quarterly portfolio review - stanford brown€¦ · all portfolios experienced lower than average...

Review of markets & portfolios: End of December 2018

Portfolio settings for: March Quarter 2019

2

Contents Comments on Markets and Asset Class Returns .......................................................................................................3

Model Portfolio Returns .........................................................................................................................................4

‘Conservative’ Model Portfolio Returns – December Quarter 2018 ........................................................................................ 5

‘Moderate’ Model Portfolio Returns – December Quarter 2018 .............................................................................................. 6

‘Balanced’ Model Portfolio Returns – December Quarter 2018 .............................................................................................. 7

‘Growth’ Model Portfolio Returns – December Quarter 2018 .................................................................................................. 8

‘High Growth’ Model Portfolio Returns – December Quarter 2018 ......................................................................................... 9

Underlying Fund Returns ...................................................................................................................................... 10

Summary of Changes to Asset Allocation ............................................................................................................... 11

Summary of Changes to Funds – for March Quarter 2019 ....................................................................................... 12

Investment Research ............................................................................................................................................ 13

Australian Shares ........................................................................................................................................................................ 14

Global Shares ............................................................................................................................................................................... 15

Property & Infrastructure ............................................................................................................................................................. 16

Australian Fixed Rate Bonds ...................................................................................................................................................... 17

Australian Floating Rate Securities ............................................................................................................................................ 18

Global Fixed Income .................................................................................................................................................................... 19

Cash (Australian dollars) ............................................................................................................................................................. 20

Gold (in Australian dollars) .......................................................................................................................................................... 21

Currency Hedging......................................................................................................................................................................... 22

US DOLLAR CASH ........................................................................................................................................................................... 23

3

Comments on Markets and Asset Class Returns

2018 marked the end of an unprecedented six year global rally which saw positive returns from each of the main asset

classes. In 2018 shares fell around the world and traditional ‘defensive’ asset classes also posted very low and even

negative returns. US rate hikes, Trump’s trade wars, a slowing China, fears of a broader global slowdown, and a

deflation of the over-blown tech boom were the main causes. The chart below shows returns from the major asset

classes for the year – with ‘defensive’ assets in the upper section and ‘growth’ assets in the lower section.

The year began with a strong share rally in January that was driven by optimism over Trump’s tax cuts. This didn’t last

long. Shares around the world suffered three broad sell-offs during the year, ending in negative territory. The first two

were triggered by inflation scares following strong US wages and jobs reports – first in February and again in October.

The third share sell-off – in December - was quite different in that fears about US inflation earlier in the year (manifest

by rising bond yields) were replaced by the more serious threat of a global slowdown (manifest by falling bond yields).

We were bullish on shares and bullish on the Australian dollar in 2017 after the Trump election, so most of our global

shares in portfolios were ‘hedged’ in order to protect them from a rising AUD. We also held emerging market shares in

portfolios. Hedged global shares and emerging markets were the best asset classes in 2017.

In 2018 we turned bearish on the Australian dollar and started reducing the currency hedging on global shares in

February to prepare for a falling AUD. In April we also turned bearish on shares, so we reduced allocations to Australian

and global shares and removed emerging markets shares to protect portfolios in the event of a sell-off. We also reduced

the currency hedging on global shares further to below 30% in anticipation of further falls in the AUD. Emerging markets

and hedged global shares were the worst performers in 2018, after being the best in 2017. On the other hand, un-

hedged shares held up and ended the year square because the fall in the AUD offset the falls in share prices.

This unusual combination of falling share prices, ultra-low interest rates and low or negative returns on bonds, meant

that all of the traditional asset classes suffered poor returns. The best returns in 2018 came from two non-traditional

assets - Gold (in Australian dollars) and US dollar cash – which we added to all portfolios in April as part of our defensive

strategy in preparation for the global sell-off.

These changes protected investors from most of the market volatility and share price falls. All portfolios remain on track

to achieve their long term cost of living objectives and all are outperforming their multi asset class peer funds.

55

60

65

70

75

80

85

90

95

100

105

110

115

Dec

-201

7

Jan-

2018

Feb-

2018

Mar

-201

8

Apr

-201

8

May

-201

8

Jun-

2018

Jul-

2018

Aug

-201

8

Sep-

2018

Oct

-201

8

Nov

-201

8

Dec

-201

8

USD cash (in AUD) +11%

Gold (in AUD) +10%

Aust Investment Grade Bonds +5%

Aust Cash +2%

Global Inv Grade Bonds (Hgd AUD) +1%

Asset Class Returns - 2018Total Returns to end of

December 2018

'Defensive' assets:

85

90

95

100

105

110

115

120

Australian Listed Property +3%

Global shares (Un-Hgd AUD) +0%

Australian shares -4%

Emerging Mkts Shares (Un-Hgd AUD) -6%

Global shares (Hgd AUD) -8%

2 Feb US wages

scare

22 MarchTrump starts

trade war + Fed's 6th rate hike

13 JuneFed's 7th rate hike

8 MayAust Federal

budget tax cuts

13 MarchStart of Hayne

inquiry hearings

20 DecTrump's tax cuts

27 SepFed's 8th rate hike

24 AugMorrison replaces

Turnbull as PM

OctoberUS inflation scare + tech

sell-off

Decemberglobal growth scare + share

sell-off19 Dec

Fed's 9th rate hike

6 July 1st round of US-China tariffs start

'Growth' assets:

4

Model Portfolio Returns

All portfolios experienced lower than average returns in the December 2018 quarter and this dragged down

returns for the year. Australian and global shares suffered significant falls in the quarter (-9% and -13%

respectively) but our portfolios were defensively positioned with reduced exposures as described previously.

Australian and global investment grade bonds (both up +2% for the quarter) provided positive returns as shares

fell, and additional protection was provided by our holdings of gold (up +10%), and US dollar cash (up +2%).

Despite the global correction in late 2018, all portfolios remain on track to achieve their long term return and risk

objectives. We are making some adjustments to portfolio holdings as a result of this quarterly review, but we

remain defensively positioned for the prospect of further upcoming turmoil in the markets.

Notes:

• Individual client returns will vary depending on their own portfolio customisation, contributions, withdrawals, and timing

differences.

• The above returns are after all fees charged by the underlying funds, and after the Lunar Model fees.

• Portfolio inception date was the start of January 2017

• Past returns are not a reliable indicator of future returns

The charts on the following pages show the returns on Model Portfolios since the start of 2017 (inception on the

Netwealth platform).

In the chart for each portfolio there are two lines:

• Blue line = returns for model portfolios, after fees on the underlying investments, and after the Lunar Model fee.

• Red dotted line = the model portfolio’s long term target return above consumer price index inflation

As at end: Dec 2018 Total returns (net)

Portfolio Portfolio Goal APIR code 1 mth 3 mths 6 mths 1 year:

since

inception

(total)

since

inception

(pa)

Lunar 'High

Growth'

To focus on downside protection to

generate total returns well above

inflation for investors who can tolerate

significant volatility of capital values

and income levels along the way

MACC 000073 +5.0% 95 / 5 -1.4% -6.0% -4.2% -1.2% 12.7% 6.1%

Lunar 'Growth'


generate total returns well above

inflation for investors who can tolerate

volatility of capital values and income

levels along the way

MACC 000072 +4.5% 80 / 20 -0.9% -4.5% -3.1% -0.5% 11.8% 5.7%

Lunar

'Balanced'


achieve significant real growth ahead

of inflation for investors who can

tolerate some variations in income

and capital values along the way

MACC 000071 +4.0% 65 / 35 -0.5% -3.5% -2.3% -0.0% 10.3% 5.0%

Lunar

'Moderate'


achieve moderate real growth ahead

of inflation while allowing some

variations in income and capital

values

MACC 000070 +3.5% 50 / 50 -0.1% -2.5% -1.7% 0.6% 9.2% 4.5%

Lunar

'Conservative'

To focus on downside protection

while providing relative stability of

income and capital values and

modest real growth ahead of inflation

MACC 000069 +3.0% 30 / 70 0.3% -1.0% -0.4% 1.2% 7.6% 3.7%

(Returns are net of internal & external fund fees & costs, net of Lunar Model fees. Inception at start of 2017)

Long term

return goal

in excess

of CPI

Neutral

Growth /

Defensive

mix

5

‘Conservative’ Model Portfolio Returns – December Quarter 2018

Portfolio Portfolio Goal APIR code

Long term return goal

1 mth 3 mths 6 mths 1 yr: since

inception (annualised)

Lunar 'Conservative'

To provide relative stability of income and capital values and modest real growth ahead of inflation, whilst focusing on

downside protection

MACC000069

CPI + 3% 0.4% -1.0% -0.4% 1.2% 3.7%

to end of December 2018

The Lunar Conservative portfolio posted a modest loss for the December quarter. Despite the sharp fall in shares, investors in the

Lunar Conservative model portfolio did not experience a major drawdown thanks to being underweight growth assets and having

significant exposure to non-traditional defensive assets such as the GOLD and USD funds. The portfolio was up 0.4% in

December, despite US shares having their worst December since 1931.The portfolio is slightly below its CPI + 3% benchmark,

however we anticipate that the portfolio will outperform when the outlook for shares improves and the Investment Committee

overweights growth assets.

Neutral Growth/Defensive Mix: 30% / 70%

Current Growth/Defensive Mix: 25% / 75%

New Growth/Defensive Mix: 28% / 72%

Returns are net of underlying fund manager and model portfolio fees & expenses.

NB. Individual client returns will vary depending on their own portfolio customisation, contributions, withdrawals, and timing differences.

Asset class DAA refers to positions on broad asset classes (e.g. going overweight or underweight shares)

Sector Level DAA refers to positions within an asset class (e.g. investing in large cap shares or small cap shares)

Value added by funds refer to the outperformance of active managers relative to their assigned benchmark

Lunar Conservative (30/70)

-1%

+0%

+1%

31-J

an-2

017

28

-Feb

-20

17

31-M

ar-2

017

30-A

pr-

201

7

31-M

ay-2

017

30-J

un

-20

17

31-J

ul-

20

17

31-A

ug-

2017

30

-Sep

-20

17

31-O

ct-2

017

30-N

ov-

201

7

31-D

ec-2

017

31-J

an-2

018

28

-Feb

-20

18

31-M

ar-2

018

13-A

pr-

201

8

30-A

pr-

201

8

31-M

ay-2

018

30-J

un

-20

18

31-J

ul-

20

18

31-A

ug-

2018

30

-Sep

-20

18

31-O

ct-2

018

30-N

ov-

201

8

31-D

ec-2

018

Components of Value Added - Cumulative

+0.37% = Value added by asset class level DAA

+0.23% = Value added by Sector level DAA

+0.10% = value added by funds above their sector benchmarks

+0.69% = Total active value added

95

100

105

110

115

120

125

Dec

-20

16

Mar

-20

17

Jun

-20

17

Sep

-20

17

Dec

-20

17

Mar

-20

18

Jun

-20

18

Sep

-20

18

Dec

-20

18

Lunar Conservative (30/70) = 3.7% pa

Long term goal = CPI+ 3.0% pa

Lunar Model Portfolios - Returns

annualised returns to Dec 2018

3.62%

+0.30%

+0.05%

-2%

-1%

+0%

+1%

+2%

+3%

+4%

+5%

Lunar Conservative(30/70) = 3.96%

Sources of Returns(annualised since inception - start of 2017)

Value added by funds = +0.05%

Value added by Dynamic AssetAllocation= +0.30%

Passive Neutral portfolio = 3.62%

NB. For attribution analysis,returns are after internal fund

fees but before Lunar model fee

6

‘Moderate’ Model Portfolio Returns – December Quarter 2018




inception (pa)

Lunar 'Moderate' To achieve moderate real growth ahead

of inflation while allowing for some variations in income and capital values

MACC000070

CPI + 3.5% -0.1% -2.5% -1.7% 0.6% 4.5%


The Lunar ‘Moderate’ portfolio experienced a minor setback during the December quarter. Investor portfolios were cushioned by

being underweight growth assets and by having high allocations to alternative defensive assets such as GOLD and USD. The

portfolio is modestly underperforming its CPI + 3.5% benchmark, however we anticipate that the portfolio will outperform when

the outlook for shares improves and the Investment Committee overweights growth assets.









Lunar Moderate (50/50)

-1%

+0%

+1%

+2%

31-J

an-2

017

28

-Feb

-20

17

31-M

ar-2

017

30-A

pr-

201

7

31-M

ay-2

017

30-J

un

-20

17

31-J

ul-

20

17

31-A

ug-

2017

30

-Sep

-20

17

31-O

ct-2

017

30-N

ov-

201

7

31-D

ec-2

017

31-J

an-2

018

28

-Feb

-20

18

31-M

ar-2

018

13-A

pr-

201

8

30-A

pr-

201

8

31-M

ay-2

018

30-J

un

-20

18

31-J

ul-

20

18

31-A

ug-

2018

30

-Sep

-20

18

31-O

ct-2

018

30-N

ov-

201

8

31-D

ec-2

018






95

100

105

110

115

120

125

Dec

-20

16

Mar

-20

17

Jun

-20

17

Sep

-20

17

Dec

-20

17

Mar

-20

18

Jun

-20

18

Sep

-20

18

Dec

-20

18

Lunar Moderate (50/50) = 4.5% pa




4.05%

+0.56%

+0.09%

-2%

-1%

+0%

+1%

+2%

+3%

+4%

+5%

+6%

Lunar Moderate(50/50) = 4.68%







7

‘Balanced’ Model Portfolio Returns – December Quarter 2018





Lunar 'Balanced'

To achieve significant real growth ahead of inflation for investors who can tolerate

some variations in income and capital values

MACC000071

CPI + 4% -0.5% -3.5% -2.3% 0.0% 5.0%


The Lunar ‘Balanced’ portfolio experienced a minor setback during the December quarter. The portfolio comfortably outperformed

its peers during the recent sell-off, mostly thanks to being underweight growth assets and by having allocations to the non-

traditional defensive funds of GOLD and USD. The portfolio is modestly underperforming its CPI + 4% benchmark, however we

anticipate that the portfolio will outperform when the outlook for shares improves and the Investment Committee overweights

growth assets.









Lunar Balanced (65/35)

-2%

-1%

+0%

+1%

+2%

+3%

31

-Jan

-20

17

28-F

eb-2

017

31-M

ar-2

017

30-A

pr-

201

7

31-M

ay-2

017

30-J

un

-20

17

31-J

ul-

20

17

31-A

ug-

2017

30-S

ep-2

017

31-O

ct-2

017

30-N

ov-

201

7

31-D

ec-2

017

31

-Jan

-20

18

28-F

eb-2

018

31-M

ar-2

018

13-A

pr-

201

8

30-A

pr-

201

8

31-M

ay-2

018

30-J

un

-20

18

31-J

ul-

201

8

31-A

ug-

2018

30-S

ep-2

018

31-O

ct-2

018

30-N

ov-

201

8

31-D

ec-2

018






95

100

105

110

115

120

125

Dec

-20

16

Mar

-20

17

Jun

-20

17

Sep

-20

17

Dec

-20

17

Mar

-20

18

Jun

-20

18

Sep

-20

18

Dec

-20

18

Lunar Balanced (65/35) = 5.0% pa




4.36%

+0.76%

+0.15%

-2%

-1%

+0%

+1%

+2%

+3%

+4%

+5%

+6%

Lunar Balanced(65/35) = 5.24%







8

‘Growth’ Model Portfolio Returns – December Quarter 2018





Lunar 'Growth' To generate total returns well above

inflation for investors who can tolerate volatility of capital values and income

MACC000072

CPI + 4.50% -0.9% -4.5% -3.1% -0.5% 5.7%


The Lunar ‘Growth’ portfolio experienced a meaningful setback during the December quarter. The portfolio comfortably

outperformed its peers during the recent sell-off, mostly thanks to being underweight growth assets and by having allocations to

the non-traditional defensive funds of GOLD and USD. The portfolio is modestly underperforming its CPI + 4.5% benchmark,

however we anticipate that the portfolio will outperform when the outlook for shares improves and the Investment Committee

overweights growth assets.









Lunar Growth (80/20)

-3%

-2%

-1%

+0%

+1%

+2%

+3%

31-J

an-2

017

28

-Feb

-20

17

31-M

ar-2

017

30-A

pr-

201

7

31-M

ay-2

017

30-J

un

-20

17

31-J

ul-

20

17

31-A

ug-

2017

30

-Sep

-20

17

31-O

ct-2

017

30-N

ov-

201

7

31-D

ec-2

017

31-J

an-2

018

28

-Feb

-20

18

31-M

ar-2

018

13-A

pr-

201

8

30-A

pr-

201

8

31-M

ay-2

018

30-J

un

-20

18

31-J

ul-

20

18

31-A

ug-

2018

30

-Sep

-20

18

31-O

ct-2

018

30-N

ov-

201

8

31-D

ec-2

018






95

100

105

110

115

120

125

Dec

-20

16

Mar

-20

17

Jun

-20

17

Sep

-20

17

Dec

-20

17

Mar

-20

18

Jun

-20

18

Sep

-20

18

Dec

-20

18

Lunar Growth (80/20) = 5.7% pa



annualised returns to Dee 2018

4.69%

+1.15%

+0.16%

-2%

-1%

+0%

+1%

+2%

+3%

+4%

+5%

+6%

+7%

Lunar Growth(80/20) = 5.94%







9

‘High Growth’ Model Portfolio Returns – December Quarter 2018





Lunar 'High Growth'

To generate total returns well above inflation for investors who can tolerate

significant volatility of capital values and income levels

MACC000073

CPI + 5.0% -1.4% -6.0% -4.2% -1.2% 6.1%


The Lunar ‘High Growth’ portfolio experienced a meaningful setback during the December quarter. The portfolio comfortably

outperformed its peers during the recent sell-off, mostly thanks to being underweight growth assets and by having allocations to

the non-traditional defensive funds of GOLD and USD. The portfolio is modestly underperforming its CPI + 5% benchmark,

however we anticipate that the portfolio will make up for the underperformance when the outlook for shares improves and the

Investment Committee overweights growth assets.









Lunar Hi Growth (95/5)

-4%

-3%

-2%

-1%

+0%

+1%

+2%

+3%

+4%

31-J

an-2

017

28

-Feb

-20

17

31-M

ar-2

017

30-A

pr-

201

7

31-M

ay-2

017

30-J

un

-20

17

31-J

ul-

20

17

31-A

ug-

2017

30

-Sep

-20

17

31-O

ct-2

017

30-N

ov-

201

7

31-D

ec-2

017

31-J

an-2

018

28

-Feb

-20

18

31-M

ar-2

018

13-A

pr-

201

8

30-A

pr-

201

8

31-M

ay-2

018

30-J

un

-20

18

31-J

ul-

20

18

31-A

ug-

2018

30

-Sep

-20

18

31-O

ct-2

018

30-N

ov-

201

8

31-D

ec-2

018






95

100

105

110

115

120

125

Dec

-20

16

Mar

-20

17

Jun

-20

17

Sep

-20

17

Dec

-20

17

Mar

-20

18

Jun

-20

18

Sep

-20

18

Dec

-20

18

Lunar High Growth (95/5) = 6.1% pa




4.99%

+1.25%

+0.20%

-2%

-1%

+0%

+1%

+2%

+3%

+4%

+5%

+6%

+7%

Lunar Hi Growth(95/5) = 6.37%







10

Underlying Fund Returns Period: December 31 2017 – December 31 2018

Asset Class / Funds Benchmark

for asset class

Bench- mark return

Average1yr return from funds used

Comments

Australian Shares All Ords

Accumulation Index

-3.5% -4.3% The Australian market outperformed global shares during the recent sell-off thanks to a low allocation to technology stocks

Investors Mutual Aust Share Fund -3.8% Large cap value fund

Fidelity Aust Equities Fund -3.9% Large cap growth at a reasonable price fund

Bennelong ex-20 Aust Equities Fund -6.8% Mid cap fund that avoids big banks and miners

Ironbark Karara Small Co Fund -3.7% Small cap fund that provided protection during previous sell-offs

Vanguard Aust Shares ETF VAS -3.1% Low cost passive index fund

Allan Gray Australia Equity Fund – Class B -7.0% Contrarian value fund with high conviction and strong history

Global Shares - AUD Un-Hedged MSCI ACWI

net TR in Un-Hgd AUD

+0.9% 1.8% Recent sell-off was offset by a weakened AUD. The Australian Dollar tends to fall during sell-offs

MFS Global (Un-Hgd) 0.5% Growth oriented fund that has outperformed in recent sell-offs

Magellan High Conviction (Un-Hgd) 3.2% Concentrated portfolio with same philosophy as Magellan Global

Vanguard World ex-Aust (Hgd AUD) VGS 1.6% Low cost passive diversified index fund for developed stock

markets.

Global Shares - AUD Hedged MSCI World

net TR in Hgd AUD

-7.8% -4.0% Fears of a global slowdown sparked a sharp sell-off in December, with technology stocks falling hardest after fuelling the boom in recent years

Magellan Infrastructure (Hgd) -0.4% Outperformed during recent sell-off as global bond yields fell

Vanguard World ex-Aust (Hgd AUD) VGAD -7.5% Low cost passive diversified index fund for developed stock

markets.

Real Estate

50% A-REIT TR + 50% G-REIT TR (Hgd

AUD)

-0.5% 3.6% Property and infrastructure outperformed shares in 2018, as bond yields fell sharply during the recent sell-off.

AMP Core Infrastructure Fund 3.6% Listed and unlisted Australian + global infrastructure assets

VanEck Vectors Australian Property ETF - MVA 6.7% Equal weighted Australian listed property ETF that has

outperformed the index and most active managers in recent years

Australian Fixed Rate

Bloomberg Australian Composite Bond Index

4.5% 3.9% Australian bonds outperformed global bonds as domestic yields remained relatively flat in 2018. RBA unlikely to raise rates in near future as property market continues to decline

PIMCO WS Aust Bond 3.6% Fixed rate investment grade gov, semi-gov & corporate debt

iShares Composite BOND ETF IAF 4.4% Fixed rate investment grade gov, semi-gov & corporate debt

VanEck Corporate Bond ETF PLUS 3.9% High grade corporate bonds

Australian Floating Rate 90 day Bank

Bills + 2% 3.9% 1.8%

Floating rate bonds outperform fixed rate bonds when yields rise. Global yields rose steadily in 2018 before plummeting

Perpetual Wholesale Diversified Income Fund 1.4% Diversified Inv. Grade debt, hybrids, RMBs

Betashares Australian Bank Senior Floating Rate Bond ETF QPON

1.8% Low cost passive diversified index fund

VanEck Vectors Australian Floating Rate ETF 2.2% Low cost passive diversified index fund

Global Fixed Rate Barclays Global Agg Hgd AUD

1.7% 2.3% Strong performance in December quarter offset an otherwise flat year for global bonds.

Colchester Global Government Bond Fund 2.1% Global Treasury fund that takes active positions on bonds and

currencies

Vanguard Global Treasury ETF (Hgd AUD) ‘VIF’ 2.5% Low cost passive diversified global inv grade treasuries index

fund

Alternative Defensive 90 day Bank

Bills + 2% 3.9% 10.9%

Provided excellent downside protection in the recent sell-off as investors flocked to traditional safe-haven assets

ETFS Physical Gold ‘Gold” 9.4% Low cost exposure to physical gold in Australian Dollars

BetaShares US Dollar ETF ‘USD” 12.4% Low cost exposure to US Dollar cash accounts

Notes:

• The above table does not include funds that clients may hold outside the Lunar Managed Account portfolios

• The weights of each asset class differ in each of the Model Portfolios. Refer to separate reports for each portfolio.

• Care should be taken when interpreting returns over a short period like a quarter. Each of the active funds have demonstrated long histories of outperformance over many years and through many types of market conditions, but they will all underperform from time to time.

11

Summary of Changes to Asset Allocation The table below sets out the main changes in portfolio settings at the most recent quarterly review. For further details of

holdings and changes to individual portfolios clients should refer to their adviser.

While markets were booming in April 2018 we shifted portfolios to a significantly defensive stance in order to prepare for

falls in Australian and global shares and also for a fall in the Australian dollar. This defensive positioning protected

portfolios from most of the pain when shares did fall heavily in the second half of the year.

While the late 2018 global correction is now behind us and share prices are now lower, many of the risks and underlying

conditions that led to the correction are still present. We are in a position to increase allocations of growth assets but still

remain defensive overall. When we make the changes they will involve increasing Australian and global shares a little,

adding Australian listed property, shifting more from global bonds to Australian bonds, but retaining the defensive holdings

of gold and US dollars.

Asset Class Changes Current position

Comments & Rationale

Australian Shares

Increase

Underweight

The local share market posted negative returns for the 2018 year for the first time since 2011, despite a booming economy, low unemployment, low inflation and record low interest rates. Shares fell heavily in the second half of the year but we were prepared for this by being under-weight in portfolios since April. We are adding one more active fund to portfolios, but remaining a little under-weight overall.

Global Shares

Increase

Underweight

Global shares also sold off heavily in late 2018 while companies were reporting record increases in profits and dividends. We were prepared for the correction by being under-weight in portfolios. We are retaining the active funds as they are but changing the mix of passive exchange traded funds to increase the overall weighting a little and increase the level of currency hedging at the same time.

Currency hedging on

global shares

Increase

In 2017 portfolios were biased toward being hedged on global shares and this added value as the Australian dollar rose. In early 2018 we reduced hedging to very low levels and this also added value as the AUD fell back. Now we are increasing hedging levels back to a little below 50%, to benefit from further weakening in the AUD. Even after its recent falls, the AUD has more potential to fall than rise significantly in the current environment.

Property & Infrastructure

Increase

Neutral

We are adding Australian listed property to portfolios as they are likely to outperform listed shares when bond yields decline. We hold no global listed property at present. Instead we hold a fund containing a mix of global and Australian unlisted and listed infrastructure assets and this held up well during the recent global correction.

Australian Fixed Income / Floating rate

debt

Reduce

Overweight

We are reducing the overall allocation to Australian debt, but increasing Australian fixed rate bonds while reducing floating rate funds, as we expect bond yields in Australia to remain low as the economy slows. We are not expecting local short term rates to rise but local economic growth rates are likely to weaken more quickly than global growth, so Australian bonds should continue to beat global bonds.

Global fixed income

Reduce weight further

Underweight

We are reducing our underweighting of global bonds further as we are wary of the risk of rising inflationary expectations (especially in the US) on bond returns. Within the allocation we continue to favour government bonds over corporate bonds, which are hurt by rising credit spreads as economies slow. While bonds are posting low returns, they are in portfolios primarily as a buffer when share prices are hit in broad corrections triggered by fears of economic slowdowns.

Gold No

changes

Overweight

Gold has no ‘neutral allocations’ in portfolios but we added it to all portfolios in April 2018. Gold in Australian dollar terms almost always does well in broad share sell-offs, as it did in the global correction in late 2018. It should also benefit in the current environment of rising tensions in the Middle East and East Asia, and concerns over Trump’s trillion dollar deficits and unstable government. We will continue to hold it for the time being but we are in a position to reduce or remove it if conditions change.

US Cash No

changes

Overweight

US dollar cash has no ‘neutral allocation’ in portfolios but in April 2018 we added it to portfolios as a defensive measure rather than increasing Australian cash. It has risen 10% since then as the Australian dollar fell, making it the best asset class for the year. We will continue to hold it while we are expecting further weakness in the Australian dollar, but we are in a position to reduce or remove it if conditions change.

Australian Cash

No changes

Underweight

No changes to Australian cash holdings

Portfolio weight

Portfolio weight

Portfolio weight

Portfolio weight

Portfolio weight

0% Hedged 100%

Portfolio weight

Portfolio weight

Portfolio weight

12

Summary of Changes to Funds – for March Quarter 2019

The following changes are being made to fund allocations in the Model Portfolios. Refer to your advisor for specific

details on allocations and funds:

Asset Class Fund Change Comments Lunar

Conservative

Lunar Moderate

Lunar Balanced

Lunar Growth

Lunar High Growth

Australian Shares

Allan Gray Australian Equity Fund – Class B

Increase Shares are trading at more attractive prices since the December sell-off. Allan Gray

only charges a performance fee,

which will reduce the total fees paid by

investors.

+3% +5% +5% +6% +6%

Fidelity Australian Equities Fund

Decrease -2% -1% -1% -2% -2%

Vanguard Australian Shares Index ETF

Decrease - -2% - - -

Global Shares

Vanguard International Shares (Hedged) ETF - VGAD

Increase

Shares are trading at more attractive prices since the December

sell-off. Foreign currency hedging will be increased, as the Australian Dollar has

fallen significantly since April 18.

+1% +4% +4% +6% +5%

Vanguard International Shares (Un-Hedged) ETF - VGS

Decrease -1% -2% -2% -2% -1%

Property and Real Assets

VanEck Vectors Australin Property ETF - MVA

Increase

Listed property is likely to outperform shares if domestic interest rates fall or

stay flat.

+2% +3% +4% +4% +5%

Australian Debt

PIMCO Australian Bond Fund

Varied

Decreased allocation to floating rate debt,

as global interest rates are less likely to

rise in the near future.

+2% - - - -6%

iShares Core Composide Bond ETF – IAF

Increase +3% +4% +3% - -

VanEck Vectors Australian Corporate Bond ETF – PLUS

Increase +1% - - - -

Perpetual Wholesale Diversified Income Fund

Decrease - - - -2% -

BetaShares Australian Bank Floating Rate Bond ETF – QPON

Decrease -5% -8% -8% -4% -

VanEck Vectors Australian Floating Rate ETF – FLOT

Decrease - - -1% -3% -

Global Debt

Colchester Global Government Bond Fund

Decrease Shifted fixed rate

exposure to Australian bonds, as Australian yields are

more likely to fall than global yields

- - - - -3%

Vanguard International Fixed Interest Index ETF - VIF

Decrease -4% -3% -4% -4% -3%

These changes are intended to be made to portfolios in the near future. The timing of changes to funds in client portfolios may vary depending on a number of factors including the state of the markets and also the circumstances of each client portfolio. Please speak to your adviser for more details.

13

Investment Research

Allan Gray Australia Equity Fund (Class B) – ETL0349AU

In increasing its allocation to Australian equities, Stanford Brown’s Investment Committee has added Allan Gray to client portfolios, opting for a manager that has high conviction in its portfolios.

The Allan Gray Australia Equity Fund is a managed fund that aims to outperform the S&P/ASX 300 by utilising a contrarian & value investment philosophy. Contrarian investing involves identifying instances where the market’s general consensus appears to be misguided and taking opposing positions. Value investing involves buying companies that are trading at a lower price than what a fundamental analysis of the company suggests would be a fair price.

Both of these strategies require buying shares that are mispriced then waiting for the market to price them correctly. This has been proven to be an effective long-term strategy, however it can take months or even years to come into fruition. The fund has a track record of significant outperformance of the S&P/ASX 300 over the long-term, although there are frequent short-term bouts of underperformance.

The Class B offering of the fund charges no base fee, with Allan Gray receiving 35% of the fund’s outperformance relative the S&P/ASX 300. This fee structure aligns Allan Gray’s interests with its investors as they are only paid when they beat the overall market index. There is a high watermark applied to the performance fee, meaning the manager needs to make up for periods of underperformance before they can be paid again.

Portfolio: Diversified holdings of medium-large sized Australian listed companies

Benchmark: S&P/ASX 300 Accumulation Index

MER: 0% + 35% of the fund’s outperformance relative to the benchmark

Dividend Frequency: Annually

Fact Sheet

Latest Quarterly Commentary

Investment Philosophy

PDS

VanEck Vectors Australian Property ETF – ASX:MVA

Stanford Brown’s Investment Committee has decided to add Australian listed property to the growth allocation of client portfolios. Listed property tends to outperform shares when bond yields are trending lower, and the view of the Investment Committee is that bond yields in Australia are more likely to fall than rise in the near future.

“MVA” is an ASX-listed Exchange Traded Fund that provides passive exposure to a broad range of Australian Real Estate Investment Trusts (REITs) listed on the ASX. REITs allow retail investors to invest in large properties such as shopping centres, hotels, warehouses and office buildings. REIT investors earn returns from rental income and any capital appreciation of the underlying properties.

The VanEck Vectors Australian Property ETF offers investors greater diversification by capping the weight of each holding to 10%. The Australian REIT market is top heavy, meaning that a small number of companies dominate the index. By applying a 10% limit to portfolio holdings, investors gain greater access to smaller companies that tend to have higher growth prospects, resulting in a strategy that has outperformed the broad based market index. The modified weighting system also reduces the dominance of retail shopping centres and provides a more diversified mix of property types including office, industrial and other sectors like healthcare and storage. It also provides a more defensive mix of large stable rent-collectors, with less exposure to smaller, volatile property developers, and offers a higher yield than the overall property trust index.

Portfolio: Equal weighted holdings of the 10 largest REITs on the ASX

Index: MVIS Australia A-REITs Index

MER: 0.35%

Dividend Frequency: Bi-Annually

Fact Sheet

PDS

https://is-tracking-link-api-prod.appspot.com/api/v1/click/6406559619874816/4694693331861504






14

Australian Shares

Benchmark returns: (-9%) in December quarter, (-4%) for 2018

Currently: Underweight in all portfolios since April 2018, in readiness for the correction in the second half of 2018

Return outlook: Around average returns over long term but further weakness in short-medium terms

Approach Outlook Comments

Top Down Below

average returns

Average to below average returns due to:

• Australian demand growth likely to slow as the housing/construction boom slows

• Mining construction boom over, export volumes strong but commodities prices weakening

• Spending and investment also slowing in China, Europe and USA

• Banks restricting lending

• Political uncertainties\y affecting confidence, investment, spending

Bottom up Fully priced with limited

upside

• The market as a whole is not expensive – at reasonable multiples and aggregate earnings outlooks

• The largest two sectors – banks and resources – are not expensive but both face significant headwinds. Banks face challenges both cyclical (housing slowdown and credit restrictions) and structural (rising regulation and costs, narrowing scope). Resources stocks face falling commodities demand and prices.

• However the other market sectors appear fully priced and/or expensive – consumer discretionary, consumer staples, healthcare, industrials, transport, infrastructure, tech, telco’s

Traditional valuation methods

Not overly expensive

• Currently not overly expensive on most fundamental measures

• A little above fair pricing on earnings, but reasonable value on real & nominal dividend yields

• Dividends yields are a little above historical average levels

Discrete proprietary

models

Around Average returns

• Long term - around average returns (i.e. around fairly priced) on long term fundamentals.

• Medium term - around average returns on medium term cyclical measures.

• Short term – around average return outlooks

Macro scenario analysis

Significant risk of

major crisis

• Large negative tail risk (albeit with relatively low probability of a major global financial crisis event in the coming year), in the event of sudden escalation in the trade war or military war.

• Australian shares always sell off in broad global corrections, regardless of the cause and regardless of local pricing. The main risk is from a global correction as US and global markets are overpriced and vulnerable, with US rising interest rates and Trump’s trade wars

Returns:

• Negative returns in the December quarter and for 2018 year despite strong aggregate growth in profits and dividends.

• Australian shares held up better than the US and most other markets in the December quarter sell-off – as it was as not

over-priced, and also because of our falling dollar

• Mid-caps and small-caps beat large caps while the market rose, but fell back further in the late sell-off –the usual pattern.

Comments on Asset Allocation:

• At Asset class level - we switched to under-weight Australian (and global) shares during 2018 in anticipation of poor returns

• At sub-asset class level – ordinarily when under-weighting shares overall expecting poor returns, we would remove specific exposure to mid-cap and small-cap shares as they almost always suffer worse in general corrections – as they did in the recent sell-off. In our ETF-only portfolios we removed small and mid-cap ETFs. However in our active fund portfolios we reduced but did not remove the active small and mid-cap funds as they each had a history out-performance in previous sell-offs. They have not done so yet.

Changes to Asset Allocation:

• Last review: - no changes. Remained underweight. In active portfolios - retained reduced bias to mid-cap and small-cap via the existing active funds. In ETF-only portfolios – remained under-weight – with no allocation to mid-cap and small-cap.

• This review: - increase allocation but remain a little under-weight overall, by adding another active fund (Allan Gray Australian Equity Fund class B) and reducing part of the allocation to Fidelity Australian Equities Fund.

• For details of allocation changes and rationale – refer to the ‘Summary of changes to funds’ section of this report.

15,000

25,000

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65,000

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2008 financial

crisis

2010-11Sovereign debt crisis

2003-7mining & credit

boom

Australian All Ords Accumulation Index

OWEN

2012-14QE boom

2015 oil/gas collapse

2016 China

stimulus rally

2009rebound

2017 resources earnings rebound, Trump tax

cuts

2018Trump starts trade wars, Hayne inquiry

Underweight Neutral Overweight

Aust Shares

Neu

tral-

--

Portfolio Settings:

15

Global Shares

Benchmark returns: In local currencies: -12.5% in December quarter, -7.7% in 2018 (‘developed’ & ‘emerging’ markets)

Developed markets – in Hedged AUD: -13.3% in December quarter, -7.8% in 2018

- In Un-Hedged AUD: -11.4% in December quarter, 0.9% in 2018 (as the AUD has fell -9.5% against the USD)

Emerging markets – in Local Currencies: -7.4% in December quarter, -10.1% in 2018

- In Un-Hedged AUD: -5.3% in December quarter, -5.6% in 2018

Currently: Underweight overall. Bias toward un-hedged in model portfolios. No specific allocation to emerging markets.

Return outlook for coming year: Poor average returns.


Top Down Below

average returns

• US: Growth strong but showing signs of slowing, unemployment very low, rising wages and interest rates. Trump spending and tax cut confidence is now being offset by trade war fears.

• Europe: Weak economic growth, fiscal limits constraining stimulus, high unemployment still, social unrest, weak spending, weak bank lending, uncertainty over political divisions & elections, but inflation and growth emerging slowly, ECB withdrawing QE support

• Japan: renewed efforts on reforms, monetary and fiscal stimulus, reliant on weak yen.

• Emerging Markets - China in cyclical slowdown, widening debt stress on USD debt caused by rising US interest rates and rising US dollar. Potential to lead to the broad emerging markets crisis and commodity slump (like 2015).

Bottom up

Fully priced – below

average returns

• US: Even after adjusting for one-off effects, many sectors are still expensive and relying on very ambitious future profit growth assumptions that allow very little room for error. Dividends and buy-backs are strong.

• Large sections of the Europe and UK markets are also stretched. The ‘dot com’ style boom in Chinese tech stocks is now unravelling quickly


US overpriced, others full

• US market is still significantly overpriced on long term measures relative to profits but supported by strong dividends, dividend growth, buy-backs and the oil/gas rebound

• Other major markets stretched on earnings. Dividend yields are high relative to cash and bonds but low relative to historical averages – a sign of over-pricing

Discrete Models

Poor long term returns,

below av short term

• US is fundamentally overpriced on long term measures - pointing to below average long term returns, below average returns over medium term, and short term outlooks are a little better than last report but still below average. Still relatively bearish on all time frames, which is rare


Significant risk of major

crisis

• Share pricing is vulnerable to any negative shocks. Large negative tail risk (albeit with relatively low probability of global financial crisis event in the coming year), in the event of sudden trade war, military war, or serious inflation breakout (less likely)

Returns:

• 2018 ended the 6 year global share rally since the 2011 US debt ceiling / credit downgrade crisis. The 2012-2017 rally was fuelled by QE asset buying, zero/negative interest rates, steady growth in the US, recoveries in Europe, and stimulus spending in China. Each of these is now fading or reversing.

• The outlooks for US shares (more than 50% of the global market) is for poor returns over the long and medium term, and are vulnerable to further short term weakness. In other markets several sectors are still fully priced or overpriced – especially in tech / online retailing stocks in the US and China, global brands in US, UK and Europe.

• Emerging markets have turned from very high returns last year and into early 2018, to sell-offs this year.


• In 2017 we were reasonably bullish on US and global shares. We were 60% hedged on developed market shares and also had specific allocations to emerging markets shares. These paid off: global shares rose strongly in 2017, emerging markets were even stronger, and the AUD rose (benefiting hedged shares).

• Then in April 2018 we turned bearish: under-weight global shares, reduced hedge ratios (preparing for a weaker AUD) and removed emerging markets. These also paid off: global shares fell, emerging markets sold off, and the AUD also fell.


• Last review: No change - The active funds we hold have histories of adding value mainly in downturns. Infrastructure generally holds up better in sell-offs – as it did again in the 2018 correction.

• This review: Increase but remain a little under-weight, increase hedge ratios to around 40%. No emerging markets allocation.

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2008 sub-

prime, Lehman, + bank crises

2011Portugal, Greece 2,

Europe bank runs,

US down-

grade

2003-7 global credit + China

boom

Global Shares (MSCI All Country World Index, in USD)

OWEN

2009 rebound,Iceland, Dubai crises

2010 Greece 1,

Ireland

2012QE 3-4LTRO, OMT

2013QE taper scares

2014US QE ends , Europe + China slow

2016China

stimulus,commod rebound,

Brexit, vote, Trump

eleection

2015commodities

collapse, China

slowdown fears,

US startsrate hikes

2017Trumpstiimus

optimism + tax cuts, revival in Rueope +

Japan,

2018Trump trade war

fears, slowing China


Global Shares

Neu

tral-

--

Portfolio Settings:

16

Property & Infrastructure Global Prop & REIT Indexes .xls

Returns:

Sector 2017 2018 Current

allocation

Comments

Australian Listed Property

+5.7% +2.9% Nil Australian listed property is heavily tilted toward retail (shopping centres) which were hurt by weakening retail sales and online competition. Held up better than shares in the share correction in the second half of 2018.

Global Listed Property (Hedged AUD)

+8.2% -4.7% Nil Returns from global listed property (two thirds is in the US) was hurt by rising US bond yields, but still remains overpriced

Australian Un-Listed Property

+12.8% +10.0% Nil

(held outside managed a/cs)

Unlisted property continues to provide steady returns – fundamentals in main commercial markets are still strong but foreign demand is weakening as Chinese investment has slowed down significantly.

Global infrastructure (Hedged AUD)

+14.8% -1.9% Small

holdings in portfolios

Also hurt by rising US bond yields this year but provides a buffer when bond yields fall in slowdown phases – like December 2018. Active funds are adding value.

The benchmark for the asset class is: 50% A-REITs (Australian listed property trusts) + 50% G-REITs (global listed property trusts). The benchmark contains no unlisted assets. (Our asset class benchmark is similar to most comparable multi-sector funds.)

Currently: No positions in Australian listed or global listed property. On unlisted property – we moved the AMP unlisted property fund outside the discretionary portfolios for technical reasons but we still favour holding unlisted property. On infrastructure assets – we hold the Magellan Infrastructure Fund (which contains listed infrastructure shares – which we classify more as a global share fund

rather than infrastructure); and the AMP Infrastructure Fund (which includes 50% unlisted directly held assets)

Returns:

o The 5 year rally in listed property trusts globally since the start of 2012 (fuelled by ultra-low interest rates and bond yields) was broken when returns were hit by the ‘reflation’ bond yield spikes in late 2016, mid-2017 and in February and October 2018.

o As a result G-REITs and A-REITs lagged returns from Australian and global shares in 2017 but they held up better than shares in 2018 as global slowdown fears overtook inflation fears.

Outlooks:

o The underlying commercial property market in Australia (mainly Sydney and Melbourne) is reasonably strong on good fundamentals: rising rents, low & declining vacancy rates, solid demand, jobs growth, tight supply, and global growth holding up.

o But commercial property and property trusts are still overly expensive. Even after recent corrections prices are still expensive relative to underlying net asset values (which themselves are expensive) and trusts are still trading on unsustainably low yields.

o Property trust yields are still well above government bond yields but there will be further downward pressure on trust prices if bond yields rise further. US yields may be held back somewhat by US Fed rate hikes, while central banks in Japan and Europe have little choice but to continue to support prices to keep yields relatively low as they scale back their asset-buying programs.

o Interest rate outlook (for debt funding within trusts) – rates are slowly rising in the US but remaining very low in Europe and Japan. Rates may also rise in Australia due to bank lending restrictions and possible credit downgrade – rate rises will probably adversely affect listed more than unlisted property.


o Listed property – the listed property sector follows the broad listed share market but provides a partial buffer when shares sell off and bond yields fall, except where property trusts are significantly over-geared and over-priced (as they were in the GFC). As slowdown fears have overtaken inflation fears, listed property should provide some protection against share market falls.

o Unlisted property generates much smoother returns than listed trusts as they don’t have the daily stock market volatility. The

trade-off is lower liquidity of unlisted trusts – with monthly or quarterly redemptions. Unlisted have beaten listed in the past year.

o Both listed property and infrastructure are likely to be held back by rising bond yields, both would provide some protective buffer in broad share sell-off in the event of major global slowdown fears, but not an inflationary spike.


o Last review: no changes.

o This review: Retain AMP infrastructure fund. Add Australian listed property by adding VanEck Vectors Australian Property ETF, which is a passive fund that has a better industry mix and higher yield than the overall listed property market.


Asset Class

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Portfolio Settings:

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Aust Listed Property TR

Global Listed Property TR - Hgd AUD

Aust Un-Listed Property TR

2008 GFC

2013 QE taper

scare

Listed & Unlisted Property (total returns)

OWEN

2010-11 Sovereign debt crisis

2016 China

rebound +

inflarion scare

Unlisted trusts frozen

2015oil/gas crisis

2014 QE rally2009

rebound

2003-7 credit boom

Global REITs

Aust Unlisted Property

Aust REITs

2018Trump

trade wars + China

slowdownscare

2017Trump

tax cuts + spend-

ing

17

Australian Fixed Rate Bonds

Benchmark returns: +2.2% in December quarter. +4.5% in 2018

Currently: Underweight Australian Fixed rate debt – with balance held in Floating rate, USD cash and AUD Gold

Return outlook for coming year: Bonds: 2% to 4% pa (Income: 3.5% + Price: -1% to +3%). TDs: up to 3% for 5 year TDs.


Top Down Below average

returns

Probably around 2% to 4% returns from the overall bond index:

• Slowing China + few local inflationary pressures with the housing / construction slowdown, stagnant wages, weak consumer spending, rising mortgage rates and mortgage stress

• Yields unlikely to rise significantly, but potential to fall in a local or global slowdown


Poor returns

Poor returns if held to maturity -

• Yields well below long term expected level so yields should rise over the medium term in the absence of a sustained recession from the housing slowdown, leaving low returns to maturity

• Yields still well below dividend yields on shares

Discrete models

Neutral – no major change

in yields

• Our yield outlook model (based on real yields, inflation and unemployment) is currently near neutral – ie not pointing to rising or falling yields ahead. This is consistent with yields remaining relatively low in the housing slowdown + slowing China


Yields would fall in almost any local or

global macro shock

• Good returns are likely when Australian yields fall due to either local or global developments. Local triggers may be a construction collapse / local bank/bad debt crisis. Global events might include an acceleration in the global trade war or China slowdown + commodities collapse, war in the Middle East or East Asia. The risks of a major shock are low but rising.

Returns:

• Below average returns from the overall composite bond index in the past 2 years. Yields were flat in 2017 and early-mid 2018 after the 2016 ‘reflation’ scare when yields rose. Good returns in the December quarter as bond yields fell sharply in the global tech/share sell-off.

• Credit spreads rose through the year – ending the two year recovery since the 2015 oil/gas/steel bankruptcy crisis. Rising spreads detracted from returns from corporate bonds although they still offer higher yields and income then government bonds.

• Higher returns are available from bonds – but it is by increasing exposure to higher risk, lower grade credit. These do well in credit upswings like 2016-7 commodities rebound but that phase is now over. The lower expected returns from high grade bonds in the current environment are the price of portfolio insurance for a major crisis sell-off (e.g. global slump in a trade war),

where government bonds would generate significant capital gains, as they have done in numerous prior slowdowns.


• Australian fixed rate bonds are primarily in long term portfolios as a buffer against sell-offs in Australian shares, which they have been historically in most share sell-offs in the past except in cases of high or rising inflation.

• After being positive about shares since the Trump election win and through to early 2018, when we turned bearish and underweighted shares in 2018 before the share falls, we put most of the defensive allocation into Floating Rate – to reduce the potential negative impact of rising yields on fixed rate bonds. During 2018 we shifted more from floating rate to fixed rate bonds.

• The share sell-off in December 2018 saw the protection work: shares fell but bonds provided positive returns as yields fell.

• As US yields have greater risk of rising than Australian yields, we should shift even more from global bonds into Australian

bonds.


• Last review: increased Australian bonds by taking a part of the reduction in global bonds

• This review: increase Australian bonds further, taken from global bonds.

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UBS Composite Bond Index

3y TDs - Total Returns

2008 financial

crisis

Sovereign debt crisis

2003-7mining & credit

boom

Aust Fixed Income - Bonds & Bank TDs

OWEN

2012-4 QE asset boom

Aust rate cuts start

2014-5 commodities

collapse

2016 commodities rebound

+ 'Reflation' yield spike

2017credit

restrictions slowing housing boom

2018trade war

fears , slowing China


Aust Fixed Rate

Neu

tral-

--

Government Credit

Gov-Credit mix

Portfolio Settings:

18

Australian Floating Rate Securities

Returns:

Sector 2017 2018 Current Asset allocation Comments

Bank Bills +1.7% +1.9% ‘Cash’ allocation in platform

cash account pays Bank Bills + 0.20%

Our internal benchmark for investment grade floating rate securities is 1% above the total return on bank bills

Senior Floating Rate Notes (FRNs)

+3.4% +2.3% Currently around half of the Australian Fixed/Floating

rate allocation

The floating rate funds contain a variety of floating rate securities, primarily investment grade bank and corporate debt. Active funds can have a small proportion of sub-investment grade debt.

Hybrids +7.6% +4.9% Nil Partial allocation contained in the active floating rate funds we use

Bank Bills:

• Bank bills are used as the basis for the benchmarks for floating rate securities as the rates paid on them are usually set at a margin above the bank bill rate. Yields on bank bills average around +0.20% pa above cash rates and government treasury bills but they tend to oscillate through credit cycles. Currently the margin is up to 0.5% as bank risk and funding costs rise.

‘Senior’ (investment grade) floating rate securities:

▪ As with fixed rate bonds, floating rate securities of non-government issuers (banks and corporate borrowers) also benefit from higher income from the credit spread they pay above bank bills. Credit spreads rise and fall through credit cycles.

• Returns from senior bank and corporate floating rate notes (FRNs) generally average around +1% to +1.5% pa above the

returns on bank bills, and this varies a little over credit cycles. They carry very low risk of loss and very low price volatility.

‘Junior’ (raking behind senior debt) mostly below investment grade - including ‘Hybrids’ like preference shares and capital notes:

• Lower ranking securities with lower credit ratings, higher risk of non-payment of interest and/or loss of capital, and higher price volatility (which can be up to half the volatility of shares). In return for the higher risk they generally pay around 3% to 5% above bank bills yields. Tier 1 and 2 bank hybrids face the risk of write-off if the bank needs capital in a crisis.

• Returns fluctuate much more than for senior debt. Lower (or even negative) returns when credit spreads are widening in credit crises (e.g. 2008 GFC, 2010-1 sovereign debt crisis, 2015 commodity collapse). Higher returns when spreads are narrowing in credit recoveries (2009-10, 2013-4, 2016-7). Returns were good in 2016-7 as spreads receded back to boom-time levels.

Returns lower in 2018 as spreads rose with fears of a China slowdown and rising bank risks in the local housing correction.


• Aside from cash, investment grade floating rate notes are the lowest risk layer in portfolios (and the lowest return, lowest volatility). They provide regular income (about 1% to 1.5% higher than cash) but offer no growth potential or inflation protection.

• Floating rate benefits from rising short term rates (unlike bonds) and also are protected from the negative effects of rising long term rates which hurt bond returns – usually during rallies and booms when bond yields are rising – like 2017 and most of 2018.

• Floating rate notes have no ‘neutral’ allocation in portfolios but we have been using them because of the very low yields on fixed rate bonds, and the risk that bonds would suffer from rising yields and inflationary fears – primarily emanating from the US.

• During 2017 and into early 2018 we were positive on shares in the rally and so two thirds of the Australian fixed/floating debt

allocation was in Floating Rate, because of the risk of rising bond yields in the rally hurting bonds.

• During 2018 we turned bearish on shares and increased defensive allocations. We retained floating rate as protection against the risk of another inflation scare hurting bond returns. Rising US yields hurt global bond returns up to October 2018, but now the risk of local and global slowdown has over-taken the risk of inflation, and this favours fixed rate over floating rate debt.


• Last review: increased investment grade corporate floating rate notes - to protect against the risk of rising US yields

• This review: reduce floating rate allocations, and consolidate holdings into the Perpetual active fund and ‘FLOT’ passive ETF.

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2008-9 financial

crisis

2011 Greece 2 + US down-

grade crises

2003-7mining &

credit boom

Australian Floating Rate Securities

OWEN

2013QE taper fears, US recovers

2015commod-

ities collapse

2016China

stimulus rebound

2010

Greece 1

2017 Trump

stimulus + Europe

revival

2012 start of QE boom + Aust housing boom

Cash rate

Senior Floating Rate Notes

Bank Bills

Hybrids

Cash rate

2018Trump trade

wars + China slow down

Zero Neutral Overweight

Floating Rate ----Neutral

Sub-Invest- 50/50 Investment -ment Grade Grade

Credit Quality

Neutral--→

Portfolio Settings:

19

Global Fixed Income

Benchmark returns (in Hedged AUD): +1.7% in December quarter, +1.7% for 2018

Currently: Underweight in portfolios (with the allocation going to Australian Floating rate, US dollar cash and AUD gold) Return outlook for coming year: around 0% to 3% (Income: 3%. Price growth (capital gain/loss pa): -3% to 0%


Top Down Below

average returns

• Probably continued low returns - global growth will probably remain slow for several years, and low to moderate inflation likely in the big markets but very little chance of runaway inflation.

• Recent regular bouts of ‘global ‘reflation’ fears have been short-lived – not the start of serious inflation cycle (ie 5%+ inflation) yet

• Inflation outlooks kept low by over-capacity, under-employment, wages stagnation, fiscal constraints, bank lending constraints and US Fed rate hikes

• Good chance of further crises & slowing in China, Europe, Japan or US, e.g. if trade war escalates

Bottom up Poor

returns • Poor returns – most bonds trading at premium and/or very low coupons, ensuring poor returns

(even before inflation) if held to maturity. Currency hedge returns declining as US raises rates.


Poor returns

• Poor returns likely if held to maturity with very little allowance for rising credit or inflation risk.

• Even after the yield rises since the Brexit lows in mid-2016, yields are still very low, driven by unsustainable central bank bond buying and depressed interest rates in Japan and Europe.

• More occasional US inflation scares and yield spikes are likely from time to time, hurting returns

Discrete Models

Neutral • Factor model based on changes in real yields and yield curve spreads still points flat US yields

and moderate returns.


moderate returns

• The base case is for low returns – on continued benign outlooks assuming uninterrupted slow recoveries in US, Europe and even Japan.

• A sudden inflationary fear like 1994 is a possibility, but there is little risk of high (ie 5%+) inflation in the US or any of the other major markets.

• Sudden blow to global growth (from any one of a number of sources – e.g. trade war, China banking collapse, Europe debt crisis, oil spike due to Middle East war, etc, would be good for government bond returns.

Returns:

• Low returns for 2018 as yields rose a little (in the US) while credit spreads also widened – both of which hurt bond returns. Good returns in the December quarter when as bond yields fell sharply in the global tech/share sell-off.

• Higher returns are available – but it is by increasing exposure to higher risk, lower grade credit. These do well in credit upswings like 2016-7 commodities rebound but that phase is now over. High Yield bonds returned losses in 2018. The lower returns from high grade bonds in the current environment are the price of portfolio insurance for a major crisis sell-off (e.g. global slump in a

trade war), where government bonds would generate significant capital gains, as they have done in numerous prior slowdowns


• Global fixed rate bonds are primarily in long term portfolios as a buffer against sell-offs in global shares, which they have been historically in most share sell-offs except in cases of high or rising inflation.

• Underweighting of global bonds added value since Floating Rate (where the allocation went) generated higher returns. It is time to shift even more from global bonds to Australian bonds, as US yields have greater risk of rising than Australian yields.

• Portfolios were biased toward Credit in 2017 when we are we expect credit spreads to contract, which they did. Then in 2018 when we turned bearish and under-weight shares, we shifted the bias toward Government and reduced Credit, expecting spreads to widen in the share sell-off, which they did.


o Last review: Reduced the global bond allocations by removing the Global Credit funds (‘VCF’) from all portfolios.

o This review: Reduce global government bonds further. Retain bias toward Government and no Corporate bonds (Credit)

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2008-9 financial

crisis

2011 Greece 2

+ US down-grade crises

2003-7mining &

credit boom

Global Investment Grade Bonds - in Hedged AUD

OWEN

2013QE taper fears, US recovers

2015commodities

collapse + Bund scare

2016commodities

rebound + 'Reflattion'yield spike

2010

Greece 1

2017 Trump stimulu

s + Europe revival

2012 start of

QE boom

2018Trump trade

wars + China

slowdown

Portfolio Settings:


Global Bonds

Neu

tral-

--

Gov-Credit mix

Government Credit

20

Cash (Australian dollars)

Benchmark returns: platform cash accounts paying around the 90 day bank bill rate (currently around 2.0%) + 0.20% pa

Currently: Underweight (allocation going to Australian Floating rate where income returns are a little higher)

Return outlook for coming year: around 2.0% pa

Australian cash

o Interest rates on cash accounts have been declining and kept very low during the RBA’s 12 rate cuts from 4.75% to 1.5% by August 2016 where it sits today.

o The RBA is unlikely to cut further (although it would like to in order to weaken the AUD) for fear of rekindling the housing / household debt bubble, unless there is a serious local or global slowdown. RBA is also unlikely to raise rates until it sees sustained wages growth, which it is not seeing yet. It is terrified of raising rates for fear it will accelerate the deflation of the housing bubble it created.

o Platform cash rates currently paying around 0.20% above the bank bill yield which is currently around 2%. This is unusually low and drags down the overall income yield from portfolios.

o The 90 day bank bill rate is usually averages around 0.2% above the yield on 3 month Commonwealth Treasury bills (currently 1.5%). But this margin varies from time to time. The bank bill margin above T-bills can rise above 0.5% in credit crises like the 2008 GFC, the 2011 sovereign debt crisis. The margin has been higher than average this year. This benefits investors in the platform cash account but hurts floating rate notes bur the effects are usually short-lived before reverting again.

Asset Allocation comments:

o Ordinarily, cash allocations are generally kept at a minimum and used for investors’ short term liquidity needs only. (Our model portfolios are intended to generate returns over long holding periods. Investors’ emergency / short / medium term cash requirements should be managed in separate portfolios).

o Given the prevailing very low cash rates we are have been underweight the allocation to Australian cash, instead preferring highly rated investment grade senior floating rate notes for very low risk and smooth returns around 1% to 1.5% above cash rates.

o Refer also to the section on US dollar cash.


o Last review: no change

o This review: no change. The preference for high grade floating rate is warranted as the risk of loss is virtually zero, and the income is higher

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Aust Cash Rate

3 mth T-bills

L/T policy cash target

CPI inflation (12m)

Aust Short Term Interest Rates & CPI inflation 2000s

mining & credit boom

Inflation target range

2008 financial

crisis2010-11

China stimulus/ mining boom

OWEN

Rate cuts start in Nov

2011

CPI inflation rate

2012-17 housing boom


Australian Cash

Neu

tral-

--

Portfolio Settings:

21

Gold (in Australian dollars)

Returns: In Australian dollars: +8.0% in December quarter, +5.0% since added to portfolios in mid-April 2018. Currently: 4% weight in all model portfolios (Neutral allocation = zero)

Return outlook for coming year: primarily a buffer against share sell-offs. Expected to rise if shares fall, otherwise hold value.

Rationale for gold

Outlook Comments

Inflation hedge

Rising inflation in US, Europe But runaway inflation is

unlikely

• Gold is one of the few assets that would do well in the event of a sudden inflation scare in the major markets. There is a relatively low risk of high inflation yet – with spare industrial and human capacity in abundance, wages growth constrained by low global wages, prices constrained by over-production, and weakening demand growth rates due to slowing population growth rates and aging / retiring trends

• However inflation has been rising recently in US, Europe and even in Japan, and may increase further if tariff-induced price rises transfer into broad price inflation.

Buffer for shares

Likely to do well in a major

sell-off in shares

• Gold (in un-hedged AUD) has generated positive returns in nearly all broad sell-offs in shares, which are caused either by late cycle fears of inflation and rapid rate hikes or by economic slowdown fears. Escalation of a global trade war should benefit gold as the traditional safe haven (government bonds) are still at very low yields, which limits their potential gains.

Safe haven in times of military

conflict

Rising military tensions

• Rising military tensions in Middle East and South China Sea should benefit gold. Current tensions are particularly potent at present because they relate to jostling positions in a new cold war between the US, China and Russia, and the unpredictable Trump.

Safe haven in times of

government debt fears

Rapidly deepening US

deficits

• The 2011 gold spike was driven not just by fears of central bank money printing, but also a loss of confidence in the US government (US debt ceiling, possible default, S&P credit downgrade, trillion dollar deficits and unprecedented monetary expansion) – rather than by fears of imminent hyperinflation or military war.

• Trump’s return to trillion dollar deficits from tax cuts and spending increases, along with his increasingly alarming and sudden shirts on trade and foreign policy, are fuelling a gathering loss of faith in the US government in some circles, and gold is a safe haven.

Returns:

o The AUD gold EFT returned 5% in Australian dollars from its mid-April addition to portfolios to the end of 2018. It was the second highest returning asset in portfolios in 2018. The best was USD cash at +10%. Shares were down, global bonds were near zero because they were hurt by rising US yields. So AUD gold did the job expected – providing a better buffer for shares than bonds.

o The main reason for the 5% return was the falling AUD (the USD gold price actually fell -4.6% as the inflationary fears of early 2018 turned into slowdown fears later in the year.

Comments on asset allocation:

o Gold has zero ‘neutral’ allocation in portfolios. In the current environment gold offers protection from rising bond yields and rising inflation, and also a safe haven in a major global crisis.

o As a safe haven asset we are interested primarily in Gold held in Australian dollars because the US dollar gold tends to rise in a variety of different types of crisis, but the Australian dollar almost always falls in any global crisis – a double benefit for AUD gold.

o The upside is that in a major US inflation scare or serious crisis (eg rapid military escalation, or US debt repudiation, as Trump has hinted at) the gold price could rise substantially – even double (like in 2010-11 US downgrade crisis, and 1979). This offers much more upside than other defensive assets (bonds, real estate) which are all currently over-priced to start with, and would be hurt by rising bond yields. In a very serious crisis (US/China military war), AUD gold and USD cash would probably be the only positive assets.

o The risk of retaining is that global risks calmly recede but US growth rates and inflation remain low, the USD gold price remains flat or falls (eg mild US slowdown), but the AUD remains flat or rises. (A GFC would be good for AUD gold as the AUD would fall).

o The preferred security is ‘GOLD’ (un-hedged Exchange Traded Fund backed by physical gold). It pays no income but has a fee of 0.18% pa which covers storage, insurance and other holding costs.


o Last review: no change

o This review: Retain current levels. AUD Gold did a good job in the 2018 share sell-off but it could do even better in a major crisis or serious inflation scare – or US government crisis - and the risks of these have not reduced since the last review.

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GOLD (in AUD)

GOLD (in USD)

USD / AUD

Gold Price in USD and AUD

2008

GFC

2010-11Sovereign debt

crisis

2003-7 mining &

credit boom 2012-14QE boom 2015 oil/gas

collapse2016 China

stimulus rally

2017 resources rebound, Trump

OWEN

AUD:USD

USD / AUD

Gold i AUD

Gold i USD

Gold (AUD)

Zero weight Overweight

---Neutral

Portfolio Settings:

22

Currency Hedging

AUD against USD: (-2.3%) in December quarter, (-9.5%) in 2018. AUD against TWI: (-2.4%) in December qtr (-6.5%) in 2018

Currently: Very low hedge ratios (24%-30% hedged) on global shares from early 2018 as we were expecting the AUD to fall

Outlook for coming year: AUD expected to remain weak – adding to returns on un-hedged global shares


Top Down Currency gains as AUD falls

• Rising US interest rates should weaken AUD → favour un-hedged

• Below trend growth for global + domestic economies, fears of Chinese or local credit / property slowdown, or global trade war should suggest lower AUD → favour un-hedged

Long term fundamental

drivers

Currency gains as AUD falls

• AUD has reduced from significantly over-valued on fundamental PPP value to now be around after recent falls this year (‘Purchasing Power Parity’ value of a currency is driven by relative real purchasing power, relative inflation, current account)

• Continuing chronic budget and current account deficits (despite the occasional surplus from windfall commodity prices), high relative inflation, declining terms of trade → favour un-hedged over long term as the AUD should continue to weaken long term.

Short term drivers

Turning more

bearish on AUD

• Current stance on global / Australian shares = underweight → default position is to favour below 50% hedging on hedged global shares.

• Interest rate differentials falling since 2011 and likely to fall further with the US raising rates certainly faster than the RBA may hike → bearish for AUD

• Commodities prices falling with Trump’s trade wars and slowing China → bearish for AUD.

• Medium term share price growth factor → now neutral on the AUD outlook


Significant risk of major

crisis

• Global macro scenario model based on outlook probabilities would suggest further declines in AUD if a major domestic or global crisis hits – likely triggers could be major banking crisis in China or sudden escalation in Trump’s trade wars → currency gains as the AUD sells off in capital flight to safe havens → would favour un-hedged

Comments on Currency Hedging in portfolios:

o Decisions on the currency hedging of foreign assets usually have a greater impact on portfolio returns than asset allocation decisions (eg the decision to over-weight or under-weight global shares) or fund selection decisions. For example in 2018 the return from un-hedged global shares exceeded the return on hedged shares by 9% as the AUD fell. The impact on portfolio returns from our decision to reduce hedging to low levels early in the year added more value to portfolio returns than our decision to under-weight global shares prior to the sell-off, and also more than ‘alpha’ achieved by active funds.

o Global Bonds – generally only available in AUD hedged versions of active and passive funds.

o Global Property – no exposure currently

o Global Shares – we reduced hedge ratios from 60% to around 40% in February, anticipating a weak AUD. We further reduced hedging to 24-30% in April when we under-weighted shares.

o After the steady decline in 2018 the AUD is now down to near its fundamental value. Although there are still some factors pointing to further falls ahead, the case has now weakened for the current extra low hedge ratios on global shares

Changes to Currency Hedging:

o Last review: no change to current low hedge ratios on global shares

o This review: Increase hedge rates but remain a little below 50% to prepare for further weakness in the Australian dollar

Portfolio Current (Dec qtr) → New (March qtr)

o Conservative: 30% 40% o Moderate: 20% 41% o Balanced: 29% 43% o Growth: 24% 41% o High Growth: 30% 41%

o This is done by reducing ‘VGS’ (un-hedged global shares) and increasing ‘VGAD’ (hedged global shares)

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Yen / AUD

AUD Trade-Weighted Index

USD / AUD

Euro / AUD

Sterling / AUD

AUD -v- Major Currencies - since 2005Foreign Curency / AUD

Sovereign debt crisis

2000s mining & credit boom

2008 financial

crisis

USD

Yen

Sterling

Euro

OWEN

Yen

USD

USD

Euro

Sterling

TWI

QE boom

AUD against:

2015 China

slowdown

2016-7 rebound

2011mining peak

Portfolio Settings:

Un-Hedged 50% 100% Hedged

Neu

tral-→

FX Hedge Ratio

23

US DOLLAR CASH

Returns: +2.5% in December quarter, +10.3% since added to portfolios in mid-April 2018.

Currently: 4% weight in all model portfolios. It was the best asset in portfolios in 2018 and an excellent buffer against share falls.

Outlook for coming year: Primarily a buffer against share sell-offs and global crisis. Further returns if the AUD weakens further

Rationale Outlook Comments

Alternative to bonds as

a safe haven if

bond yields rise

Risk of bond yields

continuing to rise – hurting bond returns

• Ordinarily the primary buffer against share sell-offs is to hold government bonds. However with bonds still near record low yields they will not be able to offer the same level of high returns in another GFC-type crisis because yields have less room to fall from current levels.

• In addition, bonds returns suffer in conditions of rising inflationary expectations. Inflation has been rising in the US and Europe, and the trigger for the next major sell-off may be a serious inflation scare (like 1994) when bonds provided no buffer and suffered losses

Safe haven liquid asset that is un-hedged

AUD is falling, and likely to fall further in a major sell-

off

• Global bond funds are always hedged on currency risk. This denies investors of the benefit of the AUD falling as it always has in general share collapses. Eg. The USD (against the AUD) gained 27% in 2008 while shares fell in the GFC. Likewise in other major sell-offs.

• Holding part of the defensive allocation in US dollars allows investors to gain from the falling AUD in a sell-off (although US dollars don’t benefit from bond gains if yields fall in a crisis)

Takes advantage

of the weakness of the AUD

AUD now not over-valued but still likely

to fall in a crisis

• In general crises and sell-offs, the AUD does not just fall against the US dollar along with other currencies. The AUD has almost always sold off more than other currencies – even other ‘high risk’ emerging markets currencies -e.g. in the 20080 GCF, 1997 Asian currency crisis, 1998 Russian default crisis,

• This adds to the attractiveness of holding un-hedged US dollars in a crisis.

Reduces sensitivity to rising interest rates

Average term in bond

markets likely to continue to

lengthen

• The average term of bonds in local and global bond markets has doubled over the past 20 years – making bonds now twice as price sensitive to rising yields. This is the result of rapid increases in bond issuance by governments and at longer terms during the QE years.

• Holding US dollars reduces the overall portfolio’s direct price sensitivity to rising interest rates and yields.

US is still the primary safe haven currency

Likely to continue for some time

• The US has been the primary global safe haven currency since WW1 and is likely to remain for the foreseeable future.

• Even when the cause of a global crisis is the US itself - e.g. in the GFC when the cause of the global sell-off was US sub-prime mortgages and US banks, the US dollar still rose against other currencies (and the AUD fell) in the panic. Likewise in the US ‘tech-wreck’.

Comments on asset allocation:

o Ordinarily direct US dollars are not a core holding in portfolios. Bonds (government bonds in particular) are the traditional primary buffer against a broad sell-off in shares.

o However when bonds are overpriced and offering very low yields with little scope to fall lower in a crisis, holding US dollars directly is a useful tactical alternative with lower risk of capital loss, and likely gains, in a sell-off.

o In addition, bond returns suffer if the trigger for a broad sell-off is a sudden inflation scare (like 1994, 1973, 1979). US bond yields have been rising since mid-2016 and have had several inflation scare yield spikes along the way. These hurt bond returns.

o The AUD fell 10% in 2018 and the USD ETF has returned 10% since we added it to portfolios in April. It was the highest returning asset in portfolios for the year and it provided an excellent defensive buffer against falling share prices.

o The AUD is now back near its fundamental value, and global share prices are now lower, so the case for holding USD cash is now not as strong as a year ago. Some factors are still pointing to further falls, and the risk of another global crisis is still present.

o The risk of retaining in portfolios is that the current downswing might suddenly end – like the China stimulus re-boot in early 2016 which triggered an instant rebound in commodities prices and share prices, and the AUD turned and rose 8% over the next year.


o Last review: no change.

o This review: Retain at current levels Although the AUD has fallen 10% since adding USD to portfolios, more AUD falls are likely if the current conditions remain, or even more so if global conditions deteriorate further into a more serious crisis.

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8,000

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All Ords Index AUD / USD USD / AUD

U.S. Dollar

2008 GFC

2010-11Sovereign debt

crisis

2003-7 mining &

credit boom

2012-14QE boom

2015 China slowdown + commodities

collapse

2016-7China

stimulus rally, Trump tax

cuts

2017 Trump trade wars

+ China slowdown

OWEN

Exchange rates

AUD per USD

USD per AUD

USD per

AUD

Share price index

Shares

Portfolio Settings:

Zero weight Overweight

US Dollars

---Neutral

24

Disclaimer

Any advice contained in this document is general advice only and does not take into consideration the reader’s personal circumstances. This report is current when written. Any reference to the reader’s actual circumstances is coincidental. To avoid making a decision not appropriate to you, the content should not be relied upon or act as a substitute for receiving financial advice suitable to your circumstances. When considering a financial product please consider the Product Disclosure Statement. Stanford Brown is a Corporate Authorised Representative of The Lunar Group Pty Limited. The Lunar Group and its representatives receive fees and brokerage from the provision of financial advice or placement of financial products. The Lunar Group Pty Limited ABN 27 159 030 869 AFSL No. 470948 © 2018 Stanford Brown.

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