Why managed funds must diversify or die

Investors need funds that can perform in highly volatile markets amid a backdrop of lower growth and economic uncertainty.

Investors in mainstream managed funds aren't exactly applauding their latest one-year fund returns.

International and Australian share funds typically posted soft performance and fund managers described the volatile investment climate as 'low growth'.

The median Australian share funds slipped by 0.5 percent while the median international share fund fell by 2 percent, according to figures from Morningstar for the 12 months until the end of September 2010.

Over the long term, Australian share funds did better and are up 8 percent a year over 10 years while unhedged international share funds, battered by the rising Australian dollar, lost 4 percent per annum over 10 years.

Alternative asset funds fared better than the traditional asset classes, recording healthy double digit returns over the year. Global real estate funds typically jumped 19 percent, high-yield funds rose 16 percent and global infrastructure funds added 14 percent over the 12 months.

Australian small companies funds, particularly those with small cap resource companies, outperformed strongly, the median rising by 11 percent and some better performers such as AMP Capital Australia Small Companies Fund A leaping by 23 percent.

There were standout funds run by seasoned share pickers such as Kerr Neilson's Platinum, which has continued to shine among lacklustre global share funds. The star fund in the Platinum group of funds was Platinum's International Brands Fund, up 25 percent over the year until the end of September 2010, or 27 percent more than the median international share manager.

Over 10 years the fund has returned an impressive 14 percent per annum for investors.

Even after losing 2.8 percent for the year, Platinum's flagship $9 billion International Fund has returned investors 5 percent each year over the past five years, compared to a 4 percent loss in the MSCI All Currency World Index.

The lesson of the global financial crisis has been the importance of understanding different investment risks, says Graeme Mather, head of investment consulting with Mercer.

The key risk is not being diversified, he says.

Investors who held several asset classes and thought they were diversified found out how much exposure to equity risk they had, he says.

Assyat David, director of Strategy Steps, says: "Investors have enjoyed a love affair with Australian shares which is understandable given our home country bias and the lure of franked dividends, but this is an increasingly risky strategy, given the very narrow focus of our market." She says financial and material shares now represent 60 percent of the Australian S&P/ASX 200 and the top 10 companies make up 52 percent alone. She recommends investors spread the market risk between Australian and international shares.

The second risk is currency volatility and how it can swamp asset class returns. At the beginning of September international equity funds that were hedged against currency volatility returned 5.5 percent against -4 percent for unhedged funds. "Investors need to actively manage currency," says Mather.

Then there is the liquidity risk. Around 100,000 Australian investors - often retirees - have had $10 billion frozen in mortgage and property funds since the GFC. David says this has taught investors that higher-than-average yields can carry structural risks. There is also the operational risk of financial groups hitting the wall and investors losing their money.

"Investors need to understand what they are invested in," says Mather. "To use an analogy, they need to understand what is under the bonnet and how well oiled is the machine and how well they work together."

It is not surprising that investors and their advisers are focusing on alternative investments for 2011. For a start they do not correlate or track with the sharemarket.

This means they diversify your investment away from the sharemarket and can be less sensitive to economic growth.

Mather recommends investors do their homework on alternative investments such as property and infrastructure but warns them not to pay over the market rates.

"Successful investing will require more focus on preserving capital and on finding diversifying assets and strategies that are less sensitive to economic growth and share prices," says Michael Coop, head of alternative investments at Ibbotson Associates.

Alternative investments are among the hot investment funds for 2011. Others include currency, commodities and retirement products that preserve capital, says Mather.

After adding 12 percent this year the question is where the $A will go from here. Hedged global share funds have performed around 10 percent better than the unhedged, so it is important to pay attention to currency risk. "It could potentially make or lose a lot of money," says Mather. "Investors can take advantage of the currency and reduce their currency hedge if they think the $A will weaken." He says to look for a currency manager that can add alpha or outperformance.

Funds such as Principal Global Investors' High Alpha Currency Fund for Australian investors were launched in November 2010. Mark Farrington, MD and portfolio manager of Macro Currency Group, says: "Our latest client-driven launch shows that appetite for currencies as an asset class remains strong, as investors search for a source of consistent, uncorrelated alpha in an uncertain market."

Increasingly sector investing is gaining popularity. In 2010 the ASX300 resource sector jumped 16 percent compared to a flat rise in the industrial sector.

Commodities rose strongly, assisted by the weak US dollar, and the gold price has soared by almost 30 percent. Mather says that when the US dollar strengthens, commodity prices will fall significantly.

For retirees, there will be more post-retirement products with flexible features such as income guaranteed for life while allowing the family access to the capital if an investor dies. The new longevity products - ING's MoneyForLife, Macquarie's Lifetime Income Guarantee Longevity Product and AXA North's Protected Retirement Guarantee - are complex products that allow pre-retirees and retirees to invest in the sharemarket and other growth assets.

Exchange traded funds have exploded this year. They include Australia's first ever dividend-focused ETF, Russell High Dividend Australian Shares ETF.

According to ETF research group Pennywise Investments, the top-performing ETFs over the year are ETF Physical Silver up 28 percent, ETF Physical Gold 26 percent and iShares MSCI South Korea up 24 percent.

Mather says there is a misconception that ETFs do not carry risks. They do, and investors need to weigh these up before they invest.

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