Why Managed Funds Their Role in Asset Allocation

Why Managed Funds & Their Role in Asset Allocation By Bruce Baker BSc MBA DFP Certified Financial Planner Director Puzzle Financial Advice Pty Ltd, AFS licence 230050 An independently-owned financial planning business http: //www. puzzlefinancialadvice. com. au Attempting to look into the future is fraught with difficulty. Failure to attempt to do so is reckless. Warren Buffett “It is better to be approximately right than precisely wrong. ” www. puzzlefinancialadvice. com. au AIA presentation 20/10/07

Why Managed Funds & Their Role in Asset Allocation • For many astute investors • Interested in building a non-simplistic portfolio • Managed Funds provide: – building blocks – To construct a portfolio – Targeted at producing better than average results AND – Avoiding some major current risks • Listed & unlisted managed funds have a role www. puzzlefinancialadvice. com. au

Today’s presentation • Quick review of basics of modern portfolio theory • Then need to consider – What are the current major investment risks? avoid. – Inflation outlook? Inflation/deflation both BIG risks now. – What are the 10 -15 year investment opportunities? over-weight. – Risk management strategies for these times • These determine best current asset mix (sectors) – then seek best investment building blocks – To achieve target asset allocation • listed or unlisted • managed or direct. • Some of best building blocks are managed funds www. puzzlefinancialadvice. com. au

Professor Harry Markowitz • Nobel Prize 1990 – for contributions to Portfolio Theory. • When building an optimal portfolio – “Risk means facing the possibility of losing rather than winning. ” – “The riskiness of a portfolio depends on the covariances of its holdings, not on the average riskiness of the separate investments. ” – Investors should create an efficient frontier of efficient portfolios, then choose an acceptable level of risk. www. puzzlefinancialadvice. com. au

Markowitz’s ideas in practice • This graph shows how blending 2 investments whose volatility is independent, we can reduce investment risk www. puzzlefinancialadvice. com. au

James Tobin - Nobel Prize 1981 • The Separation Theorem “argues that the Markowitz process of selecting securities for the most efficient risky portfolio is completely separate from the decision of how to divide the total portfolio between risky and risk-free assets. ” Share selection decision independent of risk selection decision How much cash ? Which shares? Markowitz How much risk = how much “cash”, Tobin. Conclusion: The risk-averse retiree should use the same stocks as the “aggressive” young executive www. puzzlefinancialadvice. com. au - just different amounts cash.

Lets apply this basic theory to NOW • A key to successful investing in these risky times • Is to choose your portfolio building blocks carefully. • Biggest mistakes: – Over-concentration on highly-correlated assets – Diversifying for the sake of it • you are putting un-necessary extra risk into your portfolio – Investing in assets that very expensive assets • Eg follow the herd into a bubble • Need to look carefully at valuations and warnings from history www. puzzlefinancialadvice. com. au

Record Debt Bubble This is the scariest current risk Risk 1. Deflationary crash Not sustainable • This chart does NOT provide a timing indicator for any future event. Just identifies a major risk. www. puzzlefinancialadvice. com. au

Record Global Liquidity • Milton Friedman: – To the extend we have excess money supply we should get inflation. – Yes, we have seen massive asset price inflation – last 12 years – Has not yet fed into consumer price inflation. Risk 2. Serious inflation Cause of last 12 -years of great returns That which gives can take away Liquidity bubble is not sustainable www. puzzlefinancialadvice. com. au

So what? • Period of economic extreme – the like of which has never been seen before – Precursors both • to economic depression – deflation • To very nasty inflation • Both of which can cause extreme volatility – Bill Gross – economy is like a drunk on tightrope • wobbling between fire (inflation) and ice (deflation). • There is no historical precedent – Creating great investment uncertainty • This time is different – At least from any period of recent decades – Some similarity with lead-up to some extreme past events www. puzzlefinancialadvice. com. au

What other warnings is history providing? • 100 -year average returns is about 6%pa real for shares • But typically 20 years of ~14%pa real followed by – 15 years of negative real returns eg -1%pa real – For the West, the current bull market started 26 yrs ago • Longest ever major bull market Risk 2. Western share markets centred on USA to have poor returns. www. puzzlefinancialadvice. com. au

I think USA really commenced long bear market in 2000 Chart from Professor Robert Shiller – author “irrational exuberance” who was one of those to say the US had a share market bubble in late 1990 s – and says that the US has a property price bubble now. www. puzzlefinancialadvice. com. au

Liquidity bubble is creating a cluster of bubbles US real house prices 1890 -2006 is normally steady. Reversion to the mean would be very ugly Chart from Professor Robert Shiller – author “irrational exuberance” who was one of those to say the US had a share market bubble in late 1990 s – and says that the US has a property price bubble now. Dot Com, Large Growth in 2000 Uranium, Nickel, other base metals? , housing? Western property generally? www. puzzlefinancialadvice. com. au

But are all markets in the same phase of the cycle? • Long-cycle mood swings between overoptimism and over-pessimism Which of the following, does history tell us tends to be most attractive? Markets that have boomed over the last 26 years OR Bottoming markets after 15 years down? www. puzzlefinancialadvice. com. au

Japan is at a very different stage in cycle www. puzzlefinancialadvice. com. au

And Asia non-Japan Goldman Sachs Asia non-Japan currency & asset price appreciation set for decades ahead www. puzzlefinancialadvice. com. au And is China & India to do to US, what US to Europe in the last half of 1800 s.

And Asia-non-Japan drives resource super cycle for decades • The experience of emerging Japan & Korea points towards this • For example www. puzzlefinancialadvice. com. au

In a world of fiat currency, with central banks “printing money”, shouldn’t you be assessing your investment returns in a “real” currency like Gold? Dow Gold Index www. puzzlefinancialadvice. com. au

What role should precious metals play? Gold price in A$ www. puzzlefinancialadvice. com. au

Some key themes for long-term investors • Shares – Overweight Asia – possible bubble developing • Managed funds – Overweight Japan • managed funds – Little exposure to USA • no broadly-held International share funds – Resources – may develop into a bubble in this climate • Including energy – remember peak oil + Asian demand • managed funds (Listed & non-listed) and/or direct – Expect high volatility in the above • Property (including infrastructure) – Look for Asian exposure including Japan – eg listed managed funds • Cash – (including Gold Bullion eg ETF) – may develop into a bubble in this climate Be prepared for periods of extreme volatility so don’t take too much risk Major economic shocks are likely over next few years www. puzzlefinancialadvice. com. au

Be prepared for periods of extreme volatility • Major economic shocks are likely over next few years • At some point I think we will see a deflationary crash – When virtually everything will fall in price – Might be some years away • And we might see very nasty inflation before that • So go with the flow – Deal with the risks as they emerge • Don’t take too much risk – wild downswings in various asset classes likely – But also inflation risk means • it is also important to take enough of the right risks www. puzzlefinancialadvice. com. au

Summary: Why Managed Funds? Listed and unlisted • • Because they broaden your choices to build a more robust portfolio to suit your needs, objectives & constraints for these very risky times. • Bruce Baker BSc MBA DFP • Certified Financial Planner • Director, Puzzle Financial Advice Pty Ltd • http: //www. puzzlefinancialadvice. com. au Warren Buffett “It is better to be approximately right than precisely wrong. ” www. puzzlefinancialadvice. com. au

THE END Mission of Puzzle Financial Advice “To be researcher & financial-advice partner to experienced investors seeking high-quality, conservative, unconflicted, soundly-researched tax planning and investment advice. ” www. puzzlefinancialadvice. com. au

2004 share of world GDP www. puzzlefinancialadvice. com. au

2025 share of world GDP www. puzzlefinancialadvice. com. au

This makes China less of a “tiger” than its neighbors - UBS www. puzzlefinancialadvice. com. au

www. puzzlefinancialadvice. com. au

And has the last 12 years actually already been a nasty period of inflation? • If you were sitting on a pile of cash through this period, the assets you can buy today is far less than 12 years ago. www. puzzlefinancialadvice. com. au

In summary, implications for portfolios • Beware investing in USA • 10 -15 year winners likely to be – – Asian shares and property Resource Companies incl Energy (Peak Oil) Commodities eg Gold Maybe infrastructure – global infrastructure deficit may provide opportunities? • Australia – a leg in West, a leg in Asia – Continued two-speed economy • BUT the extreme ratios and global imbalances together the extreme and opposite inflationary and deflationary forces suggest: – – – extremes in volatility likely can’t expect long-term average returns that investing and forgetting might not be smart That blind wide diversification might be dangerous That timing is probably very important www. puzzlefinancialadvice. com. au

• http: //www. nowandfutures. com/key_stats. html 16/9/07 www. puzzlefinancialadvice. com. au