"The Business Coach" Model Executive Summary

A. Changing Platform Environment

Master Trusts and Wrap Account continue to change the way Financial Planners do business and its not uncommon for planner to ask other planners down the road which platform providers they use and may be end up buying the same system. Also many clients go to planners on the same basis working off recommendations from family friends and workmates.

However currently the market is overcrowded with Platform Providers offering similar ancillary services, ie. basic data base systems, investment research on underlying fund managers, back room administrative service, monthly newsletter, consolidated of clients' reports, and custodial collection of asset based fees.

Nevertheless followed by the trend in the United States, for the Platform Providers in Australia to stay in the network race for market share, driven by the demand by Dealer Group and Financial Planners will need to provide the software that is capable of supporting customised clients needs with statistical landscaping facilities for scenario testing, easy to install, regular updated with training facilities in the form of professional qualitative and quantitative research on financial investments.

B. The Need For Efficient Solution Making Models lacking for Complex Investment Decisions

Bus-Tec Pty Ltd. has created a design reality decision-making model regarding solutions for client investment portfolios. Hence, "THE BUSINESS COACH" MODEL capitalises on the Platform Providers Administrative Research that is statistically rich in E-commerce application with centralised data base by applying landscaping with multi-functional layers and customised research analysis landscaping for personalized managed portfolios. Most importantly, moreover the process currently represents a client's needs based planning essentially to the ASIC PS 146 investment strategies criteria. The Financial Planner has educated the client, the client has made the uninformed decision and the Dealer Group and Financial Planners have therefore both significantly lowered their business and personal risk responsibility.

The client is not putting their money in a black box that can't be explained. "THE BUSINESS COACH" Model helps Financial Planners to understand the logic behind investment managers' decisions and offers investors a range of funds that is tailored to their investment objectives for risk tolerance and their concern for more disclosure.

The important advantage of the BCM over traditional managers is that it acts as an excellent Risk Management Tool, which can deliver returns, with a much lower overall risk correlation to traditional shares and bonds. An investment option such as a BCM can offer an independent value added stream from traditional asset class of fund managers; therefore this makes it a powerful tool in a traditional investment model.

C. THE BUSINESS COACH MODEL Adopted As an Entire Package for Desktop Interface

Bus-Tec Pty Ltd. - "THE BUSINESS COACH" Model promises to deliver real benefits in terms of increased productivity and more efficient knowledge management format for Platform Providers, Dealer Group and Financial Planners. The Business Coach Model which its multi-functional layers of customised scenario testing works best when closely tied to a platform providers system which statistically rich in online e-commerce, makes a popular facility for Dealer Groups and Financial Planners. Therefore, this provides the Platform Providers a means to make money out of their research facilities and system because everything happened behind the logon desktop interface and soon costs will be driven to lower unit numbers as they push to gain critical mass.

BCM Portfolio Construction Overview

The BCM investment process for Shares is equally consistent and systematic as Fund Managers with its transparent link to both stock selection and risk control for Share fundamentals. In fact, the process could be argued that structured to the provider Investor Type Benchmark Performances, Risk and Statistical Analysis are systematic in having a clear valuation score. The key aspect of this approach is the optimisation of valuation score with some degree of flexibility allowed between the portfolio generated by the optimiser and the fund portfolio.

You can describe the clients investment style as the "CORE" but acknowledge that the portfolio may at times be between balance and moderately aggressive.

BCM expects 70% of value-added to come from its bottoms-up approach using the "pop-up" ranking technique and the remaining 30% from top-down approach. BCM's "core style" is neither value of growth but at various times, it would tilt by the relative strength economic indications of macro trends.

Managed and Direct Shares

The portfolio construction process has been strengthened by the introduction of negative earnings, which can be looked on as a penalty revision to the evaluation score. The results of using this technique from a moderate value to a "core" investment style because there is little downside in a rising market.

Investment Philosophy and Style

BCM "core" technique is an active fund manager which believes that market segments are inefficient and that in-depth fundamental research and valuation analysis can add value.

BCM investment approach is a blend of bottom-up stock selection (ASX 300) and top-down sector inputs. This provides leads to investment in both "growth" and value-orientated shares.

A combination of qualitative (ie. Aspect Huntley) and quantitative screen shots (which includes profitability valuation and growth parameters) is used to narrow the stock universe down for in-depth research.

GICS and the other 24 sub sectors have high sector levels of interaction and at the same time, model the sameness about the companies within this sector.

An advantage of this approach is that it promotes diversity of opinion and insight into respective companies as to their dominant position in a particular sector.

Fundamental research focuses on identifying companies with well-articulated and believable business plans, experienced management a sustainable competitive advantage and strong financial characteristics.

As well as thematic analysis, quantitative value/momentum models are used to identify tactical sector opportunities. Both inputs are used in combination to identify sectors to over- or underweight in the portfolio.

Portfolio Construction and Execution

The process brings together stock and sector selections for both International Share and Fixed Interest and regional allocation for Shares, Property and Fixed Interest.

Stocks, which have above-peer fundamental, growth, income and valuation characteristics, are candidates for the portfolio. A stock's active weighting in the portfolio depends on the stock's potential return, combination to portfolio risk, liquidity and the attractiveness of the stock's industry. While the "top-down" views are overlaid on the "bottom-up" driven stock ideas, the latter is the key driver for portfolio positions. Sector views are implemented after consideration of the sector's relative growth and profitability and assessment of the relative valuation of each sector against the benchmark. For instance, a highly rated stock may hold a 2% or 5% active position in the portfolio. If in addition, the stock is in a sector with a targeted overview, the portfolio manager can add another 200 to 400 basic points to the sectors position for a positive view of the sector.

Dividends, Market Watch and Sell Disciplines

The Dividends, Market Watch and Sell Disciplines are well articulated and are driven by dividends, stock price targets set by you as the Portfolio Manager and driven by managed stock price targets.

Risk Management

BCM risk management disciplines for portfolio risk management and monitoring are sufficiently comprehensive. The overall portfolio risk is controlled through standard deviation, beta-tracking error all with relative industry benchmarks currency management strategy.

Investment Team

BCM provides a direct link to Morningstar or Aspect Huntley Product Share Disclosure Statements and for Compliance, which is conducted by Morningstar on a monthly to a six monthly basis.

Essential Strategic Asset Allocation Plans

The tough investment climate over recent years has highlighted the need for strategic investment plans and risk management that maintain a long-term view while being open to changes that will minimise risk. However, the market environment has changed and as many investors are expecting, over the next few years, to produce lower returns in a volatile market, a more dynamic approach may be needed.

For example, if the sharemarket has run far ahead of expected levels and has an increased risk of downturn, a risk management decision may be to move funds away from high-risk shares and into more stable securities or bonds. But the problem in the case of bonds is that further gains are becoming increasingly slim and in the big picture terms, this could derail the global recovery. Also the state of anxiety, engendered by the threat of further terrorist attacks, has the potential to derail the current cyclical recovery.

Rather than change the asset allocation long-term strategy, the diversification of the fund managers becomes a medium term goal. In other words, we are not changing the direction of the overall asset class mix - Australian Shares (32.0%), International Shares (21.0%), Australian Fixed Interest (12.0%), International Fixed Interest (1.0%), Cash (15.0%) and Property (19.0%), but we will be adding value by diversifying the portfolio over twelve (12) fund managers instead of the asset allocation spread over six (6) fund managers - see below re Key Person Risk and Proposed Implementation Remarks.

Therefore, the aim is to ride out difficult times and the best strategic approach is to use medium-term risk management that recognises major trends in the markets but has the flexibility to make adjustment to avoid risk and preserve capital. Strategic asset allocation and rebalancing of switches according to matching skills of the financial planner go hand in hand.

Now that most Platform Providers recently introduced on-line Switching, Redemption and more importantly, the straight through processing of re-weighting or re-balancing alignment of portfolio, infinitely makes the task of tactical asset allocation easier, which completes one of our main goals for an efficient and control mechanism for riding a clients portfolio with confidence. In other words, Bus-Tec designed its risk management tool (BCM) for its clients - an absolute return portfolio, ie. based on targeted risk/returns for the 5 Style Investor Type at a desired level of risk tolerance.

Key Person Risk Associated with Fund Management

Past performance is still the single biggest factor and in some cases, the only factor that we can use in deciding whether we buy a fund manager.

However, relying on the same fund managers to produce stellar performance quarter after quarter, then completely out of the left field, may find his performance has slipped in six months time. Very few fund managers deliver consistent top or second quartile results time after time. Evidence suggests that fund performance is often highly variable as investment styles and approaches go in and out of fashion. For example, empirical evidence suggests for every three managed funds a client is invested in, there is likely to be one significant personnel change each year.

Research shows basing decisions solely on past performance, even for funds with a five to ten year history, can be a risky business. If performance slips but the process remains fundamentally sound, it may simply be the current market conditions are unfavourable.

In this case, a "hold" or even a "buy" decision may well be warranted. However, those without a good understanding of the process and its key drivers will have no context against which to access any temporary fall in performance and they are likely to get out just at the wrong time. What's important to the longevity and success of such funds is the degree to which these businesses are able to institutionalise or process that is independent of key people when they leave or retire. No performance numbers will tell you that.

Any meaningful assessment to investment process involves finding answers to questions like:

1. Is the process clearly explained?
2. How long is the track record of the process (as opposed to the fund)?
3. Is the process followed in practice?
4. What is the evidence of this?
5. Can each position in the portfolio, successful or not, be justified on the basis of consistent application of the process?
6. How often have the changes be made?
7. What were the reasons for the changes?

It is only when these issues are considered in detail, that it becomes possible to understand the real drivers of performance so that when management inevitably changes or a star performer leaves, it is possible to make a realistic assessment of whether or not the fund or manager is likely to fall into a heap. But with the growing interest in boutique managers and absolute return funds where individual brilliance is more likely to be a key driver of performance, "key person" risk is a major issue.

Performance

The BCM, with its exemplary Attribution Analysis consistency quantitative ranking based on 3,5 and 10 years but also it enables qualitative assessment of how much the performance was driven by sector and stock selection due to consistency ranking for 1 month, 3 month, 6 month, 1 year and 2 years and furthermore, as a valuable benchmark of consistency of performance track performance into first, second, third or fourth quartile.

In the long term, the BCM's Attribution Analysis or quartile ranking gives added comfort that the out performance in the short term from the strategy, is sustainable. Also in the short term, negative earnings momentum is an important signal in controlling down-side in the portfolio.

The Market Watch

Also, part of the investment process is the Market Watch, which is designed to improve the market timing for buying and selling stocks. The strength of the score will depend upon the depth and breadth of the earnings revision. The evaluation score ranks Fund Managers/Stocks by excess retainers and short-term negative earning revision.

The Investor Type Optimisers

The Optimiser is the first part of the portfolio construction process and takes into account the fundamental valuation signals, earnings revisions, benchmarks, risk estimates and MERS asset mixers.

As a general rule, the difference between actual portfolio and optimiser portfolio are set at maximum aggregate deviation of 20%. This allows for what BCM refers to as the "Active insight" to occur and also allows for a debate between the client and financial planner to occur and also allows for a debate within the Compliance Manager.

How The Financial Planner Takes On The Multi Funds Responsibility To Serve His Investor's Requirements

The Multi funds investment vehicle continues to gain investor's dollar and adviser's support as each seeks easier ways to invest; however, the question is whether the funds are a suitable choice across the board.

No matter who the provider of the choice of funds is, whether it's the Multi Fund manufacturer or the dealer group, they engaged the services of an asset consultant to manage this activity, the objective will be to identify the best of a breed of fund managers and to continue with them in such a way as to satisfy the stated investment objectives.

As asset consultant, whether the task is outsourced or not, will be responsible for hiring and firing fund managers, blending investment styles, deciding asset classes exposure and relative weighting of fund managers.

They will also be involved with reporting on the underlying fund manager's performance. There is now a growing case that the culture required for large-scale manufacturing may not be compatible with that required for successful investment management. Consistent with this has been the proliferation of specialist investment houses focusing purely on delivering investment performances and nothing else. Financial Planners are attracted to the multi fund approach for the same reason it allows them to exploit their core competencies.

The life of the typical dealer principal is increasingly complex. Their responsibilities include the provision of professional advice compliance, due diligence, administration, business management and marketing. It is not surprising that some are now conceding to Business Coach Model's statistically link "black box" for their solutions for active selection, monitoring and re-weighting of asset classes of fund managers.

Financial Planners and their clients have been served particularly well by a handful of large brand managers during the past decade or more, but the recent decline of the bull market and the fading capacity of some of these managers to deliver excess returns is putting the traditional selection process under pressure.

Does The Current Concept Of Internal Multi Funds Serve The Interest Of Investors

1. Financial Planners and investors have already adopted the popular Master Fund and Wrap Account concept (85% acceptance rating), realising the value of diversification over several different business sectors and migrating from one fund option to another but this all important shift in relation performance differentials between product options and asset classes is not quantified against the investors risk profile which remains the same.
2. Obviously the inherent problem with external multi funds managers, ie. Core Satellite Approach is it doesn't suit all investors. Many of us know exactly who is managing our money and how. The flip side of multi funds simplicity is that the investment objective process and performance of the underlying fund manager is far from explicit and this may lead to investor frustration.
3. Our approach may be to utilise part core satellite approach and to surround it with high performance specialists. This is where the user friendly Business Coach Model would be controlled by the Financial Planner, thus allows acceptable risk return outcomes within the clients acceptable risk profit.

Beating The Mind Trap

Overcoming your natural negative emotions of another seemingly complex piece of software will become the key to investment success. One thing is for sure, the Business Coach Model is such a powerful tool yet so user friendly, it makes the Financial Planner feel the power lies within them.

The first stage is where Financial Planners are looking for tips, like looking for a guru who will tell them what to do and are they seeking a solution to an investment problem. What they need to progress to the point where they realise that the questions they ask are trivial and that they are most likely to do well if they make their own decisions.

The second stage is where the neophyte Financial Planners come to realise the need to learn to make their own decisions or what they need to realise is that they are like Don Quixote tilting at the windmills because this search for the perfect method is still an excuse in looking out side themselves for the solution. This is when they begin their research for the holy grail or the perfect system. Most of this research revolves around identifying the fund mangers that consistently outperform their sector specific peer group over a medium to long term of 3 to 5 years.

The third stage is where those Financial Planners who have stayed the course learn the holy grail lies within them. They appreciate that the investing results in what they do and some external system. In other words, they realise that their profits or losses are created by their actions and that they can change what they do to improve their performance.

So investing success depends on the way we make decisions. To make good decisions, we need a set of rules in the form of investing planning and the discipline to follow those rules. Our investment plan will have rules for when to buy, when to cut losses, when to take profits and how much money to commit to a single investment. How well disciplined we are in following these rules, depends upon our beliefs, emotions and skills in making decisions. This suggests that investing is really a mind game. Our investment results flow from how well we deal with many emotional biases, decision making biases, personality flaws, beliefs and attitudes that we all have to some extent.

Overcoming them is first a matter of coming to a realisation that they exist and that they apply to us. Most beginners do not even know that these problems exist. As they become aware of them, they also have to get to the point when they admit that these issues apply to then personally. Until they get beyond the denial stage, investment success will remain outside their grasp. There are many common ways in which we all sabotage our investment success through the way we think about investing and this is not due to low intelligence because the smartest investors are just as susceptible to them. Instead, they flow from the way we naturally experience emotions, tackle likes challenges, deal with information and make decisions. A good example of a psychological mind trap is called framing. The idea that we mentally put things into categories so that we can deal with the complex world we live in which can lead us into bad decisions blinded by the way we defend things. Imagine a married couple are saving to buy a holiday home in five years time. They have saved $100,000 so far and its accumulating in a saving account at 4.5% interest. Then the old car breaks down and it's not repairable so they need to buy a new one. They financed the $25,000 cost with a loan of 9.0%. When its presented like this and we are not personally and emotionally involved in the decision, we can see the apparent stupidity of this decision. Clearly, the couple should use $25,000 of their holiday home savings, which only cost them 4.5% in interest foregone, and deposit the repayments they intend to make on the car into the holiday home savings account.

The reason they do not use their savings is at least partly because they have categorised the money in the savings account as "holiday house money" and the money they intend to apply from income for the car repayments as "car money". However, this is entirely a mental construction. Clearly, each dollar is the same as every other dollar. Of course the couple may rationalise their decision by explaining that they have difficulty in maintaining their self control, being tempted to spend the intended " holiday house money" rather than save it. Categorising or labelling money causes people to perceive it differently in different circumstances to act illogically and inconsistently to rationalise poor money management.

I see this played out in the markets with people taking greater risks with some money than other money, saying money we can afford to lose. So they are treating some money differently to other money in order to rationalise any poor investment behaviour. The same could be said of people who take greater risk with what they call the market money when their investment goes up, the gains are treated as risk money they can afford to lose and the original stake as "their money". Again, this rationalisation is poor money management.

A Lego Approach To Planning

Over the past 20 years, the role of financial advisors has changed from helping investors select a ready made financial solution to helping them construct that solution from basic building blocks. Two decades ago, most investors selected a single manager to control a balanced portfolio comprising all asset classes; equities, property, bonds and cash. Most institutions did everything from managing the money, to administrating the fund and providing advice and education through tied in-house advisors. The past 15 years has seen massive changes to this model.

Many institutions now focus on either financial advice and distribution or investment management, while naturally there are others that continue to do both. Investment managers are increasingly required to provide the building blocks rather than the entire solution. Financial advisors use these building blocks to build solutions for their clients in much the same way as LEGO allows people to construct various objects using a small number of basic pieces.

The trend towards specialisation and away from the single manager has been driven by a number of factors. The emergence of Financial Planners that are independent of the asset managers has been one reason. Another has been that as performance reporting became more public, 'manager risk' - the potential for underperformance by individual managers - became obvious.

Initially this caused investors to select two or three balanced managers, but later contributed towards the move to specialist managers. An inability to manage all asset classes, particularly by institutions for whom investment management was not their core business, caused them to outsource some asset classes (eg. International equities). Finally, dealer groups, advisors and consultants recognised that they could add value for their clients if they could select high performing mangers in each asset class and customise the asset mix to their clients' specific needs.

Enhanced and index managers allow advisors to construct core plus satellite solutions, using low risk managers which reduce concerns over manager risk. Growth and value managers allow advisors to favour either of these styles and investors can select small capitalisation specialists to manage this segment of the market. Master trusts and wrap accounts have helped co-ordinate performance reporting and tax across the various managers and provide access to speciality managers at wholesale investment management fees.

The ability to pick and choose can be illustrated with international equities where investors can separately determine the level of market and currency exposure. Hedged international equity funds provide full international market exposure with no currency risk, while unhedged funds provide full market and currency exposure. Choosing a mix of hedged and unhedged funds allows the investors to choose their desired level of market and currency exposure. Active currency funds allow investors to choose the amount of active currency management they want independent of their exposure to international assets.

Hedge funds (such as market neutral strategies) allow investors to increase their exposure to active management without increasing their exposure to the underlying market risks. No longer do investors have to link the amount of active management in a particular asset class with the level of market exposure they want for that asset class.

For example, they can choose to have an underlying exposure to cash or bonds while having all their active management focused on equities or currencies.

In the United States, recent growth in the popularity of Exchange Traded Funds (ETFs), has given financial advisors in that country even more control over the structure of the portfolio. EFTs are index funds that can be bought or sold through brokers on the exchange and which provide investors with funds that track the performance of a wide range of indexes.

Where does this all end? The ability to use the basic building blocks of portfolio construction increases the flexibility of advisors and increases the possibility of tailoring the portfolio exactly to the needs of the investor. However, it also increases the responsibility of dealer groups, and in turn their advisors. They now become responsible for determining the strategic mix, exposure to active management, selection of managers and controlling implementation, rebalancing and tactical asset allocation. Many dealer groups provide 'model' portfolios for their planners, constructing diversified portfolios using sector specialist managers.

Almost every building block in the over-all financial solution can be purchased separately; the trick is knowing when to use the basic component and when to access a ready-made solution.

For example, without balanced managers responsible for actively managing the mix of assets, actively managing the mix of asset classes can be eliminated and portfolios can be left to drift away from the desired mix according to the performance of each asset class, or be rebalanced periodically to the desired strategic mix. The alternative is for the dealer group or advisor to actively manage the mix of asset classes or hire a specialist tactical asset allocation (TAA) manager. Increased choice creates the possibility of a more successful outcome.

The Everchanging Client Base Environment

History does not repeat itself. Business cycles, market trends and business opportunities, if missed 10 years ago, do not represent themselves for a second bite of the cherry.

The master fund phenomenon of the late 1980s and early 1990s was a watershed for the industry. It changed the way the industry functioned by invoking a major power shift from the fund managers that held the retail client base to the portfolio administrators.

Now the wheel is turning again - this time in favour of the service provider. Market consolidation will further hasten this shift and lead to even more rapid changes in the future. This is bad news for industry participants locked firmly in the past. In other words, if you are still using the business models that worked a decade ago, you cannot hope to compete in today's radically different environment.

We have seen the funds management industry rapidly consolidate in the last five years. At the same time, the financial planning industry has changed considerably. This has primarily been driven by the financial institutions' ever-growing appetites to build closer ties with organisations that might distribute their product for them.

The relatively low capital cost of entry and consumer demand for smaller specialised players ensures the continued emergence of boutiques. In this ever-changing financial services industry, where does this leave wealth management services? Just as in the broader industry, consolidation will inevitably occur but without the side effect of the creation of boutique players. The capital outlay required to be competitive in wealth management is simply too large for small players without the necessary backing to succeed.

Does this mean we will see a reduction in the number of market players? Not necessarily. Instead, the market will likely experience exactly the opposite effect. Just as the focus of the industry shifts towards advice and planning - and away from product and administration - dealer groups, stockbrokers and accountants will become branded providers of wealth management solutions to their customers.

A further effect of industry consolidation and the high capital barriers to entry that will impact on the wealth management area will be a decrease in the amount of platforms that are used to build and provide wealth management services. Platforms that survive the 'market-place make over' will be those that deliver the goods to the evolving 'new look' industry.

In essence, if you are a financial planner, stockbroker or accountant, your future is bright. Your dealer institution or association will have the choice of being market-leading in wealth management platforms on which you can base your business asset. You will be able to offer your own, fully branded, wealth management product - and actually own the asset in its entirety.

Fundamental to this principal is the proposition that you should be able to treat your platform provider as a supplier to your business, rather than the supplier itself being your business, as has occurred in the past.

Suppliers are changeable. Suppliers have contracts to deliver a service that in any other industry rarely involves transferring the revenue-generating asset from the customer to the supplier. For some reason, our industry is different and the result is that portfolio administration platforms are sold and valued based on the Financial Planners' funds under advice, rather than on the revenue generated by their contracts.

Financial Planners Looking For A Lifestyle

There are many demands placed on Financial Planners, enormous workloads, working 80-hour weeks. The future today is in practice management, looking at design and implementation of system processes, extricably linked to be a value chain to support Financial Planners.

Platforms that operate on this basis, those that innovate rather than replicate, and those that invest heavily and successfully in technology, have a better chance of success than the rest. The smaller master fund or wrap account operators will seek out these providers and out-source their platform development and operation to them. This saves them the massive cost of the required technology development in this competitive market, while allowing them to focus on their core competencies.

It is against this background that the number of platforms will consolidate while product operators proliferate. But these operators will be running their products and services from fewer and more sophisticated platforms. The way forward for wealth management services lies with the advice givers and their organisations. They will own the product, own the asset and they already own the client relationship. Wealth management providers that are unable to adapt their business to this paradigm will lose the battle and those that are busy replicating current or past business models have already lost the war.

With the advent of Modern Portfolio Theory in the 60's, came the notion of a broader macro review of investment portfolio to fund the right mix of investments, concluding that asset allocation represents over 90% of a portfolio return; hence the importance of asset mix cannot be overlooked. The size of your allocation will generally be determined by your objective in making an investment, increase your portfolio returns; reduce your portfolio volatility or a combination of both.

The Financial Planner needs to determine what risk/reward position they are seeking for their client. If the client were risk averse, it would be appropriate to adjust the overall risk of the portfolio according to empirical guidelines benchmark of typical moderately conservative type investor with drop down income performance. However, if the investor is a reward chaser with an equity-like volatility with no regard to associated risks, then little or no tactical asset allocation for risk but still probably appropriate for some sector diversification amongst high return products.

I suggest that for the non-institutional investor of funds, the multi funds manager approach generally makes sense. A portfolio of multiple managers utilising multiple strategies can be very difficult to achieve the desired client's outcome without BCM's powerful tool that monitor and benchmark and as long as you have done your homework and fully understand the fund manager's selection process as outlined in this Paper, you should be able to sleep well at night in the confidence that the manager is monitoring your investments. The fund of funds manager becomes an expert in both selecting and monitoring individual fund managers and it is their job to both hire and fire managers where appropriate.

This manual monitoring process on 1000+ fund managers and 2000+ direct shares, without the BCM software takes a certain level of skill and a significant amount of time. The BCM is designed to provide the Financial Planner with a daily, weekly or monthly investment performance report which breaks up the funds in mutli variable Risk/Return performance over periodical time spans on each strategy employed and any particular change to the portfolio.

Legally, Will Risk Profiling Protect You?

Risk profiling is a necessary component in liability management. Does this mean that profile investors will never complain about their portfolio volatility because they are tailored to their personality, according to a risk-profiling tool but how accurate is this risk-profiling tool.

The interesting question is will the planner (or his insurer) pursue a claim against a promoter of a risk averse tool ensuring that all recommendations would be appropriate to a client's personality are legally defensible.

However, one of the dangers of risk profiling is that it can lead one to think if a client can cope with risk, should they be given it. The planner's problem in defending a claim is that it must be acknowledged that the advice has not been based solely on the client's financial position and the advisors view on the markets but also on the client's purported risk profile. If might not be a comfortable position for a financial planner to explain that he chose to invest heavily in the stock market on behalf of a client not because he necessarily thought that it was an exceptionally good time to enter it, but because he believed that all people of a certain type should always invest heavily in the stock market, irrespective of the market conditions.

My belief is that if the volatility inherent in that advice could be too challenging, then it needs to be explained to the client, including the extent to which the advice has been composed to accommodate that. On the other hand, if the advice that is considered most appropriate to the client's circumstances involves relative low volatility, then it should be given even if the investor is a real adrenaline junkie.

However, those who are finding that their clients are shocked by recent market events, should not only be rethinking portfolio construction principles but whether low risk, profiling methodology has continued to do this.

Scenario testing for the clients expected marginal utility risk provides the building block solutions necessary for appropriate efficient frontier model

When markets are choppy and unpredictable, BCM has the ability to shine. The BCM's first aim is to preserve capital (ie. not to be subject to losses with the rest of the market) and only then do they deliver some profits to investors. This superior preservation of capital and returns is possible because the BCM can strategic budget its exposure to the following asset class risk.

• Top performing fund managers/shares over asset class or sector.
• Style mix of fund managers measure overall co-efficient correlation.
• Comparison of chosen fund managers/sahres investment against traditional investor type benchmark.
• Multi scenario testing of asset allocation to refine the desired risk factor or benchmark.

Outdated Risk Models Do Clients A Disservice And Leave Financial Planners Unprotected Against Legal Scrutiny

It is all too easy to become drawn into those same biases such as -

1. This was the position in the frontier times of the '80's and mid '90's that many advisors took the view "I know what's best for my clients". Too many instances where investors and Financial Planners irrationally set prices to believe in market efficiency. In other words, commonly assumed the position as a paternalistic role with clients.
2. Similarly, you can't go to an investment conference or read an investment magazine without seeing reference to "behavioural finance" and the implication of irrational behaviour biases exhibited by the preaching of economists Fund Managers and advisors to Financial Planners and investors. Some even think they have stumbled on a total and coherent theory of how markets operate.
3. Markets are clearly driven by greed and fear, suffered by cycles of neglect and over-enthusiasm and in doing so, can experience significant over-valuation and under-valuation at both the individual security and market level.
4. Therefore, this raises the question of how many times do we have to educate our investment professionals about most investors display a loss aversion such as they value avoiding the downside more than participating in the upside. Their money represents a lifetime of work so the client has an emotional attachment to their savings, which represents a lot more than its market value. For instance, for a client to walk into a stranger and give that control away is a huge issue so they want to retain some control or at least have the perception of control. In most cases, clients don't want to be told by advisers what to do. Surely the average Financial Planner knows this or are they thinking about their money in terms of different baskets rather than the total portfolio. Or do they think that most investors are active traders and over-confident.

Scenario Testing For The Clients Expected Marginal Utility Risk Provides The Builidng Block Solutions Necessary For Appropriate Efficient Frontier Model

When markets are choppy and unpredictable, BCM has the ability to shine. The BCM's first aim is to preserve capital (ie. not to be subject to losses with the rest of the market) and only then do they deliver some profits to investors. This superior preservation of capital and returns is possible because the BCM can budget its exposure to the following asset class risk.

• Top performing fund manager over asset class sector.
• Style mix of fund managers measure overall co-efficient correlation.
• Comparison of chosen fund manager's investment against traditional investor type benchmark.
• Multi scenario testing of asset allocation to refine the desired risk factor.

With the advent of Modern Portfolio Theory in the 60's, came the notion of a broader macro review of investment portfolio to fund the right mix of investments, concluding that asset allocation represents over 90% of a portfolio return; hence the importance of asset mix cannot be overlooked. The size of your allocation will generally be determined by your objective in making an investment, increase your portfolio returns; reduce your portfolio volatility or a combination of both.

The Financial Planner needs to determine what risk/reward position they are seeking for their client. If the client were risk averse, it would be appropriate to adjust the overall risk of the portfolio according to empirical guidelines benchmark of typical moderately conservative type investor with drop down income performance.

A portfolio of multiple managers utilising multiple strategies can be very difficult to achieve the desired client's outcome without BCM's powerful tool that monitor and benchmark and as long as you have done your homework and fully understand the fund manager's selection process as outlined in this Paper, you should be able to sleep well at night in the confidence that the manager is monitoring your investments. The multi funds manager becomes an expert in both selecting and monitoring individual fund managers and it is their job to both hire and fire managers where appropriate.

This manual monitoring process on 1000+ Fund Managers and 2000+ Direct Shares together with 24 and 48 statistical indicators respectively without the BCM software takes a certain level of skill and a significant amount of time. The BCM is designed to provide the Financial Planner with a daily, weekly, monthly or quarterly investment performance report which breaks up the funds in multi variable Risk/Return performance over periodical time spans on each strategy employed and any particular change to the portfolio.

You Can't Trust Your Instincts If You Want To Be A Successful Investor

Investment markets can be cantankerous and irrational. In favour one day, hopeless the next. All ups and downs have left many of us feeling like we are dealing with casino gambling rather than rational investments.

But is it really the market at fault? There is a growing body of research that shows investment markets are never going to be rational because they are really the result of investors gut instincts.

Why We Think The Way We Do

The human brain is described by some neuroscientists as a Maserati when it comes to solving ancient problems such as recognising the short-term trends or generating responses lightening-fast to emotional problems. The fight or flight instincts, for instance, are automatic because they are wired into the nether region of the human brain.

But our minds aren't as good at more modern problems such as recognising long-term trends or focusing on several factors at once. Our ancestors didn't have to do things that we do everyday.

The unfortunate truth is humans are psychologically programmed to be investment dunces - to buy high and sell low, to chase last year's "hot" sector and to think you're smarter than the average investment analyst.

Put us all together and it's much easier to understand why markets behave the way they do, why predictable, otherwise boring, stocks can trade at high price-earning ratios and why some stocks can deliver unexpected profit downgrades and get savaged for more than their bad news is worth.

When investors have their wealth at stake, their primitive instincts can take over. You see fear and greed and fight for a fight. They just want to be in or out. But when gains and loses aren't as apparent, they don't behave in the same way. This showed that humans are simply incapable of fully analysing complex decisions when the consequences are uncertain. What we do is to rely on shortcuts or rule of thumb.

Our ability to predict the future sends our financial decision-making processes haywire. Instead of approaching the decision logically, we rely on quick fixes such as hot tips, the latest news event and even that guy next door is going to solve the problem.

BCM Provides a Solution to Curbing our Habits

As with other irrational behaviours such as phobias, addictions and emotional hang-ups, the first step in fighting them is to be part of them - successful behaviour can be developed by being aware of some of the things you may automatically do, hopefully you can check yourself before you act on impulse. Merely learning about illusions doesn't cure them. The goal is to develop a skill of recognising situations in which a particular error is likely. In such situations, the BCM realises institutions cannot be trusted and it must be supplemented or replaced by more critical or analytical thinking.

Losing Your Way

Ego is one of the basic drivers of the human mind and there is substantial evidence that investors are full of it. Coupled with our inherent optimism, ego can be dangerous.

Translate this into the investment arena and it's easy to see why so many of us believe we can outperform the market with 'do-it-yourself' super funds and can beat professionally managed products, and why so many of us believe investment basics such as diversification are for less smart people.

The problem is that Financial Planners and investors are optimists and overestimate their ability to control their fate. They tend to dismiss the role of chance and credit skill for lucky windfalls. A little knowledge can be a dangerous thing.

BCM suggests that to curb our optimism we should consider counter measures such as - always consider the downside and be aware of what you don't know.

BCM approach to all risk, all asset classes, all performance may not control your sense of omnipotence but at least you'll be spared the pain of putting all your money in an ad hoc diversification that goes wrong. The more you put your investments on autopilot, the less risk you will crash them.

One of the key tenets of behavioural finance is that incurring a loss hurts the average investor about 2.5 times as much the pleasure they get out of making a profit. That leads inevitably to loss aversion - we loathe cutting our losses and admitting mistakes.

This also leads to regret which intensifies the pain of losing. Financial Planners and investors also put undue emphasis on hindsight and believes events are much more predictable than they are. So what seems a sensible risk at the onset often becomes a blatantly obvious mistake that should have been avoided after the investment has been lost.

To make matters worse, we are just as inclined to regret missed opportunities, as we are losers. That explains why people invest in things they know are probably unwise, being the rational thought is the fear of missing out.

Investors often try to avoid the regret by employing Financial Planners (who can cop the blame if there is a loss) going with the herd (it hurts less if everyone is losing money) or investing on past performance.

Another advantage with the BCM is to make one concentrate on the loss makers and remind us of the ways to avoid this in the future.

This fear of loosing makes us hold onto dud investments rather than selling, taking the losses and admitting our mistakes. We confuse the value of the investment with what we paid for it. The fact we paid X for something, anchors it.

The suggested counter measure is to learn as much about the long-term history of markets and decide on the long-term strategy within the "risk tolerance" you are prepared to wear and then turn off.

BCM helps Financial Planners to be just as ruthless in analysing your success as your failures. Understanding why things happen, can help you make better decisions.

Seeing Things the BCM Way

One thing we are very good at is recognising patterns so that we sometimes place importance on patterns that are meaningless or not there.

For example, the following sequence occured when a coin is tossed several times, HHHTTT or HTHTHT, most people believe the second sequence is more likely to occur because it looks more random whilst the first appears systematic even though both are equally probable. The explanation is that we tend to downplay uncertainty and project the state of the world into the future. That's why we think that the sharemarket or the fund manager has done well into the future and ultimately why investment bubbles and burst overshoot any levels that seems halfway sensible.

That's why in absence of better information, we also assume the latest prices are about right or why we think the growth shares of a few years back are dirt cheap at price earning ratios still well in excess of 20. In other words, Financial Planners and investors sell winners to buy losers. This is partly due to over-confidence and partly due to seeing patterns where none exist.

Suggested counter-measures avoid the tendency to talk long-term and act short-term. Remember, your brain can deceive you into thinking that anything that happens a couple of times is a trend.

If you have an appropriate strategy, stick to it and you should always ask yourself before making a decision whether there is a chance that the reason behind your planned trade might be random. List the reasons of not to sell before you commit.

Suggested counter-measures: look at the same information from as many angles as possible and consider the big picture behind the facts.

Summary

Basic investment disciplines, such as having a long-term strategy, researching discussions, buying and holding and dollar cost averaging can help offset our tendency to act on poorly processed information.

It is good news too that our brains are configured to learn from experience. It's a pity evolution doesn't work a bit faster.

In exactly the same way, investment services can be provided in different ways. Individuals depending on their capacity to carry risk, demand different solutions. To satisfy these solutions, the BCM has developed many scenario-testing alternatives for the clients to understand their risk tolerances in relation to the possible range of rewards.

The New Australian Superannuation Way

In Australia, the Superannuation system has traditionally focused on accumulating retirement savings that mature at the point of retirement. At this point, the members become seriously responsible for their own financial planning.

The Future is Bright for BCM Portfolio Construction Mechanism

Master Funds and Wrap Accounts

The Master Fund phenomenon of the late 1980s and early 1990s was a watershed for the industry. It changed the way the industry functioned by invoking a major power shift from the Fund Managers that held the retail client base to the portfolio administration. Now the wheel is turning again - this time in favour of the service providers. Market consolidation will further hasten this shift and lead to even more rapid changes in the future. This is bad news for industry participants locked firmly in the past. In other words, if you used a business model that worked a decade ago, you cannot hope to succeed in today's radically different environment.

Financial Institutions

We have seen the funds management industry rapidly consolidate in the last 10 years. At the same time, the financial planning industry has changed considerably. This has been driven by the financial institutions ever-growing appetite to build closer ties with organisations that might distribute their product for them.

Boutiques Wealth Creation Emergence

The relatively low capital cost of entry and consumer demand for smaller specialised players ensures the continued emergence of Boutiques. The capital outlay required to be competitive in wealth management is simply too large for small players without the necessary backing to succeed.

Does this mean we will see a reduction in the number of players? Not necessarily. Instead the market will experience the opposite effect. Just as the focus of the industry shifts towards advice and planning and away from products and administration - Dealer Groups, stockbrokers and accountants will become branded providers of wealth management solutions to their customers.

Member Choice of Funds

This is a further recognition that some members may want the right to choose the particular fund structure through which the Superannuation is accumulated. While the extra choice given new rights and responsibilities to members, there is also concern arriving in some Superannuation industry watchers that many members are not adequately prepared to make these decisions. It's important therefore that Superannuation Trustees, Employers, Fund Managers and Financial Planners recognise a responsibility to those members.

BCM, Multi-Purpose Risk Management System

A further effect of industry consolidation and the high capital barriers to entry will be the impact on wealth management and the decrease in the amount of platforms that are used to build and provide wealth management services. Platforms that service the market-place make over will be those that deliver the goods to the evolving new look industry.

All this can be done despite the size of the financial planning practice, through providing an appropriate multi investment choice for advisors who make their fund decision through BCM's "Strategic Portfolio Construction Mechanism" which provides clients with relevant information about minimising investment risk.

Choosing The Strongest Fund Manager/Stock In The Strongest Sectors Boosts Your Chances Of Success

Relative strength is simply one thing compared to another to see which is increasing the price faster. To do this, the comparisons must have a common base so if we divide the prices over the time of the listed shares or fund managers by a common base such as the market price index, we will be able to identify which shares or fund managers price are rising the fastest.

We are not restricted to shares; we can also use the first indexes of industry sectors to find the sectors that are the strongest compared with the overall market by dividing each sector index by the general market index. We could also do this for national markets compared with a world index.

Analysts have found that the strongest shares, fund managers or sectors tend to remain the strongest in their field for some time. If we can find the strongest portfolio synergy and stay with them while they are performing better than the market overall, we should have a superior outcome. This has an advantage over the fundamental analysts who might identify what is thought to be the great share based on its prospects and management but the market hasn't recognised yet. The technical analyst is therefore looking to add the timing dimension.

Relative strength analysis can be done a few different ways. It can be done by hand using the Share tables section and a calculator. The computer literate reader could use a spreadsheet. Technical analysts would use their charting software but these methods will vary slightly depending upon the features built into each charting software. We could simply use BCM Macro which charts the relative strength of every industry sector and usually inspect the charts to find which has risen fastest in recent times.

Therefore, having found a relative strong sector or stock over a specific period, the next step will be to do our research and to see whether it will fit into the portfolio.

Tougher Task To Beat Market

Bear markets has exposed a lot of weaknesses in the way we manage or advise funds for our clients. There is too much capacity and the unit trust managers, master funds, fund managers, brokers, analysts, hedge funds and other advisers basically can't deliver what their clients most want - performance. The industry seems to have eliminated diversity. The industry has grown up and is becoming stagnant and self-serving.

Master trust distributors weren't generating sustained value from asset allocation. Fund manufactured products had yet to prove that they could consistently generate absolute returns. Very strong brands had imploded as investors lost confidence, and hedge funds had not delivered in the way they claimed they would.

And now the industry wants absolute returns and the industry has no idea how to respond.

The dominance of distribution in the industry's strategic thinking had blurred the need for answers. The easy times are over for Australian fund managers who faced tougher times in beating the market. Up to 1987, they went for the entrepreneurs, then avoiding them and since going very long banks and resource stocks.

The line that 'You lost less money with me than you would have with my competitor' is not exactly a killer. The tumble with falling markets had exposed the mismatch between the industry's past promises - all tied to relative returns and customers' demands for absolute returns.

For The Beginners - Feel The Fear And Do It Anyway

The essence of successful investing is in assuming risk.

As a beginner, we all come to the stock market with completely the wrong idea. We are always looking to buy and sell stocks and always making a profit. Deep down we always think that there are people who always make money on every investment.

The realisation that this is not so was one of the most unsettling things that you can discover when you started investing and it takes longer to realise that many of the investments that anyone makes will loose money, was a deeper realisation is one of the secrets of successful investing.

The three primary elements of realisation is that what really stops us from investing successfully, is fear.

Firstly, we are frightened to pull the trigger to make the investment in the first place. Yet most of us will look back over the opportunities we did not take and bemoan the fact that so many of them would have been profitable investments.

Secondly, we are frightened to take the medicine. We make an investment and it starts to go wrong. We know we should sell and make a loss but we don't. Instead, we hold on, hoping it will come right and in the process, we will lose a large part of our investment. That is we see we are wrong but are fearful of admitting a mistake and getting it wrong again if subsequently the investment came good.

Thirdly, we are frightened to take profits when an investment succeeds. Then it exceeds all our expectations; then we fall in love with it to our peril - the profit slips away because we are fearful of missing out on more profits if the stock keeps going up. Later, when it goes down, we are fearful of admitting we did not act when we should have "rung the cash register" as they say on Wall Street.

The most valuable thing you can learn about investing in shares in to take a profit which is in all the analysis and fund managers techniques; important as they are but the way in which good investors think that it is different to the way everyone else thinks.

What is different is that good investors understand that the essence of investing is in assuming risk whereas most people have not even started to come to grips with it - dismissing it as trivial and almost self evident.

At the simplest level we are the absolute beginners when we start out; we spend a great deal of time looking for the perfect method - the guru who can tell us, the book we can read or the course we can attend that will show us how to get it right all the time.

If there is no risk, then there can be no opportunity to make a profit. The logical step from the idea that all investments involve risk that some of them will lose. It also follows that we cannot know in advance which ones will lose. If we did, we would not make them in the first place.

The implications from this are enormous and lie at the heart of what separates the best investor from all the rest. The best investors have learnt to accept risk. Once they do this, they can conquer fear. Put simply - if all investments involved risk and we cannot know which ones will succeed and which ones will fail, then there is nothing to fear.

What would be the logic of making a mistake if there is no way to know in advance whether we are making a mistake?

What the best investors do is initiate investments and close them out, whether at a profit or loss without any emotion.

One of the things that all good investors know is that they should never discuss their investments with other people. They do not need the psychological "grief" that can come from putting their ego on the line, nor do they need the reassurance of their peers. In fact, they actively avoid peer pressure or reassurance because they understand how crowds work.

Best Practice In Manager Selection And Blending

Investment management selection and blending is a key strategic priority to elite financial planners.

This paper covers evaluating the performance and diversification properties of fund of funds structures, true performance of Australian and international fund managers, evaluating and selecting managers, managing the risk in multi-manager portfolios, developing style rotation strategies and the importance of style diversification in the future.

Managing The Absolute Alpha Approach

Victor Soucik, CEO of Erideon Group, an organisation specialising in finance and technology in Australia, Asia and North America, who did his PhD on Finance in Australian managed funds for which incidentally in his academic life has received no less than ten top prestigious awards for outstanding achievement in Capital Markets, Banking, Economics, Law, and Managerial Finance.

Speaking on his PhD thesis, Dr Soucik told the seminar delegates that when coming to the conclusion about the performances of both equity and fixed interest fund managers, given the same proxy measurement benchmarks (i.e. a list of twenty one pre-existing indicators) such as, the size of the fund, value, momentum, market factors dividend yield with a mixture of interest rates and global economies, time series and various style methodologies of managers; the conclusion was that both fund classes point to Jensen's Active Alpha Style Stock Tracking Theory. Neither class is significantly sensitive to the choice of risk free proxies(see the 90 Day Bill Rate), but extremlly sensitive to relative benchmark.

Examine The Risk And Return Properties of Fund-of-Funds (FoFs)

David Gallagher is a Senior Lecturer in the School of Banking and Finance at the University of NSW.

FoFs investment products are a single managed investment portfolio, where fund assets are allocated across a number of individual investment vehicles. FoFs provide investors with an opportunity of investing a suite of investment products while also enabling investors a benefit of improved diversification, manager selection and administrative efficiency.

This study examines portfolio selection, performance and risk by examining the relationship between investment performance and diversification properties arising from the construction of actively managed equity FoFs portfolios.

Employing a simulation analysis containing 134 active Australian equity funds (sourced from 65 investment managers) over the time series 1989 to 2000, results showed that as the number of funds in the FoFs portfolio increased,

• volatility (time-series return and terminal wealth) is reduced while the mean return remains constant
• risk-adjusted performance (four-factor model and Sharpe ratio) improves as funds are added to the FoF structure
• adding additional funds eventually leads to minor deteriorations of FoF skewness.

Interestingly, construction of FoF portfolios on the basis of investment style leads to more optimal portfolios than a simple naïve selection process. In addition, selecting FoF portfolios on the basis of above median past performance outcome in a mean-variance framework achieves higher than average return for less risk. In other words, being reward for appropriate risk.

Managing Risk In A Multi-Manager Portfolio

Jeff Rogers have been Head of Investment at Victorian Funds Management Corporation since 1998. VFMC manages around $20 billion of assets on behalf of organisations in the Victorian public sector.

Speaking on the topic, Mr Rogers told seminar delegates that there can be such thing as best practices in design of multi-manager portfolio conditional upon having identified superior managers.

In order to understand a market, we need to focus in its risk structures. What we are really talking about is a risk model for portfolios invested in relevant markets. Provided you have a good risk model, you can understand, in advance, how large the portfolio exposure is to a style factor, and how great is its exposure to stock-specific risk.

After the event, you can contribute return to style factors and return to stock-specific risk. This helps you understand how well the portfolio was positioned and perhaps provide some insight into what it may achieve in the future.

Cut right down, a manager is merely a set of beliefs that is backed by a research process. The true value-add of a manger shows up in their idiosyncratic skills. It is the risk and return characteristics of that skill that really matters. The style characteristics of the portfolio that come attached represent a modest inconvenience.

An important observations is that, even if a manager has a skill, the structure of the markets in which they invest, and the constraints placed on them tends to mean there is a diminishing incremental return for active risk.

Therefore, the one way in which we can improve performance of that manager is to be overweight in that fund manager, yet at the same time to maintain an acceptable overall portfolio risk through tactical asset allocation equilibrium offset of risk exposure arbitrage.

Developing Style Rotation Strategies

Since 1998, Mathew Jeremy has been in charge of $9.3 billion of the International Equities Division for the Queensland Investment Corporation.

Speaking on developing style rotation strategies, Mr Jeremy said during the past few years, there has been major fluctuations in the performance of value and growth indices both in absolute terms and relative to history. This highlights the need for rebalancing strategies in multi-managers international equities portfolios made up of a combination of value and growth managers. It also raises the question of whether these fluctuations in style can be exploited by active management to deliver an additional source of excess return to portfolios.

Bernstein in his 1995 book 'Style Investing' proposed a four-factor model to describe style rotation in the US market up to 1993. The factors are earnings supply, the payout ratio, interest rate momentum and yield curve. This is essentially a model of pro-cyclical value/growth performance when economies recover earnings are plentiful and value outperforms growth; earnings security in economic slowdown favours growth.

Applying Bernstein's model to the MSCI US value and growth indices for the period since 1975 shows that the model worked into well up to around 1994, but then significantly fails to pick the turning points in value/growth performance through the crises and bubbles of recent years. The same conclusion applies to the European and Japanese value/growth experience.

An alternative approach is to think of the value/growth question as akin to the bond/equity decision in TAA models. Growing economies favour value and equities and slowing economies favour bonds and growth.

A simple bond yield/equity yield indicator showed that the approach works better in the US and Europe post-1993 than does the Bernstein model. It also works fairly well in Japan. These results illustrate the notion that the big fluctuations between value/growth in recent years reflects shifts in risk premium caused by the various crises and the tech bubble rather than the underlying economic forces. The bond/equity indicator and value/growth relative performance are both market-based indicators incorporating these risk premia. The question of TAA approach, however, is whether we expect risk premium to continue during the relative performance of value and growth or whether we expect economic fundamentals to reassert themselves sooner or later.

Mr Jeremy said both these approaches suffer from certain inherent limitations as investment processes. Grinold and Kahn's fundamental law of active management focuses on the role of skill and breadth; the ability of fund managers to forecast market prices and the range of decisions to which that skill can be applied. Both the Bernstein and TAA approaches are narrow processes; binary value/growth positions are about as narrow as you can get. This requires a very high level of skill to compensate for the lack of breadth. However, forecasting economic conditions and making bond/equity calls are very difficult. The high level of skill needed for these decisions exists but it is rare.

A completely different and preferred approach is to let our active manager work the value/growth call. This is an awarded broad mandate rather than a value/growth mandate and lets the manager decide what point of the market it wants to be in according to the state of the business cycle. This is a classic sector rotation approach, which allows the manager to exercise the stock picking skill over a much wider range of bets at the stock level. Stocks are also much better as tradeable instruments than the managers or indices needed to implement the top down approaches.

The broad mandate approach also has the advantage of precluding the need to rebalance one's value and growth managers.

The Myth About Shares Being The Best Long-term Investment Proposition

Information like this can be confusing to a generation of Australian shareholders that has grown up reading books, magazines and fund manager brochures that says shares can't be beaten over the long-term.

The Really Critical Thing Is The Time Horizon Used

Over 10 years shares are very likely to outperform bonds; over 50 years, shares are fairly well assumed to outperform. But the fact is that investors can't assume that shares will beat bonds over any time period. Also, if the share investment is made at the top of the speculative bubble, it may not outperform over the long-term horizon that the investor has set. Therefore, the rider that really must be attached to the general statement is 'provided that the shares are bought at a reasonable price'.

It's simply false to say that the share market will always outperform over the long-term. If that were true, everyone would be fully invested in shares and there would be no need to diversify a portfolio and that need exists, evidenced by the last century of the S and P 500 Index in the US shares market.

1. You can find six 10-year period that generated a negative return in that index;
2. You can find four 15-year periods; and
3. You can find one 20-year period.
4. There are 11 long-term periods in which a US investor could have beaten the share market's return in a cheque account paying no interest.

So, in the US context, the share market can't always be the best investment over the long-term.

Over 50 years - any 50 years - it is unarguable that any asset class can match the total return from the share market. But realistically, 50 years is not a long-term time horizon of most investors. It's more like 15 to 20 years and it's that long-term experience from the US that shows shares can not only be beaten over the long-term, they can actually send you backwards if you enter the market when they were over-priced.

Data from the Australian share market also confirms that investors over the long-term can expect to be compensated for the extra risk of holding shares with superior performance and in particular, the tax treatment of fully franked dividends has to be taken into account. In fact, franking credits lifted shares into first place on an after-tax comparison of returns for the 10 years to December 2001.

What To Look For In Filtering Stock Opportunities

1. Concentrate on the fundamentals. Look for a relative unstretched P/E ratio and one that is not based on a huge ramp-up in forecast earnings.
2. Seek a decent dividend payout and hence a solid franked dividend. Dividends provide a regular tax effective income and a rock-solid footing for your portfolio. A growth-oriented company that pays little or no dividends may give you five years of strong share price performance followed by a slump that sends the share price back to where it started.
3. Back management with a track record for delivery. The chances are that a board that has let investors down once, may do it again. It's much better to stick to those companies that have a fairly lengthy track record of reaching expectation and equally not allowing them to rise unrealistically high in the first place.
4. Avoid dependence on international earnings or foreign exchange risk. Foreign operated businesses do tend to disappoint more frequently than the local operations because Australian executives often misunderstand overseas market structures and also they are less readily monitored by Australian domiciled investors. The currency exchange may clip a few per cent off the translation anyway.
5. Seek business transparency and tangibility. In such a precautionary investment environment, the days of concept stock are well and truly over.
6. Look for good entry levels. Try and make sure you are not buying at the peak of any unprecedented share price rally. Have a look back a year or two and make sure the stock has been notably higher.
7. Look for an element of take-over vulnerability. An open register and a good cash flow multiple are an attractive combination for other reasons but given low interest rates, they lead to take-over appeal.
8. Plan your portfolio with the aim of providing a sectorally balanced group of stocks that conform to these investment principles, particularly those stocks which are influenced by cyclical movements.
9. Don't buy stocks that are loaded up with debt. It's worth running a few quick debt checks to make sure your company balance sheet remains healthy such as the Net Interest Rate Cover, Net Debt/Equity Ratio. Debt is a different beast of interest rates payments to the banks and other creditors can't be reduced or suspended without the risk of bankruptcy.

Some Key Funds Issues Considered

In the latest of our series of features on fund manager selection and other pertinent issues confronting the industry, BCM present salient issues from the perspective of a manger researcher - research and ratings house Morningstar. This is what they had to say:

Q: Which fund managers have proven to be the most reliable performers over the past few years, and do you think they will continue to do so?

A: "Reliability" is not about being the best performer over the last year, or even the past few years. At BCM, they look for fund managers who can articulate clearly what they are trying to achieve on their investors' behalf, and then demonstrate that they have done so with success.

Perpetual Investments and Maple-Brown Abbott are two 'value'-style fund managers, for example, which continue to deliver to their message, and have rewarded investors with consistent returns. These same fund managers underperformed during the 'tech' boom, but then we expected them to. Likewise, Colonial First State's Australian shares performance has suffered of late, as its 'growth' style has been out of favour with the market, but over the longer term, Colonial First State has demonstrated a consistent application of its style, and generated favourable results for investors in its funds.

Remember also not to make the mistake of attributing all the performance of a particular fund to the fund manager, as some of it comes just from being invested in a particular sector, for example listed property over the last three years. Finally, the best way for an investor to secure reliability from funds is through a diversified portfolio of assets and quality fund managers.

Q: Have investors lost confidence in fund managers, and would they have been right to do so?

While many Australian investors have been unnerved by the down markets over many years - in part because the very long bull market from 1983 to 2000 means that many investors have never experienced a period of sustained poor performance - BCM tracks funds on a global basis, and there has been no concerted "rush for the exits" by investors and financial advisers. Actually, the diversification provided by funds has insulated many investors from some of the most punishing losses suffered by direct shareholders in individual companies like HIH and WorldCom.

Nevertheless, investors do have some valid questions to ask about their fund managers. How did so many professional fund managers get caught up in the frenzy of the technology boom and bust? Why did fund managers and other professional investors vote for exorbitant pay packages for company executives? Why haven't many fund managers taken steps to communicate more effectively with their clients during times of extreme market turbulence? Why do fund managers place so much emphasis on promoting their high returns over particular time periods, and so little on promoting consistency of returns (or "peace of mind"), and explaining the corresponding "downside risk" in the form of volatility? How fund managers respond to questions like these will go a long way towards determining whether the funds management industry will retain investors' confidence.

Q: Will there be a move by investors to demand performance-based fees?

The interesting thing about fees is of course that during times of strong performance, investors don't pay as much attention to their effects as they do during down times (when the impact of fees erodes further already poor returns). So we've seen a lot more discussion in Australia over the past two to three years about the effects of fees, and one of those topics has certainly been performance-based fees.

The major advantage of performance-based fees is that in theory anyway, they align directly the fund company's interests - its income - with investors' interests - their returns. The major disadvantage may be that earnings-related fees could encourage the fund manager to "go for broke" to generate higher returns, and therefore higher fee earnings, and not necessarily take account of factors such as risk and volatility.

In the United States, several very large fund managers such as Fidelity and Vanguard (both of which have presences in Australia either in their own right or through tie-ups with local fund managers) offer funds with what are called "fulcrum" fees. This is where if the fund manager achieves a return below a certain level (typically a level below index benchmark return), the fee can be "dialled down", but if the fund manager achieves a return above a certain level, the fee can be correspondingly "dialled up".

This means that (again in theory anyway!) investors win if the fund manager does not perform because they pay lower fees, while both investors and the fund manager win if the fund outperforms - the investor from the higher returns, and the fund manager from the higher fee income.

Other than a small number of limited, primarily wholesale mandated-oriented fund managers not easily accessible to retail investors, BCM is not aware of any prominent performance-fee-based retail managed funds in Australia. And given the concentration of funds management industry ownership now in the hands of the banking sector, and the banks' desire to recoup the costs of their capital outlay and ongoing costs, the outlook doesn't look particularly bright for variable performance-based fees - rather than flat "we get them regardless of how we perform" fees - in Australia.

However, a fund manager wanting to promote itself as a lower-cost performance fee-related shop could find significant advantages in doing so. Just as the past 10 years have seen the full-on development of a mortgage broking industry, with lower costs for mortgage lending, there's no reason some players in the Australian funds management industry couldn't go the same way.

Q: What are the benefits of investing in overseas funds? What are the risks?

There are two primary benefits of investing overseas. One is diversification. Overseas markets sometimes "zig" when the local market "zags". Consider the (literally) poor Japanese investor who in 1989,with the Nikkei Index at nearly 40,000, decided to invest all their money in the local sharemarket, i.e. did not diversify offshore. Fourteen years later, that investor has lost roughly three-quarters of their initial investment!

BCM does not expect the Australian sharemarket to experience a similar catastrophe, but a prudent investor will spread their assets around and avoid taking that chance. Secondly, investing globally offers more opportunities to invest in terrific companies and investment opportunities that don't necessarily exist in Australia. In a world in which there are tens of thousands of publicly-traded firms, it seems reasonable to assume that not all of the worlds great companies are in one's home market.

There are also two primary risks to international investing. One is that overseas markets may under perform the local exchange, which has recently been experience for Australian investors, although will not necessarily be the case if overseas markets pick up again on a sustained basis.

A second risk relates to currency. An adverse movement in the $A can wipe out gains earned companies offshore - or deepen losses. Many Australian managed funds, which invest offshore, do use currency hedging to attempt to limit or eliminate exchange-rate risk, but others do not, or do not do so consistently. We think investors should be aware and understand if and how their managed fund investments overseas have currency hedging in place, and that fund managers should communicate clearly to their investors what currency hedging strategies they use, and the upside and downside attached to using the strategies.

Q: Do you think the managed funds industry will change over the next few years and if so, what changes can we expect?

The managed funds industry is always changing and evolving. For example, one of the major developments over the past few years has been the growth of masterfunds and other "investment platforms" through which people can invest. The last two to three years' prolonged poor performance in many sectors has been unprecedented for most investors, and this will have an impact.

While BCM believes that investors who have a long-term investment horizon should stay faithful to local and international shares as the demonstrated engines of growth, the recent bear market has also opened many investors' eyes to the benefits of diversification and other asset classes. Expect to see more alternative assets available through managed funds, whether they be private equity, hedge funds, or structured debt. With more people retiring over the next 5-10 years, income-producing products will become increasingly important at a time when there are a number of risks in the market. Fund managers have been, and continue to, develop new products to meet this need.

Q: Are there any particular things investors should keep in mind when deciding to invest in funds?

Investors should keep several important issues in mind when investing in managed funds, preferably with the assistance of a professional financial adviser, who will be able to consider the investor's entire financial situation (tax, other investments, and so forth).

Firstly, their investment time horizon, and their purpose for investing, should be upper-most in the investor's thinking. Share funds are typically riskier than bond funds, for example, and are therefore most appropriate for longer-term investors. Secondly, costs are critical. When choosing among three or four funds that are similarly attractive on other grounds, investors should opt for those with the lowest fees. BCM studies have shown that higher-cost funds often deliver poorer returns and can be riskier than lower-cost funds, especially in the fixed interest area.

Thirdly, remember to diversify. It's the old, old story: "don't put all your eggs in one basket". Spread your money across shares and fixed interest, growth and defensive assets, and domestic and international markets. An investor who did this, for example, over the past couple of years would have benefited from the strong performance of fixed interest and listed property cancelling out some of the damage from international shares.

Q: What are the advantages/disadvantages of investing through a boutique fund manager as opposed to a big well-known manager?

One significant advantage of boutique fund managers is that when there are terrific investment opportunities among smaller companies, a boutique manager may exploit them more easily. For larger fund managers, an investment in a smaller company frequently does not have a material effect on performance, as it represents a smaller percentage of their funds under management. But that same small company's stock might give a huge lift to a 'boutique' fund manager with a smaller asset base.

Boutique fund managers often also have a more coherent investment philosophy than some of their larger rivals. With all of their analysts and portfolio managers focusing on the same types of investments - in Australia, it's mainly Australian shares, and in particular smaller companies - they often also work as a more cohesive unit.

On the other hand, many boutique fund managers are also subject to what is called "key person risk". This is the risk that with so much of the investment management being undertake often by one or two key individuals, if anything happens to those people, the investment style may be at risk. Investors who invest with "boutique" fund managers should therefore keep a close eye on any changes at their fund manager, particularly changes to key investment staff.

On the other hand, larger firms have advantages as well. They frequently can offer funds with relatively low management expense ratios because they can afford to subsidize costs. Moreover, large fund managers typically offer a wider selection of managed funds, which can make it easier to build diversified investment portfolios, by investing through the same platform in several different options (although you could also mix and match funds offered by boutiques with differing investment approaches). Finally, larger fund managers may have resource advantages such as more analyst firepower.

Tips When Buying Stocks Is To Look At The Way A Company Is Managed

The first dimension describes a business as it is today, being essentially a matter of results and more importantly, will continue to produce them in the future. The force that causes such things to happen that creates one company in an industry that is an outstanding investment vehicle and another that is mediocre is essentially people.

1. The first dimension of conservative investment consists of outstanding managerial competence in the basic area of production, marketing, research and financial controls.
2. The chief executives should be the cutting edge in their thinking that welcomes dissent and promotes and rewards motivation.
3. The average investor can go about getting a better understanding of both management and inner strengths and weakness of companies in several ways, one successful means by way of "scuttlebutt approach" - going out talking to the company competitors, suppliers and customers to find out how an industry or company really operates.
4. Although examining financial statements is an important part of securities analysis, it's important for the investor that the company has enough momentum to keep going for three to five years.
5. It would be an over simplification to be a buy and hold investor. If a stock hasn't met its required rate of return after three years, the investor should sell.
6. Buy into companies that have discipline management and plans for achieving dramatic long-range growth in profits and that have inherent qualities, making it difficult for newcomers to share in that growth.
7. Don't be afraid to be a contrarian; focus on buying companies that are out of favour as a result of general market conditions or because the financial community has misconceptions of its true worth. In other words, the stock is selling at prices well under what its true merit is better understood.
8. Focus on the future but remember, sometimes forecasts will tell you more about the forecaster than the future. Hold the stock until there has been a fundamental change in its nature such as weakening of management through changed personnel or it has grown to a point where it no longer will be growing faster than the economy. In only the most exceptional circumstances, sell because of forecasts as to what the economy or sharemarkets are going to do because these changes are too difficult to predict. Never sell the most attractive stock you own for short-term reasons. However, as companies grow, remember that many companies are quite efficiently run when they are small; hence fail to change management style to meet the different requirements of skill that big companies need. When management fails to grow as companies grow, shares should be sold.
9. Do not be afraid to look at low yielding stocks because the most attractive opportunities are most likely to occur in the profitable but low no-dividend payouts.
10. Do not be afraid to make mistakes and it is only a mistake if you don't learn from your errors. Making some mistakes is as much an inherent cost of investing for the major gains as making some bad loans is unavoidable in even the best run and most profitable lending institution. The important thing is to recognise them as soon as possible, to understand their causes and to learn to not keep repeating the mistakes. Willingness to take small losses in some stocks and to let profits grow bigger and bigger in the more promising stocks is a sign of good investment management.
11. Diversify your portfolio but don't hold too many stocks. There are a relatively small number of truly outstanding companies. Their shares frequently can't be bought at attractive prices. Therefore, when favourable prices exist, full advantage should be taken of the situation. However, funds should be concentrated in the most desirable opportunities but notwithstanding proper diversification over a variety of industries with different economic characteristics.

    A holding of more than twenty (20) stocks is a sign of financial incompetence although 10 to 12 is a better number as capital gains may justify taking several years to complete towards a more concentrated portfolio.

    Equally, replying on a handful of stocks to achieve your investing goal, despite holding fewer stocks, has a greater opportunity to outperform the broad sharemarket but a greater risk that your portfolio will fall short.

12. Buy companies you can understand with a "two minute drill" is a handy test to help you gauge whether that stock is worth investing in or not. The two-minute monologue can be muttered under your breath or repeated out aloud to colleagues, friends or family so that a child could understand it. Then you know you have a proper grasp of the situation. For example, the type of thing you might say - "I like the Woolworths retail business as a long-term investment because the stores are usually crowded and are always finding better ways to serve customers."

    The company has a track record of growth boosting earnings per share by 16.6 per cent per annum compound over five years and more than doubling its dividend which its dividend yield is still 3 per cent fully franked and its share price has risen threefold over the same period. Woolies continue to expand their supermarkets and six to eight Big W stores each year. Chairman James Strong and CEO Roger Corbett have a history of delivering the goods and company management succession planning over the past decade has been excellent. People need to eat, drink and clean their homes, even if the economy goes through a bad patch; so it can survive a downturn in the economy.

    My main concern is that profit margins in supermarkets could fall as competition intensifies from Coles supermarkets, Foodland and Metcash. If all these companies achieve their growth plans in the next five years, some stores will be unprofitable but that won't necessarily be Woolworths outlets.

    Woolworths shares are no bargain at the current price earning ratio of 19 but the company has a solid core business and history of delivering its expansion plans, making a good long-term portfolio mainstay.

D.I.Y. Investor Bulletproof Your Portfolio

Selecting high quality shares (or Managed funds) and letting them get on with the job, is a large part of successful investing. But there is more to building a bulletproof portfolio than that.

How Seriously Should I Take Diversification?

Investors who do not have a diversification share portfolio that spans a range of stock with a range of characteristics, in a range of sectors will eventually learn why diversification matters.

Investing all your money in one of any number of high performing stocks (or Managed funds) can pay off handsomely. But first you have to find those stocks and then you have to be prepared to see your portfolio literally halve or worse, within a few days - a level of risk few investors will tolerate.

Diversification helps because it dampens the impact of falls in share prices (or Managed funds) on portfolio performance but it also allows investors to participate in gains across a broad range of stocks and sectors.

How Many Shares (Or Fund Managers) Should I Own?

Few private investors have the time, resources or desire to keep an eye on more than a dozen or so stocks (or Managed funds). Your degree of diversification required depends upon your attitude to risk and what you hope to achieve from investing. It's simple to invest in an indexed fund that will produce a return roughly equivalent to the market index before fees. But to have a chance of outperforming the market requires a more concentrated portfolio that cherry picks quality stocks (or Fund Managers) while avoiding under performers.

Should I Go For Income Or Growth Or Both?

There are really only two types of portfolios: those that make money and those that don't and there is no magic portfolio to suit everyone. Retirees often look for shares (or Fund Managers) for regular dividend payments to supplement income from Superannuation based products such as allocated pension. These investors usually require a higher proportion of income-qualifying stocks (or Fund Managers) such as listed property stocks and banks. However, to ignore growth stocks (or Fund Managers) completely means bypassing considerable opportunities.

The aim should be to maximise total after-tax return and most portfolios will usually include growth, income and a few cyclical stocks that fluctuate with the state of the economy. Younger people who earn regular income and have long-term horizons may choose to focus on high quality growth stocks (or Fund Managers) despite the fact that some will under perform in a downturn. If the time frame is less critical, growth stocks (or Fund Managers) will often (but not always) come back stronger than ever as the economy returns to a solid footing.

What types of companies should be represented?

Shares fall into one of three fairly loose categories: blue chips, second-liners and speculative stocks or "specs". A typical well-balanced portfolio might include roughly 65 per cent blue chips, 30 second-liners and 5 per cent specs.

Highly conservative investors may keep an even larger proportion of their portfolio in blue chips and avoid the specs.

Blue chips are big household name stocks like National Australia Bank, News Corp., Telstra and BHP Billiton. Only a handful of companies retain blue chip status in the very long haul and the best of them have uninterrupted records of rising profits and dividends, strong management, exceptional business franchises and first class credit rating.

Second-line stocks may be on the cusp of blue chip status or may wither to nothing. They tend to be younger, smaller companies like Cochlear, CSL and Aristocrat Leisure which have greater potential for share price volatility than blue chips but may offer scope for more rapid growth. They'll usually be earning profits and paying dividends, although youth and growing pains, size and vulnerability come into play.

Speculative stocks involve much higher risk. The companies behind them are often young and depend on winning one big contract for survival. Buying speculative stocks involves staking money on blue sky often with limited liability to assess accurately the chances of success. Remember, the old market adage "don't pay for the blue sky" and make spec shares a small component of your portfolio.

How "Actively" Should I Manage My Portfolio

Ironically, the most successful long-term strategy for most investors requires the least time commitment to the market. Buying quality stocks (or Fund Managers) and holding them for the long-term - as long as they remain quality stocks (or Fund Managers), works for most of the people most of the time and a sustainable level of diversification should ensure that most investors do not stray too far.

While it takes time to find and research quality stocks (or Fund Managers) and to refresh the rationale for holding them, it does not generally require daily or weekly market monitoring. However, trading which relies on getting in fast and getting out faster, works for some of the people some of the time and requires close daily attention to the ups and downs of the market.

D.I.Y. Investor Very Much An Amateur Player

Translate this into the investment arena and it's easy to see why so many of us believe we can outperform the market with 'do-it-yourself' super funds and can beat professionally managed products, and why so many of us believe investment basics such as diversification are for others - less smart people.

The problem, says Professor Kahneman is that optimists overestimate their ability to control their fate. They tend to dismiss the role of chance and credit skill for lucky windfalls. Investors may have bought on the way up and sold at the bottom. Several studies of managed investments have found that the average investor under performs the theoretical performance of a fund up to 50%. This is critical when it involves Superannuation savings.

Financial Planners Made To Use Portfolio Risk Modelling Software As A Compulsory Requirement

Whilst the Financial Planning Association (FPA) has developed some standard definitions, there is some work to be done in developing benchmarks if the financial planning industry is to keep its insurance premiums down, avoid law suits and more importantly, maintain the trust of clients. In general, when we look at the clients -

• It's not a question of emotions and subjectivity
• Quality income streamline needs
• Assess their risk tolerance to a set of investor style risk types
• Quantitative analysis tools so people don't get big surprises in their portfolio.
• Do they feel comfortable with negative returns?
• How do they feel with a range of returns between 1-19% pa., 2-12% pa., 4-8 % pa.

Choosing The Strongest Fund Manager/Stock In The Strongest Sectors Boosts Your Chances Of Success

Relative strength is simply one thing compared to another to see which is increasing the price faster. To do this, the comparisons must have a common base so if we divide the prices over the time of the listed shares or fund managers by a common base such as the market price index, we will be able to identify which shares or fund managers price are rising the fastest.

We are not restricted to shares; we can also use the first indexes of industry sectors to find the sectors that are the strongest compared with the overall market by dividing each sector index by the general market index. We could also do this for national markets compared with a world index.

Analysts have found that the strongest shares, fund managers or sectors tend to remain the strongest in their field for some time. If we can find the strongest portfolio synergy and stay with them while they are performing better than the market overall, we should have a superior outcome. This has an advantage over the fundamental analysts who might identify what is thought to be the great share based on its prospects and management but the market hasn't recognised yet. The technical analyst is therefore looking to add the timing dimension.

Relative strength analysis can be done a few different ways. It can be done by hand using the Share tables section and a calculator. The computer literate reader could use a spreadsheet. Technical analysts would use their charting software but these methods will vary slightly depending upon the features built into each charting software. We could simply use Access Economic which charts the relative strength of every industry sector and usually inspect the charts to find which has risen fastest in recent times.

Therefore, having found a relative strong sector or stock over a specific period, the next step will be to do our research and to see whether it will fit into the portfolio.

Tougher Task To Beat Market

Bear markets has exposed a lot of weaknesses in the way we manage or advise funds for our clients. There is too much capacity and the unit trust managers, master funds, fund managers, brokers, analysts, hedge funds and other advisers basically can't deliver what their clients most want - performance. The industry seems to have eliminated diversity. The industry has grown up and is becoming stagnant and self-serving.

Master trust distributors weren't generating sustained value from asset allocation. Fund manufactured products had yet to prove that they could consistently generate absolute returns. Very strong brands had imploded as investors lost confidence, and hedge funds had not delivered in the way they claimed they would.

And now the industry wants absolute returns and the industry has no idea how to respond.

The dominance of distribution in the industry's strategic thinking had blurred the need for answers. The easy times are over for Australian fund managers who faced tougher times in beating the market. Up to 1987, they went for the entrepreneurs, then avoiding them and since going very long banks and media stocks.

The line that 'You lost less money with me than you would have with my competitor' is not exactly a killer. The tumble with falling markets had exposed the mismatch between the industry's past promises - all tied to relative returns and customers' demands for absolute returns.

The Scientific Approach To Asset Allocation

While Financial Planners may differ on how to quantify the effects of asset allocation on portfolio returns, few question the importance of it today.

The value of asset allocation, spreading a portfolio across the four main asset classes and cash, (ie. bonds, property and equities) was increasingly ignored during the 80's, 90's and again obvious as the recent bull market ran it's course.

In fact, the place of asset allocation in the new economy investment world was questioned, no wonder so many investors strayed from a disciplined asset allocation approach because to diversify money away from equities, meant missing out on returns.

The trouble is investors portfolios took a real hammering, firstly with the tech wreck, successive corporate failures and scandals and now the threat of war.

Why is Asset Allocation so Important

One of the first to look at this issue was Dr. Harry Markowitz, who's now known as the father of modern portfolio theory and who received the 1990 Nobel Prize in Economics for his works. One of the most important findings was that the riskiness of a portfolio depends on how the investments within the portfolio move in relation to one another and that by combining investments with different volatility characteristics, you can decrease the volatility of the whole portfolio. Markowitz was the first to explain why diversification across asset classes is a sound investment principle.

However, the most startling fact founded by Gary Brinson, Randolph Hood and Gilbert Beebower quantified the impact asset allocation has on the volatility of a portfolio's return on an average of 91.5 percent. This can be explained by asset allocation.

In 2001, Roger Ibbolson and Paul Kaplan's masterpiece "Does Asset Allocation Policy Explain 90, 40 or 100 percent of Performance" looked at three issues.

Firstly they confirmed that about 90 percent of the variability in returns of a typical fund over time is explained by asset allocation.

Secondly, they then went on to look at what proportion of a funds actual return (not its volatility) is explained by asset allocation accounted for 40 percent of the variation between the returns of one fund and its peers.

Thirdly, no matter how much deliberate attention you give to the asset allocation of your portfolio, it won't affect the impact of the performance you expect to achieve.

So my advice is, after having thoroughly studied the need analysis and the risk tolerance of the client I therefore set about with a vigorous process of scenario testing for Gap Analysis matching. For an appropriate Stock/Fund picking method firstly I prefer to take what's known as a the top-down approach to portfolio construction adjudged for superior relative sector strength and secondly the bottoms-up approach whereby I sift through the most consistent top performing Fund Managers measured over 3-5 years and then thirdly I decide on what is an appropriate asset allocation which finally has the effect of the fine-tuning mechanism for the client's goals, needs, resources and attitudes.

The Risk Of The Portfolio Is Determined By The Mix Of Asset Allocation

The Business Coach Model acts as an excellent risk management tool as it can exhibit aggressive income returns with moderately conservative like risk returns.

The point about risk is not just about what the market as a whole is going to do but it's about a multitude of macro/micro factors, ie. the risk associated with a particular asset class, the style of the fund manager, the size of the companies they invest in and the risk associated with investing in any one fund manager.

The more active the asset class, the more you need to diversify to spread that risk. Fixed Interest Fund Managers don't vary that much from the benchmark and Property Securities funds also find it increasingly difficult to beat the index. But the Australian equity Fund Managers vary widely in how much they outperform the benchmark at difficult times of the cycle, so choosing the right balance of Fund Managers is important. International Equity funds managers find it hard to beat the MSCI World Index but large and small cap funds and growth vs. value is still an issue.

• Diversification is the key to your portfolio and there are many style products available to help you achieve your ideal fund.
• By investing in just one Managed Fund can almost be as risky as investing in just one company. Diversifying across a number of funds can reduce some of this hair-raising volatility while keeping your overall returns high. Diversifying is just about spreading your investments across a few managers in case one goes bad - that's just about reducing the risk.
• Various asset class sectors and countries perform differently at different times.
• Australia's sharemarkets may have held up well over a period when global markets have performed disastrously but by the end of the year, the situation may have reversed. Listed Property Trusts sector has boomed over the past twelve months but as the business cycle turns, it may return more modest gains.
• Aside from the asset classes and sectors they invest in, Fund Managers have a particular style and process by which they choose underlying securities. Their investing philosophy may be "top-down", focusing on sectors likely to do well in the coming months or "bottoms up" focusing on individual companies that are considered likely to do well - whatever sector they may be in.
• Avoid losses by trying to keep volatility low and aim for a neutrally correlated Beta Factor as being the cornerstone of portfolio strategy.
• When the market looks like falling dramatically, then even a zero return is acceptable, as the investor has no ground to make up before returns move into the positive.
• Assuming an investor has a balanced profile, then we need to allocate according to objectives. For example, if an investor wishes to enhance returns without taking on extra volatility, then allocation from the fixed interest side, assuming official rates have neared a peak of rising short term interest rates and an absolute style hedge fund with the possibility of a smaller asset allocation taken from equities. If however, the investor wishes to reduce portfolio volatility whilst not having a large impact on returns, then the larger allocation taken from equities may be appropriate and a smaller allocation from fixed interest. It's simply a matter of finding the mix that is right for the investor.

Plans And Strategies Essential To Manage Risk And Return

Choosing the most appropriate asset allocation strategy or mix of strategies is a crucial skill for investors.

The tough investment climate over recent years has highlighted the need for strategic investment plans that maintain a long-term view while being open to changes that will minimise risk.

Asset allocation strategies have had a significant impact on how investors have fared in the recent past and will continue to play an important role.

"Asset allocation" refers to the way investors spread their money across asset classes, including Cash, Shares, Fixed Interest (including Bonds) and Property. The asset allocation strategy you employ will determine the level of risk and the potential return on investment.

There are three asset allocation approaches, each with different aims:

• Strategic asset allocation is an approach where you set a target, decide on the best allocation to meet that target and stick to it. The aim is to ride out difficult times.
• Medium-term risk management is a strategic approach that recognises major trends in the markets but has the flexibility to make adjustments to avoid undue risk and preserve capital.
• Tactical asset allocation is a shorter-term approach that aims to anticipate market impacts and alter investments to make incremental gains.

Asset allocation recognises that all asset classes can add some value to a diversified portfolio and that asset allocation can be combined to achieve an effective investment plan.

Strategic asset allocation is a static approach that has been a sensible option for many years.

However, the market environment has changed and as many investors are expecting the next decade to produce lower returns in a volatile market, a more dynamic approach may be needed.

Medium-term risk management is a more recent approach to asset allocation designed to respond to significant increases in market valuations that may not be sustainable.

For example, if the sharemarket has run far ahead of expected levels and has an increased risk of downturn, a risk management decision may be to move funds away from high-risk shares and into more stable securities or bonds.

There may only be one or two or even no active risk management decisions over any year. These decisions may relate to the allocation of asset classes or the balance between growth and value investment styles.

Strategic asset allocation and medium-term risk management should work hand in hand. The strategic asset allocation is the foundation for your investment plan while the active risk management overlays this base. Tactical asset allocation may also be incorporated with shorter-term decisions designed primarily to add value rather than mitigate the impact of major risk.

Your asset allocation strategy may also change over time; for example, as long-term goals eventually become medium or short-term goals. For this reason, your asset allocation strategy may reflect your life stage, changes in investment goals and time frames.

Rebalancing your asset allocation, therefore, is not about jumping at changes in the market, but more about assessing the strategy against your goals.

When determining the asset allocation strategy that is right for you, there are several things to consider:

• What is your time frame?
• When do you need to access the investment as cash - in six months or six years?
• What is your tolerance for risk?
• Are you concerned about fluctuations in the value of your investment?
• Would you prefer a steady-as-you-go approach or are you happy to take greater risks in the hope of making greater gains?

Once you have answered these questions, you can begin to develop an asset allocation strategy that will set the tone for your investment portfolio. Given the complexity of market conditions, it is a good idea to work with a financial planner when establishing your investment portfolio and making asset allocation decisions.

Your strategic asset allocation will be closer to ideal if it reflects your investment goal, time horizon and risk tolerance.

Manage Risk Through Diversification

Diversification simply means that you don't put all your eggs into one basket. The major benefit of diversifying a portfolio is the potential to increase returns over the long term by minimising risk and reducing the negative effects of market volatility by investing globally and spreading risk across a variety of geographic investments.

Ideally, clients want their portfolio to have offsetting components that compliment each other during offsetting downturns in one area with gains in another. This is known as a low correlation, the desired result being that when one portion of a portfolio "zigs", another "zags". So when a Share Fund Manager suffers in a down turn, bond Fund Managers may outperform or when large Cap Fund Mangers plateau, small Cap stocks may rally. So no one can accurately predict which type of investment will outperform when a diversified approach makes the most sense.

Investing Versus Speculation

If you constantly move your money around from investment to investment hoping to buy low and sell high, the only way you will succeed is by being lucky - you're speculating.

If you leave your money in fixed interest investments and hope you will have enough money to last you 20 years after the day you retire, the only way that will happen is if you get lucky and inflation stops completely the day you retire. You're speculating.

If you have a plan and your plan includes a diversified portfolio of aggressive and not so aggressive funds and if you realise that the funds rise and fall in value but over the long haul, have demonstrated an ability to earn returns that are better than the average when compared to bank saving accounts or government securities, than when you or your stomach is screaming sell, then congratulations, you're investing.

By and large, investing for the potential of making above average returns requires planning, patience and a strong stomach. Aggressive funds may experience greater short-term volatility and may not outperform their indices during the same periods. It doesn't guarantee success any more than speculation guarantees failure but a good plan well executed, more often than not will win out over speculation.

The Main Alternative Investment Categories

The only free lunch on investments comes from a proper portfolio diversification. Through efficient portfolio construction, better risk reward opportunities are possible. In other words, you have your cake and eat it too. The best risk reward possibilities are represented by an efficient frontier. By diversifying into new asset classes or sectors that have low correlation with the existing asset classes of equities, bonds, property and cash, the efficient frontier can be improved to yield better risk reward opportunities.

There is one golden rule when investing; 'ensure your portfolio is diversified so that when one set of assets fall, another may rise, helping offset the downside risks.' What exactly does this mean for you and your investment?

What does diversification mean?

Diversifying your portfolio means investing in and across several asset classes such as equities, property, cash and bonds. A portfolio that contains all of these asset classes can earn the average of their combined results.

Why diversify?

By diversifying, you protect your investments against a fall in value of part of the market, as asset classes tend to behave in different ways at different times. For example, stocks and bonds may respond in completely opposite ways under the same set of economic conditions. Additionally, the volatility of your portfolio is reduced because not all asset classes, industries or individual companies fluctuate in value at the same rate. If one of your investments experiences a loss, the other investments are more likely to offset this by performing well, helping to generate a smoother return from your investment over time.

Why is diversification important to an investor?

The goal of diversification is to reduce the variability in a portfolio and allow more consistent performance under a wide range of economic conditions. Unless you can predict the future, the diversification of assets may be your best long-term solution as shifting economic conditions move major asset classes in and out of favour. Remember, it does not pay to market time. Being out of the market during a recovery because you withdrew your funds during a depression, can result in a dramatically lower return than if you had weathered the storm.

What is the relationship between risk and return?

The greater the risk that an investment may lose money, the greater its potential for providing a large profit. The opposite is also true: the smaller the risk involved in an investment, the smaller the potential return it will provide. For example, a computer company that has only just listed on the stock market could very quickly become bankrupt, or it could become a multimillion-dollar company. If you invest in the stock of this company, you could lose everything or make a fortune. In contrast, a major bank is much less likely to go bankrupt but you're also less likely to gain a great deal of money by buying stock in a company with millions of other shareholders.

You can balance risk and return in your overall portfolio by making investments along the spectrum of risk, from the most to the least. Diversifying your portfolio in this way means that some of your investments have the potential to provide strong returns while others ensure that part of your initial investment is secure.

How do Market Cycles affect investors?

Only one thing is certain about the investment market: sometimes prices go up, in other periods, they go down. It's impossible to guess at what speed this cycle of gains and losses will go on. And the peak of a rising market or the bottom of a falling market is almost impossible to pinpoint until months after it has happened. But market cycles are a fact of life.

To understand how market cycles affect you as an investor, you need to know that cyclical patterns recur in all asset classes - equity, bonds, cash and property; sometimes the majority of stocks are gaining value and other times stock prices are flat or falling. The cyclical pattern in one asset class tends to work in the opposite way to what's occurring in another class. For example, when the stock market is gaining value, the bond market may be flat or falling. However, there are exceptions, when both markets are strong or weak.

Investment Horizon And Investment Risk

Holding Period and Average Return

Those with a longer investment horizon will perceive the risk associated with equities to be less of a concern than those with short investment horizons.

The general advice given to investors is that the longer their investment horizon, the greater the proportion of their wealth that they should allocate to growth assets.

The return on growth assets is generally more volatile than income assets.

Declining market interest rates cause an increase in the price of fixed interest bonds, which in turn raises the holding return to bond investors.

Determining the Investment Horizon and Asset Mix

As mentioned on numerous occasions, Financial Planners haven't been able to focus on the fact that the majority of their clients are carrying the risk of investment performance and their investment horizon is no longer some short-term period but the investment horizon of a person in an accumulated plan is determined by their life expectancy. For example, a 55-year-old male is 23.8 years and a female is 28.3 years.

The Risks of Active Investing

All investments are exposed to broad market risks such as changes in the economy. Because these risks can't be avoided, assets with higher exposure to the market risks are priced to offer some compensation for bearing these risks. Hence, investors can expect to receive a premium for the market risk of their investments.

An Index Manager offers a simple and low cost way of investing in a broad portfolio of assets that captures the market risks. The market indices used by an Index Manager typically represent a proxy for the portfolio of assets of a particular type. For example, an Equity Index manager will typically hold portfolios that invest in companies in the same weight as the companies and represented in the index.

Active Manager

Active Fund Managers on the other hand offer investor's portfolio of assets that produce returns superior to that of the index. An active manager may decide that BHP Billiton LTD is overvalued and therefore reduce the exposure of BHP Billiton LTD by 5%. If the manager is correct and the share price subsequently declines, the managers will outperform the market.

Rewards for taking active risk

Those who have over-weighted in a particular type of security will do relatively well at the expense of those who under-weighted in the security. As with most zero sum games (activities when it's one persons gain at another persons loss), there are many participants willing to back their judgement. The belief of all active investment managers that they will be winners in delivering better than index performances but as with other games that people play, the level of skill varies considerably by the amount of participants.

It is possible for some to consistently win in the game of active management but this implies that there is another set of people who will constantly lose from adopting an active strategy.

Professional Financial Planners are more likely to have information systems and expertise to be able to provide increased performance to active management.

The financial market is a highly competitive environment and the ability to consistently add value through active management is extremely difficult. Despite this, there are some managers who have achieved out performance over a long period. The reward in terms of extra wealth accumulation by their clients can be considerable.

Active managers tend to trade more frequently in the underlying securities than index managers incurring transaction costs and capital gains tax. In addition, professional active managers charge higher fees than index managers.

Choosing an Active Manager

When clients seeking to make the active versus passive (or index) management decision, the question comes down to the trade-off between the higher fees and transaction costs associated with active management compared to the higher returns that are potentially available.

Good investment performance is attributable to a firm's information system; if it uses technology, the valuation techniques and its use of the skills of its investment professionals that it's likely to attribute consistently in any one year.

Professional Financial Planners and consultants are able to perform more detailed analysis of the active management process than a typical individual investor.

Active Management Styles

There is a large variety of active manager styles which essentially they vary as to objectivity, asset classes, asset mix, tactical asset allocation and investment horizon. One way that Financial Planners can reduce the exposure to the fund managers risk is to diversify across a number of different style of fund managers. However, the danger of over diversification amount properly screened good from bad managers is that the investor can end up with an average performance despite paying high active management fees.

Active management is an important component of investment risk. Even though extra returns are anticipated, the very nature of risk implies that extra returns will not always arise.

There is always a relationship between active risk and investment horizon. This implies that the importance of identifying which manager has superior skills is most critical for anyone with long investment horizons.

Applied Risk Management Too Difficult For Economic Environment

The guidelines contain a series of applied risk management tips, designed in a systematic approach that leaves nothing to chance when it comes to building a superior practice to build trust to deliver the value to clients.

A. The Things That Have Been The Big Issues

There are several key things about markets today which have caused an explosion in risk premiums that have long-term implications.

1. We saw a substantial cut in interest rates by central banks such as the US Federal Reserve Bank cut interest rates to a 40 year low.
2. If you are looking for a closer historical comparison for today's market points towards Japan in the 1980's compared to the US in the 1990's. The difference is the US is taking stronger steps to head off the deflationary threat, including bringing forward tax cuts and the likelihood of the US Federal Reserve budget will return to deficits to reflate the economy.
3. We can expect sharp rallies in the US market but the overall progress will be muted because the bond yields will move up quickly to effectively cap the limit.
4. It's important to remember embedded in the high returns out of the equity markets through the 1990's markets was an expansion of price earnings driven by inflation falling. Clearly returns going forward are not going to be as spectacular as we had in the 1990's.
5. One way to think about the equity market returns is that you get a dividend yield, earnings per share growth and a price earnings multiple expansion or contraction. Through the 1990's we had all three working in a significant, positive way and that won't be there in the coming decade so it will very much be driven by company earnings.
6. Be on the look out for being overexposed to regional global sharemarkets and residential property, showing all the aerodynamic traits of a house brick.

B. Investors in Shellshock Dimension

1. For many people, their goal of an early retirement has taken on a mirage-like quality.
2. People in retirement have seen their precious capital dwindle alarmingly.
3. Investors find themselves in "Catch 22". Do they put their money into markets that destroyed value last year and still look nervous with the prospects of war in Iraq or do they jump into the hottest of hottest of property booms and be prepared to ride out any price falls. Or do they sit on their hands, keep the cash in the bank and wait for the market to settle down.
4. Lower returns, higher risk and more volatility are all the regrettable part of the landscape. Investors will have to accept going forward as painful as it has been in 2002 and is looking like a massive reality check, particularly for people who have just retired or hoping for an early retirement, ie. due to a large number of retirees investing through Allocated Pension which have exposure to balance funds with around 65% exposure to growth assets, will be a bad year.

Allocated Pensions have served them well but because people have had to draw down capital over the last couple of years, they are questioning whether they are in the right product. This is a good discussion to have with a Financial Planner but it comes down to your investment horizon - is it 2 years or 15 years?

There are two types of investors - those who have already invested and those who are wanting to get into the market. Trying to pick the right time to enter the market is more difficult because of the market volatility so it's really about dollar cost averaging.

Some investors are playing the 'blame' game when it comes to allocated pensions. They are looking at allocated pensions, seeing the balance going down and blaming the product rather than what is happening with investment markets. What people need to do is concentrate on how they set it up, how they chose the underlying investment, how they blended the various Fund Managers together with what levels of income they choose.

In many ways, investors are living in fools paradise as a result of Financial Planners who introduce them into allocated pensions at a time when equity markets were performing really well and you were able to get your account balance growing while drawing down an income. Clearly, there is a difference between people who have had an allocated pension for some years and someone looking at establishing one today.

However, it's causing people to re-examine allocated pensions in an understanding they serve both as a long term investment with a significant amount of growth asset yet at the same time, have sufficient income earning assets to meet the cash and future income needs for a time horizon of five years. This sleep factor is part of an inbuilt safety factor approach for an unforeseen fall in levels of returns from underlying Balance funds coming off the 1990's of between 12 to 15 per cent pa., to an expected forecast of between 5 to 7 per cent pa. return for the next decade.

C. Today therefore is to concentrate on building a portfolio that generates income

Markets are already factoring in interest rates are bottoming out and will go up which therefore many pundits believe equity return will range between 8 to 12 per cent pa. with sharp volatility over the next 5 years is the sort of market that won't support rising share prices.

A lot of people think you can't go wrong with equities and for the past 20 years, they have been right but now people need to reassess their risk tolerances and make sure they have an appropriate minimum and maximum risk exposure to various types of assets and that they use opportunities to swing between various asset classes.

D. Low Returns and Lifestyle Bottom Line

Lower returns over the long term mean one thing for most people - less to retire on.

There is a clear message that people will need to save more or leverage what they have got. There is a growing realisation among a lot of people that they won't have enough money to retire on to support their lifestyle. People in super funds might need to consider internally geared share funds or other strategies like salary sacrifice, work longer or even a career change because if they don't, they won't get to their target. The challenge is if people think they are going to retire at 55 or 60, you will need an enormous sum of money.

E. Property Facing Shakeout

Property - that great repository of wealth was the one bright star in an otherwise gloomy investment landscape.

Although the fundamental variables that have pushed the prices up have not significantly changed such as low interest rates, high income levels and easy credit, remain in favour of residential property markets, however, there has been a great deal of negative sentiment by the mass media, lending institutions, Reserve bank and the Prime Minister stating that recent increases are unsustainable.

The stock market and technology boom and collapse is a recent reminder that in the longer term, the market tends to revert back to rational behaviour. Unfortunately most of the population believes that house prices don't fall but instead in the worst situation remain flat. Well, in the two-year period from December 1988 to December 1990, residential real estate fell across the board 30% and then remained pretty flat for the next 5 years.

It is certainly possible that a greater magnitude than the 1988 cycle could happen given, on average, Australians are now carrying twice as much debt as they did in 1988 and the fact that the 47% activity of investment properties compared to the 1% of owner occupier lending ratio, has been responsible for fuelling the dramatic price increases.

There is no doubt that we are in a vicarious position with the whole economy riding on the housing boom.

Dollar Cost Averaging Is Good Advice For New Clients Market Volatility

One of the dilemmas faced by Financial Planners when investing clients' funds into a volatile market and knowing that trying to time the market is fraught with danger. On the one hand, if markets start going up in the near future and the client doesn't invest soon, they could miss out on significant returns. On the other hand, if the market goes down after the client invests, you know they will be upset.

What Do you Recommend

One solution is to suggest that they dollar cost average into the market by gradually investing their lump sum over a period of time. There are two performance benefits from this approach. Firstly, the client is not putting all their money at risk should there by a large market fall soon after investing and secondly, they are assured the portion of their money will participate in any positive returns from the market.

Dollar Cost Averaging in a Falling Market

The likely situation could be that the markets had been rising strongly prior to placing your clients funds but despite the general market optimism, there are a few concerns that there is increased volatility around the corner. As a cautious decision for your client, I would recommend dollar cost averaging (the average unit purchase price is marginally lower) by making six equal investment tranches. Hence, when the bear market returns to a bull, the clients show considerable savings.

Dollar Cost Averaging in a Rising Market

There is no doubt that the dollar cost averaging is a prudent strategy when the market appears close to its peak or is extremely volatile but how does the strategy perform when the markets are rising.

Logic says that over any given period when the chosen investment outperforms cash, the dollar cost averaging will under perform.

However, it's likely your cautious client will be happier to give away some of the upside in order to enjoy peace of mind during what was predicted to be a turbulent market.

Comprehensive Breakdown Of Fee Disclosure And Unit Price

Fee Structure

Financial Planners are set for a squeeze in the future in profit margin and it is no telling anyone in the business anything they don't already know, that in order to make the cuts least felt, they will have to be on the clients side.

For the last decade or more, the financial service industry has come to expect and consistently deliver double-digit investment returns. However, as global economies weaken and financial markets begin to plateau, the multi million dollar question is are double digit returns sustainable and if not, what will this mean for fees. Will planners be able to continue to charge high fees for lesser returns?

The consumers will increasingly realise that there are a lot of people in the value chain that are opportunistic. When we break down the various entities of the financial service industry, the structure involves three main components:

• Product Manufacturers or Fund Managers
• The Administrators or Master Trusts or Wrap Accounts Platforms
• The Distributors or Financial Advice Givers and Discounters

The thing Financial Planners are going to have to deal with is the supply-side competition - the competition by the funds for getting Financial Planners which is driving up costs - is going to fall apart soon. The costs are just so high now in some areas, particularly in the fancy fee for service but who don't declare ongoing trails. It's just an explosive issue that the consumers are only just starting to understand how much is being taken away from them.

The commission-versus-fee argument - what is important is that the client is getting what is perceived MER's value going forward, they won't support otherwise there are lots of competitive forces outside the financial planning industry and if they think their only competition within the industry, they are very one-dimensional. Choice will test the value chain and whoever is able to blend technology and relationship will win because the consumer is buying the Financial Planners relationship; they are not buying the Dealer Group or Platform Providers of Master Trusts or Wrap accounts.

New pressure will be placed on the industry for transparency, seamlessness, personalisation and accountability to justify fees to the more discerning consumers and the industry can only provide sub double digit returns; then the consumer will begin to question and require justification of each layer of fees incurred.

If we start seeing single digit returns, then the demand for good outperforming managers who can provide 2% to 3% above the average will be great. Investors will be happy to pay high fees for returns at that level. There are reasons to be optimistic in 2003 but it would be difficult to argue strong double-digit returns. Investors will ask themselves if they are getting value for money. Is their Master Trust or Wrap Account adding value and providing value opportunities such as selection of the right Fund Managers to charge fees of 2.0 per cent on returns of 15 per cent but in a world where total fees are continuing to charge 3.0 per cent while delivering in the era single-digit returns of 8 per cent, it gets more complicated.

What is Unit Price

Investors in a Managed Fund own shares in the fund in a similar way that shareholders own shares in a company. However, the price of a share is determined by demand; that is, if there are more buyers than sellers of a share, the price goes up as much as it is the market that sets the share price.

For Managed Funds, high demand does not necessarily translate to a higher unit price than a less popular fund. Theoretically, there is no limit to the number of units available in a fund. As a new member buys into a fund, the fund manager simply issues out more units. The law of supply and demand does not apply in the same way.

It is the fund manager who determines the unit price by dividing the total assets of the fund by the number of units on issue. The total assets of a fund are in turn determined by the market price of the underlying shares and other securities just as the market value of the underlying assets change every day so does the unit value. What is useful though in measuring the net worth of the unit price is to look at the rate of change of unit price over a period of time as long as it accounts for any distribution in dividends for shares, cash for interest rates and realised capital gains.

Retail Managed Funds are generally listed in the 'Financial' section of the newspaper together with both the Buy Price (purchase) and the Exit Price (sell). The difference between these is the buy/sell spread is the administrative fee or MER of management.

Examples Of Investment Strategies Documents For SMSF

Example 1

INVESTMENT STRATEGY
FOR THE XYZ SUPERANNUATION FUND

General Objectives

The Trustee will at all times act prudently to pursue the maximum rate of return possible, subject to the acceptable risk parameters and the maintenance of an acceptable level of diversification given the Fund's assets.

The Trustee will ensure that all investments are authorised under the trust deed, are made for the sole purpose of providing benefits to members and the dependants of members, and are made in accordance with the legislative requirements applicable to complying superannuation funds.

The Trustee will invest to ensure sufficient liquidity is retained with the Fund to meet benefit payments due, and will adjust its specific objectives where it believes the risk profile of the Fund is changed.

The Trustee will consider suggestions from members for specific investments in relation to members generally or for an individual member and may make investments in accordance with those suggestions provided that they fall within the investment strategy of the Fund.

Specific Objectives

Having considered the profile of the Fund, the Trustee has adopted the following objectives for the investment of the assets of the Fund:

• To ensure that there will be sufficient liquid assets to meet benefit payments when those payments are due to be paid.
• To maximise returns by achieving, on average over a 5 year period;
  1. cash/fixed interest: CPI plus 3%
  2. property: CPI plus 5%
  3. equities: CPI plus 7%
• To provide protection against the chance of a negative return over any 5 year period.
• To provide real long-term returns of at least 5% pa above CPI over a period of at least 5 years when using a diversified portfolio of asset classes.

The Trustee has implemented this strategy taking into account the age of the members, their likely dates of retirement, the expressed intention of the members to receive their benefits as lump sums/allocated pensions upon retirement, future contributions and Fund liabilities.

Asset Allocation

The associated investment strategy to achieve the stated objectives is to invest in a diversified portfolio providing exposure to the following major asset classes:

The Fund is to be administered in accordance with current legislation and provisions contained in the Trust Deed.

Review

To monitor the success of the investment strategy in achieving the investment objectives, the Trustee will take the following action;

• Compare investment returns against investment objectives on at least a six-monthly basis
• Will review the strategy at such other times as a significant event occurs which affects the Fund.

Signed __________ Date ______   Signed __________ Date ______
       Trustee                         Trustee

Signed __________ Date ______   Signed __________ Date ______
       Trustee                         Trustee

Source: ING

Example 2

INVESTMENT STRATEGY DOCUMENT
THE ABC SUPERANNUATION FUND
As at 1 January 2004

Objectives

The trustees of the fund aim to:

"Obtain a rate of return of 2% above the Consumer Price Index over a rolling 3 year period."

The trustees' general investment objective is to achieve real medium to longer term growth, while maintaining a low level of capital volatility.

Strategy

To achieve the objective, the trustee have determined that the fund will have the ability to invest in the following areas:

• Equities (both Australian and International);
• Direct property investment;
• Property trusts;
• Cash/interest bearing securities;
• Managed investments; and
• Any other investments permissible by law.

It is noted that the trustees may from time to time seek professional advice in the formulation of an investment strategy.

In determining this strategy the trustees have taken into consideration the aspects of the investment in accordance with the fund's objectives and appropriate legislation.

Policies

The policies adopted by the trustees to adhere to these objectives are:

• Regular monitoring of the performance of the fund's investments, rates of return, risk analysis and expected cash flow requirements;
• Balancing the asset portfolio as a result of adjustments to market conditions.

The trustees will ensure investments continue to comply with the strategy, however, the trustees reserve the right to alter the strategy at any time.

Asset mix

After due consideration of the level of risk, diversity, liquidity, the ages of the members and the ability of the fund to discharge the fund's existing and prospective liabilities, the following asset mix was deemed to be appropriate:

Portfolio Review

The preparation and implementation of a financial plan is regarded as the commencing point for a long-term ongoing client Financial Planner relationship. Such a relationship is also implied at law, will be required on a continuing basis for strategic reviews, portfolio valuation, information on new investment opportunities and ongoing consultation as required.

Another form of ongoing advice is monitoring an investment portfolio, which can take many forms, but eventually it can be understood to mean keeping a constant watch on the client's investment portfolio with a responsibility to advise the clients immediately when changes are warranted. Such a constant overview involves a very heavy responsibility and Financial Planners should be clear on whether or not they are able (ie. have the appropriate monitoring tools) or wish to provide this in-depth service.

The financial review process is rated by clients as the most poorly implemented component of the Financial Planners skills set. Advisors score poorly on implementation of solutions and investment choice seemingly not from the lack of clarity with advisors communication process but rather they need to do a better job in explaining to their clients the powerful tool of quantitative research when combined with flexibility of Master Trusts.

Sadly, there is a tendency for investors and some Financial Planners to make investment decisions looking in the rear mirror. This suggests that in a bear market they regret having even a moderate exposure to equities, particularly international equities, thus thinking they have lowered their risk by increasing exposure to property and bonds, but forgetting the risk of realising capital loss can be far more damaging. In other words, investors should not change everything just because of a bad year but one of the strategies we appropriated 12 months ago still stands today.

• Remembering during review time for clients is about "information risk", meaning you have to trust good access to reliable research houses.
• As a multi funds manager, you decide on the weighting applied to each fund, which therefore, you don't need, the fund manager to over engineer and more tightly control the risks of under performing the market.
• If since the last review highlighted the variability in market returns and investors may pay more attention to alternative sources of added value and their risk, particularly if you believe some re-pricing of equity markets is still to come.
• Don't believe that any fund manager can consistently time the market in terms of whether value will outperform growth or large capitalisation will out perform small capitalisation.
• No over exposure to style bets in the portfolio - the advantage of an aggregate portfolio rather than a perfectly style neutral. In other words, if you are not going to be rewarded for taking those style bet risks, there is no point in taking them unless you are going to be consistently rewarded for taking them.
• More interest in leveraging up on the insights from reliable information research that they have on a particular investment sector manager. Therefore, prefer to spread the risk budget with managers you believe have a competitive edge.
• Not so interested in fund size but rather examine managers on the basis of their investment capacity. Fund Managers with pronounced style, consistent characteristics tend to produce higher totals.
• What about increased attention of tactical asset allocation strategies in both alternative investment and alternative strategies, ie. strategic allocation can be 6% or more in European or US private equity markets, small global capitalisation or emerging markets.
• In International shares the other main risk is currency, both in terms of conversion and exchange rate risk, ie. purchase in offshore currency and convert to local currency. In other words, the offshore funds have to rise 3 to 4% just to breakeven. The big killer for international investors is when the value of the Australian dollar is rising and the international securities are falling.
• Also worth considering is that markets such as the US has huge volatility as traders punt on figures released on economic data speeches by Alan Greenspan can be responsible on the specific day to turn over 30% of the stock.

The range of Returns Table is designed to take the client a step beyond the general trend of the asset class and allow them to gain a more detailed understanding of the inherent risk and return characteristics of each class over both short and longer-term time frames.

Measuring Asset Class Performances after periodical 6 months, 12 months, 3 years, 5 years and 7 years reviews of the client portfolio by Financial Planners to measure the performance and if necessary, suggested action for strategic recommendation as to whether a restructure of the portfolio is appropriate.

The following range of indices are used to measure the performance of specific asset classes:

Active Tactical Asset Allocation Drives Better Results

The Reasons for Rebalancing a Portfolio

Despite the inevitability of dramatic swings and distortions in investment markets, few investors cope with such periods as they should. Partly, the reason being that during periods of heightened greed and fear, whilst decisions that are good for long-term financial health often seem dangerous because the former investment Model carries with it full of surprises, whereas in the latter case, the degree of risk is statistical quantified.

Therefore, most Financial Planners would agree it's sensible to periodically rebalance portfolios. In other words, bring portfolios back to their long-term asset allocation from time to time, particularly during periods of turbulence when portfolios can easily be blown off-course.

Rebalancing can improve a portfolio's long-term return by systematically selling assets that have become relatively expensive and buying those that have become relatively cheap. By promoting diversification in asset class and Style management prevents a portfolio from becoming concentrated in being last year's best-performing asset classes or Fund Managers. This highlights the most important driver of the rebalancing policy - it restores the balance between risk and return and expected return that is agreed with the client. Whilst rebalancing reduces the possibility of extreme positive results, it also reduces the possibility of disasters. In effect, it tightens the distribution of likely outcomes.

Drifting Portfolios

Given the benefits of rebalancing your portfolio, you may wonder why rebalancing is neglected by 95% of Financial Planners, evidenced by a recent industry survey. This question is better answered with another question. Why do so many investors still chase last years best performing asset class? The answer is that putting money into assets that have soared in value sounds like a good idea despite the fact that it is often dangerous. Rebalancing means doing the opposite - reducing holdings in recent winners and piling into recent losses. During the good times there is not a lot of difference in the cumulative returns between a drifting portfolio compared to a rebalanced portfolio but the same can't be said for a sudden plunge in the markets.

Therefore, the next question is what are the appropriate trigger points for rebalancing a client's portfolio notwithstanding normally, Portfolio Managers develop their own rules?

1. The Simplified Assumption

Research suggests that sector specific assets have different trigger points that indicate when the core asset exposure of Risk Matching Processing should be brought back in line with the investors original risk/return profile outcomes, ie.

Likely Antidote

• With International shares the other main risk is currency, both in terms of conversion and exchange rate risk, ie. purchase in offshore currency and convert to local currency. In other words, the offshore stock has to rise 3 to 4% just to breakeven. The big killer for international investors is when the value of the Australian dollar is rising and the international securities are falling.
• With negative gearing, tax effective loans are the cream on top of the cake but only if the investment is validated on a non-tax basis. In other words, don't let these tax advantages drive you into debt above which you can be reasonably serviced. For example, with record vacancies in the property market, investors should think twice about; are we at the end of the property cycle. Anybody gearing/buying into the top end of the cycle, needs a very good reason.

2. Temporary Economic Changes

The big difficulty is trying to work out what is going to be temporary changes or is it more likely to be structural changes in the economy. For example -

• According to economic statistics, the future forecast for GDP of 3% growth has proven inadequate in producing a decent growth in corporate profits and jobs, yet the US global economy remains weak but calming fears on negative sentiment.
• The high degree of net foreign exposure by the Australian Banks of $190 billion calms the fears of the International Monetary Fund (IMF) that the quality and profitability of the assets is adequately covered by financial derivatives.

Likely Antidote

• Earnings surprises occur when a nations/company results differ from economists/analyst's expectations. A positive/negative surprise means that the impact on companies has delivered a better/worse than expected result. In most cases, a positive surprise will boost the sharemarket after the announcement of the profit result or alternatively a disappointing result will see the stock sold off by the market, particularly if there was a high growth expectation factored into the share prices and it is expensive relative to those expectations.
• Timing is also worth considering with dollar cost averaging, particularly that markets such as the US huge volatility such as traders figures released on economic data, and speeches by Alan Greenspan can be responsible on the specific day to turn over 30% of the stock.

3. Structural Economic Changes

With the Australian economy close to bottoming out, often an unprecedented global sharemarket boom which lasted a decade yet the US economy is faced with some fundamental troubles which could mean a sort of drawn out bear market evidenced by past experience of drawn out bear markets over the last century, ie.

• The bust of the US tech bubble has inflicted much pain which is still working its way through the US and European markets for three to four years.
• Like Japan, both Australia and US Banks are heading for a housing bubble bust caused by artificially inflated housing prices with too much money being pumped into the economy as a result of inflationary Reserve Bank policy of low interest rates and an over-generous capital adequacy ratio which such standard of one dollar ($1) in deposit generates twenty five dollars ($25) housing loan.

Likely Antidote

• The need to rebalance when taking profits, surplus cash requirements, tactical of economic signs or impact of earning surprises.
• Slumps in market performance, like recessions, inflation, capital inflows and droughts - no one knows when or how long they will last, but they will turn full cycle eventually.
• Profit warnings ahead of the reporting season are the expected phase of the cycle - usually dubbed as the "confession season" as a result of the "Australian Stock Exchange requirements" - whereby companies earnings surprises can deviate around 15 per cent of above or below 5 per cent of profit forecasts. Anything above a 5 per cent analysis would be regarded as strong domestic and global macro economic conditions.
• The objective behind combining the right balance into a portfolio with a collective beta of 1.0 is to help identify Fund Managers, which are aggressive in an active market as well as those which should behave more defensively.
• Superannuation investments typically run over decades and compound interest can blow out small differences, ie. 1% excess ongoing management fees over 30 years can represent 27% of total returns.

A Little Healthy Pessimism Because Now Might Be A Good Time To Reassess Your Long-term Strategy

Investors by now must be wondering just how many more things can go wrong. Terrorism, economic uncertainty and war make for probably the worst possible climate in which to make investment decisions.

For example, there is a popular saying among fund managers "Buy when the cannons are firing and sell at the sounding of the bugles".

There is no shortage of advice to buy now and buy often; that trying to time the market could see you out of the market when it really rebounds. The trouble is, the investor has now seen two strong rallies in the last 12 months, which have fizzled out into further losses.

In the bear case there have been sucker rallies - as part of a continuing bear market. So is it time to press on, maintaining the previous long-term strategies? Or is it time to stop, reassess conditions and perhaps make some adjustments? On balance incidental advice would be pausing, pondering and preparing for the worst. That doesn't mean investors should turn pessimistic; just that investors should be thinking a little more closely about the immediate risks.

Many fund managers and advisers will continue to argue that you should continue to invest, albeit a little more prudently. Their argument is that only the optimists make money, for instance -

1. Of course, in the bull case, these periods of maximum fear are the very time that astute, counter-cyclical investors should be buying. That's fine in theory if you're young, have a strong nerve and possess the cash flow for the resources to keep buying.
2. It is less so for the investor nearer to retirement than they care to think, or a younger but risk averse investor.
3. As a counter-argument, sometimes the risks get to a point where it's more sensible for investors to preserve their capital for better times. In other words, pessimists might save themselves from losses. All this is predicated on a medium-term view of three to five years; anyone who is prepared to ignore the next few years and invest aggressively for the very long-term might dismiss the idea of turning defensive.
4. But even aggressive long-term investors by now must realise that while they might make capital gains over a long period of time, the best way to ensure future gains, is not to pay too much for an investment.

Should High Exposure Equity Investors, Including Significant International Shares, Cut The Losses?

This is a decision only investors can take, and many Financial Advisers may be loath even to broach the possibility. But if world investment markets face dire times, this might still prove a prudent approach. Saving capital to invest in better markets can benefit even those with long-term investment horizons.

If the task of convincing an investor to sell at a loss looks daunting, advisers perhaps ought to go the "simple arithmetic" of recovery in which it takes bigger gains to get back to an original target amount after a downturn. An initial investment portfolio of $150,000, which drops 50 per cent to $75,000, needs to recover 100 per cent to regain its original level. And if an investor thinks there is a roughly even money chance that a portfolio might fall another 10 to 20 per cent, it now makes sense to hedge against that - if only to preserve capital to have more to re-invest, eventually at bargain basement prices.

To preserve capital, investors need to invest in more than cash or good quality fixed interest securities. Various hybrids issued by blue-chip companies might also do the trick - although investors should remember that some higher yielding hybrids with an equity element, includes some risk.

Diversification is a safer policy rather than attempting to pick the one magic asset class which will outperform. In general, investors should trim back exposure to shares and if they do buy shares, they should buy value-type shares with good, well covered dividends. Even if the mood does change back in favour of growth stocks, the higher dividend yield still continues. And in the income field, listed property trusts still provide one of the best defensive high yield alternatives.

In general, the idea should be to diversify as much as possible and produce a defensive portfolio rather than seek higher yielding assets, which might restore returns to the 1990's level.

So, Is the Outlook that bad?

As the gatekeepers for clients, the questions we have to continuously ask ourselves are, "Is it likely that the world investment climate could continue to deteriorate? Will the balance of risk look to be increasingly on the downside? Is the stock market priced to perfection in respect to a short, sharp successful war in Iraq?"

The more recent uncertainty might represent a change in this pricing, certainly ordinary equity investors are showing they are less and less inclined to take on extra risk. But who would want to bet their portfolio on the results of a war. It's hard enough judging the effect of economic developments, let alone something as uncertain as war.

The situation before Iraq was already precarious. The US economy was then poised on a very dangerous knife-edge. If consumers finally stop spending, the world's largest economy could tip into recession. Apart from a potential variety of psychological factors, which might trigger this reaction, there is now the very real chance that a depreciation in the US dollar, could force Americans to save more to finance their non deficits.

The US dollar has already swooned a little since last year when the Federal Reserve Bank, in effect, tried to reassure the world it would do whatever was needed to avoid the deflation which has bedevilled Japan. But perhaps the pledge went too far - promising, if necessary, to run the printing presses to create new dollars.

To many investors around the world, holding US dollars, stocks and bonds that look dangerous like a signal that the US would allow its currency to depreciate. The foreign exchange markets have taken the hint and it might need an economic miracle to reverse this trend now that the US budgets may be sent further into deficit by an open-ended commitment to war with Iraq.

If the US authorities lose control of the economy, they could still be treated with a bout of deflation, similar to that which occurred in Japan. This would be bad for shares but better for bonds and fixed interest securities. If they are pump-primed too much, the result might be inflation, which could be bad for bonds and better for shares. Taking a big bet on one or the other is fraught with danger. Once again, it's a case for diversification.

The Final Concern Is Whether It's Too Late To Go Defensive

Put simply, to redeem exposure to shares, might simply position a portfolio to miss the rebound in the stock markets. To make a judgement on this, investors need some assessment of how far the market is away from the bottom.

One of the ironies about investing is the herd mentality; for example, there are plenty of stockbrokers and fund managers preaching the market is approaching its bottom, that shares are now at a near fair value relative to bonds. For example, another popular saying amongst fund managers is "that time in the market is more important than making time".

But after the stock market falls since early January rally, it's just as likely that January might be the year's high point rather than the base for a rebound. Things might yet have to get worse to meet the ultimate test of the bottom of markets. The market is most dangerous when it looks best; it is most inviting when it looks worst.

Picking The Winners

Using quantitative asset allocation ignores emotion fund manager picking, instead, moving in and out of markets with strict discipline. It's based on computerised number crunching rather than Financial Planners gut feeling of which fund manager will perform best.

Short-Term Ranking

Top fund managers rarely maintain their numbers in ranking for more than two consecutive years. This short-term method of ranking could well see changes at the head of the pack to the "also-rans" as this constant rivalry between "value" and "growth" fund managers performances in the Australian and International markets tend to move in opposite cycles. When the value manager outperforms, the growth manager tends to under perform and visa versa.

There are also more surprises or a "bit of a left field" for Financial Planners as fund managers cycle between top fund manager and wooden spooner due to contrast of style between a mix of growth and value. Some produce remarkable returns for only one year before disappearing into relative obscurity. Growth style fund managers have under performed and are at the bottom of the table, leaving their value manager rivals having delivered better returns simply by hitching themselves to the trend but the beauty with this indicator is, it gives the Financial Planner the ability to show his skills in selecting better class assets by recognising the changes in market sectors by portfolio picking to add value such as the sign of a turn-around in the gap between growth and value stocks in both Australia and International markets in year 2003.

Long-Term Ranking

Tends to take on board with the long term 3 to 5 years mean variances, the inclusion of both growth and value manager in a portfolio that would avoid a style bias that could have ugly consequences of one investment style outperforming the other significantly, whereas it would be more of a bias outcome, solely relying on the results of a short term ranking. Somehow the long-term top ranking fund managers are always on the Financial Planners radar.

Must Have A Game Plan

Failing to plan is planning to fail. A new business requires a business plan, a flight requires a flight plan and a Financial Planner requires a "Tactical Asset Allocation" plan".

An airline pilot, for example, is required to know in advance the immediate actions for any emergency that could occur. It is important for a pilot to know in advance what the required action should be. From a Financial Planner's point of view, these predetermined actions is acting economic rational as possible to market trends which essentially requires tactical asset allocation to realign back to the client's risk tolerance.

Objectivity

The development of the Financial Planner's ability is essential to a client's wealth creation. It is paramount that the Financial Planner acknowledges that the market is always right, regardless of logic and personal views. Emotional detachment is one of the tasks demanded of a Financial Planner. He must have the ability to face up to the market reality when it's moving into downward territory. A strong tendency exists to hold the position rather than converting the paper loss to cash loss because it will often be that a minor correction will recover; however, a major correction, being 1 in 20 years as we have experienced the second longest global recession in history, markets continue to move in the direction of losses.

Moderate Losses Early, Let Profits Run

When you have a written down Plan in place such as the entire BCM's Risk Management Plan, based on the ASIC best practices Financial Services Act PS 146, acts like an automatic computer monitoring (Teaching) system.

Rules of Asset Allocation

Due to the final asset allocation, the funds in a portfolio have the ability to expand and contract. Not all asset allocations are going to be successful. It would follow that any ill conceived portfolio profiting or over-weighting in one or two of the asset classes except Cash, could put a client's portfolio at considerable risk.

However, the major consideration from a Financial Planner's point of view is that they often, through emotions of greed or fear, are over-exposed according to their targeted risk management benchmark. But again, the Financial Planner would be required to manage the levels of risk with some degree of comfort, either mandatory written or verbal endorsement by the client of operating within the risk capital parameters.

If in Doubt, Stay Out

Sometimes signals may be ambiguous or confusing. The markets may be tracking some other market that has not been examined or analysed. It may be that there is some personal commitment or distraction that precludes the degree of attention required.

The rule is simple... stay out or "dollar cost average" into the market with the number of proportional size and length of intervals determined by the clients comfortability and the Financial Planner's awareness of market trends towards recessions, recovery or cyclical decline. Because the fund manager is bullish or bearish or some media article predicts a certain outcome with apparent confidence, is no reason to put the lot on the line with either an entry or an exit snap decision. It is essential that the Financial Planner be satisfied personally that the position is appropriate.

Capital Risk Parameters

By positioning a client's portfolio to specific capital risk parameters knowingly that it is done in mind of hitching a ride with either the sharemarket or property boom, can save you from financial suicide.

When some Financial Planners begin planning a client's portfolio, they often believe that as long as they hitch a ride with the sharemarket that's headed for the moon, they will accumulate untold riches for their clients. I'm afraid if they haven't done their technical trend analysis on the markets, they could be treading water for a long time waiting for the trend to unfold.

Knowing when to be Over and Under Weight Exposure to a Specific Business Sector

The underlying principle behind this modelling system of over a wider capital exposure between the different areas of business risk, is that in theory the Financial Planner has strong grounds to justify that given certain economic or legislative conditions existed, those business sectors were likely to behave in a more predictable fashion.

However, as a suggested guide to a model application -

1. The number of over positions shouldn't be anymore than three (3) because hopefully, due to the law of averages of your selected trend models, at least one (1) of these business sectors will be heading in the right direction
2. It's better to be overweight in growth assets with a more moderate risk such as lower risk Fixed Interest and Property rather than International and Australian shares ASX 200.
3. The key is not to allow the combined overweight to exceed 15% of the total portfolio represented by the difference between the higher and lower sector of growth risk assets.

Conclusion

If you follow some of these rules, you would be more likely to limit any downside potential following a disastrous sharemarket event.

Tips On Being Rationally Focused

1. The less experimented analysis fall in love with their stocks they cover and it would be a good idea to get critical independent evaluations done.
2. People tend to be conservative in adjusting their expectations to new information and do so slowly over time.
3. People in general tend to be overweight in spectacular or personal experiences in assessing the probability of events occurring. This can result in an emotional involvement with an investment strategy if it has been winning recently, an investor is likely to expect that it will continue to do so.
4. People tend to focus on an occurrence that draws attention to themselves (such as a stock or class of asset that has risen sharply in value). Due to this type of above behaviour, people tend to be over confident in their ability. Interestingly, men tend to be more over confident than women, which results in men trading more than women and generating poorer investment returns than women. This also says that people require less information to predict a desirable event than an undesirable one (wishful thinking).
5. Crowd psychology can have a contagious effect and can magnify errors in an individual's judgement, ie. mass communications, the threat of losing or missing out, financial wealth or a strong belief that share prices can only go down.
6. The influence of investor psychology can have several implications for investors - ie. Investment markets are not just driven by the fundamentals but also by the irrational expectation and erratic behaviour of an unstable crowd.
7. Investors need to recognise that not only investors markets are highly unstable but they can also be seductive, ie. buying near the top and selling near the bottom. In other words, investors must be aware of how they are influenced by the lapses in logic and crowd influences or do I have a tendency to be over confident in my ability.
8. Investors ought to choose an investment strategy, which can withstand downsides whilst remaining focused on the broad financial goals.
9. Finally, if an investor is tempted to trade, they should do so on a contrarian basis, ie. buy when the crowd in bearish and sell when the markets are bullish. Extremes of bullishness often signals market tops and extreme bearishness often signals market bottoms.

The individual versus the crowd dynamics occurs to some extent - in the institutional investment market. Here active managers performances may be measured against a benchmark but if they are unable to perform well - for whatever reason - they may end up hugging the benchmark. The outcome of such an activity is that these managers get paid active fees but only delivering index performances.

Risk Management Strategies

1. Diversification

The principle that underlies diversification is that the returns from different types of securities and different asset classes will be affected by a wide variety of factors. By spreading the total investments across securities that behave differently, the overall portfolio becomes less volatile.

1. Diversification implies holding a large number of smaller investments rather than concentrating on holding investments in a smaller number of asset classes.
2. Diversification across a range of different class of securities will not reduce the portfolio exposure to market risk - (investor expected to be compensated).
3. Non-market portfolio risk is reduced as the number of different securities is increased and smaller and smaller amounts are placed into each security - investor cannot expect to be compensated.
4. Virtually exposure could remain to common non-market risk factor that affects subsets of securities. For example, diversifying across 25 equity investments from the same industry is not likely to be effective in reducing portfolio risk as diversifying across 25 equity investments from different industries.

Industry Diversification

Effective diversification will involve choosing securities with different characteristics that are from a range of different industries. Further diversification will be achieved by spreading those investments geographically both domestic and offshore.

Asset Class Diversification

Risk can be further reduced through diversification across asset classes. For example, combining equities, property, fixed interest and cash will provide greater diversification than simply spreading the investment portfolio across a single asset class of equities. The problem with this approach is that it not only diversifies non-market risk but averages the exposure to market risk as well. The various asset classes have different levels of market risk which is the risk in which investors can be compensated. Therefore, combining the asset classes will therefore change the expected rate of return which may not be actually desired.

2. Hedging

Hedging involves investing in securities that provides offsetting payoffs to those from existing positions. A completely hedged position can be equivalent to replacing the existing investment in cash.

The difference with hedging the existing investment is left untouched while few securities are added to make the total investment behave in a similar fashion to cash. Partial hedging involves strategies that remove some but not all of the risk arising from the original investment. For example, hedging can be used to reduce the sensitivity of a portfolio to just interest rate changes or gold price changes.

Most hedging involves the use of securities called derivatives. A derivative is a security that is specially constructed to act as a substitute for an actual investment. Examples of derivatives include futures, options or warrants. Because the gain or loss of derivatives investments is linked to the underlying asset, investors can use derivatives to increase or reduce the uncertainty of their investment portfolio.

Example

Suppose an investor has a portfolio of Australian Equities and his temporary concern is that the ASX may fall. The investor would like to eliminate all market risk from the portfolio for the next two months but after this would again like to have a portfolio with full equity market exposure.

The transaction costs of selling the entire portfolio and buying it back after two months are high. An alternative is to enter into a contract to hedge the market risk for two months. This could be done by selling a Share Price Index (SPI) future contract with a two-month maturity. The contract price or the cash equivalent of the position index taken is based on the current level of All Ordinaries Index multiplied by $125 for each unit.

By selling the future contract, the investor will gain if the index falls and lose if the index rises above the agreed price in the contract. If in the two months, the market has fallen, the investor's equity portfolio would also have fallen in price but the investor would have an off selling gain from the SPI. Futures. If the market rises over the next two months, the investor's equity portfolio would rise in value but the investor would have an off selling loss on the SPI futures. By choosing an appropriate quantity of SPI future contracts, it is possible to largely eliminate an exposure to market risk, so that no gain or loss is incurred whether market moves take place over the period.

1. Hedging reduces the potential gains on the upside and potential gains on the downside relative to the original position. There are many other examples of hedging that do not involve using futures or other derivatives.

   Example

   An investment manager may be over exposed in the Banking sector and is uncertain of the future returns of the industry. However, he feels one of the Banks is grossly undervalued. This could be achieved by increasing his weight of exposure in the favoured Bank stock and reducing his exposure in the other Banks.

2. An investment in the residential property can be useful in hedging the wealth risk of investors. The cost of accommodation is a significant proportion of retirement expense. If the accommodation costs rise unexpectedly, many retirees may find their investment savings are insufficient to meet their requirements. One way of hedging against the uncertainty is for the member's funds to be invested in assets whose investment returns are linked to changes in accommodation costs. Property investment will generally have this characteristic.

3. Insurance

Insurance allows a very similar principle to hedging in that it seeks to take a position in securities that provides offsetting returns to those in an existing portfolio. The difference is that hedging usually involves reducing both unexpected good and bad outcomes associated with uncertainty. On the other hand, insurance is aimed at protecting the investor only from unexpected bad outcomes. Insurance involves the payment of upfront costs and a contingent payoff meaning the investor will only receive a payment if certain events take place - similar characteristics to car insurance which requires an annual premium with motorists only receiving a payment in the event of an accident or theft.

Typically, investment insurance involves relatively small costs aimed at protecting against potentially large financial loss. Securities that offer contingent payoffs, which are related to underlying assets, are called Options and Warrants. A Warrant is simply a longer dated option. A Call Option gives a buyer the right (but not the obligation) to buy an underlying asset at some future date at a price specified which is termed an exercise price. A Put Option is the reverse to a Call Option.

If the prices of the underlying assets fall below the exercise price, the owner of the put option would gain by exercising his right to sell the asset at the previously higher agreed price. Again, if the underlying asset is higher than the exercised price, the owner of the put option would let the option expire. A put option holder thus stands to gain if the price of the underlying asset falls and does not lose if the price of the underlying asset rises. Those expect payoffs are reflected in the cost of the options.

In Summary

Risk management tools such as diversified hedging and insurance allows investors to reduce risk of loss while at the same time, reducing the probability of gains. Insurance involves an immediate cost to reduce the risk of future loss. Risk management requires identifying the risks involved and then making a judgement on which risk should be carried and which should be eliminated. The choice of a risk management tool is based upon which technique will be most efficient in eliminating the risk in question.

It Is Important For Investors Not To Panic And Chase Last Year's Top Performers In An Attempt To Recoup Losses

Growth managers have under-performed value managers in the past two years because stock market investors have preferred established companies that promise future earning growth. It's too early to tell whether the rebound will recur throughout the year. Anyhow, my recommendation is that investors choose a mix of growth and value managers to create a diversified portfolio able to withstand short-term fluctuations in the performance of any one fund manger.

The deteriorating world outlook is also a concern, and the war with Iraq has become increasingly likely and that could be a major headache for investors. The sharp slump in international equity markets pulled debt laden investors into margin calls, as the negative returns of managed funds with global equity bias were dragged sharply into the red. Many investors had borrowed heavily into international managed equity funds because conventional wisdom said this strategy was far less risky than gearing into direct shares.

Margin calls surged to 56520 in the second half of last year, fuelled by a 25 percentage call in global equity markets which took many managed fund investors into margin call for the first time. Those investors who were lured into borrowing funds to invest in managed funds with an international equity allocation had learnt a hard lesson. The unrelenting falls of global equity markets in the past year has had a domino effect on Australian investors who saw the value of their funds with global equities drop below their agreed lending ratio.

Naturally, these large institutions, who are more focused on distribution than investment management, have realised by mirroring the index, they can reduce costs but charge the same fees despite charging fees for active management. To be fair, Global Fund Managers encounter the same dilemma when facing pressure for benchmarking with their corporate owners.

Retail customers in Australia should be wary as APRA reported because there were several under-performers in both good and less rewarding years as 2002, yet evidence showed that these funds charged higher fees. It is now time for investors to analyse this controversy between high fees and low returns and do what their international peers are doing, such as becoming increasingly disillusioned about the whole banking wealth management models.

Therefore, from the investors' point of view, the only way to stop this self-gratified image of fund managers is for them to be benchmarked to Cash rather than sector type, because the Cash rate is the only relevant world universal currency.