Update: Since this article was originally published on Friday, July 14, all changes to allocations have been completed.
Over the next few days, we will be reducing the allocations to Australian bonds across most of our portfolios. This change is aimed at reducing the risk posed by potential interest rate rises in the future and is being made under the expert guidance of our Investment Advisory Committee. It aims to ensure our portfolios are in the best possible position to provide optimal investment returns.
What changes are occurring?
For most of our clients, the change will involve reduced exposures to Australian bonds and increased allocations to international equities, Australian shares and/or cash yield investments. The extent of these changes will depend on which Six Park portfolio you are invested in. Clients in our Aggressive Growth portfolios will not be affected by this change at all.
Do Six Park clients need to do anything?
You don’t need to lift a finger. Our automated systems will take care of rebalancing your portfolio to bring it into line with our new allocation targets. During this time, you will receive a series of buy/sell trade confirmations for your records. You will not be charged any brokerage costs for these changes. These will be borne by Six Park – like all other trading expenses.
Why are we making these changes?
Six Park doesn’t make asset allocations changes very often. Investments move up and down over time and part of the reason for robo-advice is that it avoids emotion-driven decision-making. When we do make changes, it’s under the guidance of our Investment Advisory Committee, who understand not just day-to-day markets but the way whole asset classes move over time. And when we do make changes, it’s because we see a long-term benefit to our clients, even if it costs us to do the right thing.
In this instance, the main change being made is to reduce exposures to Australian bonds across most portfolios. This is being done to help reduce the risk posed by potential interest rate rises in the future. You can read more about this below if you really love the detail! Our Aggressive Growth portfolios already have very minor allocations to bonds so will not be adjusted at this time. As part of this change, our lower risk profile portfolios (Conservative and Conservative Balanced) will have higher allocations to our cash yield ETF (which does not carry the same interest rate risk exposure). Our Balanced and Balanced Growth portfolios will have slightly higher allocations to equities to provide enhanced global diversification and growth prospects.
When are these changes happening?
The changes will be implemented over the next few days. When complete, you will see your updated holdings and your new target asset allocations reflected in your Investment Strategy profile of your on-line account.
While we can’t make performance guarantees, we believe that these changes will enhance the overall performance of your investment account with Six Park.
Australian bonds form a core part of all Six Park portfolios – and will continue to do so after this change. We are simply making some adjustments to the percentage that they represent of our portfolios in order to minimise the impact that any future interest rate rises may have.
Of course, we don’t profess to know exactly when interest rates will rise in Australia. Predictions like those are incredibly difficult to make – and even the most sophisticated money market experts seldom get such calls right.
For the moment, the Reserve Bank of Australia has offered no hint of any imminent interest rate rises (for example, read more here). However, the fact remains that rates remain at record lows and appear more likely to rise (than fall) in the future – barring, of course, any major unexpected market dislocation. Many central banks around the world appear to be positioning for (or have already implemented) the first of a series of expected interest rate increases. We anticipate that Australia will probably follow suit at some point in the future.
Now for the detail: a primer on bonds and interest rates
So what do rising interest rates have to do with your Six Park portfolio? Surely rising interest rates would be a good thing if I’m an investor?
As you probably already know, bonds are a form of debt investment. In a typical bond structure, the bondholders (i.e. investors) lend money to the bond issuers (usually companies or governments) for a fixed term. In return, they are paid a regular stream of interest payments or “coupons” (which are usually for fixed dollar amounts each period) before being repaid their original investment (i.e. face value) at the end of the term. (1)
Bonds can be a highly effective asset class. Not only do they offer stable, predictable income flows, but they also help provide diversification benefits from shares and other investments (read more here).
Most bonds are traded on a secondary market (similar in many respects to the sharemarket). Through this marketplace, those bondholders who do not wish to hold their bonds to maturity can on-sell their bonds to other investors.
A bond’s price in the marketplace will depend on a number of factors, including the issuer’s creditworthiness and supply/demand levels. However, one of the primary determinants of bond prices will be the prevailing level of interest rates in an economy. As interest rates rise, the value of a bond will tend to decline (and conversely, as interest rates fall, bond values will tend to increase).
This so-called “inverse relationship” between interest rates and bond prices might seem confusing but is best understood with an example.
Let’s assume you hold a 10-year government bond which pays 5% in interest per annum. Now assume interest rates were to rise such that new, equivalent risk, 10-year government bonds were being issued with 6% coupon rates. If that happened, other investors would have the opportunity to buy these newer, higher yielding bonds and your bond would be less attractive than the new bonds (since it offers a lower coupon). As a result, it is unlikely anyone would want to buy your existing bond – unless you offered it at less than its face value (or less than the price of the new bonds at least). In the reverse situation, if interest rates fell to 4%, your bond would then be worth more than new (equivalent term and risk) bonds being issued and you would probably be able to sell your bond for more than you paid.
Not all bonds have the same sensitivity to interest rate shifts. You can get an idea of a bond’s exposure to rising interest rates by looking at its “duration”. Generally, the higher the duration, the more dramatic a bond’s price response will be to interest rate changes.
Our selected Australian bond ETF (iShares “IAF” Core Composite Bond ETF) has a published duration of approximately 5. This basically means that IAF would be expected to lose around 5% in value if interest rates rose by 1 percentage point (although this would be partially offset by a rise in interest rate yields over time). (2)
Still with us? So, what are the allocation changes?
In order to minimise the impact of rising interest rates on your bond holdings, we will be reducing our allocations to our Australian Bond ETF across most of our portfolios. The extent of these changes will depend on which Six Park portfolio you are invested in.
We are making the biggest reductions in bond allocations across our lower risk portfolios (Conservative and Conservative Balanced). These portfolios have the strongest emphasis on capital preservation and as such, should have proportionally less exposure to interest rate driven price movements. All reductions in bond allocations in these portfolios are being offset by an increased allocation our cash yield ETF (Betashare’s “AAA” High Interest Cash ETF), which does not carry the same interest rate risk exposure.
The reduction in IAF holdings in our Balanced portfolio will be offset by both (i) a small increase in holdings of AAA (for a similar reason to above) and (ii) a slight increase in exposure to international equities (Vanguard’s “VGS” MSCI Index International Shares ETF). The latter reflects a small but strategic change designed to further enhance the global diversification and growth profile of our Balanced portfolios.
For our Balanced Growth portfolios, the reduction in bond holdings is being re-allocated to a mix of Australian and international equities. Again this is a strategic shift to improve the growth profile of these portfolios.
Our Aggressive Growth portfolios already have very minor allocations to bonds so will not be adjusted at this time.
Six Park Asset Allocations as of 14 July 2017
|ASSET CLASS||CONSERVATIVE||CONSERVATIVE BALANCED||BALANCED||BALANCED GROWTH||AGGRESSIVE GROWTH|
|Australian Shares (STW)||7.5%||17.5%||25.0%||30.0%||32.5%|
|International Shares (VGS)||5.0%||12.5%||22.5%||30.0%||32.5%|
|Emerging Markets (VGE)||0.0%||0.0%||5.0%||7.5%||10.0%|
|Bond/Fixed Income (IAF)||27.5%||22.5%||20.0%||12.5%||5.0%|
|Cash Yield (AAA)||50.0%||32.5%||12.5%||0.0%||0.0%|
|Global Infrastructure (IFRA)||5.0%||7.5%||7.5%||10.0%||10.0%|
|Global Listed Property (DJRE)||5.0%||7.5%||7.5%||10.0%||10.0%|
A note about our Investment Advisory Committee
Our Investment Advisory Committee was instrumental in assessing and recommending these enhancements. We believe the calibre of our Investment Advisory Committee is unparalleled in Australia – they’re smart; they’re eminently qualified; and they’re highly knowledgeable about the sorts of factors and events that might affect the performance of our portfolios. We are fortunate to have this human overlay to complement the highly automated, algorithm-driven system that manages your investments.
This change demonstrates the important difference our Investment Advisory Committee and its knowledge can make. We think it’s a good thing that some very smart people are reviewing market conditions and ETF products on a regular basis to make sure Six Park’s portfolios are in the best possible position to provide optimal investment returns. We don’t see this level of oversight and involvement at other robo-advisors and think it’s what makes our service so unique. And we are the low-cost provider at the same time. We think that’s pretty cool!
(1) For simplicity, this article only focuses on fixed rate rather than floating rate bonds. The latter have interest rate coupons which are based off an interest rate benchmark (rather than a fixed percentage). Holders of these bonds have limited to nil interest rate risk exposure.
(2) Interest rates are not the only factors which affect bond pricing and as such, bond prices are not perfectly negatively correlated with interest rates. IAF’s portfolio is also not static and its composition (and associated duration) will vary over time. The duration measure also assumes a parallel shift across the curve of all bonds held by IAF. In reality, bond prices of different maturities will have different interest rate sensitivities.