BUILDING PRACTICE VALUE USING DIRECT INVESTING LPAC ... BUILDING PRACTICE... · portfolio? So as you ponder these questions, you should find the following chapters to be of interest

LPAC LEADERS RETREAT 1

BUILDING PRACTICE VALUE USING DIRECT INVESTING

LPAC LEADERS RETREAT FIJI 2014

THE ESSENTIAL DIRECT INVESTING TOOLKIT FOR SMSF ADVISERS


“Terrific conference Tony, it was a pleasure

to be part of it and surrounded by anything

but average financial planners and

presenters”

CHAPTER ONE

THE RISE OF SMSF’S AND DIRECT

INVESTING

~ Bill Keenan, Lonsec

CHAPTER TWO

IMPLEMENTING MODEL PORTFOLIOS –

SOLUTIONS FOR SMSF ADVISERS

~ David Heather, Managed Accounts

CHAPTER THREE

BUILDING PROFITABLE SMSF ADVICE

BUSINESSES

~ Michael Drage, Nakodo

CHAPTER FOUR

NAVIGATING THE HYBRID HIGHWAY

~Barry Ziegler, Head of Fixed Income, Bell Potter

CHAPTER FIVE

TAKING IT TO THE NEXT LEVEL:

PROTECTED EQUITY LOANS

~Dr Tony Rumble (LPAC)

CHAPTER SIX

PUTTING IT ALL TOGETHER:

USING ETF’S TO HELP MANAGE

SEQUENCING AND LONGEVITY RISK

~ Vinnie Wadhera, CIMA, BetaShares

CHAPTER SEVEN


REAL RETURN, MULTI-ASSET ETF

PORTFOLIOS USING DYNAMIC ASSET

ALLOCATION TECHNOLOGY.

~ Mark Holzworth, IndexInvest

CHAPTER EIGHT


MODEL EQUITY PORTFOLIOS FOR THE

SMSF ADVISER.

~ Mike Williams, Head of Adviser Services, Bell

Potter


YOUR MAIN GOAL FOR 2015…

Over 3 days in November 2014 a selected group of

graduates from our ASX Listed Products

Accreditation Course (LPAC) shared their wisdom

and questions with a hand picked group of

Australia’s leading investment professionals. The

LPAC Leaders Retreat fostered discussion of some of

the most important aspects of how you run your

practice and how you provide advice to your

clients. And – in a rarity in this highly conflicted

industry – none of the presenters were asked or

allowed to sponsor the event!

The LPAC Leaders Retreat was a payola free zone

and addressed some of the tough questions facing

Australia’s top financial advisers.

Investing is just one part of the service that you

provide. As one of my valued LPAC students said

recently, the compilation of the investment portfolio

is the last piece of the advice process. Investments

are designed to help clients achieve their retirement

outcomes, and are driven by a suite of issues that

are relevant to each client.

But, that being said, it’s also true that clients rate

“investment control” as the main reason they set up

an SMSF, and they also tell us that they seek to

reduce costs and to improve tax efficiency within

their investment portfolio.

The expanding universe of Direct Investments

ASX listed products are a key enabler of these

objectives. Specifically, the idea of using a

concentrated portfolio of shares, which typically are

invested using a “long term/buy and hold” approach.

Hybrids too have been increasingly popular since the

GFC (as they were in the “good old days” of the mid-

2000’s, before yields collapsed).

Protected loans (and for some advisers,

instalments) also add to the mix, with the prospects

for tax effective investing and – more importantly –

the opportunity for return enhancement.

ETFs have also started to develop a following in the

adviser community, as new styles emerge to

supplement the traditional “low cost beta” style

ETFs.

When we provide service which includes advice on

these products we are explicitly stating that we can

do something that a traditional fund manager can’t.

That’s a big call!

In the LPAC Leaders Retreat the presentations from

our guest commentators were designed to highlight

the opportunities and risks involved in direct

investing in ASX listed products – specifically

concentrated portfolios of stocks, hybrids, ETFs and

protected loans.


Can Advisers REALLY Add Value?

The core issue is the brutally important question –

how can we add value by investing directly, or are

we kidding ourselves and our clients by not

outsourcing all investments to a fund manager?!

And as we listened, read and discussed with our

peers, inevitably we had to think about the brickbats

thrown by the advocacy movement for fund

managers.

We know there are some great managers, and if we

can consistently find them they obviously make

sense to invest with.

But the problem is probably as simple as the

statement made by a recent LPAC student (who is

head of research at one of the top 3 Australian

dealer groups – so his statement is very telling):

“The evidence is very clear – there are

definitely some active managers who beat the

index. The problem is that it’s hard to spot

them in advance and we never know when

they’re going to outperform.”

The industry feeds off the marketing machines of the

active managers. Often this forces an over-

simplification of the issues into statements which

read like truisms, but which in reality are reflecting

incredibly complex issues. Consider the following

comments:

(In relation to actively managed share

funds, Graham Rich): “Regardless of which

side of the active/passive debate you fall

on and for which types of investments, if a

1987 style equity market crash does

eventuate as some are suggesting,

investors in passive funds are in for a

certain whipping. What’s less certain is

whether investors in active funds will do

any

better.”(http://evotv.com.au/nomorepractice/10520/portf

olioconstruction-blog-will-your-portfolio-hold-up-in-a-market-

crash);

(In relation to the “No” case for hybrids, the

eminent Ben Graham): “Many investors

buy securities of this kind because they

need income and cannot get along with the

meagre returns offered by top grade

(investment grade) issuers. Experience

clearly shows that it is unwise to buy a

bond or preferred which lacks adequate

safety merely because the yield is

attractive.”

Are the “Active Fund Managers” Right?

Now, you might be wondering why I’ve included

Graham Rich’s quote above. At one level he’s talking

about the “active” vs “passive” debate which often is

taken as the difference between index funds vs

active managers trying to beat the index. But there’s

really another level in what Graham is saying, and

that is that active managers should be able to

defend their clients’ investments better in a

downturn than is available to an investor adopting

the “buy and hold” approach. Sure, he adds the

caveat (about the uncertainty of this) – but

nevertheless he goes in hard against the idea of

being a passive investor. How relevant (and in what

way) is Graham’s comment, when we consider the

“buy and hold” direct investing strategy?

http://evotv.com.au/nomorepractice/10520/portfolioconstruction-blog-will-your-portfolio-hold-up-in-a-market-crash)




Ben Graham’s position is a little clearer – he doesn’t

like preferred stocks, and by extension, he wouldn’t

have liked hybrids! (Or – would he?). Do “convertible

preference share” style hybrids contain sufficient

“safety” to justify their inclusion in the fixed income

portfolio?

So as you ponder these questions, you should find

the following chapters to be of interest. In Chapter

One, Bill Keenan from Lonsec looks at the rise and

rise of SMSF – as well as the role and potential for

the use of a concentrated portfolio of stocks which

are invested using the “buy and hold” approach.

Chapter Two is a great overview of the potential

scale benefits which can be delivered by Managed

Discretionary Accounts, from one of their advocates,

David Heather CEO of Managed Accounts.

Day Two of the LPAC Leaders Retreat began with a

stirring and provocative presentation from Michael

Drage of Nakodo. Michael has been a top adviser for

many years and has constantly been thinking about

the link between client needs, the adviser service

proposition, and practice values.

In Chapter Three Michael’s message is simple –

clients are demanding more and better service and

advisers need to adapt their business models to

maintain the value of their practice.

Chapter Four covers the detailed analysis of bank

issued hybrids from Barry Ziegler at Bell Potter –

explaining in great detail the intricacies of the

APRA/Basle 3 requirements for new bank issued

hybrids and how this can operate to the

disadvantage of investors.

Chapter Five sets out my findings on the real

performance of Protected Equity Loans within the

SMSF environment.

In Chapter Six my friend Vinnie Wadhera from

BetaShares led a discussion about the perils of

sequencing risk and some of the recent innovations

in risk management which hold out the hope for

better risk management and minimization of “tail”

risk and sequencing risk.

Chapter Seven covers the thought provoking model

portfolios developed by Mark Holzworth, a Brisbane

private client adviser and founder of IndexInvest –

an ETF model portfolio approach which uses

“Dynamic Asset Allocation” to deliver returns

benchmarked to CPI + 6% pa…ie, not the traditional

index benchmark of traditional fund managers.

Chapter Eight shows how direct share investing has

built real value for clients and advisers, and this

closing session from Mike Williams at Bell Potter was

for many, the culmination of a great 3 days at the

LPAC Leaders Retreat.

I hope you enjoy this E Book as much as we had

during the LPAC Leaders Retreat – join us for the

2015 event!

Kind regards (or as they say in Fiji, Bula!)

Tony Rumble PhD

Founder, LPAC Online


CHAPTER ONE

THE RISE OF SMSF’S AND DIRECT

INVESTING

~ Bill Keenan, Lonsec

SMSF’s are the largest segment of the Australian

superannuation market and have unique needs. This

provides opportunities for financial advisers as well

as challenges to advice models and business

systems.

Source: APRA

SMSF’s use direct investments for a number of

reasons:

• Control – greater control of investment

decisions

• Transparency – securities are in the

members name

• Liquidity – ASX listing affords good liquidity

and no fund lock-up

• Choice – more SMSF platforms and

investment options than ever

• Fees – can be cost effective

• Tax – can be tax effective if tailored to

members and low turnover


But because traditional advice models and business

systems are designed around unlisted, unitized

managed funds, advisers cite a number of barriers

which hinder their use of direct share and other ASX

listed products:

Source: Investment Trends 2014 Planner Direct Equities and SMA

Report

To assist advisers, Lonsec has been providing direct

stock (and now hybrid) model portfolios since 2000.

These can be used in two ways by advisers:

As a “Do it With Me” service when the

adviser is in contact with the client

regarding implementation and re-balancing;

As a “Do it For Me” service when the

adviser uses an MDA or SMA platform to

implement and re-balance the portfolio.

Bill Keenan, Lonsec: The Rise of SMSFs

Model portfolios improve the scalability of the direct

equity advice process and aim to deliver the

following benefits:

• Professional management – portfolio

manager provides portfolios

• Control – Advisers/Clients gain greater

control of the portfolios

• Transparency – all participants can see what

is in the portfolio

• Efficiency – easy to implement and manage

• Reporting – regular performance reports v

benchmark should be supplied by the

manager

• Support – the portfolio manager should

provide stock research and corporate action

advice.

So – how does this work in practice?

Lonsec adopts a clear investment philosophy for its

model portfolios:

“To add value over the benchmark by

constructing concentrated portfolios of

quality stocks, with low portfolio turnover.

This philosophy recognises the needs of our

financial adviser client base.”

To implement this philosophy Lonsec uses a number

of factors when it builds model portfolios:


Lonsec uses a “top down” and “bottom up”

approach when selecting stocks.

From the “bottom up”, Lonsec uses 10 filters to

identify quality stocks trading at reasonable prices:

Unlike the large portfolios adopted by traditional

actively managed funds, the Lonsec model portfolios

use a “high conviction” approach, eg concentrated

portfolios with low turnover.

• Experience and academic research

concludes that concentrated portfolios

improve the potential to generate high

excess returns.

• But we also need to ensure the portfolio is

adequately diversified to mitigate portfolio

risk. Academic research shows that a stock

portfolio can be well diversified with

between 15 to 30 stocks - there is little

diversification benefit after 30 stocks.

Source: EJ Elton & MJ Gruber, Risk Reduction and Portfolio

Size: An Analytic Solution, Journal of Business, Oct 1977


Putting It Together

Lonsec provides a number of model portfolios for

advisers seeking a scalable and credible solution to

their direct investing needs. The “Core Model”

portfolio has been provided since 2000 and shows a

very strong long term record of out-performance

(which by the way verifies the credibility of the “long

term/buy and hold” approach when used with

concentrated portfolios):

$0

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

$700,000

Q200

Q101

Q401

Q302

Q203

Q104

Q404

Q305

Q206

Q107

Q407

Q308

Q209

Q110

Q410

Q311

Q212

Q113

Q413

Q314

LONSEC CORE MODEL PORTFOLIO

Source: Lonsec

• Inception: April 2000

• Benchmark: S&P/ASX 100 Acc Index

• Total Return: 521% (13.5% p.a.)

• Benchmark: 242% (8.9% p.a.)

• Alpha: 4.6% p.a.

• Beta: 0.9

• Turnover: 20-30% p.a.

• Stocks: 12-15

The Lonsec Core Model portfolio invests in ASX large

cap stocks. To add another dimension to investor

portfolios, Lonsec also provides a small cap portfolio,

known as the “Emerging Leaders” portfolio:

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

$160,000

$180,000

DE

C' 1

0

MA

Y' 1

1

OC

T' 11

MA

R' 1

2

AU

G' 1

2

JA

N' 1

3

JU

N' 1

3

NO

V' 1

3

AP

R' 1

4

SE

P' 1

4

LONSEC EMERGING LEADERS MODEL PORTFOLIO

Source: Lonsec Investment Consulting

• Inception: December 2010

• Benchmark: S&P/ASX Small Ords

Acc Index

• Total Return: 76% (16.2% p.a.)

• Benchmark: -17% (-4.8% p.a.)

• Alpha: 21.0% p.a.

• Beta: 0.5


• Stocks: 15

For advisers with clients seeking a portfolio tilt

towards income, Lonsec provides an Equity Income

model portfolio, and a Hybrid model portfolio:


3.0%

2.5%

2.6%

3.3%

4.3%

4.5%

4.4%

4.8%

4.2%

5.4%

7.5%

0% 1% 2% 3% 4% 5% 6% 7% 8%

CPI

OFFICIAL CASH RATE

90 DAY BANK BILL RATE

10 YR GOVT BOND YIELD

S&P/ASX 100 CASH DIV. YIELD

VANGUARD HIGH YIELD ETF

SPDR MSCI HIGH DIVIDEND YIELD

RUSSELL HIGH DIVIDEND ETF

ISHARES HIGH DIVIDEND

LONSEC INCOME CASH DIV. YIELD

LONSEC INCOME GROSS DIV. YIELD

Lonsec Income Model Portfolio Source: Lonsec Investment

Consulting

• Inception: August 2002

• Benchmark: S&P/ASX 100 Acc Index

• 5 yr return: 9.8% p.a.

• Benchmark: 7.2% p.a.

• Alpha: 2.6% p.a.

• Beta: 0.9


• Stocks: 12

2.5%

2.7%

2.6%

3.3%

3.7%

5.0%

5.8%

5.8%

0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0%

OFFICIAL RBA CASH RATE

90-DAY BANK BILL SWAP RATE

3-YR GOVERNMENT BOND YIELD

10-YR GOVERNMENT BOND YIELD

AV. 3YR TERM DEPOSIT RATE

PORTFOLIO CASH DIV. YIELD

PORTFOLIO YIELD TO MATURITY

PORTFOLIO GROSS RUNNING YIELD

Lonsec Hybrid Portfolio Source: Lonsec Investment

Consulting

Lonsec Hybrid model portfolio key data:

• Inception: June 2012

• Benchmark: Bloomberg Ausbond Bank Bill Index

+ 1.5%

• Total Return: 5.7% p.a.

• Benchmark: 2.9% p.a.

• Alpha: 2.8% p.a.

• Turnover: 20% p.a.

• Stocks: 7

The Lonsec model portfolio approach is designed to

provide benefits both to clients and advisers:

Client Value Proposition

• Follow a professional model portfolio with

an established track record

• Get full support in terms of reporting,

research and corporate actions

• See the portfolio in your name

• Control the income and turnover, if

necessary

Adviser Service Proposition

• Solve your compliance and APL concerns

• Outsource to a professional manager

• Leverage off the track record and brand of a

professional manager

• Get the support you need in terms of

reporting, research and corporate actions

• But maintain control of income, tax and

turnover, if necessary.


CHAPTER TWO

IMPLEMENTING MODEL PORTFOLIOS –

SOLUTIONS FOR SMSF ADVISERS

~ David Heather, Managed Accounts

One of the problems faced by advisers using direct

investing, is ensuring efficiency in the business

systems required to efficiently implement the

investments – and to manage them over time. Costs

and scalability are key items that need careful

management by advisers.

David Heather and Managed Accounts have been

providing Managed Discretionary Accounts for

advisers for the last few years and have a strong

record for efficient design and implementation of

MDAs.

We invited David to share his insights and his

presentation was a great way to conclude the 1st

Day

of the LPAC Leaders Retreat.

David’s presentation covered some key topics of

interest for SMSF advisers:

• Implementation options available to the

SMSF adviser

• Can a Managed Discretionary Account

(MDA) Service enhance your practice and

enhance the client experience ?

• Key aspects of the MDA approach: legal and

regulatory overview, roles and

responsibilities, financial obligations

• Establishing a MDA Service as part of a

service offering: portfolio management,

documentation, advice and differentiating

yourself

• From the coalface – practical tips for

advisers considering using a MDA

• Real client case studies

Managed Accounts is a Sydney based company

founded in 2005, previously known as Investment

Administration Services or IAS.

It listed on the ASX in June 2014 with market cap

~$30m (ASX: MGP), cash flow positive and

profitable.

It is a specialist managed account provider enabling

advisory firms to implement a MDA solution without

the need for advisory firms to have a MDA Operator

authorisation. Managed Accounts looks after

$1.17bn in FUA as at September 2014

It does not provide investment management or

personal advice, and provides solutions to 25

boutique advisory firms, all differentiated from each

other through branding, portfolio design and fee

approaches

David suggested that one of the main problems for

advisers using direct equities without having

discretion to manage the portfolio, is the intensity of

activity needed in the broker “back office” to

manage the portfolio.

This in turn arises because of the need for the

adviser to prepare an SOA, or at least an ROA,

whenever the portfolio changes – and this can be

necessitated even if the change simply arises from a


corporate action, like a rights issue or off market

buyback.

Pros Cons

Potential increase in revenue Margin dilution potential through

inefficiencies

Potential reduction in cost to client Additional research, ongoing monitoring

and governance requirements

Transparency for the client Need for ongoing RoA’s for portfolio

changes and corporate actions

Client can better control tax position Increased accountability of adviser

Heightened advice risk

Inability to actively manage portfolios

across client base

Increased trade execution requirements

and corporate action response

requirements

Ongoing business growth cannot be

sustained

Manual Portfolio Implementation Source: Managed

Accounts

Commenting on the “Do it With Me” style of direct

equity advice (where the adviser discusses the

portfolio and any changes with each client), David

commented that this model can be summarized as

having the following problems:

• Compliance Risk – adviser is providing the same

personal advice as if they were selecting the

stocks themselves, not to mention corporate

events

• Practice Efficiency – additional RoA’s for

portfolio changes and corporate actions across a

growing client base can significantly impact on

practice efficiency

• Portfolio Management – client portfolios cannot

be managed in line with the model due to

compliance requirements, adviser and client

availability and implementation timeliness

which leads to different performance and risk

outcomes

• Reduction in cost to client – but that can be

wiped out in one trade that is not implemented

or is slowly implemented ?

What is a Managed Account?

In contrast, David proposed that a managed account

is the optimal solution to these problems. He

defined a managed account as:

“A portfolio of assets that are owned by an investor,

managed by an investment manager in accordance

with an agreed investment strategy or mandate, and

administered by a professional administrator who

undertakes the portfolio administration functions

and provides reporting to the investor and their

adviser.”

Managed accounts can provide the following service

enhancements:

• Compliance – no need for advice on individual

securities with personal advice at the strategy

level rather than security level

• Advice – no RoA’s necessary for ongoing

portfolio changes and corporate actions

• Portfolio Management – client portfolios are

actively managed and implementation is

centralised using sophisticated modelling

capability through wholesale broking

arrangements

• Reduction in cost to client – integrated solution

across administration, portfolio management

and advice with administration from 25bp and

brokerage from as low as 3bp

• Practice profitability – offers practice

profitability enhancement over other vehicles.

Fully implemented solutions for as low as 55bp

allowing for practice margin into investment

piece with reduced cost to deliver advice and

administration

• Scalability – across advice and administration


The various parties to and responsibilities in an MDA

arrangement are as follows:

MDA Operator

Portfolio Administration

Portfolio Management

Custody

Compliance and Disclosure

Documents

Contracting with Parties

including Client

Personal Advice

Source: Managed Accounts

The costs to client of using an MDA can be far

cheaper than other alternatives:

Source: Managed Accounts

So – in summary, the potential benefits of the MDA

can be summarized as:

• Managed accounts are the optimal solution

for a SMSF adviser focused on listed

products

• Managed accounts are a total business

solution not just another product

• You can differentiate your business from

your competitors, even without your own

MDA authorisation - understand your

requirements and match these up to the

options available to you

• Managed accounts are about portfolio

management first - portfolio management

should not be a one size fits all if you can

avoid it

• Managed accounts to drive additional

efficiency and functionality into the delivery

of SMSF’s.


CHAPTER THREE

BUILDING PROFITABLE SMSF ADVICE

BUSINESSES

~ Michael Drage, Nakodo

Michael has been working at the forefront of the

Australian financial planning industry for well over a

decade and shared his thoughts with us regarding

the makeup of a successful SMSF advice business.

He kicked off Day Two of the LPAC Leaders Retreat

with a challenging presentation on what SMSF

clients want – and how advisers need to adapt their

business model to deliver these needs within a

scalable and profitable business.

The challenge – expanding advice margins (and

resisting the trend towards contracting margins).

Michael used some market research to highlight the

multi-levels of SMSF client needs.

This showed that there is no “one size fits all model”

for the SMSF adviser: each SMSF demographic has

its own peculiar needs…and wants to be reached by

an adviser in a different way.

And, significantly, each SMSF demographic is looking

for financial advice on different aspects of the

portfolio, ranging from limited advice on specific

investments, through to holistic advice.

Michael’s “call to action” was to encourage advisers

to understand what SMSF clients want, and to let

those clients know that the adviser has the capacity

to deliver that to them. He noted that the top 3

SMSF advice needs are:

investment expertise

independence

recognised professional qualifications

Expertise and specialisation is valued most by SMSF

clients:

must be fee for service

3/4 say would be willing to pay a professional

for specialist advice- toe in water for more

51.8% get investment advice from an FP-50% of

those getting investment advice get it from non-

aligned- ie 15% of market getting 50% of the

work!

Scaled advice opens the door BUT you ‘need to know

my personal circumstances.


What is the business model for the successful SMSF

adviser?

• SMSF expertise

• Investment expertise

• Estate planning expertise

• Fee based

• Offer scaled advice

• Effective communication

• Ability to proactively manage affairs

• Strong CRM

• Communication strategy to 'know your

client'

Michael spent the next part of his presentation

talking about practice values and margins. He

showed that the norm for successful practices were

margins around the 18% - 20% range – well down

from the pre GFC norm of 30% of gross revenues.

This margin contraction was attributed to a range of

factors, including:

Higher compliance costs

Higher costs to service clients (need for

more contact/more questions/issues)

Higher investment management costs

(associated with the more profound use of

direct equities)

FOFA – removal of volume based rebates

and commissions

Fall in FUA as asset values have declined.

The double whammy with this margin contraction is

the fall in valuation metrics for advice businesses –

driven by a move away from valuations based on

recurring revenue, and a widespread move to

valuations based on EBIT multiples.

The problem with an EBIT multiple valuation

approach is that the wave of small businesses

coming onto the market over the next few years is

leading to lower EBIT multiples being available for all

businesses, including financial planning businesses.

The presentation moved to various methods of

increasing the relevance of the service model for

SMSF clients – including deeper use of direct equities

– within a more efficient business model. This was

the subject of some thought provoking networking

amongst the attendees of the LPAC Leaders

Retreat…and deeper reflection on the benefits of

streamlined investment platforms like MDA’s.


CHAPTER FOUR

NAVIGATING THE HYBRID HIGHWAY

~Barry Ziegler, Head of Fixed Income, Bell

Potter

SMSF clients are being flooded with new hybrid

offers as Australian banks continue to build their

capital base. This will grow faster as the

recommendations of the Murray FSI are

implemented – these call for even more equity

capital to be held by the banks, on top of the raised

levels now required as the Basle III standards are

implemented.

Shareholders receive hybrid offers directly from their

issuers – and are increasingly turning to their

advisers for guidance on what to do with these

offers. As Term Deposit rates continue to fall – and

with many investors worried about the bond market

(with fears of a bond “bubble” arising from QE and

its capacity to burst as “tapering” continues) –

hybrids are an increasingly popular asset class.

Growing hybrid issuance coupled with rising demand

poses stress to advisers and because of the

complexity of new style hybrids – and risks arising

from the Basle III standards – advisers can benefit

from access to robust external advice and access to

model hybrid portfolios.

Understanding different types of hybrids

Barry gave an overview of the key elements of

hybrids focussing on the main variety known as

“mandatory converting preference shares” – these

are a core part of Module 3 of the LPAC program and

all LPAC grads will be familiar with the structural

aspects of these types of hybrids.

In their traditional form these hybrids convert into

sufficient ordinary shares to ensure that the original

value invested is realized through the issue of these

shares. Shares are issued at a small discount so

investors can sell them on the market to generate

cash equal to their original investment – and it’s

these factors that allow these style of hybrids to be

held as part of the fixed income portfolio.

New rules for Bank hybrids

Barry spelt out what the new Basle III standards will

mean for hybrids issued by Australian banks.

Essentially these rules mean that there will be a limit

on the number of new ordinary shares that a bank

can issue on conversion.

This limit will apply when the bank’s ordinary share

price has fallen sharply from the levels prevailing

when the hybrid was issued. This in turn will impose

some equity risk on hybrid investors – stressing the

validity of holding hybrids in the fixed income part of

the portfolio.

The Basle III standards also require that bank issued

hybrids must automatically convert to ordinary

shares if the bank’s equity capital levels fall below a

minimum of 5.125% of total liabilities. This early

conversion is known as a “Non Viability Trigger.”

Under Basle III, APRA requires Australian banks to

hold a minimum Common Equity Tier 1 Capital Ratio

of 4.5% on 1 Jan 2013, increasing by the 2.5% capital

conservation buffer to 7.0% on 1 Jan 2016.

In addition, “D-SIBs” (ie “domestic systematically

important banks”) are required to hold 1.0% extra

capital. This means that Australian banks already will

have 2.875% extra capital above the 5.125%

minimum that would trigger an early conversion of a

hybrid into ordinary shares.

If early conversion occurs due to a Non Viability

Trigger event being declared by APRA, hybrid

holders will receive ordinary shares in sufficient

number to give them a return of their original capital

invested, subject to a maximum in the event that the


ordinary share price has fallen by more than 80%

since the hybrid was issued. For example if the

ordinary share price was $33 when the hybrids were

issued, the conversion process would automatically

issue ordinary shares down to a minimum price of

$6.60 per share.

That is, in the event of a Non Viability Trigger

occurring in that example, the hybrid investor would

start to lose capital value if the ordinary share price

fell below $6.60.

In summary the risks to hybrid investors are:

Hybrid holders will lose value and investors will not

receive any compensation if issuer is not able to

issue ordinary shares within five business days from

Exchange under a Capital Trigger Event or Non-

Viability Trigger. Scenarios under which this may

occur include if the issuer is prevented from issuing

ordinary shares by circumstances outside of its

control, including an applicable law or order of any

court, or action of any Government authority from

issuing shares. In practice this is highly unlikely to

occur to an Australian bank.

Adverse change in issuer’s financial performance

which combined with a major bad debt event could

lead to the Common Equity Tier 1 Capital Ratio

falling below 5.125%, resulting in automatic

conversion under the Capital Trigger Event.

Automatic conversion may also be required under a

Non-Viability Trigger Event.

Issuer has an optional Exchange Date, when at the

Bank’s discretion, they will redeem the issue for

$100

Exchange of the issue at the Mandatory Exchange

Date requires issuer’s share price at the time of

Mandatory Exchange to be above certain

thresholds. If these thresholds are not met in on the

stated conversion/exchange date or at future

quarterly dividend payment dates, the hybrid issue

may remain in place indefinitely.

Building a Hybrid Portfolio

Advisers should focus on the client’s needs:

Risk

Duration

Economic outlook risk

Specific terms of issue risk

Bell Potter research provides an assessment of Fair

Value for ASX listed debt and hybrid securities and

can create a model portfolio to suit client and

adviser needs, for example:

Source: Bell Potter

In compiling its hybrid research Bell Potter considers

the following issues:

Hybrids are not Term Deposits and are not

protected by the Government guarantee

scheme

Hybrids are preferred equity of the issuer

and rank behind deposits, senior debt and

subordinated debt


Dividends are discretionary and non-

cumulative

Dividends are subject to several payments

conditions including solvency

Adverse credit markets- credit spreads

widening

New issues offering a higher margin

Non-viability Trigger Event and Common

Equity Trigger provisions

Risk of conversion into equity

Default

Barry noted that there has been $32.5bn of issuance across 40 new hybrid securities since August 2011. Bell Potter has been the only broker to participate in the Book-build of all 40 issues and Bell Potter provides research reports on all issues. Bell Potter has also been the Co-Manager to 25 issues (dark green columns)


CHAPTER FIVE

TAKING IT TO THE NEXT LEVEL:

PROTECTED EQUITY LOANS

~Dr Tony Rumble (LPAC)

Protected equity loans have been available since the

early 1990s – in fact, as LPAC students know from

our case studies, I was part of the team that created

the first PEL over NAB shares for a syndicate of

Coopers and Lybrand partners in 1990.

But – do they work? Specifically, does the additional

cost associated with PELs erode their benefits?

Protected Equity Loans involve the provision of up to

100% of the purchase price of ASX listed shares with

the lender’s only security being in respect of the

shares themselves. This form of security and loan

arrangement is known as “limited recourse” finance.

The protected lender charges the borrower a

premium interest rate to cover the cost of hedging

against the risk of loss arising on default by the

borrower, which insures that the value of the shares

will not be less than the amount lent to finance their

cost.

Using data in respect of Commonwealth Bank of

Australia Protected Equity Loans initiated during the

period 1 January 1994 and which matured between

that date and 30 October 2014, we discussed the

LPAC research paper which showed that the average

returns for an SMSF in accumulation mode (eg taxed

at the rate of 15% pa) using a Protected Equity Loan

outperformed the returns of the same portfolio of

shares when purchased without capital protection

by 7.14% pa.

Actual returns were shown to vary with respect to

portfolio and time of initiation (as would be

expected). Furthermore, the frequency of the

outperformance of the Protected Equity Loan

compared to the same portfolio purchased without

capital protection was 60% of the portfolios analysed

during the 20 year period.

The financial and portfolio benefits of Protected

Equity Loans were illustrated by this analysis.

Furthermore, given that the protection created for

lenders by these arrangements insures the lender

against the risk of loss, the paper noted that

Protected Equity Loans can be seen as an

enhancement to the integrity of the financial system,

rather than as an additional source of systemic risk.

Protected Equity Loans do not impose any

requirement on the borrower/investor to make any

top up payments/increase security in the event of

the share price/s falling during the investment term.

The Protected Equity Loans are functionally

equivalent to ASX listed instalment warrants with

these features.

PELs are significantly different than:

Margin loan

Synthetic gearing facility of the type known

as “equity lever” or “share lever”

ASX listed instalment warrants with a “stop

loss” mechanism

Protected Equity Loans avoid the problem of “short

gamma”

Unlike these products, Protected Equity Loans do

not impose a requirement that the

borrower/investor must provide any top up to the

security which supports the loan, in the event of a

fall in the price of the share/s which have been

purchased using the loan.

In the case of margin loans and synthetic gearing

facilities, the investor can be required to pay a

“margin call” (or equivalent) in the event of a price

fall, and failure to make this margin call will give the


lender the right to sell some or all of the underlying

shares.

In the case of “stop loss” style ASX listed instalment

warrants, it is typically the case that the

issuer/lender can simply sell down shares in the

event of a price fall, ie it will not permit the

borrower/investor to make a margin payment.

As a result, each of these style of products exhibits

the feature known as “short gamma” – ie where

some or all of the share/s will be sold during a period

when the market falls. “Short gamma” positions are

inherently risky because the expose an investor to

the prospect of crystallizing losses during periods of

market disruption, rather than permitting the

investor to continue to hold shares until the market

recovers.

Protected Equity Loans avoid the problem of “short

gamma” and thus provide important investor

benefits not available with other forms of share

finance.

The results of the LPAC research paper showed that

the average out-performance of PEL portfolios

during the 20 year period from 1994 to 2014 was

7.14% pa.

The research also showed that:

the relative performance of portfolios

selected with regard to yield (12.69% pa

average return) scores better than

portfolios selected with regard to growth

(7.95% pa average return);

the “balanced” portfolios underperform the

“yield” portfolios;

the small concentrated portfolios perform

better than the larger portfolios.

In the current low interest rate environment, PELs

were shown to offer a wide range of strategic

planning opportunities, especially to SMSF investors

in accumulation phase.


CHAPTER SIX


USING ETF’S TO HELP MANAGE

SEQUENCING AND LONGEVITY RISK

~ Vinnie Wadhera, CIMA, BetaShares

Advisers with clients with long term share holdings

should be well positioned to weather stock market

downturns – relying on the notion that when share

prices fall, if earnings are maintained and continue

to grow, the capital value will eventually recover.

The problem of course is that for clients in

retirement phase – especially in late stage

retirement – market crashes expose them to the

problem known as “sequencing risk.”

This is a concept coined by the former head of

Treasury, Dr Ken Henry, and refers to the problem

when assets fall in value close to the time when

draw down commences. In that case, because the

client is forced to sell assets to fund retirement, they

don’t have the ability to wait for time to help the

asset price recover.

As Dr Henry put it, it’s not just the size of market

crashes that is a problem, it’s the sequence and the

time in the investor’s life cycle in which they occur,

that is the bigger problem.

Traditional asset allocation tries to deal with this by

selling down risky assets as the client ages, and

switching to fixed income investments. Of course,

when cash and bond rates are low, this doesn’t work

– as returns from these defensive assets are too low

to suit client requirements.

Enter the new wave of ASX listed investments which

offer the potential to reduce downside risk within an

overall equity investment.

The table shows the volatility in the Australian

sharemarket going back to 1992. When market

volatility spikes up, it tends to do so quickly!

Vinnie Wadhera profiled the emergence of new risk

management technology, for example the process

and system created by global risk management firm

Milliman, which can reduce downside risk with little

adverse impact to the returns of the underlying

share portfolio.

This technology is especially relevant when real cash

deposit rates are negative (ie after inflation) – as

currently is the case in the Australian market. The

table below shows the RBA cash rate and the “real”

interest rate, ie adjusted for inflation.

Table: RBA cash rate (dark red), “real” interest rate (yellow line)

Source: BetaShares


Vinnie analysed research which shows that there is a

high correlation between spikes in volatility and

market losses.

Table: Correlation between volatility and market crashes

Source: BetaShares

The Milliman risk management technology seeks to

reduce volatility when it rises, and does so by short

selling share futures contracts to reduce the

exposure to equities during these periods.

Vinnie profiled the use of the Milliman risk

management technology within the BetaShares

“Dividend Harvester” ETF (one example of a wide

range of financial products which now use the

Milliman risk management technology).

One of the benefits of this approach is that it doesn’t

require the actual sale by a fund manager of any of

the assets of the fund. In the case of ASX stocks

within a fund, this is a benefit because it preserves

access to dividends and franking credits.

Using the Milliman approach also means that full

exposure to risky assets can be resumed as volatility

subsides – and the overall opportunity is to allow for

a more consistent compounding of returns to the

investor.

The table below shows a simulation of drawdowns

for an equity portfolio, with and without the

Milliman strategy.

Source: BetaShares

Vinnie noted that ETFs are now moving to the “next

generation” where passive market capitalization

based indices are being supplemented by rules

based strategies to allow clients to implement

specific styles of investment themes.

ETF innovation is set to continue and is ideally suited

to SMSF clients who seek direct access to their

investments. Advisers servicing the SMSF sector are

ideally placed to build strategies for clients using

some of the next generation of ETFs.


CHAPTER SEVEN


REAL RETURN, MULTI-ASSET ETF

PORTFOLIOS USING DYNAMIC ASSET

ALLOCATION TECHNOLOGY.

~ Mark Holzworth, IndexInvest

The explosion in the number of ETFs available on the

ASX is both a boon and a hindrance to Australian

advisers and investors. Gone are the days when ETFs

were limited to the ASX 200 – with most asset

classes and a wide range of thematic ETFs now

available it’s true to say we are spoiled for choice.

Most research houses will now provide you with

model ETF portfolios constructed along traditional

asset allocation guidelines. That can assist as a way

of scaling ETF use across a wider range of clients,

with the benefits of diversification, lower cost and

tax efficiency.

Enter the brave new world of “Dynamic Asset

Allocation” – or DAA as it’s come to be known. DAA

aims to deal with sequencing risk – and tail risk – by

actively switching between “risky assets” and cash

(as the “riskless” asset).

Mark Holzworth is a Brisbane based private client

adviser who has been implementing a DAA approach

for his clients for over 5 years – with excellent

results. Mark’s “IndexInvest” model portfolios are

available on a number of MDA and SMA platforms

and provide advisers with access to an innovative

AND scalable alternative to the unlisted managed

funds which are the typical vehicle for this style of

investment.

Mark Holzworth, IndexInvest

What is Dynamic Asset Allocation?

DAA seeks to overcome the problems with SAA. The

table below summarises the limitations of SAA based

portfolio construction and compares these to DAA

techniques:

“Strategic Asset Allocation”

• Based on Modern Portfolio Theory

• Risk management = allocating to

“uncorrelated” asset classes

• Assumes correlations change slowly and

predictably

• Assumes investor can hold until good

returns exceed bad returns

• SAA fails when markets crash

“Dynamic Asset Allocation”

• Assumes correlations change dynamically

• Risk management = cash during periods of

volatility

• “Risk on/risk off”


• Assumes investor can’t withstand

“sequencing risk”

• DAA designed to withstand market crashes.

Mark’s approach has proven to be very resilient

since inception – which demonstrates the utility

both of the DAA approach as well as of the relevance

of ETFs as the engine for DAA portfolio construction.

The core idea of DAA is that there is a gap in the

construction of a portfolio based on “fundamentals”

– which are often ignored by markets in times of

financial distress. During such times, market

“momentum” becomes a key driver of prices.

Although long term investors can ride out these

market downswings, and should hold assets which

have been purchased at or close to their “fair value,”

investors at or approaching retirement may be in

need of more stable portfolio values.

In fact, when the variability of returns based on SAA

style portfolio construction are analysed, it becomes

clear why retirees are increasingly uncomfortable

using this style of portfolio construction:

Chart: SAA portfolio 10 year rolling returns.

Source: IndexInvest, Schroders

The chart below shows the returns Mark has

generated since 2005. In this portfolio the

benchmark is CPI + 6% and the chart shows how

consistently this benchmark has been achieved.

Chart: IndexInvest returns 2009 – 2014.

These consistent returns can be contrasted with the

variability of the typical returns delivered by

traditional “active” fund managers, as shown in the

chart below:

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10

Inflation Adjusted 10 Year Rolling Returns (%p.a.)

Objective based target return

Australian Median Growth Manager inf lation adjusted rolling 10 years return5% excess Return target

Chart: Median Active Manager Returns. Source:

IndexInvest

The IndexInvest concept identifies ETFs based on

their momentum and volatility and then uses these

filters to populate the portfolio across a range of

asset classes:


These allocations are reviewed daily and re-balanced

quarterly unless a stop loss trigger level is reached.

The IndexInvest approach is implemented using an

MDA or SMA platform to allow for systematic re-

balancing across multiple clients. The re-balancing is

conducted according to the portfolio mandate which

is set out in the offering documentation.

All ASX listed ETFs are eligible for inclusion within

the portfolio, but non-ASX listed ETFs are not eligible

(due to liquidity constraints). The IndexInvest

approach uses stop loss trigger levels of -5% (for

assets drawn from developed markets) and -7% (for

EM assets).

If a trigger level is reached the specific asset is sold

as soon as possible, with the proceeds realized

invested into cash for the rest of the quarter. If more

than one asset is stopped out, the process is

repeated.

At the start of the next quarter, ETFs are screened

using the momentum and volatility filters described

above. Any asset class that does not provide

exposure to an ETF which has positive momentum

(ie is moving up in price) or acceptable volatility, will

not be fully invested for the forthcoming quarter.

The IndexInvest approach is an example of financial

innovation using ASX listed ETFs as the engine for a

DAA style portfolio construction which is designed to

overcome the limitations of the SAA approach, in the

context of volatile and unpredictable investment

markets.

Table: Portfolio Construction as at 1/1/2013

Source: IndexInvest


CHAPTER EIGHT


MODEL EQUITY PORTFOLIOS FOR THE

SMSF ADVISER.

~ Mike Williams, Manager of Intermediary

Services, Bell Potter

What do SMSF investors (really) want from their

share portfolio?

Often we hear that these clients crave control and

low costs, as well as a good dose of tax efficiency.

Those are some of the main things we know SMSF

clients think about – but Mike reminded us in his

closing remarks about the fundamental importance

of dividends.

Dividends have driven the ASX to levels above the

pre-GFC highs – when we consider the ASX 200

“Accumulation” Index. What this means is that

dividend growth in quality stocks has been

profoundly solid since the GFC.

IN FACT, DIVIDENDS PROVIDE OVER HALF OF THE

TOTAL RETURN FROM SHARES!

Table: ASX 200 Indices: Price (Blue) vs Accumulation

(Green) 2004-2014. Source: Bell Potter

That’s a vital point to note and distinguishes direct

investing from actively managed funds. Holding

shares for the long term entitles the client to the

long term growth prospects of those dividends. But

managed funds which turnover 80% pa deliver their

customers access to current year dividends, since

the shares are bought and sold year after year.

INDEX PRICE PRICE % Change

30/10/04 30/10/14 Over 10 years

XJO 3,779 5,469 +44.7%

XJOA 21,065 47,059 +123.4

Incremental

Gain

+78.7%

(64% of total return)

Source: Bell Potter

Mike set the scene for his discussion of the client

value proposition for financial advisers

recommending direct equities to clients.

Unlike traditional stock brokers, financial advisers

are well positioned to provide stock

recommendations (and of course, Mike has

positioned his business to be in tune with

adviser/client needs)!

What is the “problem” with traditional broker

research?

Challenges created by “the research system”

Normal distribution of recommendations

within sectors

Auto generation of “appropriate

recommendation” from price target plus

yield (ie. total forecast return)

A variety of valuation models (which

generate price targets). Good example TLS.

No knowledge of specific private client’s

objectives/ risk profile.


Paid by and largely beholden to Institutions

who may have completely different M.O. to

private clients (instos: trading mentality,

rejig asset classes constantly, commitment

to short term performance, capital gains tax

not overly important)

Model Portfolios for Advisers/SMSF Clients

With this “problem” in mind, Mike spoke about the

tailored model portfolios that he is responsible for at

Bell Potter.

Attributes

Consistency in stock selection across client

base

Concise but diversified, Top 100 based

portfolios

Ability to outperform indices, albeit with

material tracking error

Lower costs given modest turnover

Avoid unattractive stocks with large index

weighting

Tax/ capital gains issues specific to client

can be taken into consideration (eg. timing

of sales)

Genuine day to day monitoring, changes

advised to clients as they occur

Prompt advice on corporate actions

(takeovers, mergers, buybacks, share

purchase plans, rights issues to name a few)

The Bell Potter approach to model portfolios applies

key ideas at both the portfolio level and then at the

level of specific stock selection:

At the portfolio level the key ideas are:

A range of sectors with rarely (apart from

Banks and resources) more than 2 stocks

from the same sector

12 - 14 stocks

Modest turnover (typically 20 – 25% pa

except in the case of unusual market

volatility or takeovers)

Balanced at all times with respect to a

range of major variables:

– cyclical, defensive, long

term growth

– exchange rates

– interest rates

– PE’s and yields

– affected by / independent

of economic cycles

– risk profiles

Mike Williams, Bell Potter

At the level of specific stock selection the key ideas

applied by Bell Potter are:


Buy (or at worst neutral) recommendation

by analyst

Earnings growth allied to attractive PEG

ratios (PE relative to earnings growth)

Favourable industry structure or dominant

position in industry

Supportive external environment

Competent operational & financial

management

Appropriate balance sheet

Scope for dividend growth or higher

dividend payout ratios

Takeover or capital management potential

(share buyback, special dividends)

Mike then gave an example of how he things

strategically in relation to specific sectors, in this

case he used the example of discretionary retail:

What could go wrong has gone wrong:

Anaemic economic growth with high

unemployment, job shedding

Cost issues for Joe Average – rates,

insurance, fuel, school fees, house prices,

utilities

Retailers “teach” consumers to only buy at

sale prices or “on special”

Falling $A = margin squeeze for large

importers (most retailers)

Short sellers make good wins out of profit

warnings, exacerbate downside

Political and legislative uncertainty

Consumer confidence uninspiring, like for

like sales weak

Strong competition amongst retailers, extra

from the internet

Some retailers (or divisions thereof) with

dinosaurlike characteristics

Bottom line? Large collection of underperformers in

this space.

What could go right?

Better economic growth, job losses off the

front page of media

$A reaches a level commentators regard as

fair value or cheap

Consumer confidence heads up, backed by

greater job security, recovery in resource

sector, firm house prices, stronger

sharemarket

Short sellers head for the exit, create

additional demand for shares

Abbott rolled by Turnbull, Shorten resigns

to become a full time cook

Interest rates stay very low for a prolonged

period

Bottom line? Many retailers are priced for doom and

gloom:

SUL next 2 years EPS growth 8% & 16%; PE 13.7x;

yield 5.1%FF

JBH next 2 years EPS growth 5% & 8%; PE 12.0x;

yield 5.4%FF

Given the serial underperformance of the last 12

months, the bounce could prove substantial.


The LPAC Leaders Retreat is an initiative of the LPAC Learning Program – Australia’s #1 Direct Investing Training

Program.

www.LPAConline.com.au

http://www.lpaconline.com.au/