIONALS USE

There are several other specific strategies that traders talk about. Here are a few examples:

• Index constituent changes. This involves trying to take positions when indexes are being reweighted in order to try to take advantage of movements in the share prices of companies that are added or removed from an index, or reweighted within it.
• Trading on news. Some CFD providers provide ready access to news about companies – directors selling shares, maybe, or corporate activity – that could affect the share price. Doing this, though, means taking on the professionals, who will be doing much the same thing but probably with faster news sources than you.
• Arbitrage means trying to make a profit from what you see as a price discrepancy – this might be a company trading out of line with its peer group, or even the same company’s stock appearing to trade at different levels on different exchanges. Some professional traders try to exploit these discrepancies by taking one long and one short position, hoping that the discrepancy will eventually resolve itself, making them money.
• An example of an arbitrage technique is pairs trading. This can take a number of forms. One could pair trade with companies in the same sector, such as buying Rio Tinto while selling BHP Billiton because you believe Rio Tinto will rise relative to BHP. One advantage of this is you’re not exposed to what’s happening in the broader market: if the whole ASX 200 crashed, the two shares would presumably crash together, and your exposure is simply the convergence or divergence of the two share prices, not the drop in the market. A more aggressive approach might be to pair trade on stocks in different sectors – even different exchanges – or to pair trade the markets themselves. For example, quite often traders will take a view on the relative merits of the Australian versus the American stock markets, and they can express that by, say, buying the ASX200 and selling the Dow Jones Industrial Average, or vice versa. Getting the best out of trades like this really does require you to watch the markets like a hawk, though, and is better suited for professionals.
• Tax management. This is a way of making some money out of a stock without selling it, since selling would trigger a tax event. A typical approach is called a capital cash release, where the stock you don’t want to sell is used as security to enable you to access more funds for other investments.
• CFDs lend themselves well to technical analysis or charting – a whole other investment discipline, and beyond the scope of this article.

For the second time in two years, one of the engines of the developed world economy is in trouble, this time Europe. And also for the second time in two years, the countries we call emerging markets – those in the developing world in Asia, Latin America and Eastern Europe, for example – look much stronger than their supposedly emerged peers in the west.

At first glance, it looks like a reason to divert your international equity exposure away from places like the US and Europe, and towards places like Asia. The truth is, Asian economies – the ones we have patronised with the emerging label all these years – look in far better fiscal condition than any of the richer counterparts in the west, with the possible exception of Australia itself. “Asia is in better financial shape than it has ever been, and also relative to the world,” says Peter Sartori, who runs Treasury Asia Asset Management, which offers Asian equity funds to Australian investors. Most emerging Asian nations don’t have deficits of any note; they are in a demographic sweet spot in which the bulk of the population are working, and not entering retirement as in places like Japan; and in many cases their biggest challenge is keeping growth in check to avoid inflation, not wallowing out of recession.

The problem is, we’ve been here before. During the global financial crisis, there was a lot of talk that Asian countries had become so strong, they would not be affected by problems in the US. Unfortunately this turned out to be rubbish – although Asian economies stood up pretty well, foreign money fled emerging markets and most stock markets in Asia did even worse than those in the west (although they subsequently rebounded much more vigorously too). So with another crisis in Europe, should we expect contagion again?

Economists generally think not: only 20% of Asian exports go to continental Europe, and most of those to relatively unscathed Germany, meaning a European slowdown should have a modest impact. “While the sovereign debt crisis has increased the downside risks to EU growth, we do not think that it represents a large risk to emerging market Asian growth for now,” says Prakriti Sofat at Barclays Capital in Singapore, who also stresses that exports aren’t as vital to Asia as they used to be because of the growth in domestic demand.

Money managers familiar with Asia are wary. “Having been living in Hong Kong in 1997 and 1998, managing Asian money and witnessing how contagion spread, I’ll never underestimate what contagion could do across Europe,” adds Sartori. “But I find it quite hard to believe that contagion could spread to Asia. My general hope and view would be that Asia would come out of this in a much strong relative position.”

A look at performance numbers does suggest that, for all the volatility, emerging markets funds have been doing better than developed world equities, particularly in the rebound since the global financial crisis. According to data from Mercer, the median emerging markets equity fund sold in Australia delivered a 39% return in the year to March 31, 1.6% a year over three years (a period which includes the whole financial crisis) and 11.5% a year over five years. For overseas shares funds generally, those figures are 17.9%, -7.8% and -0.3% – considerably inferior on all counts, although the picture is much brighter for hedged overseas funds (those that neutralise currency movements).

In fact, much discussion in Asia has focused not on threats to growth, but worries that growth is getting out of hand. The IMF recently warned about the volumes of inflows into Asia, and the creation of asset bubbles, particularly in Chinese property.

Is this a worry? “There are various bubbles in Asia,” says Hugh Young, managing director for Asia at Aberdeen Asset Management. “But they are largely property-related, not really stock markets, although they are due a fall after rapid rises. Famous last words, but there are no huge excesses in most of Asia, though markets are far from cheap.”

That’s another important point: after such terrific rises in most Asian markets in the last year, is it a good time to buy? Even long-standing Asia bulls like Sartori will only say: “Overall, we think Asian stocks can end the year higher than where they are at the moment”; he is actively avoiding India and Indonesia, finding them overvalued.

Credit Suisse Asset Management starting pulling out its emerging Asia equity exposure last November, feeling valuations were getting stretched, and instead getting its exposure by buying developed world companies which get most of their revenues from emerging markets (another popular approach – many people buy stocks such as Coca-Cola, Nestle or even BHP Billiton for exactly this reason). But, according to senior advisor Robert Parker, valuations are “starting to look more reasonable. My view is after the next two to three months we will want to go back into emerging market equity.” He favours Korea, Taiwan and – despite valuations – Indonesia.

It’s important to note that different Asian markets appear to offer different opportunities at different times. Sartori is overweight Taiwan, for example, which in recent years has thawed its previously hostile relations with China, a thawing that ought to have considerable benefits to Taiwanese industry and banking. Also, he notes that China – despite what you read about its phenomenal growth – has been a hopeless stock market performer; its CBN 600 index was down 21.8% in 2010 up to May 17. “Chinese stocks have underperformed for three quarters now and have de-rated. But we’re in the camp that is not overly concerned about China: we think the weakness is throwing up a lot of buying opportunities. Although, saying that, we’re not even close to buying a real estate stock there.”

This raises the question of how to invest in Asian or emerging markets. There are a number of ways.

The most obvious is to buy an emerging market or Asia mutual fund. Morningstar tracks 76 separate emerging market equity managed funds sold in Australia, although many of them are different sales classes of the same fund; they vary from covering all emerging markets (such as the Russell Emerging Markets Fund, up 32.36% in the year to April 30); ex-Japan Asia (such as the T Rowe Price Asia ex-Japan Fund, up 41.91%); BRICs – that handy acronym covering Brazil, Russia, India and China (such as the Macquarie Globalis BRIC Fund, hedged, up 42.23%); or country-specific (such as the Fidelity Indian Fund, at 62.97% the best-performing emerging markets fund over 12 months in Morningstar’s coverage by a mile, and the Premium China Fund, up 33.66%). Each individual fund will have its own allocation overweights and themes, and their views and successes will make a quite a difference to returns: Morningstar tracks some emerging market products that made only single figure returns in the same year that Fidelity was shooting the lights out with its India fund.

Emerging markets is the broadest approach. To take the Templeton Emerging Markets Fund as an example – probably the most famous in the world, thanks to its iconic manager Mark Mobius – as of March 31 this would have put 22.2% of your money into Brazil, 15.8% into Russia, 15.3% into India, 11.3% into China, and then smaller chunks into places like South Korea, Turkey, Hungary, Mexico and Indonesia.

At the other extreme, country specific funds are offered in Australia on China (by Aberdeen, AMP, Fidelity, Premium and Challenger), and India (Fidelity and Fiducian). These allow you to take a view on a particular Asian market, but don’t offer a lot of diversification.

It’s also possible to go it alone. Many Australian brokers allow you to buy securities on the New York Stock Exchange, which allows you access to the many Asian countries that have listed forms of their shares (called American Depositary Receipt listings) there – among them Chinese banks, oil companies, telcos, and a host of other regional blue chips such as Taiwan Semiconductor Manufacturing or Samsung Electronics. Some brokers let you buy shares in Hong Kong and Singapore too. Alternatively iShares offers exchange-traded funds in Australia, bought and sold like any other local share, which replicate the performance of indices including China, Taiwan and Korea, as well as ‘emerged’ Asian markets Singapore and Hong Kong.

Doing your own investing in Asia, though, is not to be taken lightly. It’s hard enough to keep track of what Australian companies are doing without seeing your way through companies in different countries, time zones and corporate cultures.

One thing that has severely damaged the benefits of international share investing for Australian investors in recent years has been the outstanding performance of the Australian dollar against dollar, euro, sterling – you name it. But how about Asia? “We think Asian currencies will appreciate, particularly against the Australian dollar, which is crucial for Australian investors,” says Sartori. Judging currency movements, though, is exceptionally difficult, and many managers hedge it out altogether.

In future, perhaps we won’t talk of emerging markets; everything about the performance of world economies in the last few years has supported the sense that the West is certainly no smarter than the East, and in a much worse financial state. “I don’t particularly like this categorisation of developed market, emerging market, frontier market,” says Parker. “There are many economies categorised as developed which frankly I would call emerging, and likewise some emerging markets I think are developed. The classification is just plain wrong.” But whatever you call it, it’s where the money is going. “You’ve got a quantum change in investor attitudes towards emerging markets,” he says.

BOX: Emerging debt

It’s not just in equities that many people see emerging markets as the best option. Many global fund managers are looking here for the best options in debt too.

“We are long emerging debt,” says Robert Parker, senior advisor for Credit Suisse Asset Management, which manages SFr1.3 trillion worldwide. CSAM starting pulling money out of G3 sovereign debt – in currencies like dollars, euros and yen – and putting it into emerging markets in late 2008 and continues to do so.

At Goldman Sachs Asset Management Asia, Oliver Bolitho, who heads the business, has a similar view. “Given the uncertainties about the ratings and fiscal positions of many OECD countries, there is a strong case to be made that the debt of emerging economies is an extremely attractive proposition,” he says. When Asia’s corporate bond markets develop further, Bolitho expects opportunities to increase, “and those opportunities will remain very attractive, possibly for decades.”

Australia does not, though, offer many ways of buying emerging market bonds in managed funds sold there. Instead, they can opt for funds which allocate more than most towards emerging markets while balancing it with some more stable developed-world government debt or with broader global high yield. A good example of this is the Pimco Extended Markets Fund, sold in Australia to retail through Equity Trustees, which is benchmarked half against an emerging markets bond index, a quarter against an emerging market government debt index and one quarter against a global high yield index. As of March 31 its top holdings were debt in Brazil, Russia, Mexico, Indonesia and the Philippines, and its total net return (distribution plus growth) in the year to that date was a remarkable 39.51%, although the five year average of 8.59% a year is probably a more realistic reflection of how a fund like this ought to return.

Remember, though, that returns come with risks; and while many feel that risk-reward ratio has tilted in favour of emerging market debt, it’s still nothing like owning a Commonwealth bond in Australia.

It used to be that government bonds were considered the ultimate safe haven investment. What could be safer than a government? If they run out of money they can always get their central bank to print some more. For many years, investors have looked to sovereign debt – bonds issued by governments and states rather than banks or companies – as a safe, steady, secure backstop to their portfolios.

But events in Southern Europe are changing people’s attitudes towards what government debt actually represents. This crisis – and it is a crisis, threatening the euro itself – is not about cash-strapped American homeowners, or weirdly repackaged bundles of indecipherable debt, or the failure of risk-stretched banks. It is about countries themselves – governments that have borrowed too much, can’t pay it back, and are now on the brink of default.

So what does this mean for investors and the way we use government debt in a portfolio?

“If we go back in time to before the global financial crisis, there was very much a view among investors that sovereign debt, if investment grade, was basically generic,” says Clive Smith at Russell Investments. “You could buy sovereign debt and it was set and forget: it didn’t have to be actively managed like corporate credit.” That’s what’s changed. “The events around Greece and other countries have highlighted that you can’t just assume sovereign debt is all the same. These exposures have to be actively managed within portfolios.”

Smith’s is a widely held view, particularly among fund managers who have long considered governments on their own merits just like carmakers or miners. “We’ve long believed there was complacency among global investors about risk,” says John Wilson, CEO of PIMCO Australia, one of the world’s biggest debt investment specialists. “Not every stock is the same and not every government bond is the same. That perception was not universally shared by the investment community, who tend to see assets in blocks.” David Bryant, head of Australian Unity Investments, adds: “The first thing that surprises me is that people are surprised. Greece didn’t wake up to a debt problem today. One problem has been an assumption that sovereign entities can’t fail: we have a history in Asia, Russia, Latin America where that isn’t the case.”

And analysts agree too. “In European nations this concept of risk-free is starting to be challenged by investors,” says Mark Reade, credit analyst at Citigroup. “What it has shown is that government bonds really should be assessed like any corporate bond or other investment opportunity in terms of the risk and the reward.”

It’s hard to put a figure to how much exposure Australians have to sovereign debt around the world. The biggest exposure will be through super funds. Most people go for the balanced option in their fund, in which fixed interest (or fixed income as it is called elsewhere in the world) is typically about 30% of the portfolio. “Depending on the strategy, anywhere up to half that could be in sovereign debt,” says Smith. “It wouldn’t be difficult to imagine an exposure of around 15% for sovereign debt for many super fund type options.” That would suggest at least A$150 billion of Australian assets in sovereign bonds and potentially significantly more.

On top of that there’s managed funds: Morningstar tracks 43 global bond funds with a combined A$7.29 billion under management, in addition to several more “high-octane” funds that invest in higher yielding securities; these 43 don’t invest exclusively in sovereign bonds but will certainly include them. One trend in the last year, when sovereign debt seemed to be one of the best performing asset classes, was to opt for a passive international bond fund such as those offered by Vanguard, in order to capture the performance of the whole market.

That said, most super and managed funds aren’t putting their money anywhere near Greece, or not in significant volumes anyway. Much sovereign debt holding in Australia will be domestic, and Commonwealth bonds are considered among the most secure in the world. Plenty more will be in US treasuries, which, despite the US’s economic woes in recent years, are still considered safe. The broader problem is not so much people having money in Greek bonds – a tiny proportion even of European Union debt, never mind on a global scale – but the knock-on effects of the Southern European problems on sentiment towards sovereign bonds worldwide. “The contagion effect is one of sentiment, not one of substance,” says Bryant.

And this will take a while to resolve. “This is not a two month issue,” Smith says. “How countries deal with debt levels, and the impact for investors on their sovereign debt holdings, is something that is going to be unclear in the near term. They may only realise what the ultimate impact is years down the track.”

But for shrewd bond funds, what’s happening in Europe isn’t all bad news. “In every crisis there is an opportunity,” says Wilson at Pimco. As pricing varies widely on bonds around the world because of uncertainty about Southern Europe, managers are trying to take a view on the investments that have become could value because they’ve been wrongly caught up in the panic. For each possible investment, they will weigh up the risk with the potential reward and make a call. Wilson is not a fan of index funds at a time of crisis, feeling that: “Passive investment is an incredibly dangerous thing” at times like this.

The lesson of the crisis is certainly not to abandon sovereign debt as an asset class – although the surge in the gold price in recent months suggests some investors have been doing exactly that, abandoning treasuries and other government bonds in favour of the precious metal – but to understand its role. “I think there is a lot of merit in investing in fixed income securities, and that very much includes sovereign debt,” says Bryant. “The safest place in fixed income is sovereign debt but there’s good counterparties and not so good.”

Since most Australians don’t buy bonds directly in their own right, the key thing for them to consider is manager selection. When buying an international bond fund, how diversified are they? Look at the most recent portfolio update you can find and see how it is spread across credit rating, type of issuer, and geography. This will give you an indication of the manager’s approach to risk, and how you should fit the product in your portfolio accordingly. There’s nothing wrong with taking a risk to get a return; just be sure you know what level of risk is being taken on your behalf, especially in a product you’re relying on never to lose value.

For the second time in two years, one of the engines of the developed world economy is in trouble, this time Europe. And also for the second time in two years, the countries we call emerging markets – those in the developing world in Asia, Latin America and Eastern Europe, for example – look much stronger than their supposedly emerged peers in the west.

At first glance, it looks like a reason to divert your international equity exposure away from places like the US and Europe, and towards places like Asia. The truth is, Asian economies – the ones we have patronised with the emerging label all these years – look in far better fiscal condition than any of the richer counterparts in the west, with the possible exception of Australia itself. “Asia is in better financial shape than it has ever been, and also relative to the world,” says Peter Sartori, who runs Treasury Asia Asset Management, which offers Asian equity funds to Australian investors. Most emerging Asian nations don’t have deficits of any note; they are in a demographic sweet spot in which the bulk of the population are working, and not entering retirement as in places like Japan; and in many cases their biggest challenge is keeping growth in check to avoid inflation, not wallowing out of recession.

The problem is, we’ve been here before. During the global financial crisis, there was a lot of talk that Asian countries had become so strong, they would not be affected by problems in the US. Unfortunately this turned out to be rubbish – although Asian economies stood up pretty well, foreign money fled emerging markets and most stock markets in Asia did even worse than those in the west (although they subsequently rebounded much more vigorously too). So with another crisis in Europe, should we expect contagion again?

Economists generally think not: only 20% of Asian exports go to continental Europe, and most of those to relatively unscathed Germany, meaning a European slowdown should have a modest impact. “While the sovereign debt crisis has increased the downside risks to EU growth, we do not think that it represents a large risk to emerging market Asian growth for now,” says Prakriti Sofat at Barclays Capital in Singapore, who also stresses that exports aren’t as vital to Asia as they used to be because of the growth in domestic demand.

Money managers familiar with Asia are wary. “Having been living in Hong Kong in 1997 and 1998, managing Asian money and witnessing how contagion spread, I’ll never underestimate what contagion could do across Europe,” adds Sartori. “But I find it quite hard to believe that contagion could spread to Asia. My general hope and view would be that Asia would come out of this in a much strong relative position.”

A look at performance numbers does suggest that, for all the volatility, emerging markets funds have been doing better than developed world equities, particularly in the rebound since the global financial crisis. According to data from Mercer, the median emerging markets equity fund sold in Australia delivered a 39% return in the year to March 31, 1.6% a year over three years (a period which includes the whole financial crisis) and 11.5% a year over five years. For overseas shares funds generally, those figures are 17.9%, -7.8% and -0.3% – considerably inferior on all counts, although the picture is much brighter for hedged overseas funds (those that neutralise currency movements).

In fact, much discussion in Asia has focused not on threats to growth, but worries that growth is getting out of hand. The IMF recently warned about the volumes of inflows into Asia, and the creation of asset bubbles, particularly in Chinese property.

Is this a worry? “There are various bubbles in Asia,” says Hugh Young, managing director for Asia at Aberdeen Asset Management. “But they are largely property-related, not really stock markets, although they are due a fall after rapid rises. Famous last words, but there are no huge excesses in most of Asia, though markets are far from cheap.”

That’s another important point: after such terrific rises in most Asian markets in the last year, is it a good time to buy? Even long-standing Asia bulls like Sartori will only say: “Overall, we think Asian stocks can end the year higher than where they are at the moment”; he is actively avoiding India and Indonesia, finding them overvalued.

Credit Suisse Asset Management starting pulling out its emerging Asia equity exposure last November, feeling valuations were getting stretched, and instead getting its exposure by buying developed world companies which get most of their revenues from emerging markets (another popular approach – many people buy stocks such as Coca-Cola, Nestle or even BHP Billiton for exactly this reason). But, according to senior advisor Robert Parker, valuations are “starting to look more reasonable. My view is after the next two to three months we will want to go back into emerging market equity.” He favours Korea, Taiwan and – despite valuations – Indonesia.

It’s important to note that different Asian markets appear to offer different opportunities at different times. Sartori is overweight Taiwan, for example, which in recent years has thawed its previously hostile relations with China, a thawing that ought to have considerable benefits to Taiwanese industry and banking. Also, he notes that China – despite what you read about its phenomenal growth – has been a hopeless stock market performer; its CBN 600 index was down 21.8% in 2010 up to May 17. “Chinese stocks have underperformed for three quarters now and have de-rated. But we’re in the camp that is not overly concerned about China: we think the weakness is throwing up a lot of buying opportunities. Although, saying that, we’re not even close to buying a real estate stock there.”

This raises the question of how to invest in Asian or emerging markets. There are a number of ways.

The most obvious is to buy an emerging market or Asia mutual fund. Morningstar tracks 76 separate emerging market equity managed funds sold in Australia, although many of them are different sales classes of the same fund; they vary from covering all emerging markets (such as the Russell Emerging Markets Fund, up 32.36% in the year to April 30); ex-Japan Asia (such as the T Rowe Price Asia ex-Japan Fund, up 41.91%); BRICs – that handy acronym covering Brazil, Russia, India and China (such as the Macquarie Globalis BRIC Fund, hedged, up 42.23%); or country-specific (such as the Fidelity Indian Fund, at 62.97% the best-performing emerging markets fund over 12 months in Morningstar’s coverage by a mile, and the Premium China Fund, up 33.66%). Each individual fund will have its own allocation overweights and themes, and their views and successes will make a quite a difference to returns: Morningstar tracks some emerging market products that made only single figure returns in the same year that Fidelity was shooting the lights out with its India fund.

Emerging markets is the broadest approach. To take the Templeton Emerging Markets Fund as an example – probably the most famous in the world, thanks to its iconic manager Mark Mobius – as of March 31 this would have put 22.2% of your money into Brazil, 15.8% into Russia, 15.3% into India, 11.3% into China, and then smaller chunks into places like South Korea, Turkey, Hungary, Mexico and Indonesia.

At the other extreme, country specific funds are offered in Australia on China (by Aberdeen, AMP, Fidelity, Premium and Challenger), and India (Fidelity and Fiducian). These allow you to take a view on a particular Asian market, but don’t offer a lot of diversification.

It’s also possible to go it alone. Many Australian brokers allow you to buy securities on the New York Stock Exchange, which allows you access to the many Asian countries that have listed forms of their shares (called American Depositary Receipt listings) there – among them Chinese banks, oil companies, telcos, and a host of other regional blue chips such as Taiwan Semiconductor Manufacturing or Samsung Electronics. Some brokers let you buy shares in Hong Kong and Singapore too. Alternatively iShares offers exchange-traded funds in Australia, bought and sold like any other local share, which replicate the performance of indices including China, Taiwan and Korea, as well as ‘emerged’ Asian markets Singapore and Hong Kong.

Doing your own investing in Asia, though, is not to be taken lightly. It’s hard enough to keep track of what Australian companies are doing without seeing your way through companies in different countries, time zones and corporate cultures.

One thing that has severely damaged the benefits of international share investing for Australian investors in recent years has been the outstanding performance of the Australian dollar against dollar, euro, sterling – you name it. But how about Asia? “We think Asian currencies will appreciate, particularly against the Australian dollar, which is crucial for Australian investors,” says Sartori. Judging currency movements, though, is exceptionally difficult, and many managers hedge it out altogether.

In future, perhaps we won’t talk of emerging markets; everything about the performance of world economies in the last few years has supported the sense that the West is certainly no smarter than the East, and in a much worse financial state. “I don’t particularly like this categorisation of developed market, emerging market, frontier market,” says Parker. “There are many economies categorised as developed which frankly I would call emerging, and likewise some emerging markets I think are developed. The classification is just plain wrong.” But whatever you call it, it’s where the money is going. “You’ve got a quantum change in investor attitudes towards emerging markets,” he says.

BOX: Emerging debt

It’s not just in equities that many people see emerging markets as the best option. Many global fund managers are looking here for the best options in debt too.

“We are long emerging debt,” says Robert Parker, senior advisor for Credit Suisse Asset Management, which manages SFr1.3 trillion worldwide. CSAM starting pulling money out of G3 sovereign debt – in currencies like dollars, euros and yen – and putting it into emerging markets in late 2008 and continues to do so.

At Goldman Sachs Asset Management Asia, Oliver Bolitho, who heads the business, has a similar view. “Given the uncertainties about the ratings and fiscal positions of many OECD countries, there is a strong case to be made that the debt of emerging economies is an extremely attractive proposition,” he says. When Asia’s corporate bond markets develop further, Bolitho expects opportunities to increase, “and those opportunities will remain very attractive, possibly for decades.”

Australia does not, though, offer many ways of buying emerging market bonds in managed funds sold there. Instead, they can opt for funds which allocate more than most towards emerging markets while balancing it with some more stable developed-world government debt or with broader global high yield. A good example of this is the Pimco Extended Markets Fund, sold in Australia to retail through Equity Trustees, which is benchmarked half against an emerging markets bond index, a quarter against an emerging market government debt index and one quarter against a global high yield index. As of March 31 its top holdings were debt in Brazil, Russia, Mexico, Indonesia and the Philippines, and its total net return (distribution plus growth) in the year to that date was a remarkable 39.51%, although the five year average of 8.59% a year is probably a more realistic reflection of how a fund like this ought to return.

Remember, though, that returns come with risks; and while many feel that risk-reward ratio has tilted in favour of emerging market debt, it’s still nothing like owning a Commonwealth bond in Australia.

Gold is an asset for troubled times. It’s real, it’s solid, it’s valuable: you know what it looks and feels like. So when all else is chaos – from sub-prime to dodgy Greek finances and even an errant Icelandic volcano – investors tend to flood to the safe haven of gold.

And now, reflecting these uncertain times, gold is within reach of an all time-high. In December it set a new record of US$1225 an ounce. At the time of writing it looks likely it’s going to beat that high – and many analysts think there’s much more to come. Some are even talking of US$2,000 an ounce.

It’s also easier for investors to get exposure to gold than ever before. You can buy the physical stuff, or a certificate that gives you a right to it; you can buy an exchange-traded fund, which behaves like a share but tracks the gold price; you can buy shares in gold miners.

But an investment in gold must be thought through too, because it doesn’t behave like other assets. It has also been less of a good performer in Aussie dollars than US. And buying something at an all-time high isn’t always the smartest thing to do.

What’s been driving the gold price? One reason is that gold is often seen as a hedge against inflation. If the world is in an inflationary environment, owning gold is commonly said to mean that you won’t be left behind. People have been especially nervous about inflation over the last year because of the amount of stimulus that governments from the USA to China – and pretty much everywhere else besides – have pumped into their economies to help them come out of the global financial crisis.

Another reason is that many of the world’s biggest counties are worried about their currencies. The US dollar is weighed down by the country’s deficit and the state of its economy and banking sector; the same is true of the euro, especially since Greece ran into trouble; and you can find similar worries for yen and sterling. It might seem odd viewed from Australia, where the currency has been one of the best performers in the world, but in a lot of places gold is seen as a better bet than holding your own paper money.

This is a particularly big deal if countries’ treasuries decide they don’t want to hold currency. China has over US$2 trillion of foreign exchange reserves, mostly denominated in US dollars. If they were to lose faith in that currency and start putting it into gold instead, the difference in the gold price would be pronounced.

“All the major currencies have got inherent problems,” says Angus Geddes, founder of Fat Prophets, the research and advice group. “Gold is really going to be a recipient of investment flows in the next few years as it gets re-rated as a hard currency.”

This relates to the fact that traditional safe haven assets don’t look as safe as they used to. “The principal tailwind for gold at the moment is the issue of sovereign debt,” says Geddes. “We have a number of countries that have extensive financing issues with their national debt. Greece is the obvious candidate but there’s also Spain, Italy, Portugal and on a larger scale the US and UK. That issue is not going to go away.” So where people once thought of government bonds as bulletproof, they no longer do; gold looks a better alternative, especially when you add the fact that government bonds are still mostly paying very low yields.

There are other long-term reasons too: jewellery consumption in emerging markets (especially India); cost of extraction as miners have to go deeper and into tougher parts of the world; and, most obviously, that gold is finite, just like oil, and the more you pull out of the ground, the less there is to find, by definition. (Unlike oil, though, gold is still around for centuries after you’ve taken it out of the ground and remains in circulation indefinitely.)

That’s the bull case. But there’s another side to it.

One problem with buying gold from an Australian perspective is that gold is valued in US dollars, so if the Aussie dollar rises against the US dollar, it cancels out much of the improvement in the gold price. That said, you can buy a lot more gold with your Aussie dollar now than you used to be able to. Geddes acknowledges the strength of the currency but adds: “Gold in a relative sense is going to do a lot better than the Australian dollar in the next few years.” Funds in Australia vary in their approach to the currency; the Baker Steel Gold fund sold in Australia through Select Asset Management hedges some exposure but not all.

Others think that after the run in the gold price, it’s the wrong time to buy. “Gold is supposed to be a hedge against inflation,” says Tim Farrelly, principal of Farrelly’s, an investment strategy group in Sydney. “Over the last 300 years broadly if CPI has gone up 50-100%, gold has also gone up 50-100%. But in the last 10 years gold in US dollar terms is up 300%, and CPI 22%.” Farrelly’s argument is that if you believe that over the long term gold and inflation track each other, then gold’s due to fall an awful long way to slip back into that pattern. “If you bought it 10 years ago, well done. But I wouldn’t buy it now.”

On the valuation question, some argue that context is important. “While gold has had a great run up over the last decade, it still remains below its inflation-adjusted peak in 1980, when gold was worth US$2306 an ounce in today’s prices,” says Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors. Oliver is positive on gold in the medium term, but thinks it may be better to get exposure in a broader commodities fund for diversification.

Fund managers try to insist on a long-term view. “People often get obsessed with what the gold price has done in the last few months, or 12 months,” says Dominic McCormick of Select Asset Management, which distributes Baker Steel’s gold fund in Australia. “Our view is we have been in a bull market in gold in US dollar terms since 2000, 2001. Every year since then the US dollar gold price has closed higher.” His view is that all the drivers that have sustained this bull run are still here, particularly the monetary and fiscal situation globally. “We are in a low nominal and real interest rate environment, particularly in the key economy of the US. There probably will be a bit of a sell-off when the Fed starts raising short term rates, but we don’t think that necessarily marks the end of the longer term bull market.”

Even so, over the much longer term, McCormick thinks there are dangers. “Our view is that this gold market will probably end up as a bubble, because that’s the nature of gold. That’s how we think the game’s going to end but we’re not seeing evidence of it yet.”

There’s also the behaviour of gold as an asset to consider. While Oliver is still positive on gold, he does point out there are dangers. “Investors should realise that gold is highly speculative,” he says. “It’s not grounded by an income stream like most shares, property, bonds and cash. As such there is no general agreement as to how it should be valued.” All the gold ever produced is still out there, he says, and come back on to the market; all sorts of odd factors can influence price. “This can make for a volatile ride over time and suggests that gold should not be dominant in an investment portfolio.”

Investing in gold miners is a whole separate subject since there are so many other variables involved. “Gold mines by their nature are going to give you indirect exposure to gold,” says McCormick. “The problem is, it’s still in the ground. And often it’s hard to get it out of the ground.” While they are not as pure a play on the gold price as an ETF, they can have merit. “They come with a few other risks like management and geopolitical risk, but we still think they make sense as one way for the more aggressive investor in particular to get exposure.”

Analysts are quite positive. “Gold equities have underperformed the gold price here in Australia and overseas,” says Geddes. “Gold price is near an all time high, but gold shares are well below their all-time highs which were prior to the global financial crisis. I see a lot of catch-up happening.” One thing that will impact gold equities is M&A activity. “The amount of corporate activity in precious metals is likely to increase,” he says. This has been most obvious in a bid by Australia’s biggest gold miner, Newcrest Mining, for the second-biggest, Lihir Gold, but Geddes thinks this trend will filter down to small and mid caps and will drive performance accordingly.

In general, nobody thinks gold should be the be-all and end-all of an Australia’s portfolio, but many feel there is benefit in an allocation to it – perhaps 5% of a portfolio – as a diversifier, a hedge (whether against inflation or another financial crisis) and as a likely medium-term performer. And – as the box alongside explains – there’s never been a greater variety of ways to try it out.

SIDEBAR How to buy

There are several ways to invest in gold.

• Buying physical gold. The Perth Mint allows you to buy bars of bullion (a 50-ounce bar will make you feel like you’re in Goldfinger but will set you back A$62,513.77), gold coin (from one twentieth of an ounce to a kilo), or certificates confirming your ownership of gold stored within the Mint’s vaults. It’s all government guaranteed, just in case sometimes tries to be Goldfinger for real. Bullion and coin clearly gives you a genuine exposure to gold – there’s no risk of holding something synthetic that’s meant to track gold but turns out not too – but comes with storage costs.
• Exchange-traded funds. An ETF is bought and sold like any other share, but represents something else – often a stock market index, for an example. You can buy Australian-listed ETFs that track the gold price. One is ETFS Physical Gold, previously known as Gold Bullion Securities; unlike some gold ETFs around the world, this one is backed by physical allocated metal held by a custodian, HSBC Bank USA. It’s cheap: the management fee is 0.4% per year.
• Gold equities. This involves buying the shares of a gold mining company, such as the two biggest in Australia, Newcrest Mining and Lihir Gold. (The former is in the midst of a takeover bid for the latter.) Miners are exposed to the gold price, but share price movements will depend on plenty of other things – chiefly their ability to find it and mine it efficiently. Some mining stocks will perform better than gold over a period of time, others will do much worse.
• Gold funds. There are managed funds that invest in gold equities (often with exposure to other precious metals too). An example is the Baker Steel Gold Fund, managed by the Anglo-Australian investment group Baker Steel Capital, but offered in Australia through Select Asset Management. This fund invests mainly in small to mid cap equities globally, but can put up to half its money in gold/precious metal ETFs, futures and commodities. It charges 1.89% management fee and a performance fee of 10.25% for outperformance of its benchmark, the FTSE Gold Mines Index.
• Gold futures. These are derivatives which can use leverage to gain exposure to movements in the gold price. Investors need to be sophisticated and experienced before using futures to invest, especially with heavy leverage.

Australia is, as some of its natives say, a quarry and a breadbasket. Mining and farming have been two of the main drivers of its economy for decades and will only grow in importance as Asian industrialisation and wealth brings greater demand for resources and crops.

Both also represent natural asset classes for investment. But, while Australia’s mining industry is within easy reach of investors through the dozens of listed resource companies, getting exposure to the agricultural and pastoral theme has been harder. AWB Limited, which is active in grain trading, rural businesses and financial services, is a rare example of a large-cap listed stock in the agribusiness sector.

Instead, two very different themes have emerged around Australian agriculture as an investment class: the tax-effective managed investment scheme, and institutional products.

The first class has a very mixed reputation in Australia. The Australian Taxation Office, among the more draconian of the world’s tax bodies, has long granted a tax deduction on interest when investors borrow to invest in, among other things, agriculture. This fact has led to a wealth of managed investment schemes being developed – collective investment products which put money into a dazzling range of livestock and horticultural possibilities, including vineyards, ostrich farming, truffles, timber, cricket bat willow and macadamia nut plantations.

The form with these schemes has typically been that the investor participates in a lease of some land that is used for a crop or plant (or, in the case of livestock, animals themselves). A fee is then paid to a manager who would, in the case of a horticultural scheme for example, be responsible for planting, maintaining and harvesting the crop, and for finding a buyer. To make the best of the tax benefit, the structure is usually that the sponsor (or an affiliated bank) lends the buyer the money to make the investment, charging interest, which then becomes a tax deduction.

Even in the best of times many of these products have had a very bad name. Fundamentally, financial planners have felt that too many investors have got so caught up in the tax exemption (natural in a place where many people lose half their income to tax) and completely lost sight of the question of whether the underlying investment is actually any good. While there are reputable players involved – Macquarie has become a major player in this area – the ground is fertile for disreputable players, and when that happens, there can be a double hit: investors can not only lose their money if the scheme fails, but might also find the tax exemption revoked if the ATO decides there was never any realistic chance of it making viable income in the first place. One experienced financial planner tells Cerulli he only knows of one investor who has ever held one of these investments to maturity and received a return on their capital.

Through the 2000s the sector did appear to raise its game and improve transparency, performance and professionalism. For investors who could live with the fact that the schemes, even if successful, would take between five and 20 years to generate income, and that in almost all cases they didn’t own but leased the land, they might even have made sense. But things turned really sour in the financial crisis. 

Then, the two largest managed investment schemes in the country, the forestry schemes Great Southern and Timbercorp, collapsed, affecting 61,000 investors who had put $3 billion into them. These were supposed to be profitable and environmentally sound schemes which would help reduce reliance on old growth forests and support the plantation of millions of hectares of plantation timber. It’s hard to see an obvious way back into the mainstream for managed investment schemes.

There is, however, another field: institutional funds. Macquarie, for example, has a business arm called Macquarie Agricultural Funds Management which manages assets from beef cattle and dairy to grains, oil seeds, wheat, canola, sorghum, barley, almonds and wine grapes for institutional clients. The most visible expression of this is the Macquarie Pastoral Fund, which has raised A$800 million in investments and commitments and invested over A$500 million of it, mainly for institutions. All told Macquarie manages more than three million hectares of agricultural assets in Australia, and manages about A$1 billion in the sector, making it one of the largest agribusiness groups in the country.

For groups like Macquarie land ownership is only part of a broader range of businesses: another line would be agricultural risk products, if for example Cadbury wanted to hedge its cocoa exposure. Shipping finance and advisory services to agribusiness companies, and agricultural commodities research, are part of the same overall business.

But the ownership of land, cattle and crop is the most visible part of it, and it rests on a straightforward macro theme: giving investors exposure to the increasing protein consumption in emerging markets, particularly Asia, and more particularly China. Australia is ideally placed for export to these markets; it is acknowledged worldwide as a green, clean, disease free provider; and it is among the world leaders by volume in terms of exports of things like beef and grain.

Customers for this exposure tend to be institutional, partly because any product that gives exposure to farm production tends to be long-term by necessity, often a closed-end, lock-up fund with a five to eight year maturity. Superannuation funds are among the potential buyers: in July three super funds, the Catholic Superannuation Retirement Fund, AustralianSuper, and Auscoal, alongside AMP Capital Investors, raised about $200 million to invest in Australian farms through the Sustainable Agriculture Fund. The premise here was a sustainable, diversified farming product rather than any kind of tax minimisation scheme, and was developed with Melbourne University’s Land and Environment Faculty. The fund will invest in wheat, cattle, dairy and crops. Elsewhere, First Super announced it would invest in agriculture and would look at purchasing distressed Timbercorp assets; others that have either engaged institutional funds or invested directly in agriculture include Telstra Super, AMP Future Directions and Victoria Super. AMP as an overall entity was long considered one of the largest pastoral landowners in Australia, although it’s difficult to quantify.

It is not, though, anything like as much as some think it should be, which suggests room for greater engagement of the A$1 trillion superannuation industry with this asset class. Australian Agribusiness Group put out a report in November saying that less than 0.01 per cent of superannuation funds went into Australian agriculture, yet that international pension funds had put in more than $1.5 billion, or three times the local total. AAG argued that doing so would have protected Australian super funds from the global financial crisis. AAG also claims that the top 25% of Australian agriculture provided 11.2 per cent annual returns over the last 12 years with one third of volatility of the All Ordinaries index.

Some feel that the Australian agricultural sector has not helped itself by failing to promote the fact that it is at the cutting edge of agricultural technology, and indeed has had to be in order to thrive without the government protection afforded to farmers in other countries. Australian farmers have had to improve efficiency to compete and today export five times more food than Australia could consume, Macquarie says.

While Macquarie is the biggest name in the industry, some boutiques have sprung up too and more are likely to follow. Rural Funds Management, for example, is an agricultural fund and farm manager with $300 million under management, and manages a portfolio of large-scale farming and agricultural enterprises in land, water, infrastructure, poultry, viticulture, cotton, almonds and cut flowers. Established in 1997, it is the responsible entity to seven managed investment schemes, one tax-deductible scheme, and is the manager of an unlisted public company and two unit trusts. It was acquired by Great Southern in 2007 and briefly changed its name, but for obvious reasons has since changed it back again.

For the future, there is certain to be evolution of commodities as an investment class, and soft commodities – those you can eat – will inevitably be part of that even if the trend is initially driven by metals. This is partly because there’s a strong case to be made for their merits as a diversifier in a portfolio, and partly because it is such a clear area of strength in Australia. Whether this comes through mutual funds, structured products or exchange-traded funds, or a combination, remains to be seen.

We’re all getting older. Australian society is in the midst of a landmark demographic shift, as the baby boomer generation enters retirement. That group – those born between 1946 and 1964 – accounted for two fifths of all employed Australians in 2007, according to the Australian Bureau of Statistics; now they’re gradually leaving the workforce.

From an investment perspective there are two ways of looking at this fact. On one hand, our ageing population has fostered a clutch of retirement income products designed to help money last in retirement: to combat, if you can put it that way, the chance that we’ll live longer. But on the other, ageing has become an investment theme in its own right. There are funds that draw their income from surrendered life insurance policies, funds based on retirement villages, funds that draw on the greying theme and lean their resources towards caravan builders and manufacturers of hearing implants. This article looks at both sides of the coin: retirement products, and age-themed investments.

On the retirement income side, the challenge is to preserve income, make it grow, and keep it accessible. “Retirees’ concerns are the provision of lifelong income and the security of their capital,” says Darren Johns, a certified financial planner at Align Financial in Sydney’s Northern Beaches. “They make a decision. Either they’re going to accept some investment risk, and potentially be rewarded for taking that risk; or they’re going to give their money to an institution and say: I’m happy or you to bear the risk in exchange for some kind of guarantee of steady income with limited potential for growth. Everybody’s different.”

One of the consequences of the global financial crisis is that the second camp Johns describes has grown considerably. Retirees with money in allocated pensions, which bear market risk, suffered badly through the crisis, seeing their retirement capital shrink dramatically, and although much of the losses have since been recouped, many are scarred by the experience.

In this environment, new products have focused on providing greater security. The two most well-known entrants have been Axa’s North product, and ING’s Money for Life. Axa North, which was actually launched pre-crisis in 2007, sought to bring capital protection to retirement products; it offers a range of investment options, with varying degrees of market exposure, and capital protection from five to 20 years. Galvanised by the financial crisis, it already has more than A$1.1 billion under administration – a strong start but no surprise to Axa which has offered a similar product in the US for 15 years. Over there, the market is worth US$1.4 trillion.

ING moved into the market in October 2009, and advanced the Axa approach by guaranteeing income for the whole of an investor’s life rather than a set term. It sets a protected income base on the first day (the amount you invested), which is used to determine your guaranteed income and the maximum you can withdraw each year under the terms of that guarantee. While the protected base can’t fall, it can rise, and is recalculated every two years.

“It gives you a combination of certainty and control,” says David Kan, executive director in the retirement and investment solutions group at ING. “You are certain your income won’t run out as long as you live; it won’t go down as markets go down. But you have full access to your capital at any time. And if you die, the capital returns to your beneficiary or estate, unlike a lifetime annuity.”

It is an open secret that Macquarie will be the next major name into this business. “We have made it reasonably clear we are interested in this space,” says Macquarie’s Andrew Robertson, head of a group called longevity solutions at the bank, though he declines to put a date to it.

“There is a real recognition that these things [guaranteed retirement income products] are going to become important,” he says. “What’s driving that recognition is what we call the sequence of returns.” What does he mean? Well, start out with $100 in an investment product with $10 a year in withdrawals, and assume that during your investment, there will be good and bad markets. It all balances out, right? Well, not exactly. If you get good returns early on, then bad ones later, you will see an increase in your balance and then a fall; you’ll be able to make your $10 a year withdrawals and still have something left in the account at the end of 10 years. But if you get the bad markets first, your balance drops early on, and your withdrawals mean there’s less capital to grow when markets rebound. In this instance you might run out after seven or eight years and have nothing left in the account. “This idea that it’s all about time spent in the market, not when you invest, has become a mantra that the industry is based around and everyone believes,” he says. “The problem is, it doesn’t work for accumulator saving products. Retirees are fundamentally exposed to these sequence-of-returns issues.” The only way to avoid it, he argues, is through a guaranteed product.

Consultants expect other providers to follow.”We feel that in a year’s time you would have a couple of other players,” says Nick Calill, principal and consulting actuary at Watson Wyatt. “These things are huge business, trillion dollar sellers in the US and Japan, so it’s natural that they will be rolled out here.”

However, nothing comes for free, and some financial advisors are alarmed by the level of fees involved in these products. Guarantees cost money, on top of the investment costs. Ultimately everyone will decide on the trade-off between fees and security. “The problem I have with some guaranteed super products is you pay a fairly heavy price for the guarantee, and if I pay a couple of extra per cent in fees it’s going to reduce my long term return,” says Paul Moran at Paul Moran Financial Planning in Carlton, Victoria. “It might be more stable with a guarantee attached to it but it does mean giving up a reasonable percentage of the return I’m likely to get.”

 Kan says ING’s research ahead of the launch showed that people would be comfortable with total fees around the 3% mark, including the guarantee, and that Money for Life matches that, at between 2.75% to 3.15% when purchased through a platform, and lower when bought through ING’s own platform, Select. “You do pay a fee for a guarantee, but we haven’t had feedback that it’s too high,” he says.

“There’s no product which is right for everyone,” says Calill. “Objectives will differ. One big one is the bequest motive: whether or not it’s a high priority to have money left over for the next generation. One of the stated advantages of not annuitizing is that you have access to your capital and if you die early there’s still something left.” So the pros and cons depend on what you wanted from a product in the first place. “You need to be careful to look at the fees you are paying, and there can be constraints that govern the extent to which you get your protection – if you draw more than a certain limit from these products you lose some of the protection they offer. They can be good, but not for everybody.”

Some planners report another knock-on effect of the financial crisis:  a return to fashion of boring old annuities. These guarantee you income for the rest of your life in a lifetime annuity, or for a set term in a term annuity. They are often index-linked to inflation, but have no exposure to markets and do not generally allow you to pull money out as and when you need it – plus, if you die earlier than expected, the money is lost and is not passed on to your dependents.

Frank Gayton is a financial planner who learned the hard way the value of these straightforward products when clients who had split their money between annuities and allocated pensions lost a huge chunk of their capital in the allocated pension and came back to him asking why he hadn’t put the lot in an annuity. “We are always very comfortable with annuities and they have really come back into our thinking,” he says. Available rates are attractive, he says: the week before speaking to the Sun Herald he did a quote for someone on $460,000 of savings who was able to lock in a rate of 7.03% on a 36 year term. “The global financial crisis has forced everyone to think that what efficient market theory tells us, doesn’t always happen that way,” he says.

He is not enticed by the ING/Axa school of capital protected, market exposure products. “It does sound very expensive to me,” he says. “The thing about a plain annuity is what you see is what you get.” Of major providers, Challenger has been a driver of this revival in annuities.

Aligned to this trend has been a return to what Johns calls “harder assets – holding a portfolio of cash and term deposits. I don’t know if it’s exclusive to the retirees market but I’ve had more inquiries about gold in the last 12 months than the last 12 years.” Generally speaking, when he looks at retirement income products, one of his main concerns is avoiding the plight of investors who are tied up in mortgage, income and structured funds that are still now allowing redemptions or withdrawals even a full year after most people consider the global financial crisis to have passed. “The king for retirees is liquidity,” he says.

How about the flipside – making money out of the ageing theme?

“A few years ago there was talk of launching funds which in the industry were known as zimmer frame funds: they invested in stocks such as mobility scooters, pharma and medications targeted to the elderly,” recalls Johns. “These were businesses which were directly involved in producing products or services for retirees or the elderly. I don’t know if it got any traction.” As a field of distinct managed funds, it didn’t, but the greying theme does inform the investment decisions of many fund managers who see growth ahead in companies in this area – be it Fleetwood, the caravan manufacturer, which is exposed to the trend of many people retiring and wanting to enjoy their free time travelling but on relatively modest financial means; Cochlear, which makes hearing implants; or international pharmaceutical companies like Roche or Novartis, which appear in many portfolios of Australia-based global equity funds.

Australian Unity is an example of a manager that has launched products based on a similar theme. It has offered three series of a product called the Retirement Village Investment Note between 2005 and 2009, the most recent of them providing around 8 to 8.5% per annum, secured by income from retirement villages. Adam Coughlan says Australian Unity sold about A$100 million of these types of products during that period. “Underpinning that is the demographic trend: retirement village income is very stable, underpinned by real property.” Products like these, with a fixed term of three, five or seven years and a rate of income that varies accordingly, do raise the suspicion of some planners wary of anything that limits liquidity, but they are an example of the use of the ageing theme to secure returns and build new offerings.

Another example was the ING Real Estate Community Living Group, formed by the stapling of two listed property trusts that among other things invested in aged care facilities. That, however, has not worked out. “It’s been an absolutely atrocious investment,” Moran says. “It’s had a 95% fall in value.” Partly this was the market but that doesn’t explain the extent of the losses. “It was caught up in the property trust collapse, but part of the problem is that these aged care facilities tend to be specialised properties. And if the aged care facility closes for whatever reason, you’ve got to find another to go in there.” Additionally, there’s something of a conflict at the heart of them, he says. “We feel there is a contradiction, or a natural tension, between the community desire for affordable aged care and the investor’s expectation of a profit.”

Nevertheless, tailoring a share portfolio to make the best of the ageing theme does make sense: as the chunk of Australia’s population that is in retirement grows, it’s natural that needs will increase for products targeting the elderly.

BOX: Life Settlements

If you’re getting on in years and have a life insurance policy you no longer really need, perhaps because the people who were your dependents no longer depend on you, you may have considered selling your policy back to the life office you bought it from, gaining a modest fee. But a new industry provides an alternative to people in that position, and has in turn used the policies to create a new investment class.

Life Settlements, a Victoria-based group, is so far the only Australian group to have attempted a model tried widely in the United States, known as viatical settlement. It buys up life insurance policies in the US; it collects when the original holders die; and the returns create the income for a fund sold in Australia.

There is a certain squeamishness in an investment class that delivers better returns the earlier people die, but the idea is actually quite entrenched in the US. As an investment, the theory is that it is reasonably stable and predictable and is uncorrelated to traditional financial markets. “It has this very interesting attribute of having a very low correlation to the rest of the market, but has aspects of being a bit like a bond in that it’s a financial instrument issued by a very highly rated credit entity – an insurance company – and you have a known cashflow at the end,” explains Stephen Knott, a director at Life Settlements. The US policies his firm buys are of a type called universal life, and they have a fixed benefit payable at the end with no unpredictable variation. “You have simply the uncertainty of the exact term,” he says – that is, how long someone lives.

Since that last point is unpredictable, funds like these tend to hold a minimum of about 200 policies to get diversification, “to manage the fact that although the various lives will have a predicted expectancy of X, the only thing you can be sure of is that it will not be exactly X.” There is, then, “a high degree of certainty of payment.” Life Settlements’ fund had 568 policies in it when the Sun Herald spoke to it, issued by 70 different insurance companies and equating to about US$1 billion of funds under management. Knott argues there are advantages to this compared to a bond, in that life policies are issued against reserves monitored by regulators and are legally distinct from a company’s assets, unlike a bond.

Life Settlements, like many others, hit problems in the financial crisis when it suspended redemptions as liquidity fell away. Knott presents this as an obligation under Australian law: “If we can’t satisfy ourselves we can sell assets at a reasonable price, we suspend until we can determine a reasonable price.” He says 50 to 60 mainstream mutual funds were in temporary suspension at the same time in a host of asset classes and that the problem was one of global market liquidity rather than anything specific about his company’s approach; redemptions reopened in March 2009. One change that came with the crisis is that the fund now hedges for currency movements, since that was playing havoc with investment returns, albeit sometimes very positively. The fund returned 14.57% for the 2009 calendar year.

The fund is sold to retail through platforms like BT, Macquarie, Oasis and Netwealth. Generally, though, the bulk of the funds have come from institutional investors to date.

Where does it fit in a portfolio? “We have a view on that: it is an alternative asset somewhere between your growth and defensive assets,” Knott says. “We’ve got institutions who say it’s a strange type of bond or a fixed interest type investment even though the return is not fixed.”

It’s notable, though, that nobody else has made much of an effort to enter this field. Andrew Robertson at Macquarie says he has been “staying across that market”, but “we are very aware of the fact that this has some significant reputation risks associated with it. I’m not sure we’re yet comfortable that the asset class is worked out. There is a risk of unscrupulous behaviour where people are cheated out of a policy that they shouldn’t be selling at that point in time.”

And planners generally are yet to be convinced. “There’s been an issue in the past with liquidity,” says Paul Moran. “In fact, you’re relying on people dying to create liquidity and to get a return. But I can understand there is a case to be made for them as an asset.”

And Calill, who looks at them more from the point of view of institutional investors, is similarly cautious. “From our clients’ point of view, it wasn’t immediately obvious that they should buy a product which would do better if people stopped living longer but worse if they lived for a long time.”

There’s nothing like a stock market collapse to remind people how useful bonds can be. Investors with a decent allocation to defensive investments such as bond funds enjoyed a buffer from the financial crisis, and while it may have seemed a drag during the market rebound of the last nine months, that’s more than compensated for by the insulation it provided on the way down.

Terms like ‘income’ or ‘defensive’ cover a multitude of different products, styles and ideas. They go from tedious plodding cash and bond funds through mortgage funds to high-risk, high-reward credit products and even into high yielding stocks. The boxes on this page talk about the different types of products available and how to tell them apart.

As a rule of thumb, though, this type of investment has become a lot simpler since the global financial crisis, as the things that looked clever and lucrative a few years ago were often the ones that came unstuck. “The last two years have seen an incredible turnaround in the types of investment people have been considering for the income component of their portfolio,” says Peter Dorrian, head of Australian retail at Pimco, one of the world’s leading fixed income managers.

“If you think back to 2006, bond funds struggled to gain a lot of traction because the income investment class was dominated by things like mortgage funds, highly geared property funds, and even hedge fund of funds.” But all those areas ran into trouble for one reason or another and the trend today is towards the straightforward. “The little old bond market, long forgotten by investors, has suddenly got increased interest.”

Adam Coughlan, general manager for retail at Australian Unity Investments, agrees. “Where investors got themselves into trouble in the financial crisis was with some of the very high yielding types of products available,” he says. “I would say this: if it seems too good to be true, it is. Now we’re starting to see people using bond funds more for their traditional defensive purposes.”

Data from fund researcher Morningstar shows that of the 116 new income funds launched in 2009, 82 were at the straightforward end of things: Australian cash, Aussie bonds, global bonds or a combination of the two. Just three mortgage funds appeared.

So what should investors think about when looking for income products? “There are two related but different roles a defensive asset can play in your portfolio,” says Dorrian. “Firstly as a buffer against the volatility of the equity markets and global asset markets, and secondly as a provider of income to a portfolio on a very dependable and reliable basis.”

“When you go into any bond fund there are two risks you need to think about,” he adds. “One is the risk of not getting income, the other is the risk of not getting 100 cents in the dollar back when it matures.” That risk varies depending on who issued the bond. A government, for example, can raise taxes to ensure it repays its debts; a company can’t do that and has to rely on its own balance sheet. 

So just as with stocks, an important decision to make is just what level of risk you want to take. Government bonds won’t generate much money but they’re unlikely to fall over. Corporate bonds pay out more, for more risk. Globally, professional investors have spent much of the last year trying to work out how best to take advantage of opportunities in what is called credit: higher yielding, riskier bonds from companies. “One trend I’ve noticed in the last 12 months is an interest in credit funds, born out of an incredible spike in the yields and returns available,” says Dorrian; two Pimco funds sold in Australia have some credit exposure and he says “both have had good inflows from investors in the last 12 months.”

But in an area like this it is essential to have professional management involved. It can be difficult for investors to access, and tricky to understand. “We think it is very important for people to understand the systemic risk in any part of the market they invest in,” says Kathy Cave a portfolio manager at Russell Investments. “When you buy equity there is a list of shares – the ASX 300, for example – but in fixed income that’s not the case.”

Another decision to make is whether you want international exposure. “When you’re buying an offshore bond, you are taking on a whole different level and style of risk,” says Coughlan. “The first one investors need to be conscious of is the exchange rate: the Australian dollar is at historically high levels but if it continues to go up then income will naturally go down in Australian dollar terms. That’s probably the biggest risk those investors will face.”

The risk Coughlan refers to – that gains on your overseas investments will be wiped out by a rising Aussie dollar – can be mitigated: many products offer a hedged and an unhedged version, giving you a choice about whether you want to be exposed to movements in currencies.

A separate point, though, is where the best prospects are. Australia is a high-interest country: the Reserve Bank of Australia has for many years set interest rates higher than is common in other major economies like the US or Japan, and the gap is getting wider now as the bank raises rates while other countries are still keeping them low as they emerge from the financial crisis.

“We’re a big believer in diversifying your portfolio so you need to have exposure outside Australia,” says Dorrian. “But the other side of the argument is that Australia has traditionally been a higher interest rate country than many around the world: the US cash rate is virtually zero and it doesn’t look like changing until early 2011. Australia has come through in better shape and investment returns from the bond markets look pretty promising in the next 12 to 18 months.”

Not everyone agrees where the opportunities are. “We actually think international might be more attractive than domestic bonds at this point,” says Cave at Russell, which recently changed the strategic asset allocation in its multimanager products to increase the allocation towards international bonds. Greg Michel says ING Investment Management, where he is director of fixed income, has a bias for interest rate exposure in Australia versus the UK, US and Japan. In any case, as he points out: “The fixed income market is already a global market when you consider the range of issuers in Australian dollars – a multitude of foreign financial institutions and supranationals whose businesses are operated in the main well outside Australia. At the same time, most of the larger iconic Australian companies are active borrowers in foreign capital markets.”

A third question is when it is time to return to unloved assets – and in particular, mortgage funds. Many of these ran into serious liquidity problems during the global financial crisis and investors have not been quick to forgive them, but Coughlan at Australian Unity argues that many were perhaps misusing them in the first place.

“The typical mortgage fund was used by two types of investor,” he says. “The first type was using it as, in effect, a high returning bank account. The other type was a pension style client who saw a rate of interest better than the banks.

“When the financial crisis hit, the first group were the ones that didn’t want to be trapped in there – they were really using them not in the way they had been designed.” Their attempts to exit swiftly led to problems such as redemption freezes. But, Coughlan says, “the lesson has been learned, removing these investors from the funds and leaving in place the pension style client who the product is best suited for. Most mortgage fund providers by the end of this quarter will be through that process and we’ll see a really good level of stability from those funds. Things are definitely looking up for the mortgage fund sector in 2010.”

All providers agree that the push towards income products is driven by a broader change in Australian society. “We are seeing a demographic shift,” says Craig Hobart, head of retail at Tyndall Investment Management. “More baby boomers are approaching retirement, and demand for quality income streams is something we have identified as a gap.” And Cave at Russell speaks of “a focus on people who are in the post-accumulation, decumulation phase of their lives,” says Russell. “They are no longer accumulating super but are starting to use it.”

Michel says people wanting a fund for income should consider the following key considerations in choosing a fund: the stability of the income stream; the creditworthiness of what that fund holds; any use of derivatives by the fund; entry and exit charges; the fund’s size; and the experience of the fund’s managers.

Australians today have a greater range of choice in this field than ever before, but for the moment, it seems they’re exercising that choice with greater caution than was the case before the financial crisis. And that’s no bad thing. “It would be very disappointing if we didn’t learn from our mistakes,” says Coughlan.

BOX: What’s an income fund?

You get a sense of the diversity of this style of investment by looking at fund research Morningstar’s classification of income products. The researcher considers them to fall in to 10 different camps, roughly along these lines:

• Australian cash: invest mainly in very liquid market securities like bank deposits and bank bills. They usually mature in less than 12 months.
• Australian cash enhanced: similar to Australian cash, but can also have exposure to bonds, corporate debt and asset-backed securities, and may use derivatives. Usually have about a 12 month duration.
• Mortgage funds: mainly invest in registered first mortgages secured over Australian property, but sometimes in fixed interest, money market securities or cash.
• Mortgage funds – aggressive: Like mortgage funds, but may invest 20% or more in mezzanine debt, development and construction loans, pre-developed land, or specialty loans such as to hotels and retirement villages.
• Australian bonds: invest in traditional Australian fixed interest securities such as government or Australian corporate bonds with a maturity of more than one year.
• Global bonds: invest in foreign government and corporate debt with a maturity of more than one year.
• Global/Australian bonds: Combine global and Australian bonds, with at least 25% of the total in Australian.
• Diversified credit funds: Invest in credit securities in Australia and/or worldwide. This involves active selection to try to get better returns than government bonds; usually they invest in securities rated BBB or above (the definition of investment grade), but not always.
• High yield: Invest in credit securities where the average credit quality is below BBB, or sub-investment grade (sometimes called junk). Typically invest heavily in emerging market debt, junk bonds, structured credit and unrated issues.
• Multi-strategy income: Combine different sectors to improve yield, which might include domestic and international government bonds, corporate debt, private debt and hybrid securities.

Even this impressive list does not include several other styles investors might consider as sources of income, such as high-yielding equity funds, or listed property funds.

Note: fixed income or fixed interest? Bankers and investors in most of the world use the term fixed income (even sometimes for bond products where the income isn’t actually fixed). In Australia, the term fixed interest tends to be used instead. They mean the same thing.

BOX: Income products and the financial crisis

Although income products are usually painted as defensive investments that protect you in the bad times, it’s worth recalling that it was bond-related products that kicked off sub-prime, which in turn led to the global financial crisis.

Five years ago, it had become common for investors to put money into products like collateralised debt obligations (CDOs), which packaged together dozens of debt instruments in order to make a return, usually combining leverage to boost that return. “But the leverage was not always appropriate and because you were investing in assets that were similar, it didn’t provide you with diversification benefits,” says Cave. “They could go badly wrong, and that’s what happened.”

Usually, if something goes wrong in an asset, it doesn’t affect the rest of the market. “The recent experience was dramatically different,” says Michel. “The freezing of markets for these assets was not a specific credit event but rather a market wide liquidity event, with many traditional income based assets being impacted.”As investors tried to pull out of funds that were never intended to face sudden redemptions from so many people simultaneously, the problem spiralled; it was in this environment that managers like Basis Capital had to suspend redemptions from funds and in some cases eventually shut them down at considerable cost to investors.

It wasn’t just CDOs. Peter Dorrian at Pimco recalls how investors had moved their income allocation out of safe bonds and into things like mortgage funds, property trusts and fund of hedge funds. In each case, something went wrong in these asset classes. “In the case of mortgage funds it was for structural reasons, where there was a mismatch between the ability to provide liquidity and the underlying assets they invested in,” he says. In hedge funds it was a similar problem: the liquidity of what the funds were invested in, versus the weight of redemptions seeking to get out. “And while most property trusts survived the crisis, they are engrossed in massive capital raisings which do nothing positive for investors other than reduce gearing levels.”

The financial crisis also gave guaranteed funds a bad name, for two reasons: in the worst cases, the bank that had provided the guarantee (such as Lehman Brothers) went under, rendering it useless; and in others, while investors didn’t lose their money, they found themselves locked into an unproductive fund for up to seven years.

While there’s still plenty of life in guaranteed products provided you trust the guarantor, there is still a sense of suspicion about them. “We have seen a few products launched that have some kind of guarantee attached to them,” says Cave. “It’s a different profile – some of them are fixed terms and are not necessarily simple investments. You are giving up the flexibility to get out of products for a guarantee over a period of time.”

Nevertheless Coughlan argues that “there are still good products out there that do what they’re meant to do but have a fixed rate of return.” Australian Unity offers a fixed term product – called an income note – secured on income from retirement villages. “Retirement income is very stable,” he says. “Something underpinned by real property is a safer way of getting income.” The notes are fixed at three, five and seven years, with interest ranging from 8 to 8.5% according to the term. “That’s a pretty attractive return for retirees.”

BOX: Yield stocks and income funds

While most investors think of bond funds when they talk about income product, the Australian share market supports a different kind of income product: the dividends on shares.

Australia has one of the world’s highest-yielding major stock markets. Better still, it’s the solid blue chips like Telstra and the Commonwealth Bank of Australia that tend to exhibit consistently high dividend yields.

High yielding stocks have a lot to recommend them. For a start, they provide the income from the dividend, which in many blue chip stocks is around 5 or 6% a year. Secondly, they may be fully-franked: this means the company has already paid the tax on them so you don’t have to pay tax on it yourself. And third, like any other share, you have a very good chance that the value of the share itself will go up over time.

Yields go up and down not only according to how much a company pays out, but how its share price is moving. If the share price goes up, that’s good because you get capital growth, but your yield expressed as a percentage will go down – because $1 a share when the share price is $30, is a lower percentage yield than $1 a share if the stock goes up to $60. Correspondingly, we have seen big movements in yields over the course of the last year as stocks have rebounded, from a peak of around 7.25% for the ASX 200 to about 3.7% today (or about 5.6% on a grossed-up basis taking into account the tax benefit).

While one can build a portfolio of yield stocks just by buying them through a broker, there are a number of funds that are designed to invest in shares from an income perspective. For example, Tyndall Investment Management launched one in late 2008 with a mandate to generate an income stream of 2% higher than the grossed up yield of the ASX 200 Accumulation Index (which, at the moment, means about 7.6%). It considers the capital growth of the stocks a secondary investment objective, and it tailors its investment technique to focus on after-tax returns.

“We’re trying to take a conservative approach to high yielding stocks: utilities, telcos, consumer staples and financials,” says Craig Hobart, head of retail at Tyndall. Big positions include Spark Infrastructure, Telstra, Westpac, Woolworths, Duet, Commonwealth Bank of Australia, AMP and Axa. Property trusts, notably, represent only a little exposure – through Lend Lease, which the index does not consider a property trust anyway.

So where does such a fund fit into a portfolio? “The traditional way of doing asset allocation is to have defensive and growth investments, with defensive being cash and fixed income, and growth being equities,” says Hobart. “With this product, rather than focusing the question around defensive and growth, it works when people say: what’s my income requirement?” Advisors talk to clients about what they need this year, next year and so on, and build a portfolio based on those income needs; a share income fund can be part of that approach.

There is some cause to hope for dividend payouts to increase in the year ahead. “One of the consequences of all the capital raising is that debt has really fallen and balance sheets in Australia are quite lazy now,” says Hobart. “Gearing ratios have fallen across the industry. The consequences of that are, as the economy recovers, corporates are going to be left with strong balance sheets.” That gives them options to do three things: share buybacks, which usually help the share price; increase dividends, which helps people who want income; or buy other businesses, which can be good or bad for a company. Hobart, naturally, is hoping they take the dividend option. “There was a time when companies did cut dividends – February 2009 was the worst we’ve seen in recent history in terms of dividend revision – but we’re through the eye of the storm and we’re going to see a far more normal dividend profile.”