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Investment Philosophy & Portfolio Construction

Posted by Sean O'Kane & Neal Durling on 15 February 2018

 

About Medical Financial Group

Our role is to maximise the probability of you achieving your financial objectives.

We take this responsibility very seriously and value the trust our clients (and their families) put in us.

This document outlines our investment philosophy and how we manage money. It's important, however, to first put this step in context.

Discovery

Money means different things to different people and truly understanding what's important to you and your loved ones forms the basis of our advice relationship with you.

In maximising the probability of you achieving your financial objectives it's important we don't make any assumptions about what we need to do to perform this role.

The purpose of our discovery meeting is for us to understand your financial objectives at a deeper level. Our resources and those of our deliverables team can then be harnessed to give you the highest probability of success. We use this information to produce an Advice Road Map, which is your financial life on a page and Terms of Engagement offer which we present at the Engagement meeting.

Engagement

Based on research, we believe clients are looking for value outcomes rather than products and the following in particular:

  1. Long term advice relationship built upon trust
  2. Understanding and transparency at all levels and throughout the end to end engagement process
  3. To understand and feel in control of their financial situation

At the Engagement meeting we will present your draft Advice Road Map and our proposed scope of advice together with the fees to engage us. We believe this process builds trust, delivers clear expectations with a transparent fee structure and allows you to understand the engagement process and the outcomes we are working toward.

Strategy

Whilst there are many strategies we use for clients this document is specifically focused on investment.

Effective strategy has the largest impact on your eventual financial outcome. How much to invest, when to start and which structure(s) to use are all important considerations. How to achieve a strong after tax outcome and how leverage could be used will also be considered.

Our Investment Philosophy:

  • Educating clients improves investment returns
  • Time in the market not timing the market
  • A disciplined approach underpins successful investing
  • It's less about beating the market than harnessing it
  • Asset allocation and diversification are key
  • After tax returns are what matter
  • Minimising costs can improve returns

These beliefs form the core of our approach and are important for you to understand.

Belief 1: Educating clients improves investment returns

We believe a big part of investing is simply avoiding the mistakes that the large majority of investors make. There have been many behavioural finance studies showing that without advice investors will consistently make mistakes which cause them to perform poorly. According to the 23rd Annual Quantitative Analysis of Investor Behaviour by Dalbar:

  • In 2016, the average equity mutual fund investor underperformed the S&P 500 by a margin of -4.70%. While the broader market made gains of 11.96%, the average equity investor earned only 7.26%.
  • Equity fund retention rates decreased materially in 2016 from 4.10 years to 3.80 years. (This is directly related to psychology and behaviour.)
  • In 2016, the 20-year annualized S&P return was 7.68% while the 20-year annualized return for the Average Equity Fund Investor was only 4.79%, a gap of -2.89% annualised.

Some of the reasons that Dalbar has identified for this happening and indeed we see with clients are shown in the diagram below:

 

 

Belief 2: - Time in the market not timing the market.

Warren Buffet, arguably the most successful investor of all time, has a great quote that sums this up nicely "Our favourite holding period is forever." The diagram below is taken from the JP Morgan Guide to Markets and in simple terms shows the difference between the low point during each calendar year and the ultimate year end return.

 

 

You can quite clearly see that in almost all years there is a big difference between the low point for that year and the ultimate return at the end of year. Taken from the same report, the following shows the impact on not having your money fully invested in the market and missing the best days for investment returns. It's quite staggering to think that by missing the best 10 days over 21 years the reduction in performance is 212% per annum or almost 40%.

Belief 3: - A disciplined approach underpins successful investing.

Truly successful investing is not about chasing the highest return in any one year, but taking a strategic and disciplined approach.

At the heart of this is not reacting to short-term performance but, rather, understanding that different market conditions will favour different asset classes, investment styles and strategies resulting in a tail wind for some of your investments and a head wind for others.

Because of this, within a diversified portfolio is quite usual for some investments to be underperforming others and at times even go down.

This in itself is not a reason to change your portfolio and indeed holding these investments is often important so you can benefit from the time when market conditions favour these investment types.

The diagram below shows asset class returns for each of the last 15 years and lists them in order from highest to lowest. You will see there are a number of years where the top performing asset class becomes the bottom performer the following year.

 

Belief 4: It's less about beating the market than harnessing it

In Vanguard Investments Research Report, "The case for low cost index investing" the xero-sum game theory is explained:

The theory states that, at any given time, the market consists of the cumulative holdings of all investors, and that the aggregate market return is equal to the asset- weighted return of all market participants. Since the market return represents the average return of all investors, for each position that outperforms the market, there must be a position that underperforms the market by the same amount, such that, in aggregate, the excess return of all invested assets equals zero.


Figure 1 illustrates the concept of the zero-sum game. The returns of the holdings in a market form a bell curve, with a distribution of returns around the mean, which is the market return.

 

Figure 2 shows two different investments compared to the market. The first investment is an investment with low costs, represented by the red line. The second investment is a high-cost investment, represented by the blue line. As the figure shows, although both investments move the return curve to the leftmeaning fewer assets outperformthe high-cost investment moves the return curve much farther to the left, making outperformance relative to both the market and the low-cost investment much less likely. In other words, after accounting for costs, the aggregate performance of investors is less than zero sum, and as costs increase, the performance deficit becomes larger.

 

And this is borne out in the returns of actively managed funds compared to the index, shown below:

 

So if it's not about beating the market index, what is it about? We will explain this in our following beliefs:

Belief 5: Asset allocation and diversification are key

We believe a sound investment strategy starts with an asset allocation suitable for the portfolio's objective, built on reasonable expectations for risk and return, and using diversified investments to avoid exposure to unnecessary risks.

There have been a number of studies that show asset allocation is by far the biggest determinant of return, as shown below:
 

Diversification is a genuine way of reducing uncertainty in your portfolio by spreading your investments across multiple asset classes and multiple securities. We employ a core and satellite investment approach that uses a low cost diversified index fund as a core and then select active managers as the satellites.

It's important to point out that the aim of this approach is not to try and beat the market. The purpose is to improve diversification, reduce volatility and provide some protection in falling markets.

Our asset allocation guidance is taken from Jana who have 30 years of experience in the field. Our fund selection is done using 360 Research, Morningstar and Lonsec research houses.

For all of our portfolios we run a correlation matrix from Morningstar, using historical returns, to see how each investment correlates with the others. Clients often think they have some diversification by holding two different funds, when in fact the historical correlation between the two can show quite the opposite.

All of our portfolios are reviewed quarterly, unless we are provided with advice during the quarter from one of our consultants that a change is required.

As a large number of our clients are starting their investment journey, we usually implement the portfolio in stages, over a period of time, to reduce complexity and implementation cost.

 

Belief 6: After tax returns are what matter

Who owns an investment and their tax rate will have a big impact on the after tax returns received. In the US publication of after tax returns for all investments is mandatory. Unfortunately in Australia this is not the case, although the more tax aware funds will provide this information.

Let's look at some examples of the impact of tax on a super fund where the top tax rate is 15% and an individual whose tax rate is 47.5%. Both are for a $500,000 investment yielding 6% income and 2% capital growth per annum:

For the super fund:

  • $500,000 x 6% = $30,000
  • $500,000 x 2% = $10,000

Taking off tax on the income portion:

  • $30,000 15% ($4,500) = $25,500

Remember tax on capital gains is not paid until realised so it has been ignored in this example. Therefore, after tax on the income has been taken into account, the year- end return is:

  • $35,500 or 7.1%

And now let's look at the 47.5% tax payer:

  • $500,000 x 6% = $30,000
  • $500,000 x 2% = $10,000

Taking off tax on the income portion:

  • $30,000 47.5% ($14,250) = $15,750

Therefore after tax on the income has been taken into account the year end return is: $25,750 or 5.15%

Thus overall a 1.95% difference!

Tax is only paid on capital gains when the gain is realised and where the asset has been held for more than 12 months the gain is discounted by 50%. Thus a 47.5% tax payer might only pay a tax rate of 23.75% and even be able to choose a year when their income is lower to reduce the liability further.

Fund managers don't always take this into account when buying and selling assets in a fund and Investors are often unaware of the tax impact of high turnover funds.

Fortunately we are aware of this which is why we favour low portfolio turnover funds i.e. buying and holding with a focus on growth and tax effective income for investments where the individual has a top tax rate of 47.5%.

For super funds this is less of a concern as the tax rate is far lower.

Belief 7: Minimising costs can improve returns

When investing there are a lot of things out of our control especially market returns.

Therefore we need to ensure that the things we can control, such as costs and taxes, are managed well.

In respect of costs, high admin and management fees can act as a drag on performance, which is often not represented in better after tax returns for clients.

Morningstar recently studied the fund characteristics which predict future outperformance, a summary of which is shown below:

So does that mean we only use low cost index funds and ETFs? No.

As explained earlier we use an indexed core with selected active fund managers where they are expected to add out performance, diversification or downside protection qualities for our clients. This is, however, only done after carefully considering their relative cost.

Author: Sean O'Kane & Neal Durling
Tags: Financial planning Investment

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The information on this site is of a general nature. It does not take your specific needs or circumstances into consideration, so you should look at your own financial position, objectives and requirements and seek financial advice before making any financial decisions.

The financial planning services are provided by Medical Financial Pty Ltd trading as Medical Financial Planning (AFSL 506557)