The Australian equities market has had the wobbles at times this year, which is bad news for the multitude of investors who have filled their investment portfolios with local shares.
The uncertainty around the medium-term performance of the local bourse is one reason experts encourage investors to take a portfolio approach to investing.
This involves ensuring your money is invested in ASX-listed shares and other asset assets such as international equities, fixed interest and property.
Arnie Selvarajah, chief executive of online broking business, Bell Direct, says this is useful if you want to develop a defensive strategy. This is an approach to investing to help protect your investment when markets are volatile or dropping.
Selvarajah says investors who wish to take this approach should create a portfolio whose assets are capable of delivering consistent growth, as a result of stable underlying performance, to help drive cash flows and yield.
“The portfolio should perform well relative to the market, regardless of cycles,” he explains.
In general, Selvarajah says investors should look for assets with a price-to-equities ratio is below 17. This is because the average P/E ratio is about 17. So assets whose P/E is less than this have the potential rise above the average level, delivering a good return. A price-to-earnings ratio is a measure of a stock’s share price to its earnings per share.
Assets in the utilities and health sector often fit the defensive category. Says Selvarajah, “These businesses tend to perform better in down cycles because people still use their products and services.”
While sector selection is important, it’s also possible to build a defensive portfolio through the right choice of asset classes.
Matt Heine, joint managing director of wealth management business netwealth Investments, says the traditional approach to building a defensive portfolio is by having a higher allocation to low-risk asset classes such as cash, fixed interest or other income-generating assets. But there is an increasing trend to use active asset allocation when managing a portfolio, switching in and out of assets depending on current market conditions.
“This seeks to reduce exposure to asset classes that are expensive or overvalued and take advantage … [of] asset classes that seem cheap or are undervalued, therefore reducing the volatility of a portfolio and seeking to smooth the return,” says Heine.
But Michael Miller, financial adviser, MLC Advice Canberra, has a different perspective. “Unless you have a very specific view that a market is going to turn quickly, it can be a good idea to make changes to your portfolio gradually rather than all in one move. This reduces the risk of getting your timing wrong, and could also save on tax if you have a high level of capital gains in your existing portfolio,” he advises.
Miller’s favourite method for moving a portfolio to a more defensive footing is to start by turning off all the dividend, distribution and rent re-investment plans.
“A good growth portfolio will still throw off a healthy amount of income each year which, if you keep as cash or re-invest into something more defensive, will build that side of your portfolio without having to incur capital gains tax and brokerage on the sale of existing growth assets,” he explains.
If you need to make a bigger move and sell some of your existing growth assets, to move the capital to a more defensive asset, make sure to review the tax position of your assets.
Says Miller, “A capital loss can be used to offset a gain in the same year, so selling an asset that has made a loss in the same financial year as selling one that has made a profit, might mean you don’t have a capital gains tax bill overall.”
Peta Tilse is the managing director of Sophisticated Access, an online investor certificate registry, and a former portfolio manager. She says the problem for investors who want to build a defensive strategy by investing in lower-risk assets, such as cash, over the last 12 months is that term deposits are delivering a return of between 2 per cent and 3 per cent, which doesn’t meet investment return objectives for most.
“Investors have been moving up the risk spectrum to meet return requirements. They’ve been buying the newer bank hybrids in lieu of term deposits, but the risks just aren’t the same,” she explains.
As Tilse notes, hybrid instruments – which combine equity and debt features – have an attractive yield. They can behave like a fixed interest investment in the good times and more like equities when market volatility increases. But they are riskier than term deposits and cash and investors who choose hybrids need to be conscious of this.
Given the uncertain nature of the market at the moment, and the low returns cash and fixed interest investments are producing, investors are showing a greater interest in alternative investment strategies. This is a broad category of assets that can include mortgage-backed securities and unlisted property trusts, for example.
Assets in this class typically have the potential to generate higher than average returns, to help improve a portfolio’s overall performance. But they also carry higher risks than other asset classes such as fixed income, which is why often only a small proportion of the investor’s total assets is tipped into the alternative bucket.
Tilse says investors have been turning to defensive strategies as markets have reacted to events such as unconventional monetary policies in the United States, Europe and Japan, and ongoing volatility in Greece’s economy.
“Investors need to be mindful of these sorts of changes, as markets are global and will impact us here,” she says.
While every investor’s approach will be different, taking a portfolio approach and investing across multiple asset classes in this environment, can help to protect returns from the ongoing machinations in global financial markets.