Now, these products do sound quite appealing. The latest set includes returns that are linked to the performance of Berkshire Hathaway (Warren Buffet’s company); China and India; US Real Estate (that appears quite cheap compared to Australian property…unfortunately for the US there is still a massive over-supply); our favourite sharemarket, ASX200. They’re capital protected and you can borrow up to 100% of the investment! There are numerous other components to the product but there is one aspect to the product that stopped me looking any further into it…the incorrect definition of how the issuer calculates stock market volatility.

Now, this perhaps doesn’t sound much on the surface, but the products final payout is dependent on the level of calculated volatility of the underlying assets (the higher the vol the lower the payout) so the fact they use the wrong formula destroys my interest and I cannot have any faith in it. For those who are interested in this error, when calculating annualised sharemarket volatility based on daily prices you calculate the annualised figure by multiplying the daily volatility by the square root of 252 (which is the approximate number of trading days in a calendar year)…this product multiplies the daily volatility by the square root of 365 (obviously the number of days in the year) which results in an artificially inflated figure that is not at all a reflection of annual volatility…hence the marketing materials and anything else to do with this product is quite meaningless to me and should be to anyone else looking at this product. And don’t forget, the higher the vol the lower the payout and the vol is calculated incorrectly too high!

 According to a [Newport Beach] city report on lifeguard pay for the calendar year 2010, of the 14 full-time lifeguards, 13 collected more than $120,000 in total compensation; one lifeguard collected $98,160.65. More than half the lifeguards collected more than $150,000 for 2010 with the two highest-paid collecting $211,451 and $203,481 in total compensation respectively….Lifeguards are able to retire with 90 percent of their salary, after only 30 years of work at as early as the age of 50.

I’ll quote an extreme example from the Canadian academic, Moshe Milevsky.

Lets suppose five 95 year olds place $100 each into a term deposit, paying 6%, and after 1 year the $530 ($500 + 6% interest) is split between the survivors. Now apparently the probability of a 95 year old surviving one year is 80% which means we expect there to be four survivors splitting $530 between them or $132.50 each. That is a return of 32.5% comprising of 6% interest plus 26.5% in mortality credits.

Now a lifetime annuity does not actually allow you to cash out at the end of 1 year or any term for that matter. But, the above example still shows you how a return can be enhanced by a long life thanks to others invested int he product dying earlier. For those who live a long long time it is highly unlikely the returns on any sharemarket portfolio will outperform the lifetime annuity. So, for the retired with excellent health and a family history of long life, perhaps the lifetime annuity should be a serious consideration for part of the retirement investment portfolio.

Please note…my remuneration has absolutely no connection with the sale of lifetime annuities. In fact my employer would probably hate this article!!!

It is amazing that economists of the bigger banks are suggesting rate hikes, particularly given they are more likely to suffer the consequences of a housing market decline. Either way, Charlie believes that the real sufferers of a housing market decline are likely to be companies in the consumer discretionary sector and as we’ve seen in recent days, some of the bigger players in property securities, like Westfield, Mirvac and Co.

As mentioned in earlier posts, Australian investors are facing some big risks…

• very very high commodity prices (for when they crash they really crash)
• record high residential property prices (that have effectively propped up this ecoomy through the GFC)
• China needing to slow and contain inflation
• a Euro Sovereign crisis that could always overflow into global financial markets
• record high AUD that is contributing to our two speed economy and preventing foreign investment

Our markets are mostly financial services and commodities (plus a fair share of property) so when investing ensure these risks are considered in full.

Contrary to suggestions in my last post, yields across the yield curve have moved a bit today…as the above chart shows the curve is up between 5bp and 9bps. This is a result of the Reserve Bank increasing its inflation outlook over the next 2 years. The Reserve Bank believes inflation will be above its target range due to increases in the costs of fruit and vegetables thanks to the Queensland floods as well as wage inflation caused from the mining sector. It also expects unemploymet to fall to 4.25%.

1. Commodity Prices in a  bubble
2. Australian house prices in a bubble
3. China must/will slow, given inflationary pressures, and internal asset bubbles
4. Australian dollar at irrationally high levels
5. Euro Sovereign crisis must result in defaults for Greece, Portugal, Ireland,
6. US economy is stuffed and recovery will be slow for many years

Whilst these are extreme views its not difficult to make a case for any of them. His markets forecast was that he was forecasting global shares to outperform Australian shares…fine. BUT, he then articulated that he was still quite confident in the Australian economy, Australian sharemarket and that our interest rates will rise (which is clearly a consensus view).

My comments…how on earth can anyone (and many do) agree on points 1,2,3, and 5 and not think our economy (and sharemarket) is facing a potential perfect storm (I actually put this question in these words to him)? To me unfortunately  his conflict of interest, as a fundie, got in the way of his answer. Either way, I’m also a little concerned about points 1 through to 3 (or even 5 given our reliance on the global banking system…point 6 is a factored in and its likely impact other than to keep the US dollar weak) and the downside risks to our economy and markets. If interest rates do go up, then that could be the catalyst to set off point 2 which could flow into the financial system and the rest of the Aussie economy and therefore sharemarkets. If China slows, as Nouriel Roubini is forecasting along with many others, then the biggest impact on our market will be the impact on point 1 (although aided by a cushioning effect from point 4 also dropping) which could be quite shocking (~35% of our market is Resource based).

I’ll end by quoting Jeremy Grantham from his latest newsletter, “beware the sell-side strategist offering arguments as to why overpriced markets are actually cheap”…whilst the analyst wasn’t necessarily saying assets were cheap he was denying the potential impact of these expensive markets on our own therefore suggesting our market is fairly priced…unfortunately given the downside risk I’m not so sure.

Plenty of food for thought.

With last week’s high CPI figures coming out there has been increased talk about the Reserve Bank increasing interest rates. The above yield curve chart shows that since 12 April, the yields on government bonds have actually decreased across the board by around 20bps suggesting less long term confidence in our economy than two weeks ago. As has been commented on, the CPI figures were high largely (not totally) because of the high Food and Energy prices…keep in mind the Reserve Bank’s actions will have virtually zero impact on Food and Energy prices as they are high because of a combination of natural disasters, middle east conflict, and a bit of proprietary trading by those nasty US investment banks.

With home prices starting to fall (I did say that residential property would peak when my partner and I purchased a property back in February), the Australian dollar killing our tourism and foreign investment, and underlying inflation (excluding volatile items) actually near 10year lows, whilst our economy is still looking well, as the yield curve movement suggests our economy is not as rosy as the papers and fund managers make us believe and controllable inflation is under control.

Hopefully no interest rate rise today!

Brilliant!

International equity small-cap stocks widely outperformed large-cap stocks over the year to September 2010, returning 24.4 per cent and 12.7 per cent, respectively in US dollar terms.

I took the above from today’s InvestorDaily email and whilst the fact that global small cap outperformed large cap is not surprising, as it is bound to happen from time to time, what is surprising is the complete lack of selection of global small cap fund that advisers and investors have. I noticed at my place of work we have very few on our approved product list so I looked up Lonsec to see what other funds they may have at least “Recommended” and there were only three!…BlackRock, Zurich, and Schroder.

The Fama and French three factor model has been around for almost twenty years, many of us have read Jeremy Siegel’s book, “Stocks for the Long Run”, and there are many local and international papers which have similar messages…that is…over time small cap stocks outperform large cap stocks on a risk-adjusted basis. Of course, the past doesn’t equal the future, but we are creatures of habit most of the time and our market has shown little appetite for small cap…bizarre.

One of the recent posts I put up referred to S&P’s SPIVA report which also showed that active managers have recently been more successful in small cap stock selection than large cap and this makes intuitive sense. There are fewer analysts covering small cap space so there are more opportunities for mis-pricings so we can make a simplistic conclusion that the small cap part of the market is less efficient than large cap. OK…so small caps are the go…but there’s usually a but…small cap stocks are much more volatile and I must admit it is this volatility that is often the turn off (perhaps the additional illiquidity is too)…so there is a reasonable fear factor associated with them and I can understand that.

What I don’t understand is this insistence on regional biases…particularly Asia. Personally I don’t understand why you would constrain your investment universe (and opportunity) simply based on region. Why not place your funds with a global small cap or global unconstrained manager (with proven skill and aligned bias) and let them make the bet as to whether Asia is worthy of an overweight. By investing in an Asian managed fund we are really choosing a Global Small Cap fund anyway, so my simple message is go global and don’t reduce your investment opportunity.

Please note…despite these comments I have no views as to whether global small cap investments are likely to outperform or perform well moving forward.