Why index management and term deposits are the wrong strategies

Mark Thomas argues that financial planners must convince their spooked clients that index management and term deposits are the wrong strategy.

At a time when retail investors desperately need professional advice and active management, they have never been less inclined to listen or act.

In the aftermath of the global financial crisis (GFC), investors have developed a bunker mentality.

They have thrown in the towel and are being sold a ‘pup’ model predicated on low cost, low active risk and limited advice. It is the perfect storm. In the next three to five years, investors’ investment expectations will be ravaged.

Investors are now giving passive or index funds their full attention, as well as government-endorsed term deposits.

Add to this the mooted regulatory changes, which essentially outlaw any form of financial incentive by way of commission or volume rebate, and it is little wonder investors are adopting what they perceive to be a far less risky strategy.

Tragically, it’s the wrong strategy. And their financial advisers know it. Why? The environment post-GFC is a far less certain world.

Massive stimulus packages, which could only be described as nuclear bombs being thrown at street riots, will eventually lead to higher inflation. In the meantime deleveraging and weak growth pose the threat of deflation. Such market conditions are not friendly to equities.

But once sustained economic growth returns, it will almost inevitably be accompanied by higher inflation. This, too, will have a negative impact on equities.

Historically, we know stocks prices only respond well to the certainty of inflation. Once inflation moves beyond the certainty range of 1-4 per cent, price to earnings (PE) ratios fall dramatically.

This is hardly surprising — PE ratios merely reflect the premium investors will pay for growth. The lower the risk to growth, the higher the premium paid. It is simply human nature that people will pay more if there is a greater probability of success.

Higher inflation has flow-on effects to the economy. Wages are about 70 per cent of the cost base of a developed economy with a services sector (in the US, services are approaching 80 per cent of gross domestic product).

Rising costs imply lower profits for companies. So it is only natural with today’s fears about deflation and tomorrow’s concerns with inflation that investors are unwilling to pay for the future. PE ratios deserve to be low.

It’s our belief we are in the early stages of ‘lesser certainty’. In such an environment the broad market can track sideways for decades, with wild swings from year to year.

This ‘range-trading’ environment reflects the stop-start nature of the economy that is restrained by poor confidence, too much government and consumer debt and increased taxes. This also leads companies to be more restrained in their investment, resulting in lower productivity and smaller profits.

Although some sectors and companies will be somewhat insulated due to mega trends (commodities and superannuation are obvious examples), most will be tied to the economic cycle.

So being selective is paramount. Stock picking can add value in these market conditions.

Which brings us back to this perfect storm. Consumers have justifiably lost confidence in professional advisers. In their eyes massive losses are being bailed out with taxpayer funds.

Combine this with the drop in consumers’ super fund balances and it is not surprising that the word ‘disgust’ keeps popping up.

Dr Frank Ashe from Macquarie University’s Applied Finance Centre describes disgust as a powerful and lingering emotion that shares no ownership.

Maddoff, Goldman Sachs, sub-prime and Lehmans — these are the protagonists in the play dubbed the GFC, which has disgusted the investing public.

It’s a condition, Ashe contends, that can only be cured with palliative attention, supplemented with loads of education from advisers.

Right now those retail investors are not listening. Their only interest is in government-backed deposits and direct investments that they control and understand.

Financial planners can save their clients considerable money by avoiding the middle man and buying BHP. Super profit tax or not, there will be demand for the things BHP produces.

Investors can cover their need for diversification overseas with the use of exchange traded funds (growth in these securities has been 133 per cent in the last year according to the ASX).

After all, asset allocation is 80 per cent of the total return, according to well-established theories about market efficiency. Such a strategy would give them 1 per cent exposure to China and 6 per cent exposure to Europe.

These clients’ financial advisers know an asset allocation that gives 1 per cent to China and 6 per cent to Europe is investment folly. How do I know this?

Last year, we surveyed 900 financial planners around Australia. The results were astounding. They were economic realists; despite newspaper hype that the GFC is over, they were far more cautious. The events of this year certainly justify their realism.

But despite their cautious outlook, the vast majority of financial advisers surveyed strongly believed that stock selection, not index management, was the way to generate returns for clients.

More than 90 per cent were adding active fixed income products to their clients’ portfolios within a year.

Despite some magazines carrying the headlines that financial advisers ‘will never invest in emerging markets again’, the survey found that 79 per cent actually believed that emerging markets were in better shape than the developed markets, and another 17 per cent thought they were on a par with developed markets.

Finally, and perhaps most surprisingly, they were still positive about alternative assets, especially fund of hedge funds.

Clearly the financial advisers see the need for active management in this environment. But can they get their clients to listen?

Right now they are still treating their ‘disgust’ symptoms. Let’s hope they can quickly find a cure. Because if they can’t they will soon be dealing with disappointment when these passive investment strategies fail to deliver the anticipated returns.

Mark Thomas is chief executive officer of van Eyk Research.