The Positioning of Westscheme in meeting the Challenges of Market Turmoil
On 13 February 2008 the Westscheme Trustee Board considered the current uncertainty in investment markets with Dr David Chessell, Director of Access Capital Advisers, Westscheme’s investment adviser. A number of interesting observations were made.
Panic generally follows periods of sustained euphoria in financial markets. While no two episodes are the same, booms generally lead to excesses of some kind (in this case an irresponsible relaxation of standards for US residential loans) that sow the seeds for the subsequent panic.
Listed equities are very sensitive to these swings in sentiment and it is common for equities to give up a sizeable portion of the gains attained during a boom in the subsequent market downturn.
Strategies that rely on listed equities as the main growth driver of an investment portfolio are bound to experience periods of negative returns. This puts enormous pressure on decision makers to make tactical deviations from long term strategy when they would generally be better off holding their nerve.
Westscheme’s principal (default) investment option is the Trustee’s Selection, which is used by around 97% of its members and holds about 94% of its funds under management. The Trustee’s Selection uses a two portfolio strategy: a Market Portfolio (MP), which holds listed Australian and overseas equities and cash, and a Target Return Portfolio (TRP), which holds unlisted investments. This approach diversifies the sources of growth for the Trustee’s Selection.
The TRP is intended to provide returns that are greater than equities with a risk that is between equities and fixed interest (bonds), and a low correlation with equities. In plain language, the TRP is intended to provide more stable returns than relying on equities, without sacrificing performance by holding fixed interest, the defensive asset of choice of most Australian superannuation funds.
Since Westscheme's adoption of the two portfolio strategy, there has been one major 'experiment' of how it works in an investment market downturn - the “tech” wreck of 2001-2003. The TRP continued to deliver returns of between 7%-13% during 2001-2003. We may be in the early stages of the second 'experiment'.
The US housing market is the epicentre of the current downturn. Westscheme has very little direct exposure to the US housing market.
A US recession, if one eventuates, will have negative implications for corporate earnings and earnings from TRP assets. Westscheme has slightly below average exposure to US listed equities compared to most other superannuation funds. The values of Westscheme's TRP assets are only expected to fall in line with any decline in economic activity, in stark contrast with the massive sell-off in listed equities that have been occasioned by US recession fears.
Because many of the investments in its TRP are valued on a discounted cash flow basis, a key issue for Westscheme in assessing the impact of the financial crisis on projected returns is whether long term interest rates will increase. In prevailing circumstances there is no compelling reason valuers should adopt higher discount rates to value TRP assets. While one effect of the credit crisis is that risk margins have returned to more normal levels, in a crisis money seeks a safe haven and so the risk free rate, if anything has declined since the onset of the crisis and risk margins for TRP assets have been unaffected. Neither is expected to blow out if the crisis continues.
One important change in the design and construction of the TRP since the 2001-2003 sharemarket down-turn has been the increased geographic diversification of Westsheme's TRP holdings. This reduces exposure to the Australian economic cycle, but has increased exposure to the cycle in the rest of the world, including the US. While US assets account for about one fifth of Westscheme's total TRP, they largely comprise stereotypical infrastructure assets with low sensitivity to the economic cycle.
Westscheme enters the current episode of panic in better shape than the vast majority of superannuation funds in Australia. At the end of December 2007 it is ranked in the top quartile in the SuperRatings survey over one, three and five years and the TRP is generating returns well in excess of target. On average, based on the Trustee's Selection option, Westscheme currently has 7.5% less exposure to Australian equities and 0.5% more exposure to overseas equities than most superannuation funds.
Even if the returns generated by the TRP decline from current high levels (and this is likely irrespective of the US economic plight), there is every likelihood that TRP returns will remain positive and it is most likely that the TRP will outperform equities over the long term.
Adherence to the current investment strategy is likely to deliver superior returns to members of Westscheme during the current market ructions. In the meantime, Westscheme's normal rebalancing process ensures that new cash flow will be directed towards buying listed equities during this period of depressed prices.
As always however please be aware that there is no guarantee that past performance will be replicated in the future.
Howard Rosario
Chief Executive
21 February 2008
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