The Financial Fortnight That Was - Thursday 6th August 2009

It has been a good month and a half since the previous edition. The end of June and all of July has been extremely busy tidying up end of financial year issues and preparing for the new financial year ahead. The business has also seen a strong inflow of new clients which has been great.

Since that last edition, equity markets slid away slightly to the end of June but have rebounded strongly through July. The market news section will provide more details regarding these movements.

Also in this edition we:

revisit the ongoing debate between index and active management approaches to investing,
look at Dalbar's Quantitative Analysis of Investor Behaviour study,
summarise the movements in markets since the last edition including 3, 5 and 10 year return history,
look at reasons why you should and should not change your financial adviser,
provide a link to Scott Francis' latest Eureka Report articles,
link to recent videos uploaded to the Fama & French Forum,
discuss how much senior Australians can afford to hold outside of their superannuation pension thanks to the Snior Australians Tax Offset, and
provide evidence of the three factor model in action.

Enjoy the read!!

A Quote for Consideration

The S&P/ASX 200 index has outperformed two-thirds of active Australian general equity funds over the last 5 years.

Standard & Poor's Index Versus Active Funds
Scorecard, Mid-Year 2009

Financial Topic Demystified
Index versus Active Management

There have been a number of publications in Australia over recent weeks looking at the question of whether investors are better off following an index or active management approach to investing. Three come to mind:

1) Standard & Poors Index versus Active Funds Scorecard, Mid-Year 2009 - showing that over a five year horizon, benchmarks have outperformed a majority of actively managed funds across equity and bond fund categories.

2) APRA's Investment performance ranking of superannuation firms which highlighted superannuation investors would be better off on average with their money invested in "passive" low-fee index funds.

3) An article written by Nigel Wilkin-Smith - Now is not the time for indexing - published in the Australian Investor's Association regular publication Investor's Voice - which highlights arguments against taking an index approach to investing.

Although I do not subscribe to the views espoused by Dr Wilkin-Smith I mention it because it does summarise the main argument against indexing, that the efficient market hypothesis is so flawed that investors can easily identify mispricing and as a consequence out-perform the index through investing in segments of the market or even individual shares that will out-perform going forward. It should also be noted that Dr Wilkin-Smith is Head of the Strategic Research Unit, Van Eyk Research, an organisation with the principl role of identifying investments that are better or worse than others.

Without going into any more detail I think a recent article written by Scott Francis for the Eureka Report outlines the arguments for applying an index approach to investing

Should you follow the index?

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To see how this is applied in practice please take a look at the Building Portfolios page on our website.

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Fascinating Financial Fact

Dalbar's Quantitative Analysis of Investor Behavior

Each year for the past 15, Dalbar has published data looking at an analysis of investor behaviour in the United States through quantiative measurement. Dalbar develops standards for, and provides research, ratings, and rankings of intangible factors to the mutual fund, broker/dealer, discount brokerage, life insurance, and banking industries. They include investor behavior, customer satisfaction, service quality, communications, Internet services, and financial-professional ratings.

In particular, this yearly analysis is an attempt to measure the effects of investor decisions to buy, sell and switch into and out of mutual funds. (Equivalent to managed funds in Australia.) The report has consistently shown that the average investor earns significantly less than mutual fund performance reports suggest.

The study covers the past 20 years of performance dats from January 1989 through to the end of December 2008. The key finding was:

Over 20 years the average investor earned 1.87% compared to 8.35% for the S&P500

The report provides one simple reason - When the going gets tough, investors panic. They buy when the market rises and sell when the market drops.

To read the media release regarding the latest findings please follow this link - Dalbar's 2008 Quantitative Analysis of Investor Behavior Media Release

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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 July 28th the P/E ratio for the S&P/ASX 200 was 11.36. The dividend yield was 4.94%.

Volatility Index (VIX)

Another index we are keeping an eye on in the USA is the CBOE Volatility Index. This index purports to be a key measure of market expectations of near term volatility conveyed by the S&P 500 share index. The higher the level of index, the higher are expectations for volatility in the S&P 500 index. For more information on how the VIX is calculated please take a look at - www.cboe.com/micro/vix/introduction.aspx

The close for the VIX on the 31st of July was at a level of 25.92. This is slightly higher than the 12 month closing low of 18.81 but well off the 12 month closing high of 80.86.

Market Indices

	Since last ed.	Since Start of 2009	1 Year	3 Year	5 Year	10 Year
Australian Shares
S&P - ASX 200	4.47%	14.01%	-14.73%	-5.23%	3.72%	NA *
International Shares
MSCI World - Ex Australia	4.21%	12.91%	-19.21%	-6.55%	1.51%	-0.64%
MSCI Emerging Markets	6.12%	42.70%	-7.09%	7.35%	16.73%	11.03%
Property
S&P - ASX 200 REIT	-1.32%	-14.73%	-42.78%	-27.84%	-14.28%	NA *
S&P/Citigroup Global REIT - Ex Australia - World - AUD	4.27%	-12.12%	-25.82%	-16.59%	-2.77%	5.42%
Currency
US Exchange Rate	1.69%	19.53%	-12.22%	2.64%	3.46%	2.42%
Trade Weighted Index	0.92%	18.17%	-8.98%	0.92%	1.75%	1.41%

* - Data unavailable as ASX 200 only commenced on 31st March 2000

General News

The following major economic parameters have been announced since the previous edition:

Consumer Price Index (Measurement of Inflation) has risen at a rate of 1.5% over the 12 months to the end of June.
Unemployment remains at 5.8% as at the end of July.
RBA left official interest rates at 3.0% in the August board meeting.
Westpac-Melbourne Institue consumer confidence index has risen to 109.4 in July, a 9.3% rise.

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Should you cheat on your financial adviser?

Scott's Financial Happenings Blog - Posted Tuesday 21 July

FundAdvice.com is an American website I regularly refer to in gleaming important issues that need to be addressed with clients and those seeking general information through our website and email service.

On their site they regularly publish video pieces for those who prefer to take in information visually. The latest video covers the topic of whether investors whould be looking for a new financial adviser.

Why not to change adviser?

This is an interesting topic given the turmoil of 2008. Tom Cock, the presenter of the video, suggests that one reason for not jumping the gun is because you lost money in the bear market. I think this is backed up by research conducted by Dalbar which looks at the habits of investors suggesting that investors on average tend to switch investment strategies at the wrong time and actually harm the returns they should have received. Reminds me of the saying "Jumping out of the frying pan into the fire".

Tom Cock goes on to say that you should be careful chasing the next "hot idea" promoted by some advisers or by moving to an adviser or investment strategy that has a solid 1 year track record. He suggests that anything less than 10 years is noise.

So why should you change adviser?

Tom proposes 3 key criteria:

An adviser who can save you money. i.e. provide the same or similar advice for a lower cost
An adviser with a better long term strategy.
An adviser who is more in tune with your individual needs.

If you would like to view the video please take a look at - Should you switch financial advisors?

If you want to see how this firm stacks up on those 3 points please take a look at our website or get in contact directly.

Regards,
Scott Keefer

Other blogs since the last edition have included:

17th June

How confident are you that your active manager will beat the market?

18th June
Are markets rational?

7th July

Should we trust the forecasters?

28th July

10 Steps for retirement planning

30th July

Most active managers Underperform - S&P Index v Active Funds Scorecard

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Eureka Report Articles

Since our last edition Scott Francis has contributed another six articles to Alan Kohler's Eureka Report. Click on the link below to be taken to this item:

24 June - Who can I complain to? - The last thing investors need in the current climate is bad advice. There are places to turn.

1 July - A lotto winner's handbook - The first thing you should do when you receive a windfall is resolve not to make any hasty decisions.

1 July - Should you follow the index? - Setting up your portfolio to track the market index means you won't get ahead of the pack, but ensures you won't trail it, either.

7 July - Recycle your debt - Balancing tax-deductible and non-deductible loans, or 'recycling debt', is an easier way to pay off a mortgage and build an investment portfolio.

13 July - Shares or cash? Look to the long term - Historically, the Australian share investments have had a premium of better than 6% over a simple investment in a cash account.

22 July - Did ANZ short-change its loyal shareholders? - The discount was not deep on ANZ's capital raising, and shareholders were limited in the parcel they could take. The bank should have chosen a fairer system.

Click here to be forwarded to all of Scott's Eureka Report articles

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Case Study - How much can a senior Australian hold in investments outside of a superannuation pension before paying tax?

A new client couple have recently sought advice on structuring their investment and superannuation portfolios. They were able to make a lump sum contribution into super and then roll this over into their pension portfolio. The common instinctive response would be to agree with this approach as you would be moving assets from an environment where you would be taxed at marginal tax rates into an environment where all income earned by those assets would be received tax free.

This is particularly pertinent for some as they hold shares and / or managed funds which are sitting on capital losses. To transfer assets from your own name into a superannuation / pension account is deemed to be a change of ownership and thus a capital gains event. Transferring these assets into superannuation and then pension mode whle they are sitting on capital losses may therefore be be a worthwhile move.

However, there are also higher levels of fees payable once in super pension mode so there are extra costs that need to be weighed up and if there are no tax benefits from making this move you might actually be worse off.

A key in making the decison is the Senior Australians Tax Offset (SATO).

How does SATO work?

The government provides senior Australians with a tax rebate. For the 2008-09 year it is $1,602 for each member of a couple.

Seniors are also eligible for the Low Income Tax Offset (LITO) of $1,200.

So basically what this means is that seniors can each earn up to $24,680 per annum (2008-09) each and not pay any tax or lose any franking credit benefits. (For a single the amount would be $28,867)

The Low Income Tax Offset is rising to $1,350 for the current year (2009-10) and $1,500 for 2010-11. If SATO remains at $1,602 then the maximum amount of taxable income you can each earn before paying any tax will be:

2009-10 - $25,680
2010-11 - $26,680

Implications of SATO

The implication of this is that seniors relying on their assets to produce their retirement income can earn up to $25,680 of income in the current financial year before paying any tax. Therefore you can hold assets outside of a superannuation pension that earn this level of income before you would lose anything from not transferring these assets into super and then pension mode.

If we estimated that the average income being produced by a portfolio was 5% this could see you holding up to as much as $500,000 of assets per person before having any tax to pay.

What about franking credits?

The couple I spoke to thought they were not paying any tax as they always received a tax refund from the government. However, care needs to be taken that you are not losing some of the benefits of the franking credits that are receivable from owning shares.

Let's use an example. Say you were paid dividend income of $25,000 in a financial year and all of those dividends were fully franked. When it came time to declaring your income you would actually have $25,000 of income plus $12,700 of franking credits. Your taxable income would be $37,700. What would happen is that you would lose some of those franking credits in tax. So rather than receiving the full $12,700 of franking credits as a refund from the ATO you would lose around $1,900 in tax.

If held within a superannuation pension you would receive back all of the franking credits in full.

Capital Gains Tax

This simple explanation does not factor in capital gains tax implications. If you thought you would sell some of your investments before they were passed on to your estate, and through doing so realise a capital gain then you would need to leave some room to move to allow you to have some capital gains each year and still not pay any tax.

Concluding Comments

The exact breakdown of how much you could ideally hold in investments outside of super is particular to each individual or couple and should take into account likely income to be produced by these assets and investment philosophy, in particular whether you think you will be realising capital gains through retirement years.

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Other resource of interest - Fama & French forum videos

Professors Fama & French published academic research in 1992 which forms the core of this firm's philosophy towards investing. The details of their paper can be found on our website - The Three Factor Model.

Earlier this year, in conjunction with Dimensional Fund Advisors, the professors started an online forum through which they could discuss a range of important and interesting investment topics.

Over the past two months they have added to the series of vidoes found at the forum. They are well worth a look.

Dollar Cost Averaging - Does it make sense to dollar cost average? It depends. Standard financial analysis says dollar cost averaging is suboptimal. If you focus on only your investment outcome, investing a lump sum immediately lets you construct the best portfolio you can today; slowing the process with dollar cost averaging just keeps you in something other than your best portfolio until you are done. Behavioral finance provides a different perspective. Because of the difference between the way people react to errors of omission and errors of commission, dollar cost averaging may give investors a better expected investment experience.

Did diversification fail when we needed it most? - Investors may doubt the usefulness of diversification after the recent market decline. Ken French explains that diversification cannot reduce the volatility of the overall market, but it is still important because it reduces the risk associated with individual firms or asset classes. Ken also discusses the perception that correlations between assets rise when market volatility is high.

Should stockholders sit this one out? - The answer depends on why stockholders want to leave the market. During the financial crisis, some investors discovered that their tolerance for risk is lower than they thought, so it might make sense for them to permanently reduce their exposure to equities. Investors who wish to avoid the price impact of the recession, however, are probably too late. Today's stock prices already reflect the anticipated effects of the slowdown, as well as any effects the recession has on expected future returns.

All are well worth a look. If you would like more information about what we see as the academic research that underpins a sound approach to investing please take a look at our Research Based Approach pages on our site.

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Three Factor Model in Action
Dimensional Fund Performance Graphs updated to the end of June 2009

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 June 2009.

Commentary:

The graphs show strong monthly returns over the month for the Australian share asset classes with international share investments relatively flat for the month mainly due to the impact of currency movements.

Over the long run, the graphs continue to clearly show the existence of the risk premiums (small, value and emerging markets) that the research tells us should exist.

Australian Share Trusts - 7 Year returns:

	7 Yr Return to June 2009	Premium over ASX 200 Accumulation Index
ASX 200 Accumulation Index	9.33%	-
Dimensional Australian Value Trust	11.94%	2.61%
Dimensional Australian Small Company Trust	13.57%	4.24%

International Share Trusts - 7 Year returns:

	7 Yr Return to June 2009	Premium over MSCI World (ex Australia) Index
MSCI World (ex Australia) Index	-0.76%	-
Dimensional Global Value Trust	0.85%	1.61%
Dimensional Global Small Company Trust	2.66%	3.40%
Dimensional Emerging Markets Trust	11.86%	12.62%

NB - These premiums are higher than what we would expect going forward.

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.

Please let us know if you have any feedback regarding these graphs by using the Request for More Information form to the right or via our User Voice feedback forum.

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Requesting feedback

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 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.

We welcome your feedback.

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I 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,

Scott Keefer

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 Keefer

1 Park Road - PO Box 1688

Milton QLD 4064

(07) 3876 6223

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