The Financial Fortnight That Was - Tuesday 19th August 2008

We have a bumper issue for you this fortnight highlighting some new updates on our website and a response to feedback received via our Feedback Forum.

In this edition we also look at emerging markets, provide a summary of the movements in markets over the past fortnight and look at how the ANZ Staff Superannuation fund goes about investing. We hope that you find the material informative and relevant.

Enjoy the read!

A Quote for Consideration

Q: How can individuals find managers who can beat the street?
A: Most people think they can find managers who can outperform, but most people are wrong. I will say that 85% to 90% of managers fail to match their benchmarks, if you properly specify their benchmarks.

Q: That's pretty pessimistic.
A: Yes. But because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value . The investment business is a giant scam. It deletes billions of dollars every year in transaction costs and fees.

Q: So what should individuals do?
A: Most people should simply have index funds to keep their fees low and their tax down. No doubt about it."

Jack Meyer, former Harvard Management CEO
(Harvard University Endowment), credited with tripling the endowment from $8 billion to $27 billion during the 10 years he was at the helm.

Excerpted from BusinessWeek interview, "Husbanding that $27 Billion", December 27, 2004

Financial Topic Demystified

Emerging Markets

Australian investors tend to have a very strong home bias towards Australian equities. We often see prospective clients seek advice and they have predominantly Australian investments. Over the past few years this has been a successful approach with the Australian market performing well compared to major overseas markets. However there has been one particular area of international markets that has had strong recent performance, namely Emerging Markets. So what do we mean by emerging markets?

The term is used to describe business and investment activity in industrialising or emerging regions of the world. From an economics perspective, these economies are said to be in a transitional phase between developing and developed status. They are countries that have begun to open up their economies to the world. The classification of emerging markets is not an exact science and as such there is not a definitive list of countries included in this definition. However, to put some names to these economies, the top 4 markets in this space are generally referred to as the BRIC economies - Brazil, Russia, India and China. If you have had any exposure to the international financial media you would quickly identify that these are some of the fastest growing economies in the world - 2007 growth results reported by the International Monetary Fund saw all four with strong performances - Brazil (5.4%), Russia (8.1%), India (9.2%), China (11.4%).

Growth in the domestic economy is nice but what share market investors are looking for is growth in the value of shares within these economies. The MSCI - Emerging Markets Index, is the index which is widely used as a benchmark for returns. The past 12 months have seen a decline of 21.48% for the year to date or 6.91% for the year to the 15^th August 2008. However, even with this particularly poor year included, 3 year returns to the 31^st July have been 16.2% and 5 year returns 19.7%. In comparison the MSCI World Index ex Australia has seen returns of 1.8% over 3 years and 6.3% over 5 years while the ASX200 has seen returns of 8.7% over 3 years and 14.44% over 5 years. This places the Emerging Market returns as favourable over these periods of time.

However, as with all major investment markets, to capture higher returns there is a trade-off between risk and return. The greater the risk, the greater the expected return. Emerging Markets are no different and have experienced significant downturns. Consider the Asian and South American monetary crisis in the late 90s. These economies also have some regulatory issues that need to be considered before investing, for instance the strict monetary and political controls in China and regulatory issues in Russia.

So what is our stance on investing in Emerging Markets?

We invest in Emerging Markets to provide an extra risk - extra return premium for our investors. Investing in Emerging Markets also provides an extra level of diversification to smooth out volatility. We invest in these markets by using an index style approach. Not picking winners (or losers) but holding a wide spread of investments across emerging markets. This keeps the cost of investing low and provides Our preferred fund, Dimensional Emerging Markets Trust, holds shares in companies listed in Argentina, Brazil, Chile, China, Czech Republic, Hungary, India, Indonesia, Israel, Malaysia, Mexico, Philippines, Poland, South Africa, South Korea, Taiwan, Thailand, and Turkey. (You will note that it does not hold assets in Russia mainly due to the regulatory controls in place in Russia.) In a standard portfolio, an investor would have an exposure of about 5.5% of their growth assets in emerging markets.

Scott Francis has recently written an article for the Eureka Report, published yesterday, which looks at the topic of Emerging Markets in the context of using an exchange traded fund - Emerging markets via the ASX

To find out more about our investment philosophy please have a look at our web page on Building Portfolios.

Fascinating Financial Fact

Australian Sharemarket Volatility

Vanguard Investments have put together a really useful chart plotting the volatility of the Australian share index since June 1978. On the chart they have highlighted 7 significant share market falls of more than 10% over that period. The chart also tracks the length of the decline and the corresponding time taken to recover from the decline. - Click here to be taken to the chart - Australian Share Market Volatility

The average fall has been 21.2% with the average decline of 8.6 months. The more positive part of the chart shows that the average recovery period has been 15.3 months. Another statistic that is not included on the chart but has been widely reported is the average rebound from market lows over 12 months which has been 34% in Australia. See Vanguard's Robin Bowerman's blog for further commentary - Looking Back.

So where is the current Australian market?

The most recent low was reached on the 5th of August with the ASX200 falling to 4,758.5. The high can be tracked back to the 1st of November when the ASX200 reached 6,851.5. This is a fall of 30.55% over a period of just over 9 months. Comparing this to the past 30 years, this decline is one of the more severe (or has been one of the more severe for those who's glass is half full) - 3rd worst out of the last 8.

What insights can we learn from this data?

If you do not believe in market timing, then this data clearly shows the risk of pulling out of the market after the market has had a significant decline. Especially now after the market has already fallen over 30%. It could go further. The largest decline has been 43.5%. But the possible 12 month rebound, based on averages, would outstrip this further fall.

For those with a very long investment timeframe, the graph shows that the share market has always rebound and kept rising over time and overcome the market declines that are inevitable.

If you do believe in market timing then we would love to hear from you.

Of course, it could all be different this time.

Market News

ASX P/E Ratio and Dividend Yields

The P/E ratio is a common broad indicator of the price of shares. It is a calculation of the price of shares compared to expected earnings. A higher ratio indicates that share prices are more expensive. The historical P/E ratio for the ASX has been between 14 & 15. The dividend yield is the calculation of dividend payments divided by the market capitalisation of the company or index. The historical average in Australia is around 4%.

As of August 12^th the P/E ratio for the S&P/ASX 200 was 10.26. The dividend yield was 5.03%.

Market Indices

Since our previous edition, all but Emerging Markets have experienced rises. The S&P ASX200 Index has fallen risen 1.58% from 1^st to the 15^th of August. It is now down 13.93% from the same time last year and down 21.42% for the calendar year so far. The MSCI World - ex Australia, a measure of the global market, has risen 1.82% over the same period. The index is down 12.06% from the same time last year and down 14.71% for the calendar year so far.

Emerging markets have experienced negative movement with the MSCI Emerging Markets Index falling 2.94% since the 1^st of August. This index is down 6.91% from the same time last year and down 21.48% for the calendar year so far.

Property trusts have rebounded further since the 1^st of August with the S&P ASX 200 A-REIT Index rising by 3.11%. The index is down 37.52% from the same time last year and also down 34.18% for the calendar year so far. The S&P/Citigroup Global Real Estate Investment Trust (REIT) Index, a measure of the global property market, has risen 2.53% over the same period. It is down 12.90% from the same time last year and down 9.68% for the calendar year so far.

Exchange Rates

As of 4pm the 15^th of August, the value of the Australian dollar has fallen strongly against major benchmarks since the last edition. It is down against the US Dollar by 7.84% at .8639. It is up 4.25% from the same time last year but down 2.01% for the calendar year so far. Since August 1^st the Aussie has also fallen 5.72% against the Trade Weighted Index, with the index now at 67.6. This puts it up by 0.80% since the same time last year and down 1.60% for the calendar year so far. (The Trade Weighted Index measures The Australian dollar against a basket of foreign currencies.)

General News

Since our last edition the Reserve Bank of Australia board met on the 5^th of August and decided to keep the official interest rate target steady at 7.25%. The statement published with the decision indicated that the RBA believes that demand in the economy has been restrained and: "On balance, however, it is looking more likely that demand will remain subdued, and economic growth will be fairly slow, over the period ahead. Inflation is likely to remain relatively high in the short term, with the CPI affected by high global oil prices. Looking further ahead, inflation in both CPI and underlying terms is likely to decline over time, given the outlook for demand, provided wages growth remains moderate. The Bank's forecast remains that inflation will fall below 3 per cent during 2010 ... with demand slowing, the Board's view is that scope to move towards a less restrictive stance of monetary policy in the period ahead is increasing."

The Australian Bureau of Statistics has released the latest employment data with the official unemployment rate remaining steady at 4.3% as of the end of July. The participation rate has also remained steady at 65.3% with employment levels rising by 10,900 jobs.

Of particular interest over recent weeks has been the release of the National Australia Bank's Business Survey. The survey indicated that business conditions are worsening with business outcomes and business sentiment falling.

Lessons from the ANZ Staff Superannuation Scheme

Scott's Financial Happenings Blog - Posted Tuesday 12 August

In my scanning of the financial press over the past few days I came across an interesting item reported by Financial Standard - 'ANZ Super cuts options by 40pc'. The article reported that the trustees of the ANZ Australian Staff Superannuation Scheme had overhauled its Australian and International equities portfolio by appointing new managers. By doing so they suggest that investment costs will fall by 40% from current levels for the aggressive and balanced investment options.

This is great news for members of the scheme. For those of us who are not members we can still learn a lot about how the trustees have managed this outcome. A large part of the answer comes from the investment style undertaken by the fund managers they have chosen.

No prizes for guessing that the core investment style being employed both in the Australian and International context is index investing. We are not shy in stating on our website and in our communications - index investing keeps fees lows. As the article reports "Both core managers will adopt a passive investment style, with the aim of matching or exceeding marginally the investment performance of the Australian and international share markets respectively."

Within the Australian equities component of the scheme, the trustees have appointed Macquarie Investment Management as the core manager with 70% of Australian equities now invested in the Macquarie Pure Index Fund. I tried looking for more information on this fund but kept coming to the Macquarie True Index-Linked Australian Shares Fund. The reported management fee for this fund is 0.103%, very cheap. One downside, this not actually a pure index fund as it employs an arrangement with Macquarie Life to guarantee that the fund does not underperform the actual index but the principle stands. Knowing Macquarie, they have to be earning more than 0.103% so it is safe to suggest that the risk of the underlying investments are greater than what would be undertaken if you held a pure index fund and therefore returns are actually higher than index returns with Macquarie skimming off the premium. The fund profile actually suggests that shares outside the actual index may be used.

Within the international environment the trustees have appointed Barclays Global Investors with 70% of international equities invested in the BGI Fission Index Fund. The trustees suggest that information on this fund is not publicly available. The only information I have found states that the fund guarantees that it will match the MSCI World - ex Australia Index return plus add a small premium. The fund does not officially charge management fees. Unfortunately it does not indicate what investments it undertakes to guarantee the index return and how much risk is taken on. BGI have to be making money somewhere so you can expect that the investments are not pure index investments and contain extra risk for investors as compared to holding pure index investments.

Turning a blind eye to the manufactured index approach undertaken by Macquarie and BGI for a moment, the underlying principle of reducing costs through employing a passive investment approach is extremely sound. It is what we recommend for our clients without the funky use of derivatives or other strategies to guarantee index returns - just pure index investments. (Check out our Building Portfolios for more details.)

All of this is particularly fascinating given that this is the superannuation scheme for staff of one of the 4 major banks in Australia - the ANZ. For those who were not aware, ANZ partner with ING Fund to run the funds management arm of their businesses. The majority of the funds they promote through this joint venture have an active approach to investing with fees ranging from 1.44% to 2.9%. The lower fee options are actually Vanguard Index funds which can be purchased directly through Vanguard for 0.75% retail.

Obviously the trustees of the ANZ Staff Superannuation Scheme do not follow the ANZ/ING fund management approach and prefer to use an index approach. Interesting how things change when the people at ANZ are investing their own assets for retirement and not the assets of their clients.

Regards,

Scott Keefer

Other blogs over the past fortnight:

14^th August - Sharemarket volatility and how markets rebound from lows

14^th August - Summary of Sound Investing - 8th August 2008

18^th August - Impact of a falling dollar

Click here to be taken to Scott's Financial Happenings Blog

Eureka Report Articles

Since our last edition Scott Francis has contributed another two articles to Alan Kohler's Eureka Report. Click on the links below to be taken to these items:

13^th August - Reply to letter of the week - Scott replies to a letter written by a subscriber to the Eureka Report based on Scott's article - What price index funds? . The letter and reply were both published in the Eureke Report.

18^th August - Emerging markets via the ASX - The iShares EM exchange traded fund offer investors access to the potential long-term outperformance of emerging markets.

Click here to be forwarded to Scott's Eureka Report Articles

Other Websites of Interest

Over the next few editions we plan to highlight a number of other sources of valuable financial and investment information on the internet. Our fourth site is from one of our preferred fund managers - Dimensional Fund Advisors Australia -

www.dfaau.com

The site provides a wealth of information about the Dimensional approach to investing which we favour. The site covers their investment philosophy, how they apply this, the particular strategies they use in the Australian context and a library of interesting and relevant information.

Response to feedback

Since our last edition we have received some feedback from a subscriber which we would like to address:

Feedback:

"Why can't we invest in US Vanguard index funds at low fees? Why not also invest in LICs like AFIC with fees of about 0.13%?"

Our response:

Thanks very much for the question.

The problem with investing in USA index funds at low fees is that you have currency risk and the tax issues associated with investing in USA based assets. The tax issue particularly provides additional complexity for retail investors because the fund will be paying USA based income to investors. The USA Vanguard website also indicates that it is against the law to offer its USA based funds to many overseas investors.

LIC's (Listed Investment Companies) are a very low cost investment option in the Australian environment. However, they have one 'risk' that a simple index fund does not have - they can trade at either a discount or premium to the value of their underlying portfolio. This can potentially increase or decrease returns over any period for an investor. This is not a risk that I am personally comfortable exposing client portfolios to.

The following article looked at the returns from LIC's over time. Their performance was not that impressive compared to the average market return.

Why LICs can be DUDS

We encourage subscribers to ask questions or make comments either directly by sending an email to our email address: financialfortnight@acleardirection.com.au or by engaging with our feedback site:

Financial Fortnight Feedback Forum

After clicking on the link that follows you will be taken to our Financial Fortnight User Voice page. On that page you will be able to provide suggestions or vote on suggestions that have been made by other subscribers. By submitting an idea, you enable other users to view your idea and add their vote if they think it is worthwhile. By casting your vote you are telling us whether you think the ideas are worthy and which ideas should be implemented first. Where possible, the ideas which receive the greatest amount of votes will be actioned first.

Recent update to our website - Financial Seminar Presentations

We have integrated a new page into our website focusing on the seminar presentations that we are making to our clients, prospective clients and other interested groups. Scott Francis in particular has conducted a ranged of presentations over recent years to groups such as the Australian Investors' Association, the Australian Computer Society - Young IT Professionals and also school student groups.

The initial page features videos from Scott's recent presentation at the Australian Investors' Association National Conference held on the Gold Coast. The presentation dealt with asset allocation and correlations.

Please click on the following link to be taken to the page - Financial Seminar Presentations.

Recent update to our website - Building Portfolios page updated

We have updated the Building Portfolios page on our website to include Dimensional performance data up to the 30th June 2008. The data continues to show the premiums for small, value and emerging market trusts over the standard index returns (as reflected by the Large Company Trust performance).

Australian Shares:

The following tables represent the Australian share returns in two ways. Firstly is the average annual return over 5 years followed by the growth of $10,000 invested over 5 years. All returns are after Dimensional fees, and returns are to the end of June, 2008. As you can see the performance of the actual funds show that small companies and value companies, invested in a strategic way, provide a higher return than just the index return ( with the Dimensional Australian Large Company Trust reflecting the index return).

Average Annual Returns:

	5 Year Annual Return to End June 2008
Dimensional - Australian Large Company Trust	16.81%
Dimensional - Australian Value Trust	19.49%
Dimensional - Australian Small Company Trust	22.87%

Growth of $10,000 Invested:

	5 Year Annual Return to End June 2008
Dimensional - Australian Large Company Trust	$22,359
Dimensional - Australian Value Trust	$24,359
Dimensional - Australian Small Company Trust	$28,005

International Shares:

Within International shares these same sources of return premiums from value and small companies can be found.

There is also an extra sub-category to add to this mix - companies in Emerging Markets. Emerging Markets are those that are not yet developed but have significant potential for growth. Consequently they also are riskier and therefore can provide an extra risk premium for an investor who is comfortable to take on this extra risk. Our preferred fund, Dimensional Emerging Markets Trust, holds shares in companies listed in Argentina, Brazil, Chile, China, Czech Republic, Hungary, India, Indonesia, Israel, Malaysia, Mexico, Philippines, Poland, South Africa, South Korea, Taiwan, Thailand, and Turkey.

While we have not gone into as much detail with our returns data, the three year and five year returns show the value and small company premium over the index (the Dimensional Global Large Company Fund being close to the index return), as well as showing the effectiveness of the Emerging Markets fund.

Average Annual Returns:

	5 Year Annual Return to End June 2008
Dimensional - Global Large	5.12%
Dimensional - Global Value	9.08%
Dimensional - Global Small	8.60%
Dimensional - Emerging Markets	19.72%

Growth of $10,000 Invested:

	5 Year Annual Return to End June 2008
Dimensional - Global Large	$12,836
Dimensional - Global Value	$15,443
Dimensional - Global Small	$15,106
Dimensional - Emerging Markets	$24,594

Recent update to our website - Dimensional Fund Performance Graphs Updated

Since our last edition we have updated the Dimensional Fund Performance Graphs page on our website. The graphs show the performance of the Dimensional funds that we use to build investment portfolios for our clients. They have been updated to contain data up until the end of July 2008.

The graphs show negative returns in the Australia market and flat returns for international markets over July.

So far during August, all the Dimensional trusts, except the Australian Small Company Trust, have seen improved returns with the global trusts, except the Emerging Markets trust, experiencing greater than 6% improvements.

Overall, the graphs continue to clearly show the existence of the risk premiums (small, value and emerging markets) that the research tells us should exist. Please click on the following link to be taken to the graphs - Dimensional Fund Performance Graphs.

For anyone new to our website, it is important to point out that we build investment portfolios for clients based on the best available academic research. Take a look at our Building Portfolios and Our Research Based Approach pages for more details. In our view, this research compels us to use the three factor model developed by Fama and French. In Australia, the most effective method of investing using this model is through trusts implemented by Dimensional Fund Advisors (www.dfaau.com). We do not receive any form of commission or payment from Dimensional for using their trusts. We use them because they provide the returns clients are entitled to from share markets.

However, academic theory is nothing if it can not be implemented and provide the returns that are promised by the research. Therefore, we like to provide the historical returns of the funds that we use to build investment portfolios.

Some words of caution:

- past performance does not provide a good prediction of future performance

- the premiums on top of the market return that have been experienced are above what we would expect in the long term, value premiums should be 2-3% small company premiums 3-4% over the relevant market index.

Please let us know if you have any feedback regarding these graphs by using our Feedback Forum.

We hope you have enjoyed reading the latest edition. If you have any comments or suggestions for future topics please do not hesitate to get in contact.

Have a great fortnight!

Cheers,

The Two Scotts

The Financial Fortnight is a publication of A Clear Direction Financial Planning. It contains general financial advice. Readers should check this advice with a professional financial adviser before acting on any of the material contained in this email.

Scott Francis & Scott Keefer

1 Park Road - PO Box 1688

Milton QLD 4064

(07) 3876 6223

A Clear Direction Financial Planning is an Authorised Representative (No. 283723)

of FYG Planners Pty Ltd ABN 55 094 972 540

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Registered Office: Level 1, 10 Wilson Street Burnie Tas 7320