Archive for year: 2019

Earlier this month, at his first public speech for 2019, RBA Governor Phil Lowe conceded the rate outlook is now “evenly balanced”, dropping the rate tightening bias present in RBA communications throughout 2018. In its latest forecasts contained in the Statement of Monetary Policy, the RBA has also revised lower its GDP and inflation forecasts.

So what has caused this change in outlook?

Weaker global outlook
Overall, global growth was strong in 2018 with falling unemployment and above-trend economic growth in the advanced economies. In Q4 2018, a few factors weighed on the growth outlook and the financial markets, including trade tensions between the US and its trading partners, slower growth in Europe and Asia, and political risks including Brexit and rising global populism. A greater-than-expected slowdown in China especially weighs on the outlook for Australia.

Stubbornly low inflation
With an improving domestic economy and tightening labour market, the RBA had been expecting inflation to move higher to its target band of 2–3%. That has not eventuated, and underlying inflation has been around 1.75% for some time. While there has been some pickup in wages growth, it remains subdued. In addition, rent inflation and the cost of new dwelling construction have remained soft given a weaker housing market.

Falling dwelling prices and a constrained household sector
Despite an improving labour market and falling unemployment rate, Australian households remain under considerable pressure, and household consumption growth has been weaker than expected. Factors weighing on household spending include subdued wages growth, rising cost of living (utility prices and mortgage interest rates), the high rate of part-time employment and underemployment, high household indebtedness, falling consumer sentiment in recent months, and also the declining wealth effects from falling house prices and weaker equities markets.

Tighter credit conditions
While domestic financial conditions remain accommodative overall, credit conditions for housing and small business have been tighter. Banks are facing higher funding costs as well as tightening lending standards as a result of the Royal Commission.

What’s ahead?

This change in rhetoric has seen financial markets pricing in a 60% chance of a rate cut by 2019, but in our opinion the RBA is likely to remain in wait-and-see mode. While it was forced to revise down its growth forecast, GDP is still expected to grow by 2.5% in 2018-19 and 2.75% in 2019-20, which is around the long-term trend level, while the unemployment rate is expected to stabilise around 5.0%. In addition to inflation, the RBA is likely to watch:

The business sector
As mining investment and exports return to more normal levels, non-mining business sector is expected to drive growth forward. However, business conditions and confidence have been trending lower, as measured in the NAB Business Survey. There are a few headwinds facing Australian businesses, including policy uncertainties associated with the federal election, slowing growth in China, tighter lending standards, falling building approvals and peaking mining exports. Retail conditions especially have been weak for quite some time—another reflection of a constrained household sector. The upcoming federal election is likely to contain business friendly policies to stimulate the economy and investment, while large infrastructure spending is also expected to drive investment growth in the medium term.

Household sector
The household sector remains constrained. As income growth has been weak, households have been saving less of their income to maintain consumption. Wages growth is therefore needed to maintain sustained consumption growth. The RBA will watch developments in the labour market closely. Leading indicators including the NAB survey employment index and SEEK job ads have pointed to a peak in employment growth. A marked slowdown in the labour market could see the RBA start cutting rates.

Dwelling investment
As the apartment building boom passes its peak, the fall in dwelling investment will be a drag on the economy and will likely see job losses in the construction sector and related industries. The RBA forecasts dwelling construction to decline by a cumulative 10% over the next two years. Given falling house prices, new approvals for houses and units are likely to be slow to come online. While infrastructure projects can absorb some construction employment, the overall drag on the economy would be significant over the near term.

Exports
The lower AUD will likely support export growth. While 2019 export growth will be driven by the completion of several large-scale LNG projects, once they reach full capacity their contribution to overall economic growth will be reduced. Rural exports this year are also expected to be lower due in large part to the severe drought.

Vertical integration in the advice sector has been a point of discussion within the financial services industry for many years. There are obvious conflicts that can potentially arise when advice is owned by an investment product manufacturer, and these have already been the subject of extensive scrutiny. Despite attempts to manage conflicts under vertical integration, the issue is still a concern for the industry and a key topic of the Royal Commission’s report.

However, while everyone would agree that conflicts can be better managed, government and regulators have stopped short of full structural separation between the provision of advice and the manufacture of investment products. The Royal Commission report, while highlighting the tendency of advisers among the ‘big five’ financial institution advice businesses to recommend in-house products, nonetheless baulks at the idea of forcing a separation of advice.

The Royal Commission’s view is that structural separation would be a “very large step to take” and that it is unclear whether the benefits of separation outweigh the costs. Ultimately, the issue comes down to how conflicts are managed and how a vertically integrated model aligns to the client’s best interest duties.

Vertical integration has become increasingly topical in the area of managed accounts. In recent years we have witnessed significant growth in managed accounts as a means of implementing holistic investment solutions. A catalyst to this growth was the Future of Financial Advice (FOFA) reforms, which took effect in 2013 and led to many financial advice groups seeking greater efficiencies in their businesses, and in some cases alternative sources of revenue, by creating their own in-house managed account portfolios.

While the Royal Commission has not mandated separation between product and advice, best interest obligations and conflicted remuneration are certainly areas of focus. There will be increased scrutiny on the governance structures overseeing in-house managed portfolios, including the composition of the investment committees and the range of qualified and experienced professionals involved in investment decisions. There will also undoubtedly be increased focus on remuneration structures within managed accounts (e.g. margin that financial advice groups might receive on fee rebates from the underlying fund managers, as well as model management fees and how these are used).

Finally, where financial advice groups are building internal managed portfolios and recommending them to their clients, the client’s best interest will need to be considered. This means advisers will need to ask themselves if an in-house solution is truly in the client’s best interest, and under what circumstances an alternative solution would be more appropriate.

Ultimately, a strong governance framework, careful management of any potential conflicted remuneration and a focus on the client’s best interests fall well within the spirit of the Royal Commission’s findings and are certainly relevant to the sphere of managed accounts. For advisers implementing managed account solutions, this is a topic that will continue to be raised as government, regulators and industry participants work to improve the quality of advice and bring it in line with community expectations.

As platform technology leads to further growth in the popularity of managed accounts, don’t be surprised if the vertical integration debate quickly changes to how advisers are using managed accounts and how conflicts are being managed.

The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services industry is mandatory reading for all super funds and their Trustees. It provides clear guidelines about the sale of financial advice and the purpose of MySuper products, as well as the simplification of insurance and more stringent benchmarking of service providers. This will result in a sweeping focus across organisations to ensure that strategic plans and KPIs are appropriately aligned and managed. The report clearly reinforces organisational responsibility as front and centre in the solution.

The impact of the Royal Commission for many in the industry will be lasting. The key takeout for many industry participants should be that most providers face challenges in some shape or form. We believe the true test of an organisation will be; if another commission (hypothetically) were to be held in 5 or 10 years’ time, will providers have had the foresight to seek out the issues of tomorrow and solve them, or will they be doomed to repeat the mistakes of the past.

We have identified three key areas highlighted in the report, which we believe will substantially shape the industry going forward.

1. Greater accountability for Trustees

With further consolidation across the industry inevitable, Trustees will need to have the processes in place to appropriately consider potential merger opportunities and ensure they are making decisions from a position of “best interests” and not “power/control”, or face being held accountable.

Further to this, the issue of appropriately assessing service providers, whether they are related to the entity or not, and holding them to account will also be vital in delivering optimal member outcomes. This will require ongoing uplift and oversight of service providers, to ensure that value is being delivered at all times.

For those Trustees that fail to adhere to their best interest duties, the Commissioner recommends the application of civil penalties. The challenge for funds, and their Trustees, will be on how to structure appropriate KPIs and remuneration structures, especially at Board and senior management levels, and whether they will have the capacity to deliver services with reasonable care and skill.

2. The challenges of assigning one default account

The report highlights the strong need for the industry to converge to its true membership base. SuperRatings remains supportive of one default account being created upon entry into the workforce, which we also highlighted in our submission to the Productivity Commission’s review. However, this is a deceptively complex challenge.

The report does not explicitly state what ‘machinery’ would be developed to ‘staple’ a person to a single default account. We believe there are three main approaches that could eventuate and note that each is not without substantial administrative and implementation challenges. Thus, it is not surprising that despite broad agreement across the industry, this initiative is yet to be executed. We envisage that an:

1. Employee could be defaulted into a fund attached to their first employer, with that becoming their superannuation fund for life. This could result in significant concentration of default flows to a handful of providers;

2. Employee could elect a superannuation fund when they apply for a TFN. Employees at this age may lack the skills to make an appropriate decision, so advice or guidance would be paramount;

3. Employee could continue to be defaulted into a fund attached to their employer, but a rollover of their existing accumulation account to the new super fund would need to occur each time their employment changed. This would increase the administration burden borne by superannuation funds but could expose employees to different superannuation providers throughout their working life.

Options 1 and 3 would still see the corporate play a role in determining a default super fund when arguably they don’t want the burden. Option 2 removes corporates from the decision-making process, but this option could spell the end of corporate super as we know it, and with it, the benefit of tailored solutions which are in the members’ best interest.

3. Key implications for Corporates

The report recommends ‘no treating’ of employers, this is effectively the corporate version of no hawking.  As such, funds will need to examine how to appropriately attract and service employers.

If corporates continue to nominate a default fund, the selection of this fund will need to be based on a robust framework. In lieu of set guidelines from the government, an assessment in-line with the member outcomes framework would be a potential minimum standard. We remain focused on the importance of reviewing investments, fees, advice, administration and governance arrangements as the pillars of a strong assessment of any fund.

The pricing models in this area should also give corporates pause for thought.  Reflecting on the commentary about the charging models for advice and mortgage broking, a range of pricing structures also exist in the corporate tender management space. Evidently, we believe best practice pricing in this space is an up-front fixed fee model. While this is a cost for corporates, we believe it brings significant long-term benefits for their employees that outweighs the initial cost.

Final thoughts

While the report may have lacked the theatre of the hearings, it has been clearly designed to address key issues identified by the Commission. As noted at the outset, we believe the key takeout for many industry participants should be that most providers face challenges in some shape or form. What providers do about them is the true test.

We are seeing providers act in advance of legislative change wherever practical, which is pleasing to observe. However, the path ahead for some will be more challenging than others. As historical issues are addressed, it will hopefully also provide an industry less divided across historical battlelines. Given the path forward in advice remains one of the most tricky to foresee, we hope that this will provide a key opportunity for these sectors to more effectively work together.

In the not-to-distant past, managed accounts were seen as a single cog in a client’s overall investment solution. While offering advantages for certain clients seeking a more personalized approach, advisers and model managers were limited in their ability to provide diversified, multi-asset model portfolios using a managed account structure.

Fast forward to today and the situation is very different. Developments in platform technology have meant that managed account solutions encompass a variety of portfolio structures, from single sector equities to holistic multi-asset portfolios. This has made managed accounts far more relevant to financial advisers as they seek portfolio solutions that can meet different client objectives and risk characteristics. Instead of offering an alternative for clients with sufficient knowledge of how managed accounts work, advisers can now use managed accounts to provide a full, actively managed investment solution that meets their clients’ needs.

This flexibility has led to improved implementation and greater efficiency compared to the traditional notional (paper-based) model portfolio structure. Today’s managed account structure enables effective implementation of a range of different investment philosophies and portfolio construction approaches. A good example of this is dynamic asset allocation, which under a notional model portfolio structure is impossible to implement responsively due to the administrative complexities involved.

There has also been an evolution in the composition of portfolios within managed accounts whereby multi-asset portfolios are becoming increasingly investment vehicle agnostic, with portfolios increasingly including a mix of Separately Managed Accounts (SMAs), Exchange Traded Funds (ETFs) and traditional managed funds. Greater flexibility and the ability to implement dynamic asset allocation views in a timely manner will become more important, especially as we move into a market environment characterized by increased volatility and potentially lower returns.

Along with this increased flexibility, there is of course a greater requirement for the model manager to be sufficiently equipped to manage, implement, monitor and report on the managed portfolios. As the managed account sector matures, with large institutions increasing their presence in the market, the barriers to entry from a platform, responsible entity, and superannuation trustee perspective have increased. This means that financial advisers need to conduct appropriate due diligence on their model managers to ensure they have not only the right research and investment expertise but also robust governance structures and reporting processes.

The trend towards multi-asset managed portfolios will only continue to grow as financial advisers recognise the efficiency that managed accounts can bring to their businesses. The ability to construct and implement dynamic, multi-asset portfolios has enabled advisers to enhance the value of their offering and provide clients with better portfolio communications and a superior advice experience. Technology platforms supporting managed accounts have already made significant advancements, and this will undoubtedly continue as model managers are able to access an ever-expanding range of investment products, allowing advisers to implement more sophisticated model portfolios.

As technological barriers are removed and managed accounts become more central to the way advice businesses operate, the challenge for advisers is to partner with the right model manager to ensure that solutions are aligned with their investment philosophy and that the manager is able to meet the needs of the adviser’s clients. For the model manager, the challenge is to offer the right mix of capabilities while remaining competitive. This inevitably requires both parties to adapt, but the reality of change is impossible to ignore. In this new world, success starts with acknowledging the change and creating a strategy that anticipates the growing power of managed accounts and their revolutionary impact on the advice industry.

An all too common mistake in investing, is to simply back last year’s winner. On the face of it, it seems appropriate to follow what worked last time and all too often investors pile into the best performing asset class of the last year in the hope that success will be repeated. However, as the below table shows, very rarely do asset classes consistently outperform and backing last year’s winner could very easily end up making you a loser.

This table reveals the best performing asset classes for each financial year since 2008, and shows that, on a very regular basis, one year’s winner fails to repeat its outperformance in the following year.

Chasing last year’s winner (financial year returns)

Source: Lonsec, Bloomberg, FE

Conversely, the table reveals that avoiding asset classes that performed poorly in the previous year can cost investors in the following year. For example, if investors had reduced their exposure to Aussie shares following a negative return in 2012, they would have missed out on one of the better performing asset classes in the subsequent two years (+21.9% and +17.3% respectively).

It’s a reminder that a well researched, diversified portfolio is better over the long term than chasing last year’s winners. Identifying your long term goals and building a portfolio to achieve that aim, rather than just chasing an immediate performance ‘sugar hit’ is more likely to deliver the desired outcome.

Lonsec portfolios utilise our extensive manager and equity research knowledge to build portfolios that aim to perform over the medium and long term. Reducing the volatility of the portfolio is a key goal of our selection process and asset allocation decisions.