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International shares: To hedge or not to hedge?
Strong Aussie dollar wipes out international share gains …
In our recent article, “Should you hold international shares in your investment portfolio?”, we argued that there are diversification or risk reduction benefits from holding international shares as part of a share portfolio. To keep it manageable, we did not directly address the exchange rate risk that comes with owning shares denominated in another currency.
However, with the Australian dollar (AUD) appreciating 36% against the US dollar (USD) and 25% against the Reserve Bank’s trade weighted basket of currencies over the six months to September 2009, we are concerned that some poor decisions are being made in response.
The past six months has seen strong local currency gains in international shares almost completely offset by exchange rate losses when converted to AUD. This has resulted in some investor disenchantment with international shares. The knee jerk reaction has been to either reduce the international share allocation and/or to choose share funds that are protected against exchange rate movements i.e. hedged.
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How far to financial freedom?
What you live off when you’re not working …
In our introductory meetings with potential new clients, we want to obtain a preliminary view of their “Net Investment Wealth”. It quickly gives us an idea of how far along the road to financial freedom or financial independence they have come and how far they have to go.
Net investment wealth is your net worth less your lifestyle assets. It’s the stuff available to live off when you are no longer earning income from your work.
To make the concept more concrete, consider Steve and Kate Wilson. Their assets and liabilities are shown below:
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The Golden Rules of Investing
When it comes to investing, there is an inordinate amount of information and opinion that is freely available. Most people have an opinion about the direction of the economy, markets, which asset classes or sectors will do best, and which specific securities will out perform. And most of these opinions are supported by valid reasoning and sometimes by informational “evidence”.
But how helpful is this when investing?
To be a good investor over the long term you need to abide by some intelligent investment rules. Unfortunately, devising the rules is a much tougher act than coming up with forecasts and opinions. Following the rules is even tougher, especially when they may conflict with your forecasts and opinions.
The three golden rules:
- Never invest until you have an articulated, long term strategy with a clear set of rules for investing;
- Never disobey the rules;
- Never ignore the rules. To do so makes them obsolete. Replace them with revised and improved rules, but never ignore them.
Ownership of family wealth
Which structure is best?
For our clients, there are predominantly four ways they hold their personal wealth. They are:
- Directly, either as an individual or jointly;
- In a private investment company;
- Through their family trust; and / or
- Via a self managed or public superannuation fund.
Which structure is best? It depends. But given our emphasis on focusing on the things you can control, the structure choice is one that needs serious consideration. There are a number of often competing factors to take into account, with taxation, asset protection and succession / estate planning usually most prominent. This article considers some of the issues.
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Franked dividends and your investment strategy
Is franking a free lunch …
Many D-I-Y investors skew their investment portfolios towards shares that pay franked dividends. This is particularly prevalent amongst trustees of self managed superannuation funds who appear to over value the benefit of franking credits.
There appears to be a view that franking offers “a free lunch”, resulting in its overemphasis as a driver of investment strategy.
We believe investors should not favour particular shares simply because they pay franked dividends. The usual thinking behind such behaviour is, in our view, flawed.
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Financial Planning: Personal Financial Advice or “Product Flogging”?
They make used car salesmen look good …
The financial planning industry (and a number of accountants dubiously playing on the edge) has come under intense fire recently.
The downturn in investment markets has exposed a number of products that have not turned out to be in clients’ best interests. These include high yield mortgage funds, absolute returns funds, agribusiness and protected equity products and excessive margin lending.
Criticism of planners and offending accountants that promoted these products is well justified. In many instances, it is difficult to resist the conclusion that their sale was driven or too heavily influenced by what was best for the promoter.
But, judging from public responses to a number of recent newspaper articles adverse to financial planners many people also blame their financial adviser for recent poor investment performance and/or failing to get them out of share markets prior to the downturn.
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Mortgage or Super?
Are you better off reducing your mortgage or contributing to super?
A lot of people ask this question. Unfortunately, as with many wealth management decisions there is no straight forward answer. The appropriate choice depends on a number of issues, some of which we address in this article.
The obvious starting point is to look at the numbers. Assume you have 15 years until you can access your superannuation benefits free of tax. You have a mortgage that is costing you 7.0% a year (after tax) and a small amount of super. Over the next 15 years, you expect to have at least $13,375[1] a year of surplus cash flow.
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Investment Gobbledegook …
There are no orphan shares …
A lot of what passes as serious investment commentary is simply “gobbledegook” i.e. nonsense or drivel. It defies share market realities and is at odds with the philosophy that markets work.
Yet, unfortunately, some of the people and organisations generally regarded as finance experts are the main proponents of this gobbledegook. Let’s consider a couple of examples.
In a recent article in the “Sydney Morning Herald”, a private client adviser of a major stock broker explained why the share market had fallen for the past three days, after a period of strong gains, as follows:
“I think it comes down to a bit of profit-taking. I guess the market is acknowledging we’ve had it pretty good for the last couple of months and it’s time to take a breather.”
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Protected Equity Products: Can you have your cake and eat it?
Loss protection and tax advantages …
Protected Equity Products (PEPs) are heavily marketed at this time of year.
They are promoted as an opportunity to benefit from share market growth, without the risk of losing capital. They involve borrowing up to 100% of the purchase price of a basket of shares for a minimum period (generally 3 – 5 years). You keep the dividends and any gains and are protected against investment loss.
The loan interest is also usually prepaid to bring forward a tax deduction and reduce a current year “tax problem”. What a deal – no downside and tax benefits!
However, even with this basic explanation, the alarm bells should ring for smart investors. PEPs play to at least one psychological bias (i.e. “loss aversion”) that investors should be wary of and contradict at least one of our wealth management decision making principles (i.e. “It’s about ends, not means”).
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Should you hold international shares in your investment portfolio?
Invest in international shares for reduced risk …
Many individual investors, particularly do-it-yourselfers, do not hold international shares in their investment portfolios. Why would you, they ask – returns have been poor for almost a decade now.
But the argument for allocating part of your share portfolio to international shares is not based on returns. Returns cannot be reliably predicted – past performance does not provide a guide to future performance.
As part of your portfolio, international shares offer the prospect to reduce risk without affecting expected return i.e. increasing your risk adjusted rate of return. This is partly the “don’t put all your eggs in one basket” idea. But also because global share markets do not go up and down in tandem with the Australian market, international shares can reduce the variability of your share portfolio’s returns.
The risk reduction effect, or diversification benefit, is sometimes called “the only free lunch in finance”. But if this argument for holding international shares is accepted, how much should be allocated to them?
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