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More than 20%, or US$11 trillion worth, of bonds on issue worldwide are currently trading at negative yields1.
While we have not yet reached that point in Australia, interest rates are at record lows after the RBA’s recent back-to back cuts. Indeed, when it comes to rates, we are in uncharted territory, with the view currently prevailing that rates are unlikely to return to normalised levels any time soon. Rather, we appear to be firmly in a ‘lower to go’/‘lower for longer’ environment.
This presents a significant challenge for investors and their advisers – and not just for those seeking income. Given this, we believe that now is an opportune time to re-evaluate investment portfolios: from the perspective of asset allocation broadly; intra-asset class allocation; and the individual components of portfolios. Such analysis should be conducted with a rigorous focus on efficiency, headline costs and net-of-fee returns.
While the environment is challenging, the positive news is that there are still investment options available that can provide both income and growth, as well as investments that have the potential to outperform traditional benchmarks without the drain of high fees.
In this page we will lay out five ways advisers can set their clients’ portfolios up to meet the challenges presented by a low interest rate environment.
1 Source: Bloomberg
1. Make your cash work harder
It’s more important than ever to seek out cash and alternative options that provide both a positive real return and liquidity.
We believe the two essential features of a cash holding are:
- high capital stability with a respectable rate of return, and
The RBA has recently cut the cash rate to a record low of 0.75% p.a., with further cuts expected by many. Given inflation is currently running well above 1.00% p.a., those earning interest on their cash at the official RBA rate are not even keeping pace with inflation.
Worse yet, with cash invested on platforms typically returning well under the RBA cash rate, investors face the potential for significantly negative real returns. To overcome this, investors need to look at alternative options.
Term deposits may offer better rates, but lock cash away for a fixed period. Given that a core requirement of a cash holding is that it is readily available to take advantage of investment opportunities as they arise, the marginally better returns from a term deposit can come at a significant opportunity cost.
Switching into ETFs from a lesser-performing option is a straightforward exercise that can significantly improve an investor’s cash returns.
The BetaShares Australian High Interest Cash ETF (ASX: AAA) holds only cash deposits yet offers both attractive interest rates above RBA cash and platform rates, and the liquidity we believe investors should be seeking. For investors who are happy to move out of cash and up the risk spectrum, an exposure to senior floating rate bonds or hybrids offers potentially higher returns.
The chart on the next page shows the growth in value, since March 2012, of $10,000 invested in AAA, and in a floating rate bank bond index (tracked by BetaShares’ QPON ETF) and a hybrid securities index (the performance benchmark of BetaShares’ HBRD Active ETF), against the return from the AusBond Bank Bill Index. It illustrates the higher returns potentially available from a move up the risk spectrum, and also the higher volatility that goes hand-in-hand with such a move.
Value of $10,000 invested in March 2012
AAA’s performance is net of fees and costs. Shows performance of index QPON aims to track, but taking into account the ETF’s fees and costs. HBRD is actively managed – chart shows performance of HBRD’s performance benchmark, but taking into account the Active ETF’s fees and costs. Past performance is not indicative of future performance of index or Fund. You cannot invest directly in an index.
BetaShares Australian High Interest Cash ETF
ASX Code: AAA
• Invests in diversified cash deposits with major banks in Australia
• After-fee rate of 1.27% p.a. as at 16 October 2019, well above the RBA cash rate of 0.75% p.a.
• Typically significant pick-up over cash rates available on platforms after expenses
• ASX-traded with T+2 liquidity to take advantage of market opportunities – no need to lock cash away in term deposits
• Lonsec – Recommended; Zenith – Recommended
BetaShares Australian Bank Senior Floating Rate Bond ETF
ASX Code: QPON
• Senior floating rate bonds from major Australian banks
• Australian bank senior floating rate bonds historically have exhibited a high level of capital stability and low volatility, even in equity market declines
• Expected total return of ~1.85% p.a. including the estimated benefit of roll return but before fees (yield to maturity, assuming unchanging reference rate, of 1.62% p.a.) as at 16 October 2019.
• Lonsec – Recommended
BetaShares Active Australian Hybrids Fund (managed fund)
ASX Code: HBRD
• Attractive, tax-efficient income paid monthly
• Diversified exposure reduces the risk of directly holding individual hybrids
• Active management by a fixed income specialist targets lower volatility (hybrids volatility historically has been one-third of that of the sharemarket)
• Running yield of 2.81% p.a. net (before fees and franking credits) or 3.84% gross (before fees but including franking credits) as at 16 October 2019.
• Lonsec – Recommended
2. Defence can be the best offence
A well-chosen exposure to fixed income has the potential not only to reduce portfolio risk, but also to at times outperform equities.
Falling interest rates are generally welcomed by investors, who anticipate the economic stimulus a rate cut provides, and the boost to equity valuations that can result.
Sometimes, however, falling interest rates can reflect concerns about declining corporate earnings, and the worry is that deteriorating economic conditions mean that returns from shares are much less certain. We arguably face such a scenario today.
In this type of environment, the more predictable income and capital returns from bonds become even more attractive.
Although bond yields are low, investors should remember that income is only part of the bond story. Falling yields in recent times have meant that fixed coupon bonds have generated very healthy capital returns. In an environment where equity valuations may be stretched, bonds can not only reduce portfolio risk, but also have the potential to outperform equities. As an example, the average yield to maturity on Australian bonds over the two years ended 30 September 2019 has been 2.23% p.a. whilst the annualised total return has been 7.35% p.a.2
It is vital to understand, however, that not all bond exposures are created equal. We believe that broad duration and credit provide the majority of fixed income fund returns – and so it is essential that a fixed income allocation offers exposure to these sources of return.
Many Australian fixed income funds benchmark to the Bloomberg AusBond Composite Index. We see this particular benchmark and funds that track it as an inefficient solution for bonds, as the AusBond Composite has a large allocation to short-dated government securities that offer little diversification (due to a lack of duration), while also paying nothing above cash/bank bills.
Instead, we believe long-duration fixed coupon bonds (both corporate and government) provide the solution.
Long-dated investment grade corporate bonds historically have tended to behave like government bonds (as they are priced off the government curve), but with a meaningfully higher yield. Alternatively, for investors seeking lower-risk fixed income exposure, long-dated government bonds provide an attractive alternative.
CRED and AGVT comparative performance: 30 September 2019
Source: Bloomberg. Shows performance of indices CRED and AGVT aim to track and does not take into account the ETF’s fees and costs. Past performance is not an indicator of future performance.
BetaShares Australian Investment Grade Corporate Bond ETF
ASX Code: CRED
• Invests in a portfolio of Australian investment grade corporate bonds
• Longest maturity corporate bond exposure in the Australian ETF market – provides superior total return and portfolio diversification potential to the Bloomberg AusBond Composite in a falling rate environment
• In the 12 months following inception on 31 May 2018, CRED was the best-performing fixed income fund in Australia, returning 11.36%, against the median fund return of 5.94%
• No actively managed Australian bond fund (among the 88 with 3+ year track records) outperformed CRED’s Index over the 3 years, 5 years or 10 years to 31 May 20194
• Expected total return of 3.15% p.a. including the estimated benefit of roll return but before fees (yield to maturity of 2.42% p.a.) as of 16 October 2019
• Lonsec – Recommended
BetaShares Australian Government Bond ETF
ASX Code: AGVT
• Invests primarily in Government bonds issued in Australia
• Government bond allocation in AGVT considered ‘default risk free’; overall portfolio very low risk
• Generally considered the ultimate “safe-haven” asset in times of uncertainty and volatility
• Longest duration Government bond exposure in the Australian ETF market
• As of 16 October 2019, expected total return of ~1.61% p.a. including estimated benefit of roll return but before fees (yield to maturity of 1.25% p.a.)
2 As represented by the AusBond Composite Index. Past performance is not indicative of future performance.
3 Source: Morningstar
4 Source: Morningstar Direct. Universe defined as ‘Australia Fund Bonds – Australia’ (Morningstar Category). You cannot invest directly in an index. Past performance is not an indicator of future performance.
3. Real assets for real returns
With reliable revenue streams, real assets can provide potential for strong income and attractive returns that are not tied to the economic cycle.
In uncertain times, investments that demonstrate resilience are prized.
Many equity investments provide returns that vary with the economic cycle, and so in times of economic uncertainty can be particularly vulnerable.
One class of assets that historically has proven resilient in economic downturns is real assets – this includes assets such as listed property, utilities and infrastructure, including toll roads, airports and electricity grids.
These real assets provide relative cash flow certainty as their fortunes are less tied to the economic cycle. They typically have long-term, built-in contracts that allow revenue to be increased in line with, or above, the inflation rate. An investment in real assets therefore offers a high level of in-built protection against inflation.
Historically, assets such as toll roads, ports and airports have performed well in falling interest rate environments, as their more predictable and often regulated cashflows become worth more in today’s dollars as rates fall. Listed real assets have tended to show lower volatility and suffer smaller drawdowns during broad market declines.
Real assets also benefit from population growth, as there is an increasing number of people driving on toll roads, using electricity or flying to and from airports.
For those interested in this investment thematic, we believe a diversified exposure to real assets is the best approach, avoiding the sector and stock concentration that comes with, for example, an investment solely in A-REITs.
Legg Mason Martin Currie Real Income Fund
Since inception performance (net) to 31 July 2019
Past performance is not a guide to future returns. Source: Martin Currie Australia as at 31 July 2019. Data calculated for the representative Martin Currie Australia Real Income account A$ net of management fees. Periods over a year are annualised. Inception Date: 1 December 2010. This strategy is not constrained by a benchmark, however for comparison purposes, it is shown against the S&P/ASX 200 Accumulation Index and the blended 50% A-REIT 300 Index / 50% S&P/ASX Infrastructure Index.
Indicative only, actual portfolio may differ. As the BetaShares Legg Mason Real Income Fund (managed fund) ASX: RINC commenced in February 2018, this information is based on the unlisted Legg Mason Martin Currie Real Income Fund, a comparable fund managed by Martin Currie Australia using the same strategy to illustrate how the strategy has performed over a long time period.
BetaShares Legg Mason Real Income Fund (managed fund)
ASX Code: RINC
• Holds a portfolio of listed Australian real assets such as A-REITs, utilities and infrastructure securities
• Actively managed exposure to high quality real asset businesses that demonstrates sustainable and growing income streams
• Strong diversification of company risk relative to A-REIT Index
• Attractive income potential – forecast portfolio yield as at 30 September 2019 of 5.5% p.a. (including franking and before fees)5
• Mercer’s best-performing Australian equities fund strategy over the year to 30 June 2019 (17.4%)6
• Lonsec – Recommended, Zenith – Recommended
5 Yield forecast is calculated using the weighted average of broker consensus forecasts of each portfolio holding and research conducted by Legg Mason Australia, and excludes the Fund’s fees and costs. Franking credit benefit assumes a zero tax rate. It is not to be interpreted as the offset achieved by unitholders during this period. Actual yield may differ due to various factors, including changes in the prices of the underlying securities and the number of units on issue. Neither the yield forecast nor past performance is a guarantee of future results. Not all investors will be able to benefit from the full value of franking credits.
6 Source: Mercer. Past performance is not indicative of future performance.
4. Smaller companies, bigger growth profiles
Mid- and small-cap companies can benefit more than large cap stocks from low interest rates, and may offer higher earnings growth potential than the top 20.
Investors can tend to think of the sharemarket as a homogeneous entity whose ‘parts’ move in line with the ‘whole’. However, this isn’t always the case. Different ‘size bands’ of the equity market perform differently – and different tiers of the market often don’t move in parallel.
So how do different parts of the market react to changes in monetary policy? When the RBA changes interest rates, it is naturally trying to influence the domestic economy. Is the impact felt across the board, or is it felt more strongly in some sectors than others?
In low interest rate and low-growth environments, stocks that offer secular growth should command a greater premium than cyclical stocks or financials, which should benefit the Australian small and mid-cap sector to a greater extent than large caps. This is because “secular” growth is not tied to the growth environment in the same way “cyclical” growth is.
Mid and small-cap stocks currently also offer higher earnings growth potential than the top 20 Australian stocks. As of September 2019:
- the mid-cap part of the Australian market has an estimated forward EPS growth ~38% higher than the Top 20 – but trades on a P/E multiple only 5% higher
- the small-cap part of the market has an estimated forward EPS growth ~16% higher than the Top20 – but trades on a P/E multiple ~7% lower 7
For these reasons, we believe smaller Australian companies, in preference to larger ones, offer the potential for better total returns in a low interest rate environment.
Estimated EPS growth
EX20 (Australian stocks 21 – 200 by market capitalisation)
SMLL (managed fund of stocks outside the top 100)
Source: Bloomberg. As at 30 September 2019. Past performance is not indicative of future. performance.
BetaShares Australian Ex-20 Portfolio Diversifier ETF
ASX Code: EX20
• Holds stocks 21-200 of the largest companies on the ASX by market cap
• With many portfolios having a heavy bias towards large cap banks and miners, EX20 helps diversify exposure away from those sectors in a single trade
• Provides cost-effective exposure to this part of the market
• Lonsec – Recommended
BetaShares Australian Small Companies Select Fund (managed fund)
ASX Code: SMLL
• Diversified, cost-effective exposure to the smaller end of the sharemarket
• Excludes larger stocks to which many investors are already exposed
• Uses a series of screens that aim to identify companies with positive earnings and a strong ability to service debt
7Source: Bloomberg. ‘Estimated EPS growth’ is the estimated Compound Annual Growth Rate (CAGR) of the operating EPS over the company’s next full business cycle (typically 3 – 5 years). Past performance is not indicative of future performance. Actual results may differ from estimates.
5. International diversification – don’t trade off returns for fees
International exposures should offer both diversification and performance benefits. Investors shouldn’t have to sacrifice either just to keep fees down – quality and income can be found at low cost.
International exposures are a core part of a balanced portfolio, offering both diversification benefits and the potential for attractive income and growth returns. We believe investors should demand both from their international allocations.
A lot of investment money has flowed to low-cost funds tracking market cap-weighted indices such as the MSCI World Index, adding portfolio diversification – but only modest income and growth. Other investors have given their money to expensive active managers, who, after fees are taken into account, often underperform low-cost passive exposures.
We believe there is a better way, one that provides the diversification and performance benefits that investors should be insisting on, but without eye-watering fees.
Selecting stocks based on quality, or on their potential to generate attractive, sustainable income, has the potential to provide growth and income returns superior to market cap-weighted approaches – without the high fees of active managers.
QLTY comparative performance: 30 September 2019
Past performance is not an indicator of future performance. Where a product was launched during the period, performance shown is the performance of the relevant index the Fund aims to track after deducting the Fund’s MER, plus live track record.
12 month dividend yields: INCM’s Index v MSCI World Index as at 30 September 2019
Source: Bloomberg. Graph shows yield level of INCM’s Index (the Nasdaq Global Income Leaders Index) v MSCI World Index, not ETF and does not take into account ETF management costs. You can not invest directly in an index. Past performance is not an indicator of future performance of Index or ETF. Yield will vary and may be lower at time of investment. INCM’s Index yield shown gross and net of witholding tax (i.e. shows from the perspective of an Australian tax payer), and MSCI World Index yield shown gross of witholding tax.
BetaShares Global Income Leaders ETF
ASX Code: INCM
• A globally diversified portfolio of companies that seeks to generate high and sustainable dividends
• As of 30 September 2019, INCM’s yield is 5.35% p.a. before withholding taxes and fees (4.61% p.a. after withholding tax), compared to a yield of 2.48% p.a. before withholding tax for the MSCI World Index
• Since common inception, INCM’s index has historically demonstrated lower maximum drawdowns and volatility, and higher total return and Sharpe ratio (net of the funds management fee).
BetaShares Global Quality Leaders ETF
ASX Code: QLTY
• Quality score methodology selects global businesses that demonstrate high and sustainable ROE and low financial leverage
• Has outperformed major active managers and MSCI World at a fee of just 0.35% p.a.
• QLTY’s index has generated total returns over 5 years net of fees of 17.65% p.a. vs Magellan Global Equities Fund 15.97% p.a. and Platinum International Fund 9.52% p.a.
• QLTY’s index historically has exhibited reduced declines during market falls, compared to the MSCI World Index and many active peers
• A portfolio of high-quality global brands, including Apple, Adobe, Visa, and Mastercard
• Lonsec – Recommended
About BetaShares – enhancing the adviser value proposition
BetaShares is a leading Australian manager of ETFs and other Funds traded on the ASX. Our range of Funds is one of the largest and most diverse available in the market. We offer investors simple, cost-effective access to equities, cash, currencies, commodities and alternative strategies.
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To request any of the services above or to discuss our solutions please contact our Adviser Business team on 1300 487 577 or email@example.com.