Why do people invest?
One of the many roles of financial markets is to provide an avenue for private investors to accumulate...
Why do people invest?
One of the many roles of financial markets is to provide an avenue for private investors to accumulate wealth and generate additional income. As the Australian government makes it harder to access pensions and welfare, people will need to look for other ways to generate extra income. This transition has been underway for some time, with more and more Australians are relying on their superannuation to pay for their retirement. Table 1 shows the growing importance of superannuation and investment income for the Australian household. This growing reliance on investment income raises important questions, like:
- How can I generate additional income?
- Am I generating additional income in the best way possible?
- What are the future prospects for generating sufficient additional income?
How can people invest?
Australian financial markets have evolved over the years, so households now have many ways to invest. Some instruments will offer the potential for higher returns, but this generally comes with higher risk and greater volatility (and the chance of experiencing losses). Understanding these risks is critical for an investment process. Investors also have the option of generating their returns via income or capital growth. There are many things to think about when looking at these options, but a good rule of thumb is that income and its stability become more important as the investor gets older and closer to retirement. However, in reality it is likely that many investors do not adjust their investment strategy to match their age and risk profile.
In basic terms investors allocate their wealth between growth and defensive assets. Growth assets include shares (both domestic and international) and property, with defensive assets including bonds and other fixed income assets. Modern portfolio theory suggests that as an investor’s risk aversion increases, so too will their allocation to defensive assets. Age is a big factor in risk aversion. The “100 minus age” rule says that someone close to retirement should have a portfolio with 40–50% defensive assets, while someone just starting out in the workforce should only have 10–20% of their wealth in defensive assets. This argument is based on the idea that a risk-seeking investor is willing and able to handle “short-term” losses.
How do Australian’s invest?
Table 2 presents the average asset ledger for an Australian household. Outside of the family home (owner occupied dwelling) the value of shares, superannuation funds, and investment properties form a sizable proportion of household wealth. Given the significance of this cohort it is essential that households are following a prudent investment process, otherwise the potential exists for the generation of inferior returns, or worse wealth destruction.
Superannuation balances clearly play a significant role on the household balance sheet. Many of these funds are managed by professionals, either Industry Super Funds or Retail funds, thereby reducing the chances that an individual invests inappropriately. However, approximately a third of the wealth in super funds is in self-managed funds (SMSFs), thus potentially heightening the risk of poor investment outcomes due to overly an aggressive investment strategy. While every investor is different, for the average investor it is most likely inappropriate to have an excessive allocation to shares and other growth assets.
The Australian Securities Exchange (ASX) conducted a survey concerning private investors recently. Figure 1 gives a brief overview of where Australians are investing their money. Direct shares and real estate play a big role, which suggests that Australians may rely too heavily on growth assets. However, this outcome is not completely without reason. Bonds and other fixed income investments are noticeable in their absence, or close to it. It appears that Australians think that a term deposit is the best defensive asset, but over the past ten years any investment that gave a return below the official cash rate was not a good one.
Figure 2 presents a starker view of Australian households’ reliance on shares over bonds. Contributing to this disparity is the relative immaturity of Australia’s retail bond market. However, there is little doubt that Australians have a strong disposition to placing their wealth in shares or property (growth assets). Supporting the overallocation to equities is the 400% capital return since 1988 with total returns, which includes dividends, even higher again. Table 3 highlights for the S&P ASX 200 that dividends play a crucial part in return profile for equities.
Has it worked?
At this point it is worth fleshing out why equities are so popular in Australia. The first is the lack of viable alternatives, with $1.9 trillion of Australian bonds on issue compared to the ASX’s market capitalization of $2.3 trillion.
Australian equity investors have also experienced reasonable returns since 1988, even considering the effects of the Global Financial Crisis (GFC). This means that many investors are carrying considerable non-realized capital gains and no doubt hold expectations that these gains will continue. With ongoing gains not guaranteed, the reliance on shares is suggestive that many investors may suffer from behavioral biases. Specifically, investors may have formed the incorrect expectation that recent strong returns will continue indefinitely.
Finally, the Australian tax system offers very favorable terms with regards to how franked dividends are handled, a point compounded by the even more favorable treatment of franked dividends and capital gains within the superannuation environment.
Table 3 provides a more granular view of the performance of the S&P ASX 200 Accumulation Index in each of the previous 11 financial years. During that time, the average return has been 10%, with 60% coming from dividends and the rest from price appreciation. The RBA cash rate, which is a stand-in for the return on a term deposit, is much lower than these returns. Even though the average return over the period would be considered acceptable for most investors, it was not achieved consistently. If you don’t include the generally stable income return, the returns ranged from -11.1% to +24.0%. It is this range of returns that lies at the heart of the question of whether Australian’s have an appropriate allocation to equities.
What worries investors?
From the previously mentioned ASX report, Figure 3 provides a breakdown of what concerns investors. Underperformance and not identifying the correct companies are pressing concerns which can be generally addressed by utilizing index funds. The highest concern relates to handling excessive volatility, especially with retirees. This outcome immediately raises the question as to whether the current allocations to equities are appropriate. The textbook answer is no. If investors are that concerned with volatility, then they should be seeking alternative investments, namely defensive assets.
How to deal with low interest rates is another important issue. Even though this issue is reducing due to central banks raising interest rates to deal with excessive inflation, it could have negative repercussions for equities. Investors also need to be aware that real interest rates, which are calculated by taking the nominal rate and subtracting inflation, are now negative. So, holding an investment like a term deposit that simply matches the cash rate is detrimental as the holder is experiencing a loss in purchasing power.
As seen in Table 3, in simple terms the dividend yield of the ASX200 has maintained a relatively constant spread over the RBA cash rate. Therefore, as the cash rate rises investors will expect dividend yields, but not necessarily dividend payments, to increase. An increase in yield can come via two mechanisms. The first is that a company’s profits, and therefore the funds available for dividends, grow at a rate that matches the rising interest rates. This is the preferred outcome for investors as such a scenario would support current share prices. The less palatable option is that share prices will fall, which has the effect of increasing the yield but at the expense of one’s capital. Importantly, the investor will be worse off in this situation because the dollar amount they receive will be the same and their capital base will have reduced.
Worry factor – equities
An important consideration for investors is how much anxiety dividend volatility causes. If their tolerance of volatility is low, it makes sense to look for alternatives that are better suited. Figure 4 shows that since the COVID-19 outbreak, the sustainability of dividends has grown in importance for Australian investors. The effect of diversification on return and volatility has also become a concern for investors. Based on these points, it seems like now is a good time for investors to look for alternative investments that can give them a steady income with little change in their capital value. As discussed below, the latter point may become a greater concern as the recent bull market, which was partly fueled by excess liquidity and favorable growth conditions after the COVID-19 outbreak, reverses and equity markets undergo a correction.
Alternatives – credit
Figure 5 shows that in general most people prefer a relatively stable return. The exception being high net worth individuals, who are prepared to take greater risks to accelerate their wealth accumulation. However, the theme from Figure 5 is inconsistent with the asset allocation decisions of most Australians. A contributing factor to this outcome may be the lack of understanding of the alternative products.
One class of investment that is not well understood in Australia is credit funds. The relatively small size of the Australian credit market and the negative publicity concerning credit’s role in the GFC are two of the main reasons why credit funds aren’t as popular as they could be. But as a result of the top banks withdrawing from many lending markets more suitable investment vehicles have become available. Thereby, the Australian credit market has become a realistic option for investors who want a steady income and low volatility in their capital.
Table 3 also illustrates the performance of the Moody’s USA BBB Corporate index against the S&P ASX200. This index has been selected as a proxy for a standard credit fund. The justification for utilizing the index as a proxy for a credit manager is that it reacts to the prevailing credit conditions and interest rate environment. However, it is not entirely representative as it is a credit manager’s role to adjust their portfolio such that they minimize any capital losses as credit conditions deteriorate and rates rise, while also gaining from increasing income as interest rates rise.
The return profiles of the two indexes are distinctly different. Crucially, income has made a more meaningful contribution to the returns of the credit index, with the capital returns remaining relatively stable. For an investor this means that, regardless of the market conditions, the probability of them being able to reclaim at least their initial investment at any point is much higher with a credit fund.
Figure 6 provides a clear demonstration of the contrasting return profile of a credit fund and an equity index. The chart compares the value of a dollar invested at the start of 2020 until September 30, 2022, for both Moody BBB index and the S&P ASX200 Accumulation index. Importantly this period covers the initial negative effects of the pandemic and the subsequent rally. The most striking feature is the relatively linear way the returns for the BBB index have progressed versus the equity index, which has been quite volatile. Importantly, the compounded value of the original investment is not materially different.
Returning to the implication of Figure 5, for investors that prefer guaranteed or stable returns, a credit fund may be worth consideration.
Credit funds were not immune to declining income returns during the recent periods of low central bank rates. However, there is a distinct mechanism underwriting the income generation of credit funds. In basic terms, a fund will invest in securities that pay a spread over a benchmark rate such as the bank bill swap rate (BBSW). The spread is set, and remains fixed, at the initiation of a given security. A security with a lower credit rating (higher risk) will have a higher spread to compensate investors. The BBSW rate is driven by the official cash rate. Therefore, as the official cash rate increase so will the income that a credit fund generates.
Another characteristic of credit investing is that unlike equities – where an investor buys equally ranked shares in a company, for example BHP – credit investors have the option of investing in debt securities with different levels of risk. The reward for investing in a higher risk debt security is that the spread over the BBSW rate will be higher. A security’s rating is roughly based on the credit worthiness of the assets underlying it and the level of protection from defaults. Generally, the rating of a security is determined by an independent ratings agency, such as Moody’s or S&P, thereby enhancing the legitimacy of the ratings. A key attribute of a credit manager is to match their risk exposure to the upcoming economic conditions. That is, when the economy is looking stronger a manager will increase their exposure to the riskier securities, and vice-versa when the economy is looking weaker. While decreasing risk may have a negative effect on a fund’s income, the credit manager is able to protect the capital of its investors.
While rising rates are good for income returns, they are generally detrimental to the capital value of financial assets. A credit manager has at least two levers at their disposal to minimize the negative effects of increasing interest rates. One option is to invest in floating rate securities because the increase in income directly offsets the lost capital value. Another strategy is to invest in short-dated securities. This strategy works because unlike equities, which are meant to exist in perpetuity, a debt security has a maturity date. When a security reaches its maturity, the holder will receive the face value of the security[1]. Without delving into the details, its sufficient to know that in a rising rate environment a credit manager prefer securities with shorter maturity dates. Additionally, if a credit manager holds a floating rate security to maturity they will receive the face value of the security, thus negating any interim capital losses.
What might work going forward
Like a smart military general, successful investing is not about winning the last battle but rather planning for the next one. Figure 7 shows that over the last 100 years a typical investor has done well for themselves. However, there are four distinct periods where returns have stagnated. To win the battle in these periods requires access to investments with a strong income yield and minimal risk to the underlying capital. An appropriately structured credit fund is one example of an investment with the capability to meet this challenge. Additionally, such a credit fund will not be left lagging behind when equity markets enter a new bull market.
Due to the many challenges facing financial markets, for example rising cash rates, high inflation and geopolitical tensions the possibility of stagnant capital returns for years to come is very real. Therefore, for the average Australian investor, the question to ask is a fairly straightforward one – after such a strong period of equity returns, is my portfolio set up in a way that fits my investment goals and risk profile?
Conclusion
If the answer to the last question is negative, investing in a credit fund may solve the problem. As shown in Table 3, a credit fund is a good investment because it can give a steady return no matter what the market is doing. The returns are possible because a credit manager has many tools at its disposal to change the shape (shorthand for risk exposure) of its portfolio to match current market conditions. The goal is to protect capital and provide a relatively stable income stream.
The risk appetite of Australian investors is somewhat inconsistent with their portfolios. This outcome is no doubt influenced by both structural and behavioral issues. Structurally the Australian tax system favors dividends, and debt markets have not developed at the same pace as their international peers. Behaviorally, Australian investor may be suffering from recency and anchoring biases. That is, recent returns have been strong, so the expectation is that they will continue to be that way. Alternatively, investors may be anchored to the expectations that Australian shares will continue to deliver strong income and suffer minimal losses. However, with recent developments in investment markets, now may be a good time to think about how to change one’s portfolio to match their true risk tolerance.