Thursday, 22 September 2016

Colombo Stock Exchange Trade Summary 22-Sep-2016

Maximising wealth using equity investments

Maximising investment returns requires due consideration of a wide range of aspects including valuations, yield, price determination, volatility, liquidity and more. Equity investments have historically played a pivotal role in maximizing portfolio return.

In this article, Chartered Financial Analyst Alistair Corera, shares his thoughts on using equity investments to maximise wealth. He holds more than 20 years of experience in investment management and is presently Orion Fund Management's Director and Portfolio Manager.Excerpts from the interview.

Q:Why should investors consider including different asset classes in their portfolio?

There are several reasons as to why an investor should contemplate the idea of having multiple asset classes in his/her portfolio. One is to have a blend of different features in your portfolio that each asset class can provide. For an instance, the return from equities is predominately from capital appreciation. The timing of the return is also uncertain. On the other hand, the return from fixed income investments such as fixed deposits or bonds is mainly in the form of interest or yield. You also have greater certainty about the timing of returns in these types of investments. By mixing both asset classes you can design a portfolio that provides you a desired level of yield, at the desired frequency and also benefit from capital appreciation.

Another reason would be to reduce the volatility of returns of your portfolio. Each asset class will respond differently to varying conditions that one typically encounters. As an example, rising interest rates tend to be unfavorable for equities. On the contrary, hikes in interest rates would be favorable for cash or short term fixed income investments. By having a mix of asset classes, the volatility of your combined portfolio value will be less than in a situation where your portfolio consists of a single asset class.

Q: Is portfolio management important to maximise wealth in the long run?

The important thing is to have a goal and a plan. A portfolio management approach instills that. A plan or an investment policy provides a context against which you take investment decisions. It also provides a basis to monitor and evaluate progress. If you are not grounded with a plan, the tendency is to react to all news and events in a haphazard manner, and not in line with your particular needs. This is particularly true if you consider the long run because many events that occur on a daily basis have no relevance to the long term outcome of your portfolio. Many people find themselves reacting, at a cost to themselves, whereas the correct decision in some instances would have been to let it pass.

Q:How has equity performed historically compared to other asset classes?

Historically, equity returns from a diversified portfolio have been attractive and higher than returns from fixed income when considering over long periods. The performance of the All Share Price Index (ASPI) is the common measure of average returns from listed equity. From 1985, when the ASPI was launched, the annualized rate of return to date is approximately 16%. This is higher than fixed income. Comparisons with other asset classes are not straightforward because of the lack of data.

Q:What are the main characteristics of equity that an investor should be aware of when allocating investments?

A key characteristic to be aware of should be volatility of equity returns. For instance, while the annualized return for the 31 years since 1985 has been approximately 16%, you have sub periods where the returns have been dramatically different from the long term average. If you take the 4 year period from Sep 2001 to Sep 2005, the market returned 57% a year. The seven year period from 1994 to 2001 on the other hand delivered a negative return of 15% on an annualized basis. An investor should be aware of this and ensure that he/she can handle this volatility. They should be able to handle it both in terms of individual financial circumstances and mindset. For example, if a person needs an assured income every year to meet living expenses, equity will not be suitable to meet that need.

It is also helpful to understand the makeup of equity returns. It has two components – dividend yield and capital appreciation. The dividend yield has averaged around 2% – 5% per annum with the remainder by way of capital appreciation. The dividend component is fairly stable over time, while the capital appreciation component is not.

Q:Can you advise how to determine the extent of equity allocation for an Investor?

At a basic level, the factors that mainly play a role in this decision is your age, individual financial circumstance and risk appetite. I would suggest that an investor secures his/her day-to-day income requirement with a source that is not volatile. For most, this is met by your salary and/or capital set aside in regular interest bearing investments.

A certain amount could also be set aside for emergency needs invested in a non-volatile asset.

Once this component is secured, the allocation to equity can be calibrated based on age, risk appetite, goals and time horizons.

There is an old rule of thumb that suggests your equity exposure should be ‘100 less your age'.

Hence a 40 year old should have 60% of his savings in equity. It is doubtful this can be applied broadly as ultimately, it is a very individual specific process.

Q:Any tips on how to pick outperformers?

Outperformance happens when the market consensus underestimates.

For instance, market consensus expects earnings of a company to grow by 10% over the next 5 years. The stock is then priced to reflect that. However, the company actually delivers growth twice as high.

The price of the stock will increase at a faster pace to reflect that, which delivers outperformance. Investors targeting outperformance seek to identify such opportunities beforehand.

Opportunities for investments that will outperform also present themselves when sentiment is bad and investors are acting irrationally.

Situations, where there are structural changes is another area that may see investments that will outperform.

Q: Equity is a risky asset class. How can an investor curtail risk?

When equity is termed as a risky asset in finance literature, it refers to price volatility. You can have an upward moving stock price, but it moves in a jagged manner so it is volatile.

The down moves, when you are experiencing it will show up as a loss, but this is not permanent and will reverse when the up move kicks in. This has to be differentiated from an investment that goes bad and you lose completely.

Avoiding permanent loss involves being careful with the companies you invest in. Price volatility on the other hand is characteristic of equity that you can’t completely avoid.

What is required is managing it by suitable diversification, and controlling equity exposure.

Q:Why should an investor seek professional fund manager advice to manage one's investments?

While the theory is relatively straightforward, execution is not. The hardest part is controlling emotions and preventing them from distorting your investment decision making. For instance, it is very uncomfortable to buy in a falling market although that is when the better opportunities maybe available.

Q:What are the main points to consider when selecting a good fund manager?

The most important thing is to understanding their investment process and investment approach. This is not an easy task as Sri Lanka does not have organizations providing fund rankings and fund research, which would typically address this need.

In the absence of that investors will have to rely on the reputation of promoters and track record. Assessing track record should be over a reasonably long period that ideally covers different market conditions.

(“Investment Insights” is a collaboration between the CSE and CFA Society Sri Lanka to enhance investor knowledge in capital market investing. All posts are the opinion of the interviewee and should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the Colombo Stock Exchange, CFA Institute, CFA Society Sri Lanka or the interviewee’s employer or organization.)

Quotes for the day

"Prosperity isn't found by avoiding problems, it's found by solving them." - Tim Fargo