Unsurprisingly the impact of COVID-19 was the main discussion point during this August reporting season, with many companies focused on getting through the current environment and preparing or modifying their business models to succeed in the new COVID environment. But overall the reporting season was better than expected with some sectors such as consumer discretionary and online retail seeing huge increases in sales, benefiting from the government stimulus and the structural shift to online retail due to the lockdowns.

Lonsec’s Portfolio Manager for Listed Products, Danial Moradi, takes a look at the key themes coming out of the August 2020 reporting season.

Reporting season highlights

  • Whilst perhaps the most challenging period since the Global Financial Crisis, the August 2020 reporting season turned out to be better than expected with the initial impact of COVID-19 less than initially feared.
  • COVID-19 and its impact on the corporate sector was at the centre of this reporting season, with companies focusing on adjusting their business models to prosper in a “COVID normal” environment.
  • Overall, the market experienced negative earnings growth over the year, but there were also some positive surprises, particularly in the retail and technology sectors, largely driven by the shift in consumer spending.
  • Consumer Discretionary was amongst the top performing sectors in August, with the sector benefiting from government stimulus, particularly online retail which saw a surge in sales during the lockdown from people spending more time at home.
  • Banks, on the other hand, saw profits and dividends diminish whilst Energy and Industrials also saw sharp declines in earnings impacted by the lockdowns and restrictions.

The August 2020 reporting season was better than initial expectations, with the positive impact of the unprecedented levels of government stimulus buffering the potential extent of the decline in earnings and dividends over the June quarter. Overall, market earnings per share (EPS) declined by 20% in FY20, with all sectors, excluding Technology and Discretionary Retail, experiencing negative earnings growth over the year. Banks, Energy and Industrials saw the sharpest declines in earnings, capturing a number of industries adversely affected by the lockdowns and restrictions.

At a stock level, within the ASX 200 universe, JB Hi-Fi (JBH), Reliance Worldwide (RWC), Cleanaway Waste Management (CWY), IDP Education (IEL) and WiseTech Global (WTC) reported stronger than expected performances, while Telstra (TLS), AGL Energy (AGL), Insurance Australia Group (IAG), Origin Energy (ORG), Seek (SEK) and Vicinity Centres (VCX) delivered relatively weaker results and forward guidance.
Unsurprisingly, the COVID-19 pandemic and its knock-on impacts on the corporate sector was front and centre during reporting season, with many companies focusing on getting through the current phase relatively unscathed and preparing their business models to prosper in a “COVID normal” environment. This uncertainty has made short term forecasts almost impossible for many companies, with many refraining from providing FY21 earnings guidance. The next formal opportunity for company guidance updates to be reinstalled is at the time of the respective AGMs, to be held in October and November for the June financial year-end stocks.

Despite the lockdowns, several retailers in the Discretionary segment reported material increases in sales over the June quarter, with the sector benefiting from ongoing government stimulus, mortgage deferrals and early superannuation releases. This trend seems to have continued into the new financial year, with JB Hi-Fi (JBH) and Harvey Norman (HVN) reporting comparable sales growth in excess of 40% in July 2020, while furniture retailer Nick Scali stated that sales have grown by 70% over the same period.

Online Retail and e-commerce have also been amongst the main beneficiaries of the COVID-19 pandemic, with many online businesses seeing a huge influx of orders during the lockdowns. This was evident in the performances of the likes of Afterpay (APT), Kogan.com (KGN), Temple & Webster (TPW) and Redbubble (RBL), with many reporting sales growth in excess of 100% in the June quarter. While these elevated levels of sales activity are unlikely to continue post the lockdowns, COVID-19 has to some extent expediated the structural shift to online retail, a trend we expect will continue for some time given the relatively low penetration of online sales (c.10%) in Australia.

While COVID-19 has been a tailwind for many retailers, its impact on the retail Real Estate segment has been far from positive. While the Office and Industrial sectors have to-date been relatively resilient given the challenging market conditions, rent waivers, increasing provisions, negative leasing spreads and the prospects of higher vacancy rates have to-date resulted in asset price devaluations of 10-15% in the retail sub-sector, with rent collections tracking at around 50%. Retail REITs such as Scentre Group (SCG), Vicinity Centres (VCX) and GPT Group (GPT) are continuing to see pressure from tenants regarding rent reductions and abatements, a trend which is unlikely to subside until rents are rebased to more sustainable levels given the structural shift to online sales for many retailers. This has resulted in the sector trading at a significant discount to net asset value, implying the likelihood of further asset price devaluations over the medium term.

Looking ahead, at this stage consensus estimates are suggesting a 10% rebound in earnings in FY21, however, this is likely to remain volatile over the year, with further COVID-19 related restrictions likely to postpone an eventual economic recovery into FY22. At the sector level, while a more stable earnings growth profile is expected from the Healthcare and Consumer Staples sectors, earnings within the Banks, Insurance, Gaming and Industrials sub-segments are expected to rebound sharply in FY21 and FY22, implying a trough in earnings in FY20.

The sharp earnings contraction across the market in FY20 has also resulted in a large decline in market yield, reflecting significant declines in payout ratios in the second half, with many companies not declaring a final dividend. Looking ahead, the consensus dividend yield for the market in FY21 is currently around 3.3%, which is still 30% below the long run average for the ASX 200 benchmark. The deferral or reduction of bank dividends has played a large role in this, and at this stage, given the current earnings projections for the sector, overall market yield is unlikely to return to FY19 levels until FY23.

From a valuation perspective, the market has largely tried to see through the COVID-19 impact on earnings in FY20, with spot valuation metrics in many segments approaching historical peaks. At the same time, the premium paid for earnings certainty and quality remains elevated, supported by historical low interest rates and increasing uncertainty about the shape of the economic recovery post the expiry of stimulus measures in 2021. This is likely to result in periods of elevated volatility in the market, particularly if the economic recovery is postponed into 2022.


This information is provided by Lonsec Investment Solutions as a corporate authorised representative of Lonsec Research Pty Ltd who hold an AFSL number 421445. This is general advice, which doesn’t consider your personal circumstances. Consider these and always read the product disclosure statement or seek professional advice prior to making any decision about a financial product. You can access a copy of our financial services guide at lonsec.com.au

This video is provided by Lonsec Investment Solutions Pty Ltd ACN 608 837 583, a Corporate Authorised Representative (CAR 1236821) (LIS) of Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec Research). LIS creates the model portfolios it distributes using the investment research provided by Lonsec Research but LIS has not had any involvement in the investment research process for Lonsec Research. LIS and Lonsec Research are owned by Lonsec Holdings Pty Ltd ACN 151 235 406.

Past performance is not a reliable indicator of future performance. This is general advice, which doesn’t consider your personal circumstances. Consider these and always read the product disclosure statement or seek professional advice prior to making any decision about a financial product. While care has been taken to prepare the content of this video, LIS makes no representation or warranty to the accuracy or completeness of the information presented, which is drawn from public information not verified by LIS. The information contained in this video is current as at the date of publication.

Copyright © 2020 Lonsec Investment Solutions Pty Ltd ACN 608 837 583

Strategic asset allocation (SAA) is a critical element of your investment strategy. It refers to how much of your capital you allocate across various asset classes when taking a long-term view of your portfolio. SAA drives the bulk of your risk and return outcome over your investment time horizon, which means it’s critical to review and update your SAA when appropriate to ensure your portfolio remains on target to achieving your investment objectives in a risk-controlled manner.

Lonsec formally reviews the SAA for its model portfolios every two years, including most recently in August 2020. The objective of our reviews is to ensure that the Lonsec strategic asset allocation framework remains robust and continues to be effective in achieving the stated objectives of each of our risk profiles in the long term. This has been an extraordinary year in terms of market movements and responses from governments in combatting the COVID-19 pandemic, but ultimately the principles driving our SAA have not changed.

Lonsec provides two sets of asset allocation risk profiles, one set comprising ‘traditional’ asset classes only and another incorporating ‘alternative’ asset classes. Both sets consist of six risk profiles ranging from Secure to High Growth. Lonsec formally reviews these strategic asset allocations every two years, combining qualitative and quantitative analysis.

The following offers an overview of how we have approached our SAA review this year in the wake of the global pandemic, and takes a look at some of the key issues investors should be considering in formulating their own asset allocation.

Take a long-term view

While COVID-19 has thrown up some unique challenges, the changes made to Lonsec’s SAA at this review have been relatively minor in nature. Market corrections are always uncomfortable, particularly while you are still in the midst of one, however it’s important to recognise that crises are relatively common in the context of long-term market behaviour. Over the last 50 years investors have lived through the oil crisis in the 70’s, the ’87 stock market crash, the Asian crisis, the Tech wreck, the Global Financial Crisis, and now the COVID-19 pandemic.

The quantitative impacts of these events are already captured in our long-term risk and return estimates, so it’s important not to extrapolate further. Cash rates have come down and risk premia have widened for most risk assets. This should benefit risk assets such as equities and real assets over cash and bonds. Bonds offer little in terms of expected returns, however they still play an important role in portfolios as risk-off diversifiers.

There have been two major outcomes at this 2020 review. Firstly, we have reclassified direct property as an alternative asset given it shares similar characteristics with other private market assets such as private equity. Secondly, the allocation to global small caps was removed, reflecting not only difficulties in accessing quality products in this space, but also the structural changes taking place where companies are generally electing to stay private longer.

The long-term absolute return objectives for each risk profile were lowered at this review, due to the cash rate being revised down from 3.0% p.a. to 1.7% p.a.. These absolute return targets are indicative numbers derived from the expected cash performance in the long run. Strategic asset allocation involves taking a very long-term view on asset class returns, but more importantly, it is a measure of asset class relativity. It is important to not overemphasize short to medium term expectations when defining a long-term strategic asset allocation framework.

The following table outlines the updated absolute return objectives and suggested investment timeframes for the Lonsec Risk Profiles (for both the traditional risk profiles and those with alternatives):

In order to develop realistic targets and optimise your allocation, you need to determine long-term capital markets assumptions, including asset class returns and volatility, which are forward-looking and are not directly related to current market valuations. Lonsec’s capital markets assumptions are determined through a combination of our own internal valuation models, consensus forecasts from fund managers, historical asset class performance, and our broader investment committee analysis and discussion.

Again, the need to take a long-term view is critical. Stepping outside the current market dynamic requires discipline, especially when news relating to the pandemic is all we hear and read about, but that it is purpose of your SAA.

Optimise your asset allocation

The next step is to optimise your asset allocation by taking your assumptions and efficiently combining risk and return exposures to create portfolios that are most likely to deliver on your target. Lonsec’s optimisation process draws on inputs such as forward-looking long-term asset class returns and historical risk and correlation data to arrive at a recommended set of portfolios.

It is important to note that a traditional mean-variance optimisation process has limitations. Notably, only statistical measures of risk (such as standard deviation) are considered, to the exclusion of other sector-specific risks such as concentration risk, default risk, liquidity risk, and duration risk. Lonsec applies appropriate constraints on selected asset classes during the optimisation process to mitigate these risks within our risk profiles. These are either ‘upper-limit’ constraints to limit the asset class exposures, or ‘zero allocation’ constraints, to eliminate asset class exposures from some of the risk profiles. Apart from these non-statistical risks, Lonsec has also assessed the appropriateness of each individual asset class across our risk profiles. For example, Lonsec considers any emerging market investments in the more conservative risk profiles as inappropriate.

The optimisation process is essential, not only because it makes your portfolio more efficient, but because it limits other potential risks and ensures your portfolio is in the best position to deliver on your objectives. Moving outside traditional approaches and taking a holistic view of your risks and objectives is key.

Test under different scenarios

We have set our long-term assumptions and optimised our allocations, but the job is not yet done. The final step is to test our portfolio allocations under a range of different investment scenarios to make sure our proposed framework is sufficiently robust.

Lonsec analyses how the change in diversification characteristics of asset classes under particular scenarios affects total portfolio outcomes. The optimisation process relies on one set of risk and return assumptions and long-term average correlations. While these inputs aim to capture the likely relationship between assets over the long term, there will be times when these relationships break down or are not as strong.

Certain investment environments can result in changes to the relationship between assets, which was seen during the GFC when many asset correlations increased. Lonsec generally considers different investment environments, such as inflationary, low economic growth, and market stress/crash, to see how the proposed frameworks behave. Lonsec also conducts forward-looking Monte Carlo simulations for each of its risk profiles, which generate a large number of simulated return paths based on different sets of underlying assumptions.

The primary purpose of the simulations is to examine not only the average simulated return and risk, but more importantly understand the value at risk of our risk profiles. The chart below displays the deviation in expected annual returns in any one year, with the coloured area representing the likelihood of each risk profile generating annual returns within this range over 50% of the time. The blue vertical line represents the likelihood of generating annual returns within this range 90% of the time.

Continue to review and update

Overall, Lonsec’s 2020 review has resulted in relatively minor changes to the strategic asset allocation across our risk profiles. As previously noted, the reclassification of direct property and the removal of global small caps as a discrete allocation saw some reallocation of capital in the real assets and equities sectors. Because SAA is based on a forward-looking, long-term view, typically SAA weights do not change dramatically, and this is why Lonsec only reviews them every two years. However, the process is essential to achieving your objectives, and the success of your portfolio depends on getting SAA right. Even after you have set your long-term allocations, you still need to come back to them and rigorously test the assumptions you have made.

IMPORTANT NOTICE: This document is published by Lonsec Investment Solutions Pty Ltd ACN 608 837 583, a Corporate Authorised Representative (CAR 1236821) (LIS) of Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec Research).  LIS creates the model portfolios it distributes using the investment research provided by Lonsec Research but LIS has not had any involvement in the investment research process for Lonsec Research. LIS and Lonsec Research are owned by Lonsec Holdings Pty Ltd ACN 151 235 406. Please read the following before making any investment decision about any financial product mentioned in this document.

DISCLOSURE AT THE DATE OF PUBLICATION: Lonsec Research receives a fee from the relevant fund manager or product issuer(s) for researching financial products (using objective criteria) which may be referred to in this document. Lonsec Research may also receive a fee from the fund manager or product issuer(s) for subscribing to research content and other Lonsec Research services.  LIS receives a fee for providing the model portfolios to financial services organisations and professionals. LIS’ and Lonsec Research’s fees are not linked to the financial product rating(s) outcome or the inclusion of the financial product(s) in model portfolios. LIS and Lonsec Research and their representatives and/or their associates may hold any financial product(s) referred to in this document, but details of these holdings are not known to the Lonsec Research analyst(s).

WARNINGS: Past performance is not a reliable indicator of future performance. Any express or implied rating or advice presented in this document is limited to general advice and based solely on consideration of the investment merits of the financial product(s) alone, without taking into account the investment objectives, financial situation and particular needs (“financial circumstances”) of any particular person. Before making an investment decision based on the rating or advice, the reader must consider whether it is personally appropriate in light of his or her financial circumstances or should seek independent financial advice on its appropriateness.  If the financial advice relates to the acquisition or possible acquisition of a particular financial product, the reader should obtain and consider the Investment Statement or the Product Disclosure Statement for each financial product before making any decision about whether to acquire the financial product.

DISCLAIMER: No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented in this document, which is drawn from public information not verified by LIS. The information contained in this document is current as at the date of publication. Financial conclusions, ratings and advice are reasonably held at the time of publication but subject to change without notice. LIS assumes no obligation to update this document following publication. Except for any liability which cannot be excluded, LIS and Lonsec Research, their directors, officers, employees and agents disclaim all liability for any error or inaccuracy in, misstatement or omission from, this document or any loss or damage suffered by the reader or any other person as a consequence of relying upon it.

Copyright © 2020 Lonsec Investment Solutions Pty Ltd ACN 608 837 583 (LIS). This document may also contain third party supplied material that is subject to copyright.  The same restrictions that apply to LIS copyrighted material, apply to such third-party content.

It has been an interesting month in markets. The S&P 500 Index reached 12 month highs with markets brushing off March’s COVID-19 panic. There have been many discussions about how narrow the rally has been in that a handful of stocks have driven the sharp rebound. In fact, just over 35% of stocks in the index have had a positive gain over the year. Leading stocks in the technology sector have been the winners, with Alphabet Inc (Google), Amazon.com Inc and Apple Inc rebounding strongly from March. Essentially, growth and quality stocks have been rewarded and the impact of COVID-19 on such companies has been minimal relative to other sectors. In some instances, the pandemic has accelerated growth for online retail businesses such as Amazon. On the other hand, there have been notable losers. Airlines, retail property and infrastructure assets such a toll roads and airports have been losers on the back of COVID-19. This divergence has been reflected in the recent Australian reporting season with companies such as JB Hi-Fi reporting record annual profits, while Qantas continues to cut more jobs as it prepares for a $10 billion revenue hit.

A key challenge for investors at the moment is whether to continue to back the ‘winners’ and pay more for growth, or to look for value amidst some of the ‘losers’ and try to identify a bargain. From a portfolio perspective we have taken the view that the current market conditions are favourable to quality/growth companies particularly given the low interest rate environment. However we also continue to have some exposure to the value part of the market, as we believe that some of the bad news has lowered the price of some of these sectors and that over the medium to long term there is an opportunity for these stocks to rebound.

While the current market dynamics are different to what we experienced during the tech bubble what is very similar is some of the narrative. I recall prior the collapse of the tech sector we were in a ‘new paradigm’ where value investing was dead and growth companies prospered. History generally doesn’t repeat but it can rhyme. Ensuring that your portfolios are not anchored to one part of the market and they remain diversified, particularly in an environment where uncertainly persists, remains important.

IMPORTANT NOTICE: This document is published by Lonsec Investment Solutions Pty Ltd ACN 608 837 583, a Corporate Authorised Representative (CAR 1236821) (LIS) of Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec Research).  LIS creates the model portfolios it distributes using the investment research provided by Lonsec Research but LIS has not had any involvement in the investment research process for Lonsec Research. LIS and Lonsec Research are owned by Lonsec Holdings Pty Ltd ACN 151 235 406. Please read the following before making any investment decision about any financial product mentioned in this document.

DISCLOSURE AT THE DATE OF PUBLICATION: Lonsec Research receives a fee from the relevant fund manager or product issuer(s) for researching financial products (using objective criteria) which may be referred to in this document. Lonsec Research may also receive a fee from the fund manager or product issuer(s) for subscribing to research content and other Lonsec Research services.  LIS receives a fee for providing the model portfolios to financial services organisations and professionals. LIS’ and Lonsec Research’s fees are not linked to the financial product rating(s) outcome or the inclusion of the financial product(s) in model portfolios. LIS and Lonsec Research and their representatives and/or their associates may hold any financial product(s) referred to in this document, but details of these holdings are not known to the Lonsec Research analyst(s).

WARNINGS: Past performance is not a reliable indicator of future performance. Any express or implied rating or advice presented in this document is limited to general advice and based solely on consideration of the investment merits of the financial product(s) alone, without taking into account the investment objectives, financial situation and particular needs (“financial circumstances”) of any particular person. Before making an investment decision based on the rating or advice, the reader must consider whether it is personally appropriate in light of his or her financial circumstances or should seek independent financial advice on its appropriateness.  If the financial advice relates to the acquisition or possible acquisition of a particular financial product, the reader should obtain and consider the Investment Statement or the Product Disclosure Statement for each financial product before making any decision about whether to acquire the financial product.

DISCLAIMER: No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented in this document, which is drawn from public information not verified by LIS. The information contained in this document is current as at the date of publication. Financial conclusions, ratings and advice are reasonably held at the time of publication but subject to change without notice. LIS assumes no obligation to update this document following publication. Except for any liability which cannot be excluded, LIS and Lonsec Research, their directors, officers, employees and agents disclaim all liability for any error or inaccuracy in, misstatement or omission from, this document or any loss or damage suffered by the reader or any other person as a consequence of relying upon it.

Copyright © 2020 Lonsec Investment Solutions Pty Ltd ACN 608 837 583 (LIS). This document may also contain third party supplied material that is subject to copyright.  The same restrictions that apply to LIS copyrighted material, apply to such third-party content.

As the ETF market expands, Australian investors are able to take advantage of new investment product innovations, implement a range of different strategies, and gain exposure to different markets and sectors. The depth of the ETF market has opened up opportunities to investors, but it also presents risks for the unwary.

Due diligence is essential when picking an ETF for your portfolio. Even if you’re looking for passive index exposure, not all ETFs are created equal. Experience and track record count, as does the robustness of the investment process and the risk management framework.

Some ‘smart beta’ approaches may be considered under a process which leverages the expertise of analysts covering active managed funds if there is a level of discretion or judgement. Also, the efficacy of the index being tracked should form a key consideration of your research efforts, especially in an environment of ever-increasing index proliferation and complexity. Below are the three key questions you should be thinking about when you’re on the hunt for the right ETF.

  1. What am I getting exposure to?

This is the first question you should ask. Sometimes you need to dig a bit deeper to discover more about an investment product’s risk and return characteristics, including the sectors, factors, or regions the product is targeting. Sometimes, a product may have unexpected risk and return outcomes during different market regimes, including periods of intense volatility or uncertainty.

Is the index concentrated in particular sectors, companies, or countries? Even if you are investing in an index, you need to be aware of your exposure. The US S&P 500 Index is market cap weighted, with significant weights to mega cap tech stocks like Apple and Amazon. In Australia, the financial services and materials sectors predominate the S&P/ASX 200 Index.

Do the holdings make sense in terms of the fund’s objectives? Investors need to look beyond the fund’s name or the index it tracks and examine the underlying holdings to understand the fund’s risk and return profile, and judge whether it adheres to its stated objective. Finally, look at how long the index has been around. Even as new indexes are constructed, the index provider’s tenure in the marketplace can indicate a measure of stability.

  1. Who is managing my money?

Finding out more about the provider and the investment team that sits behind the product is essential. How experienced is the ETF provider? Has been around through different market cycles and seen the best and worst of what the market can throw at you? Having experienced people in the senior investment team is important, but it can also lead to key person risk if the fund’s strategy is too reliant on the expertise of a small number of people, or if processes are not widely understood throughout the fund.

What are the fund’s and the manager’s total assets under management? Product break even points vary, but a useful rule of thumb is $50 million. Managers can sustain lower balances if it is part of a broader suite of products, but you should make sure there is a sufficiently deep pool of funds to ensure efficiency and scale. Greater assets under management can also enhance a fund’s liquidity.

How does the company manage risk? Ideally, there should be a disciplined investment process, broad market expertise, and sophisticated risk systems in place.

Does the company provide trading support and ongoing education? Trading support and actionable investment strategies can add value for investors, especially when it comes to incorporating the product within a broader portfolio. Good managers will be transparent about the type of investors the product is suitable for and how it to maximise the product’s value in a portfolio context.

  1. How am I getting exposure?

You need to know what you are exposed to, but just as importantly, you need to know how you are getting that exposure. Firstly, what is the index weighting methodology (market-capitalisation, price-weighted, fundamentally weighted, rules-based, or equal-weighted)? The weighting methodology has a major impact on performance and the risk/return characteristics among seemingly similar indices.

Does the ETF hold derivatives or synthetics? Derivatives can be an effective way to manage risks, but they can also add an additional element of complexity. Understanding how risk overlays work, how they behave under different market conditions, and the risk and return trade-offs they make, are all necessary for a complete due diligence.

How often is the index rebalanced? Frequent rebalancing will ensure closer index tracking, but increases turnover, trading costs, and potentially realised taxes. How many companies or bonds are in the index and what are the diversification guidelines? If the fund only partially replicates the index, it may invest in fewer securities, especially at the less liquid end of the market. Rather than holding every stock, it may hold a representative sample, but you should understand how this sample is determined.

Finally, what are the fund’s total fees? The fund’s management fee as well as the bid/offer spread needs to be considered as part of the total cost of transacting. High trading volumes can mean greater liquidity and usually also mean tighter spreads. Brokerage and tax should also be factored into your individual holding return.

Keep monitoring your portfolio

Once you have chosen the investment products that are the right fit for your portfolio, that isn’t the end of the story. You should monitor your investments and ensure that the products you picked continue to do what you expected of them. Sometimes investment teams change, liquidity events pop up, or the market enters a period of volatility. Keeping tabs on your portfolio means more than just checking your account balance. It requires ongoing due diligence to ensure that the people you entrust your money to are sticking to their mandate and delivering on their product’s promise.

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2020 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

The ETF market in Australia remains buoyant despite the ravages of COVID-19, with total FUM at 31 March 2020 of close to $57b, up 24% year-on-year despite the severe market sell off in March. Much of this growth has been driven from strong product innovation and subsequent fund inflows in non-Australian equity sectors, with the Equity Global Strategy, Fixed Income Australian and Global, Commodity, Global Infrastructure and Mixed Asset all recording +50% FUM growth. These were driven by a mix of long-standing market themes such as the quest for yield as well as the need for a defensive hedge against market volatility lead to gold ETF inflows.

As a postscript to the March data, the subsequent April 2020 has seen the ETP market record its second biggest month in history with over $1b in inflows according to BetaShares data. This along with the April recovery in equity markets led to FUM rising +$4b for the month to close at $61.3b; however this is still short of the all-time industry peak value of +$66b recorded in early 2020. In terms of the net flows, BetaShares data highlights that the strongest April flows were in Australian equities ($575m), Commodities ($264m) and Short ($234m). This was funded by net outlfows from Fixed Income ($224m). This data perfectly highlights the increasing role that ETFs are playing as an efficient vehicle to rebalance portfolios.

As an overall observation, the COVID-19 sell off has proven to be a strong stress test for the ETF market both in Australian and globally. This is not to say that is has all been smooth sailing, with the most acute issue having been that a number of local Fixed Income ETFs started to trade at sizable discount to NAV at the height of the March dislocation. Additionally, spreads on global equity ETFs tended to gap out considerably in March in the immediate aftermath of widely used NAV proxy the S&P500 futures contracts going into limit down on very volatile days. However, as a general rule price discovery remained solid across ETFs throughout. Additionally, the FED bolstered Fixed Income ETFs in the US when they announced that they would be in part be implementing QE measures by buying ETFs that track the corporate bond market.

The rise of the ’boutique’ issuers

While Vanguard and iShares remain the dominant passive ETF issuers in the Australian market, holding 33% and 26% of FUM respectively as at March 2020, boutique ETF innovators such as BetaShares, Van Eck and ETF Securities (collectively ‘the Boutiques’) continue to experience rapid growth. This has been at the expense of StateStreet, which now has significantly less FUM than BetaShares with Van Eck snapping at its heels.

The strong FUM momentum outside of what used to be the ‘big 3’, i.e. Vanguard, iShares and StateStreet, is due to a number of factors. The first is that of the ‘big 3’, only Vanguard has been issuing new ETFs. Neither iShares nor StateStreet has issued a new ETF in the Australian market for some time, which has been a change in the dynamic of the local market given the pivotal role both played in building the ETF sector in Australia. By contrast, Vanguard has issued seven new Lonsec rated ETFs in the last two years which include three active ETFs.

The second and most critical reason has been the strong execution on their business plans by the Boutiques. They have continued their strong roll-out of new ETFs, contributing 18 new ETF to the Lonsec rated universe over the last two years. BetaShares has been the most prolific, adding nine funds, while Van Eck added six and ETF Securities the remainder. Most of these products were issued in sectors outside of Australian equities including smart beta and regional global equities, Emerging markets including regional allocations (China, India), hard assets, credit, cash and ESG options.

Another area contributing to FUM growth is the success the Boutiques have had in growing a number of key ETFs to substantial scale. Again BetaShares has led the pack, with each of A200, FAIR, ETHI, NDQ, AAA, QPON and HBRD all having market caps above $400m and in the case of AAA now well above $1.6b. Van Eck has also had great success with two equity smart beta options, with each of MVW and QUAL having a market cap in excess of $800m. Finally, ETF Securities has seen the FUM of GOLD grow to above $1.6b.

Figure 1 – FUM Split by Issuer March 2020

Top 10 continues to be equity heavy

ASX CODE NAME $M
VAS Vanguard Australian Shares Index ETF 4,199.39
STW SPDR S&P/ASX 200 3,094.58
IVV iShares S&P 500 ETF 3,029.76
VGS Vanguard MSCI Index International Shares ETF 2,011.73
AAA Betashares Australian High Interest Cash ETF 1,682.88
IOO iShares S&P Global 100 ETF 1,678.67
VTS Vanguard US Total Market Shares Index ETF 1,677.14
GOLD ETFS Physical Gold 1,637.95
MGE Magellan Global Equities Fund (Managed Fund) 1,614.34
IOZ iShares Core S&P/ASX 200 ETF 1,582.18

VAS has continued its ascendancy as the largest ETF on the ASX with a market cap of approximately $4.2b despite the market impact of the COVID-19 sell off. IVV is closing in on STW for the second position, with both the relative outperformance of the S&P500 versus the ASX200, currency impacts and re-balancing to global equities closing the gap. AAA has continued to rise up the ranks in the last few years, driven by yield hungry investors interested in the listed enhanced cash space. Finally, GOLD has had strong inflows during recent more volatile markets and has also benefitted from strength in the gold price.

As an overall observation, the ‘top 10’ continues to be dominated by Australian and global/US equity ETFs. MGE, AAA and GOLD are the only active ETF in the cohort, with the remainder being passive trackers of mostly marketcap weighted beta indices.

LONSEC STRONGLY RECOMMENDS THIS DOCUMENT BE READ IN CONJUNCTION WITH THE RELEVANT PRODUCT DISCLOSURE STATEMENT IMPORTANT NOTICE. Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Lonsec receives a fee from the fund manager or financial product issuer(s) for researching the financial product(s), using objective criteria and for services including research subscriptions. Lonsec’s fee is not linked to the rating(s) outcome. Lonsec Investment Solutions Pty Ltd ABN 95 608 837 583 CAR (CAR: 001236821) of Lonsec receives fees under separate arrangement for providing investment consulting advice to clients, which includes model portfolios, approved product lists and other financial advice and may receive fees from this fund manager or financial product issuer for providing investment consulting services. Refer to the Conflicts of Interest Policy at: www.lonsec.com.au/aspx/IndexedDocs/general/LonsecResearchConflictsofInterestPolicy.pdf Lonsec does not hold the financial product(s) referred to in this document. Lonsec’s representatives and/or their associates may hold the financial product(s) referred to in this document, but details of these holdings are not known to the Analyst(s). Warnings: Past performance is not a reliable indicator of future performance. Any advice is General Advice based on the investment merits of the financial product(s) alone, without considering the investment objectives, financial situation and particular needs of any particular person. It is not a recommendation to purchase, redeem or sell the relevant financial product(s). Before making an investment decision the reader must consider his or her financial circumstances or seek personal financial advice on its appropriateness. Read the Product Disclosure Statement for each financial product before making any decision about whether to acquire a financial product. Lonsec’s research process relies upon the participation of the fund manager or financial product issuer(s). Should the fund manager or financial product issuer(s) no longer participate in Lonsec’s research process, Lonsec reserves the right to withdraw the document at any time and discontinue future coverage. The product rated in this publication may have related financial products or be associated with other financial products and platforms. The rating may only be applied to the financial product outlined in this publication at first instance, seek professional advice before you make an investment decision on related or associated financial products and platforms. You should be aware that the mandate, fees, underlying investments, the issuers of the related and associated financial products and platforms may be different from the financial product specified in this publication. Disclaimer: This document is for the exclusive use of the person to whom it is provided by Lonsec and must not be used or relied upon by any other person. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented in this document, which is drawn from public information not verified by Lonsec. Financial conclusions, ratings and advice are reasonably held at the time of completion but subject to change without notice. Lonsec assumes no obligation to update this document following publication. Except for any liability which cannot be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error or inaccuracy in, misstatement or omission from, this document or any loss or damage suffered by the reader or any other person as a consequence of relying upon it. ©2020 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

Gold has been in the headlines over the last couple of weeks, as the price of gold has recently surpassed the much anticipated $2,000 per ounce mark. The gold spot price is up approximately 26% in USD for the year as at 30 June 2020 compared to the Australian equities market (S&P/ASX 200), which is down just over 7% for the same period. So, why has gold appreciated? Gold has historically been viewed as a safe haven asset in times of uncertainty, it is viewed as a store of value offering protection against inflation and has also offered diversification benefits from traditional asset classes such as equities.

Over the past 12 months we have seen uncertainty dominate markets. In 2019 geopolitical tensions particularly between the US and China on trade contributed significantly to market volatility and overall nervousness in market. Roll forward to 2020 and we have been hit by a global health pandemic, geopolitical tensions have increased between the US and China and to add to this we have witnessed increased civil unrest in the US and we have a highly politicised US presidential election coming up. The elevation of macro-economic and geopolitical risks has increased ‘flight to quality’ episodes at the same time monetary policy is becoming less potent and low to negative rates reduce the opportunity cost of holding gold. Furthermore, the debasement of the USD has increased the preference of gold as a ‘safe haven’ asset relative to the USD.

From a portfolio perspective Lonsec views gold as an alternative asset. The low correlation to traditional assets enhances portfolio diversification, particularly in times of uncertainly. Given the increased uncertainly in the macro economic and geopolitical environment Lonsec added gold to the Lonsec Multi-Asset Portfolio on 17 March via the GOLD (ticker code) ETF which provides exposure to physical gold. We have subsequently also incorporated GOLD in our Listed Diversified Portfolios in both instances sitting within an alternatives allocation. The exposure has performed as expected, helping smooth portfolio returns in periods of market stress. Outside of providing diversification gold can also assist in hedging inflation risk. While we do not foresee inflation as a near term risk inflation pressures may emerge down the track particularly if we see global supply chains reconfigure and manufacturing industries come back onshore which would see a likely jump in inflation.

It is however important not to view gold as some kind of investment panacea. In non-stressed market environments gold will likely lag risk assets. Returns in USD have been around the 3 to 4% mark in stable market environments. Furthermore, gold can be volatile and 20% drawdowns are not uncommon therefore portfolio position sizing is important.

Whilst the gold price hitting the $2,000 milestone is significant, what’s more important is that if we are heading into a period of increased bouts of volatility, having exposure to assets that can perform in such environments should assist in dampening the adverse impacts on portfolios.

IMPORTANT NOTICE: This document is published by Lonsec Investment Solutions Pty Ltd ACN 608 837 583, a Corporate Authorised Representative (CAR 1236821) (LIS) of Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec Research).  LIS creates the model portfolios it distributes using the investment research provided by Lonsec Research but LIS has not had any involvement in the investment research process for Lonsec Research. LIS and Lonsec Research are owned by Lonsec Holdings Pty Ltd ACN 151 235 406. Please read the following before making any investment decision about any financial product mentioned in this document.

DISCLOSURE AT THE DATE OF PUBLICATION: Lonsec Research receives a fee from the relevant fund manager or product issuer(s) for researching financial products (using objective criteria) which may be referred to in this document. Lonsec Research may also receive a fee from the fund manager or product issuer(s) for subscribing to research content and other Lonsec Research services.  LIS receives a fee for providing the model portfolios to financial services organisations and professionals. LIS’ and Lonsec Research’s fees are not linked to the financial product rating(s) outcome or the inclusion of the financial product(s) in model portfolios. LIS and Lonsec Research and their representatives and/or their associates may hold any financial product(s) referred to in this document, but details of these holdings are not known to the Lonsec Research analyst(s).

WARNINGS: Past performance is not a reliable indicator of future performance. Any express or implied rating or advice presented in this document is limited to general advice and based solely on consideration of the investment merits of the financial product(s) alone, without taking into account the investment objectives, financial situation and particular needs (“financial circumstances”) of any particular person. Before making an investment decision based on the rating or advice, the reader must consider whether it is personally appropriate in light of his or her financial circumstances or should seek independent financial advice on its appropriateness.  If the financial advice relates to the acquisition or possible acquisition of a particular financial product, the reader should obtain and consider the Investment Statement or the Product Disclosure Statement for each financial product before making any decision about whether to acquire the financial product.

DISCLAIMER: No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented in this document, which is drawn from public information not verified by LIS. The information contained in this document is current as at the date of publication. Financial conclusions, ratings and advice are reasonably held at the time of publication but subject to change without notice. LIS assumes no obligation to update this document following publication. Except for any liability which cannot be excluded, LIS and Lonsec Research, their directors, officers, employees and agents disclaim all liability for any error or inaccuracy in, misstatement or omission from, this document or any loss or damage suffered by the reader or any other person as a consequence of relying upon it.

Copyright © 2020 Lonsec Investment Solutions Pty Ltd ACN 608 837 583 (LIS). This document may also contain third party supplied material that is subject to copyright.  The same restrictions that apply to LIS copyrighted material, apply to such third-party content.

Super funds have started the new financial year with some positive momentum but face a period of stark uncertainty as Australian cases of Covid-19 rise and Victoria enters harsher lockdown conditions.

While we have seen stabilisation in markets, they remain vulnerable to further shocks, while super fund performance is contingent on how communities and economies cope with further waves of infections.

According to estimates from leading superannuation research house SuperRatings, the median balanced option returned 0.9% in July as markets continued to rebuild following March’s falls. Overall, super funds have made it through in good shape but are preparing for more market ups and downs through the rest of the 2020 calendar year.

“The outlook is still unclear but based on recent performance super funds have shown they can weather the Covid-19 storm,” said SuperRatings Executive Director Kirby Rappell.

“Looking at SuperRatings’ balanced option index, the sector is 4.0% below where it was at the start of 2020. This is less than ideal for members, but thanks to the recovery we saw over the June quarter we have already made up a lot of ground. Hopefully this momentum can continue, and members can swiftly regain their super wealth.”

According to SuperRatings’ estimates, the median balanced option is down 1.2% over the 12 months to July. The median growth option is estimated to have fallen -1.7% while the median capital stable option is steady at 0.5%.

Accumulation returns to end of July 2020

  CYTD 1 yr 3 yrs (p.a.) 5 yrs (p.a.) 7 yrs (p.a.) 10 yrs (p.a)
SR50 Growth (77-90) Index -5.1% -1.7% 5.8% 5.9% 7.7% 7.8%
SR50 Balanced (60-76) Index -4.0% -1.2% 5.5% 5.3% 6.9% 7.4%
SR50 Capital Stable (20-40) Index -0.9% 0.5% 3.7% 3.8% 4.6% 5.1%

Source: SuperRatings estimates

Pension returns have performed more or less in line with accumulation returns over the past year. The median balanced pension option is estimated to have fallen 1.2% over the 12 months to July, compared to a drop of 1.9% from the median growth option and a modest rise of 0.5% from the median capital stable option.

Pension returns to end of July 2020

  CYTD 1 yr 3 yrs (p.a.) 5 yrs (p.a.) 7 yrs (p.a.) 10 yrs (p.a)
SRP50 Growth (77-90) Index -5.6% -1.9% 6.5% 6.7% 8.5% 8.7%
SRP50 Balanced (60-76) Index -4.1% -1.2% 6.0% 6.0% 7.5% 8.1%
SRP50 Capital Stable (20-40) Index -1.0% 0.5% 4.3% 4.3% 5.1% 5.8%

Source: SuperRatings estimates 

July’s results represent the fourth month in a row of positive returns for super, following the 9.2% drop members experienced in March. While the results are promising, there is still a way to go before members recoup their losses, and the Covid-19 situation in Australia remains precarious as other states brace for potential spikes in infections.

“We can certainly take heart from recent performance, but we should not underestimate the challenge that we still face,” said Mr Rappell.

“Markets are incredibly difficult to navigate at the moment. Globally, we are seeing a disconnect between the rise in share valuations and the weakness in economic data. Meanwhile, the low yield environment will only be exacerbated by governments issuing more debt to shore up budgets and continue providing support to those affected by the virus.”

Growth in $100,000 invested over 15 years to 30 July 2020

Source: SuperRatings estimates

Taking a long-term view, super returns have done an incredible job at accumulating wealth for retirees over a period that includes two major financial and economic crises. According to SuperRatings’ data, since July 2005, a starting balance of $100,000 would now be worth $235,877 for members in a balanced option. For a growth option this would be slightly higher at $236,235. A member with full exposure to Australian shares would have seen their balance growth to $254,188. In contrast, returns on cash would have seen the balance grow to only $157,939.

With central bankers around the world committing to keep interest rates low for many years to come, this creates an issue for retirees looking for income. Traditional defensive assets such as cash and fixed income which typically form a large percentage of retiree portfolios are producing levels of income significantly below historical averages.

In Australia, the RBA is keeping the 3-year yield for government bonds at 0.25%, in what is known as yield curve control. Interest rates have been suppressed for the last decade, however what is unique about the current economic climate, is that with inflation yet to emerge and central bankers focused on generating growth and employment, their signalling to the market has moved further out. Lower for much longer!

Thanks to Covid-19, investors face “lower for even longer” when it comes to yields. With interest rates at historic lows and around a third of ASX-listed companies having suspended, cancelled, or revised dividend payments, generating the same level of income that investors have enjoyed in the past is becoming ever more challenging.

In this environment it is understandable that investors might start to view yield as overrated, especially if they are seeing potential growth opportunities that are going begging. Aiming for total returns and drawing down on capital as needed might seem like a smarter way to fund your retirement. However, while a total return strategy is valid, it comes with risks that all retirement investors should be aware of. In fact, the Covid-19 situation is itself the perfect example of how a total return strategy can come unstuck.

Drawing down on capital to provide regular income might work when markets are rising and volatility is relatively low, but when a crisis hits, investors can end up sacrificing more capital than they desire. This can be detrimental to your client’s ability to regrow their capital following a period of sustained losses, making it more likely that they will fall short of their retirement funding needs. It may be harder to target yield in this environment, but you should not neglect it as core building block of your client’s portfolio.

Where to find income in a Covid-19 world

Generating income was already challenging before the Covid-19 outbreak. Now, with companies hit incredibly hard by lockdown measures and central banks embarking on unprecedented easing measures, it is more difficult than ever before.

Lonsec has analysed its own retirement portfolios and factored in a 30% cut to dividends across its entire equity and A-REIT book. Over the next 12 months, Lonsec expects that yield will fall well short of the long-term yield target of 4%, especially for lower risk profile portfolios. It expects yield to be maintained at this level in the long-run and to pick up once companies begin paying dividends again in the latter part of next year, but in the meantime it is going to be an uphill battle.

The question is how to target additional sources of income without materially adding to risks in the portfolio. The key here is diversification. Just as it is important to diversify across your growth assets, it is equally important to diversify sources of yield. Even within equities, there are many ways fund managers are able to gain exposure to different sources of income. In the fixed income space, this means looking beyond safe but relatively low-yielding government bonds to things like corporate credit and syndicated loans, where informed asset selection and prudent portfolio construction can deliver solid results.

This is where an active portfolio approach can make a big difference by giving investors the flexibility to take advantage of the opportunities that have arisen to source additional sources of income for multi-asset portfolios. Certain sources of credit and syndicated loans are something Lonsec looked at carefully as the Covid-19 crisis hit.

Leading up to the crisis, some areas of the credit market were looking overpriced, but recent market dislocation has thrown up some potential opportunities for close observers. In our conversations with fixed income fund managers, especially back in March when bond markets were all but locked up, one common theme was the emergence of value and the sudden appearance of opportunities that had not been seen in that area for many years.

Lonsec took advantage of this situation and made some key changes to its own retirement portfolios. It added the Bentham Syndicated Loans Fund, which is a sub-investment grade strategy that offers a higher yield than those with an investment grade focus, and the Ardea Real Outcome Fund, which offers a return source that is not dependent on duration or credit risk. Lonsec also increased its exposure to Talaria Global Equity, a strategy that sources much of its income from option premia and tends to benefit from these types of environments when volatility is elevated.

Yield should form a key building block of your retirement portfolio

Once again diversification and risk management are key, but an active portfolio approach can allow investors to pull a number of different levers to generate higher income returns without materially altering the risk characteristics of their portfolio. Targeting income is not always easy, and investors will still need to manage their expectations, but it can done, even in the current environment.

Falling back on a total return approach to generate your required income is possible, but it can leave investors exposed during a crisis. As the following section explains, it is worth getting the income component of your retirement portfolio right.

Sequencing risk is real, and not just for those transitioning to retirement

While market bumps are nothing to be feared for those building wealth, a sudden major event like the Covid-19 pandemic can spell disaster for those entering the decumulation phase. While we will inevitably experience losses, both in the leadup to and during retirement, the timing of losses can matter a great deal.

Sequencing risk refers to the order in which investors experience returns, and it can have a big impact on retirement outcomes. Making withdrawals during a falling market has the potential to accelerate the depletion of capital. This is why going for total returns can be risky, especially during the period we are in now, where there is heightened market volatility and a lot of uncertainty regarding a potential second wave of infections and further lockdown measures.

If your client’s portfolio is not structured appropriately, they could end up drawing down on their capital at a time when it is been heavily depleted by large market losses. This could leave them exposed to much greater sequencing risk than you they might have envisaged.

When capital returns are potentially high and yields are low, it is natural that investors will consider a total return approach to achieve their objectives. However, we should beware the risks. Capital growth is still a core objective, even for those in the retirement phase, but we should be careful how much capital we are prepared to sacrifice to meet out income needs. Inevitably, we may find ourselves getting by with less income that we hoped, but this is better than the alternative.

As soon as disaster strikes, and we face very subdued capital returns or even an extended bear market, that is when a well-structured portfolio delivers real value. That is why you should focus on growth, yield, and risk control as individual portfolio building blocks. We might need to be smarter about how we source our income, and more active and flexible in our approach, but it is worth it if we want to weather a crisis.

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2020 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

When we think of the most important components of our portfolio, it is easy to overlook cash. Investors seeking to diversify their investments will typically keep a portion of their funds in cash or enhanced cash funds to ensure a readily available funding source for expenses or to allocate to other assets. Despite the importance cash plays in our portfolio, we tend not to focus heavily on the risks that enhanced cash funds can pose during periods of market stress.

As the Covid-19 pandemic rolls on, with further lockdowns and more stringent social distancing measures in some parts of the world, it is critical that we learn the lessons of the dislocation that hit credit markets in March. This means taking a close look at the risks inherent in enhanced cash products and how to mitigate them to create a more robust portfolio, especially during bouts of volatility.

As a relatively low risk, defensive asset, investors typically expect their cash to provide regular income and capital stability within their diversified portfolio. Some investors, in order to generate enhanced returns relative to cash funds, invest in enhanced cash products that carry greater risks that some investors may not always be fully aware of. These risks have come to light in recent months and emphasized the need to carefully manage the cash component of your portfolio.

Enhanced cash products in the past few months have been impacted by the Covid-19 health crisis, which has caused financial market volatility the magnitude of which was last seen during the Global Financial Crisis (GFC) in 2008-09. This volatility has caused the Reserve Bank of Australia (RBA) to reduce the official cash rate to a record low 0.25% and hold the yield curve out to three years in a range around the same level.

Record low interest rates have significantly reduced the income received by investors, and this problem has been further compounded by capital stability concerns as financial markets turmoil has seen the price of some cash assets fall and yields rise relative to the RBA cash rate. As a result, some enhanced cash funds in this record low yield environment surprised unit holders by producing negative absolute returns during the March quarter, while other enhanced cash funds continued to produce positive returns, albeit with relatively low yields.

This has served as a timely reminder that you need to look at not only the returns but also the risk characteristics of individual enhanced cash products. This is critical in order to understand the impact of financial market volatility on the risk of your cash holdings.

Enhanced cash funds are exposed to credit risk, term risk, and liquidity risk. These refer respectively to the risk of losing capital due to default by security issuers, the changes in interest rates that adversely affect the price of the securities, and the inability to convert the securities into cash without any loss of capital. Given these risk factors, the returns for enhanced cash are sourced from each of these risks accordingly (i.e. credit premium, term premium, and liquidity premium). Among all the premiums, credit premium is typically the main contributor of enhanced cash fund returns when compared to cash fund returns.

Enhanced cash products typically invest in high quality investment grade securities and cash accounts with an average credit rating of A+ or A1, where the probability of losing capital or suffering delayed payments is very limited. These investments may include overnight cash accounts, bank bills, promissory notes, asset-backed securities such as registered mortgage-backed securities (RMBS) and floating rate notes (FRNs) issued by semi-governments, and corporates, all of which are common constituents of enhanced cash strategies.

Of these securities, RMBS and FRNs are assets that are sensitive to price movements, which in the current Covid-19 situation are at risk of becoming stressed if credit and liquidity conditions deteriorate. As a result of stressed market conditions, some of these security prices are adjusted lower. Enhanced cash fund unit prices become materially impacted and those investors looking to redeem their funds may find the fund product’s sell spread has widened or redemption price has risen materially.

This sell spread change considers the increased trading costs during such a volatile period, which is passed on to the investor redeeming their funds, rather than impacting unit holders that remain in the fund.

These lower unit prices and increased transaction costs caught investors unawares in March and caused some enhanced cash funds to achieve short-term negative returns. A stressed liquidity and credit experience with enhanced cash funds also occurred during the GFC. The severity and duration of the GFC was different to the current crisis, and many enhanced cash funds recaptured their underperformance relative to cash funds following the GFC. The lesson is that the search for additional return beyond cash rates, which comes with increased risk, must be done cautiously.

On average, enhanced cash products usually have within the fund securities with a longer weighted average life or maturity than traditional cash funds. This longer maturity profile exposes enhanced cash funds to greater interest rate risks and therefore an expected higher term premium. When interest rates are falling, enhanced cash funds with their longer maturities benefit from the rise in securities prices and receive a capital gain greater than a cash fund. However, when interest rates are rising, enhanced cash funds are at a slight disadvantage because of this interest rate risk when compared to cash funds.

Overall, given current financial market conditions, it is important to take a closer look at enhanced cash funds and make prudent assessments based on the different risks they are exposed to. Compare the credit risks, maturity profile (also known as duration), and liquidity, both across individual enhanced cash products and compared to cash funds and understand the trade-off that is being made to achieve a higher return. It is important to critically assess these differences, especially during downside scenarios and periods of heightened uncertainty.

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2020 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

Important information: Any express or implied rating or advice is limited to general advice, it doesn’t consider any personal needs, goals or objectives.  Before making any decision about financial products, consider whether it is personally appropriate for you in light of your personal circumstances. Obtain and consider the Product Disclosure Statement for each financial product and seek professional personal advice before making any decisions regarding a financial product.