Asset allocation: What you must know

PORTFOLIO POINT: Australian investors have the benefit of excellent yields in a variety of asset classes. Lock them in.

Although you may not think so just now, Australia is a lucky country for investors. From a yield perspective we are the envy of the world. Also while many different asset classes offer similar yields, an Australian investor can continue to apply widely (or perhaps wildly?) different asset allocation strategies and still be rewarded.

So in a world where growth is uncertain, there is good news for the Australian investor and asset allocator. But, to me, the essential point in late 2011 is that these yields might not last and you may need to lock in your position against a lower-yielding, higher-taxing future.

In addressing your portfolio allocation challenges, imagine a comparison between you and an American or European investor on several key investment parameters.

• Local shares pay dividends of about 5% on average versus 2% for an American or European investing in their local sharemarket.
• If you’re a pension investor, then local tax paid by your company will be fully refunded, enhancing your yield a further 2%, while elsewhere others may have to give up to a quarter of their dividend in tax.
• You can invest in Australian bank shares yielding about 10% which don’t look like those overseas banks that may one day be restructured into naughty “bad banks” or nationalised.
• You can even earn about 5% income from investing in their overseas shares as long as you choose to hedge your currency – and by doing so collect about 3% of top-up income from hedging contracts, which favour you and cost others.
• Of course you also feel empowered investing outside of your home while the Australian dollar buys much more than it ever has; whereas the US investor isn’t so sure now is a good time to fund an overseas holidays for her/his investments.
• You also have less reason to worry about whether or not to speculate in “no yield” gold and commodities since one-third of your stockmarket is in that industry, as is 10% of your nation’s GDP – you may in fact be over-exposed.
• You earn 5% on money in the bank while they earn 1%.
• After inflation, you’re ahead 2% and those overseas are behind 3%.
• You can earn up to 7–8% investing in less secure hybrid equity/bond securities – whereas in other countries only the Mafia can demand that rate, or those lending to southern European countries.
• You can enjoy rents from commercial property trusts of about 7%, while offshore investors might capture locally a slightly lesser 5–6%.
• Your residential property yields 2% after costs versus 6% rental yields offshore '¦ hmmm, something may be not right!

Aside then from residential investment property, this also means that despite the many different asset allocation strategies that Australian investors implement (see chart, below), most are yielding an impressive 5–7% income. In a low capital growth investment environment this means Australians can perhaps be more relaxed about their tactical asset allocation and stick more to their strategic asset allocation then those elsewhere. In other parts of the world and in foreign media you read, there is a stronger imperative when average yields are subinflation to hunt for enhanced return by changing allocations and exploring alternative assets. (To see what I mean, read the following piece by New York-based Byron Wien.)

Source: Wealth Benchmarks

Nevertheless, I continue to recommend investors periodically take stock of their portfolio and keep it in balance which in today’s volatile market might deliver a precious extra 1% return. To read how a local institutional investor such as Damien Klassen at Wilson HTM approached tactical asset allocation settings, see below. (Klassen calls it 'Resuming the brace position'.)

• Click on the image for the complete report

However, in contrast to many local institutional investors I recommend revisiting equities. Indeed, for those who recently enjoyed a 10% rally in bonds, including 13% for the year to 30 September 2011 in inflation-linked bonds I introduced earlier, then your next rebalance will be to trim your appreciated bonds and buy more unappreciated shares.

I worry that one day Australia will not be the lucky investor country perhaps because:

• Interest rates continue to fall '¦ and so does our dollar.
• Banks get their financing in order and no longer need to pay above the odds.
• Bank profits stagnate and boom resource prices fizzle.
• Bank deposit guarantees reduce yet one day are needed.
• Sharemarket prices step up or company earnings down so yields compress, but prices don’t keep appreciating thereafter.
• Residential property prices languish further from a demographic bulge of negative geared investors wanting a better return or money to put into super or just spend.
• Inflationary pressures return once more.
• A responsible desire of government to avoid being beholden to bond markets becoming the next Italy, US or UK, but in doing so the government chooses to balance its budget through cherry-picking from the Henry tax review, revisiting dividend imputation, negative gearing, capital gains concessions or tax-free super.

To deal with some of these risks it may prove prudent to then lock in to higher interest rates through long-duration term deposits or preferably tradeable bonds. It is important to realise also your current stellar equity yield will not be as high when the All Ordinaries flirts again with 5000 but disappoints for not going all the way thereafter. As I write it is at 4395.

So be careful waiting first for the share market to recover before re-investing. If you can see the reliability of yield (from the graph below) and be blind to the enormous fluctuations in price, you might have the courage to be a sensibly allocated share investor. And of course if the Australia dollar returns to its earlier US70–80¢ range then you will miss the opportunity to invest offshore during a rare time when Australia was on top of an upside-down financial world map.

Finally, make sure you are properly using your superannuation tax shelter. Example strategies like equalising benefits between spouses, commencing reversionary pensions, reducing your taxable components and maximising contributions may help in case of future rule changes. (To read more on SMSF rebalancing, see today’s piece by Bruce Brammall.)

So when you hear the siren song that this is a trader’s market or that profits only come from frenzied asset reallocation, cover your ears and stay a lazy long-term investor just a little bit longer. Enjoy and perhaps lock in one of the world’s highest investor incomes.

Doug Turek is the managing director of boutique wealth advisory and money management firm Professional Wealth.