Proving your value in an uncertain market

According to the latest Investment Trends research poll, investor confidence in September hit its lowest level since the global financial crisis. Investors expect a mere two per cent, which is down from six per cent last quarter.

For sophisticated advisers – particularly those in the SMSF sector – this presents an opportunity to demonstrate the value of Adviser’s Alpha.

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Alpha in investment circles is commonly used to describe outperformance of a market return. Advisers basing their client value proposition around long-term investment outperformance – effectively market timing and security selection – do so in the face of mounting evidence that these efforts help neither their clients nor the advisory business in the long term.

The term ‘Adviser’s Alpha’ refers to a framework within which the real value of financial advice can be understood to be more than simply pointing to a portfolio return number versus market benchmarks.

Advisers in the SMSF sector seek to add value to clients in a range of ways: portfolio construction, tax and contribution strategies, asset location, insurance and estate planning, as well as social security advice.

Rather than tying an adviser’s value proposition inextricably to outperforming investment markets, the Adviser’s Alpha approach provides a more pragmatic framework that looks for the adviser to act as a wealth manager, financial planner and behavioural coach – providing discipline and reason to clients who can often be undisciplined and emotional.

In times of market shocks, an adviser’s experience and stewardship can be particularly valuable to clients, because left alone, investors can make choices that impair their returns and put at risk their ability to achieve their long-term objectives.

In that sense, the Adviser’s Alpha framework suggests a better measure of an adviser’s value is to judge it against what an investor would likely do without professional advice.

In financial planning circles, the shift to a fee-based model has also promoted stronger client relationships and more reliable income streams that do not depend on a transaction, and, along with that, momentum is building for higher professional standards.

However, explaining the value of ongoing fees can be a challenge when the right advice may well be to sit tight and ride out the recent market gyrations because the well-constructed, properly diversified portfolio is just as appropriate today as it was when it was implemented based on the client’s profile and long-term objectives.

Some clients can simply under-appreciate – in the heat of a market event – the wisdom of not allowing short-term market actions to blow a well thought-out investment strategy off course. That is the challenge for advisers in their role of behavioural coach.

But for other clients, market volatility may well be the catalyst for opening a broader discussion around risk, either within the portfolio or as a result of the real-world reaction of clients when market values have dropped sharply.

A good example is the considerable media discussion around the levels of concentration risk with SMSF portfolios.

Data and analysis from various industry analysts covering both retail and institutional offerings demonstrate that Australians allocate a large proportion of their equity exposure – usually at least 50 per cent, and in some cases substantially more – to Australian equities. This represents a significant overweight to Australia compared to its weight in global markets of closer to three per cent.

So-called ‘home bias’ is a common phenomenon observed in other regions such as the US, UK, Canada, and Asia, to name a few.

There are valid reasons this home bias phenomenon has been observed all around the world. There can be regulatory limits on investing abroad. In some regions, the cost of investing overseas may be substantial. Behavioural biases, such as the preference for the familiar, contribute to the phenomenon. And last, but certainly not least, tax rules can incentivise investing locally and/or discourage investing abroad. This is particularly relevant in Australia, where imputation credits are a primary reason many investors’ portfolios are considerably overweight Australian equities.

When you look at the S&P/ASX 300, the top 10 securities currently represent about 50 per cent of the market.

For context and comparison, the top 10 stocks in the US market account for about 17 per cent, 31 per cent in Japan, 38 per cent in the UK, and 47 per cent in Canada.

The concentration of a small number of companies also means that investors are highly concentrated in certain sectors. Today, financials and materials and mining companies together represent more than 60 per cent of the S&P/ASX 300. This is in line with historical norms, but nevertheless represents a high degree of exposure to two sectors, particularly since no other sector represents more than eight per cent of the index. And for global context, the Australian market is more concentrated in its largest two sectors than all those noted above, only matched by Canada (60 per cent).

So, not only are we highly concentrated in Australian equities, our exposure within Australian equities is highly concentrated in a few companies and sectors, and the degree of this concentration has been growing over time.

So, has this hurt investors?

As always with investing, it is hard to say and depends on the measurement period. There will certainly be many SMSF investors and advisers who would be grateful for having had a high level of home bias during the years of the GFC.

However, over the past three years, international equities (+26.1 per cent annualised) have markedly outperformed Australian equities (+14.7 per cent), but on a longer-term basis of 10 years the local market has outperformed (+6.9 per cent versus +6.2 per cent).

It is hard to be critical of investors for maintaining a strong home-country bias through an extended period when:
• the domestic economy was generally healthy and growing;
• there was strong performance in those few areas – financials and mining – where our market is concentrated; and 
• healthy dividends that receive favorable imputation treatment were seen.

The challenge for advisers and SMSF investors is that nobody can forecast future market returns and there is certainly no guarantee the past will repeat itself.

Where we do have more certainty though is that home bias and concentration risk can be managed by diversification across global markets.

Investors may not be able to insulate themselves from market volatility in the global world we live in, but a clear opportunity for advisers is that they now have a wider array of asset allocation tools to help build client portfolios.

Robin Bowerman, principal, market strategy and communications, Vanguard Australia