Strategic Super Investor – Pt 1 of 3

posted on December 20th, 2012 by Bellmont Research Team

Simon Headshot

The Strategic Super Investor has spoken with three SMSF professionals and provided each advisor with a different SMSF investor scenario. We asked them to allocate a portfolio according to the circumstances of each case. In each issue for the next 12 months, SSI will track each portfolio and our expects will comment on performance and adjust asset allocations where appropriate…

John and Jane Brown are in their late 50’s they have both recently retired and have approached me saying they wish to invest in Australian equities using $400,000 from their SMSF. They have a long term time frame and have a conservative risk profile. Before launching into any stock selection I believe it is vital to understand the current economic environment and then ensure you have the right strategy to meet your objectives. Many investors jump straight to the stock selection and end up having a scattered portfolio with no real strategy defining their investment selection.

Current Environment

Looking firstly at the current economic environment, I believe there are two key long term economic trends that are going to affect the equity market for many years. That being debt and demographics. We are all well aware of the current debt situation in Europe and the fast approaching “fiscal cliff” in the United States.

While our government balance sheet is the envy of most Western economies our household balance sheets are highly indebted.

However, Australia also has a significant debt problem. While our government balance sheet is the envy of most Western economies our household balance sheets are highly indebted. The current debt to income ratio as quoted from the RBA sits at approximately 150%, one of the highest in the developed world. Over the past 20 years this has risen four-fold as households around Australia took on more liabilities; as we accumulated this debt it fueled economic growth and asset prices went through the roof. However, we have reached a tipping point, where this debt has become unsustainable. We are now starting to see households paying down their mortgages, credit cards and increasing their savings; this deleveraging is occurring worldwide and while increasing debt pushes up asset prices, unwinding debt has the opposite effect in suppressing asset prices.

Demographics

While global debt issues have been highly publicised, the second long term economic trend of demographics has not received near as much attention but is likely to have just as big an impact over the long term. In Australia, as in most Western nations, we’ve got an ageing population. The significant ageing population has been brought about by two factors: the explosion in population growth post World War Two, namely the baby boomers – those people born between 1946 and 1960, and the decline in birthrates since the introduction of the contraceptive pill in the 1970’s.

The economic trend of demographics is likely to have just as big an impact over the long term.

In 2011 we entered the period where the proportion of working age Australians who are actively contributing to some form of economic output is about to decline substantially as the first of the baby boomers (those born in 1946) reach retirement age. On top of the drop in economic output, domestic consumption is likely to drop significantly, as retirees spend on average much less than younger households.

Given the long term economic trends of debt and demographics it’s highly unlikely that investors will obtain the sorts of returns that were achieved in the lead up to the GFC when for many, investing was as simple as purchasing an asset and watching it increase in value. Looking at the Australian equity market since the end of September 2009, the S&P/ASX 200 Accumulation Index (the ASX 200 including dividends) has had a very mediocre return of 5.64%*. In order to generate reasonable returns across all asset classes, but especially in equities investors need to have an intelligent investment strategy and be disciplined in its implementation.

The buy-write strategy

As it is unlikely that capital appreciation is going to be the main driver of returns, the standard index portfolio, index tracking ETF or managed fund is not suited to this new investment environment. Instead we are focusing on generating additional income and growth through the use of index call options to substitute the lack of capital appreciation and reduce risk. By incorporating an index option over our portfolio we are agreeing to cap potential capital gains in a particular period, in return for certain income. The income generated cushions against share price falls and enhances returns in slowly falling, sideways, or slowly rising markets.

This approach to investing has been around for many years and is known as the buy-write strategy. While it is common among investors to adopt this approach using individual stocks and stock options, it has generally had a poor performance due to high transaction costs, lack of liquidity, and limited diversification. However, by slightly tweaking the buy-write strategy to incorporate a portfolio of stocks and writing index options (instead of individual stock options), many of the shortcomings associated with the buy-write are easily overcome.

The buy-write portfolio using index options is not a new strategy; numerous academic studies have been undertaken examining the success of the buy-write portfolio strategy from both a return and risk perspective. The most applicable study for the Australian Market was a paper released in 2004 by SIRCA and the Capital Markets Cooperative Research Centre (CMCRC) which examined the buy-write strategy involving the purchase of a portfolio underlying the S&P/ASX200 and simultaneously writing just-out-of-the-money S&P/ASX200 call options. The study looked at a 15 year period from 31st December 1987 to 31st December 2002 and produced some key results including the following:

  • The buy-write portfolio outperformed the S&P/ASX 200 Accumulation Index by 2.23% pa
  • Total risk (standard deviation) of the buy-write portfolio is smaller than the total risk of the portfolio – 5.78% vs 6.15%
  • The risk-adjusted return of the buy-write portfolio, as measured by the Sharpe Ratio, outperforms the risk-adjusted performance of the index portfolio – 0.168 vs 0.067

In summary

“The results confirm that the buy-write strategy generates a higher return than the index portfolio, and the standard deviation of returns on the buy-write portfolio is less than the standard deviation of returns on the index portfolio. On both a total risk and beta-risk adjusted basis, the buy-write strategy outperforms the index portfolio.”

On the back of the study produced by SIRCA & CMCRC the ASX introduced the S&P/ASX200 Buy-Write Index, XBW, which tracks the performance of writing index calls against the S&P/ASX200 Accumulation Index. While you cannot invest directly into the index, it is a tool that enables investors and advisers to independently track the performance of the buy-write portfolio strategy. Since the 1st of July 2004, the inception date of the index, to the 1st July 2012 the XBW has outperformed S&P/ASX 200 Accumulation Index by 36.73% during this period.

At Bellmont Securities we have taken the theory of the buy-write portfolio and applied it in practice with great success. The portfolio has generated a performance of 40.50% since inception*. As the world enters a fundamentally different investment environment of continual low growth and high unemployment, underpinned by substantial debt issues and an ageing population, investors must adapt their strategies. For Mr & Mrs Brown I would be advising the Bellmont Buy-Write Portfolio for their investment strategy. In this article I have examined the current economic environment and strategy that would be applicable for Mr & Mrs Brown, in the next edition I will focus on the breakdown of the portfolio structure and holdings.

This article is part one in a four part series. To read the part two please click here.

*All returns are before fees, not including franking credits (except for the BHP Buyback – Jun11); Inception date is July 23rd 2009; Returns up to 30th June 2012 are for the Bellmont Direct Accounts. All subsequent returns are from the Bellmont Managed Accounts; Past performance is no guarantee or reliable indication of future returns.

Strategic Super Investor Cover Dec 2012Strategic Super Investor Dec 2012 pg1Strategic Super Investor Dec 2012 pg2Strategic Super Investor Dec 2012 pg3



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