Reece Birtles, Chief Investment Officer, Martin Currie Investment Management
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Retirees have traditionally relied on fixed interest and cash allocations in their portfolios to provide sufficient income for life. But the yield or the income return from these defensive asset classes has fallen significantly over the last decade, creating a disconnect between our understanding of income and the traditional risk/return theory.
The impact of COVID 19, the global economic slowdown and increased use of extraordinary monetary policies by central banks have further reduced returns from cash and fixed interest to the point where many cash rates and ten-year bond yields in developed countries now return a 0% or even a negative yield. These policies may have supported many weakened economies but have made it even more difficult for retirees drawing income streams to fund a large portion of their income needs by the yields on cash and fixed interest allocations.
In this episode, we discuss some of current strategies for generating sufficient income for life with Reece Birtles, Chief Investment Officer, Martin Currie Investment Management, and we address some the challenges facing inflation, longevity risk and income sequencing risk.
Welcome to the Netwealth Investment Podcast Series. My name is Paul O’Connor, and I am the HIMR.Today we welcome Reece Birtles from Martin Currie who the Chief Investment Officer, Australia of Martin Currie Investment Management Limited (Martin Currie) based in Melbourne. Good morning, Reece.
Thanks Paul great to talk to you.
Martin Currie is a subsidiary of Franklin Resources, Inc. that is a global investment management organisation operating as Franklin Templeton listed on the New York Stock Exchange (NYSE:BEN). With employees in over 34 countries, Franklin Templeton is headquartered in California and has over $2.1tr in assets under management as at 30 June 2021. Martin Currie Australia adopts an investment approach that combines fundamental bottom-up research with quantitative inputs. The fundamental process can be best described as a contrarian value philosophy with the belief that markets can become too optimistic or pessimistic about a company’s future prospects.
Traditionally, the defensive or fixed interest & cash allocations in portfolios have provided the bulk of the income retirees need to fund their lifestyles but over the last 12 years, the coupon or income return from these asset classes has fallen significantly. The impact of COVID 19, the global economic slowdown and increased use of extraordinary monetary policies by central banks have further reduced returns from cash and fixed interest to the point where many cash rates and 10 bond yields in developed countries now return 0% or even negative yields.
These policies have supported many weakened economies but have made it even more difficult for retirees drawing income streams to fund the large portion of their income needs by the yields on cash and fixed interest allocations.
However, there are an increasing number of equities strategies that focus on providing stable income including a number of Martin Currie products that Reece oversees so will be interesting to discuss how this work and the role they can potentially play in retirees portfolios.
To start with Reece, can you provide the listeners with a summary of your journey through asset management that has seen you work abroad and return to Australia as Martin Currie’s Chief Investment Officer?
Thanks, Paul, I guess I was always interested in markets as I was growing up. I had some - my great uncle was one of the founders of the ASX. And so, there was always plenty of stories in the family. And my family started a self-managed super fund in the eighties, so I always had plenty of interest in markets and did a Master of Finance. And I was luckily enough, responded to a job in the newspaper in 1995 to join JP Morgan in Investment Management.
And that obviously started a pretty long journey. And I guess one of the things that happens in this industry is you can be, you need lots of different experience. And we went through the JP Morgan period, Citigroup Asset Management worked on domestic equities, doing resource stocks before doing banks and insurance, and then went over to London and was working on global equity portfolios and European equities. So that diversity of experiences is a really important thing in terms of your formative years and learning different ways and means of doing things. And I guess that sort of really set me up for coming back to Australia in 2006 and thinking, you know, how do I really want to run an investment team? How do we really want to achieve the best results for clients in terms of creating a repeatable investment process? You know, really backing our philosophy and approach and really trying to develop the right cultural aspects within a team, which to me was really important, then that's something you can’t buy. You really have to build with time and effort with people.
Yeah, those words certainly make sense, getting the right cultural mix within an investment team, I'd imagine to be one of the challenges on going there. But no, I didn't realise you were sort of born to manage money, given your, did you say your grandfather was one of the founders of the ASX? From a very young age it appears, a young Reece was set on his journey.
Yes, it was my great uncle, is one of the legends of the industry.
Gotcha. Gotcha. Traditionally, default investment options reduced allocation to growth assets and increased the allocation to defensive assets as the investor ages. So do you think these, I guess, traditional glide path portfolios can still generate enough income to meet the needs of retirees in 2021?
Yeah, I think it's a real challenge Paul, as you mentioned in your introduction, the yields on defensive assets are so much lower than they were ten years ago. Well, 15 years ago now, I guess, you know, if you think about it, the ability to earn a 6% plus yield out of a term deposit in the 2000s was quite typical. So, you can imagine, as you are, you got towards retirement and you move from your 70/30 balanced fund and you needed an income stream, you could really sort of lock in this very attractive yield with zero risk. But today, with yields on, for example, ten deposits a half per cent or less, you just can't do that anymore. And it really has created sequencing risk in a manner that is quite different to the way it was originally conceived, which was that, you know, if you retired when equity markets were low, your retirement balance was quite poor and that was really seen as the big sequencing risk event. But today the real challenge is if you retire and move from 70% growth assets to, say, 70% defensive assets, you know you're going to be locking in yields, you know, across your defensive asset classes of less than 2%. And so, the dollar income that you can generate, say, off a $500,000 balance if you're only earning a 1% yield, that $5,000 a year is just not enough for a typical couple in retirement. So, so I really don't think you can follow that traditional path of moving from sort of high growth allocations to high defensive allocations when you retire. Given the yield structure that is that is available today.
Yeah, well, we have we've certainly noticed yields, you know, come down significantly over, I guess, pretty much over the last 40 years. I think to you, go back to when central banks started targeting inflation in the in the mid-1980s. But you're probably old enough, like myself to remember annuities paying 15%, lifetime annuities. So how the world has changed over the last 30 years... So, Martin Currie has done a lot of research on sufficient income for life. Can you elaborate on this work and including the key risks and challenges retirees need to address?
Sure. For us at Martin Currie, a number of our parents retired in the late 2000s, and we were personally going through the experience of trying to understand, you know what a retiree needs compared to what traditional investment products offered. So clearly, you know, when before you're 65, you're trying to maximize the wealth - given your risk tolerance. But when you get to 65 and retire, your investment problem becomes one of 'do I have enough income to support my cost of living?'
So, for a typical Australian couple, they might need about $50,000 a year to live. They get a government pension of about $20,000, so they need $30,000 a year from their investment portfolio. And this is a very different problem to the accumulation stage, which has driven most portfolio construction. And so, it really drove us to this concept of sufficient income for life. And so, what we mean by that, you know, firstly, it's about adequacy, you know, can you generate on a $600,000 for typical portfolio that $30,000 a year of income required to support your cost of living? And so that requires a yield on your investments or in excess of 4 or 5%. So above that drawdown rate, that might be typical in portfolio construction for retirement. And then you also need that income to grow over time to offset the cost of inflation. And finally, you want less volatility than you have in accumulation because you really don't want that variability in that $30,000, you want it to be quite consistent and growing over time. You don't want to have a drawdown in your income level that means you don't have enough money to cover your cost of living that year. And so that really drove us to a different type of concept. So, it's about adequacy of income level. It's about longevity in terms of having the growth assets to protect you against inflation.
It's about sequencing risk in terms of, you know, when you retire, you don't want to be moving from those growth assets with high yield into defensive, with very low yield and not getting sufficient levels of income.
Yeah, it's interesting those comments you're making there, Reece, because it certainly resonates, say that traditional modern portfolio theory focused on trying to maximize return for a given level of risk or vice versa. I guess it is the traditional building block we have used on portfolios in the industry there. So, you certainly do articulate well the challenges of people drawing a pension out of their portfolios when they retire.
So, what type of strategies should investors with diversified portfolios consider providing a sufficient income for life? And I guess I'm also thinking with the recent spike in inflation across developed markets. Do these types of strategies protect investments from inflation that would obviously further impact on their real return?
Yeah. So, when we look at different asset classes through the lens of the level of income and income risk, as opposed to total return expectation and capital volatility, and we see a very different risk return trade off. So, the most defensive asset class, call it term deposits, has no capital risk. But when you look at the level of income risk, you know it's been extremely volatile. You know, you've had a 90% reduction over the last 15 years. And you know, clearly that's just a massive shock to any income retirement portfolio.
But when you look at asset classes like equities, you find that whilst a capital volatility might be around 15 or 20% per annum, the level of income volatility from high quality share portfolios can be less than 10% over time, so there's much less income variability, whilst at the same time they can have higher yields available.
The other thing to really consider is just how valuable franking is to a retiree in Australia on a zero-tax rate. Being able to earn an extra 2% per annum return in terms of a cash refund from the tax office from franking credits is just makes a massive difference to income that can be generated.
So, we think high quality equity income portfolios from domestic equities is an important aspect. The other one is real assets. You know, real assets such as property infrastructure, utilities have less variability of their earnings because they tend to have contracted cash flows, and they also have inflation protection built into them in terms of renewals of those rents or their tolls or their tariffs in their structures. So, we think that, you know, domestic equities, real assets are definitely very good for to consider for these retirement portfolios, and they both do have inflation protection. Clearly, they have, you know, unlike defensive asset classes, they have built in mechanisms for growth, and their capital value is only partially impacted by changes in rates and inflation expectations over time.
Yeah, some interesting comments you've made their, Reece, particularly, I guess, the one around the volatility of dividends. Um, and I guess, you know, I was thinking as you were making the comment there that the volatility of dividends is so much lower than the overall share market volatility. And it sort of makes sense because companies want to be able to maintain that dividend and do everything, they can continually build that dividend. But their actual capital value of their share price will really wash around with both the economic cycle and also, I guess, the strength of the economy - where the companies domiciled there. So, some really valuable points you've made there. And then also I read obviously real assets and you're going to get a bit more capital stability as well with some exposure to real assets as opposed to listed assets in a portfolio.
Longevity risk and sequencing risk are two of the key risks that retirees really need to consider. So, can equity income strategies address either of these risks? And I guess I can appreciate the income bias equity strategies are typically less volatile than other types of equity strategies. And hence, you know, I guess in my mind I can help with sequencing risks, but I guess I'll be interested in your return. You comment specifically around longevity risk.
Yes, longevity to me is really about, you know, not eating your capital.
So, you know, if you build an income portfolio that is really just turning a, you know, $100 of capital into income and your capital base is declining over time, then you're really going to impact your capability of longevity.
There's no point having a 10% yield of a portfolio that's generating a return that's less than that because it just means your capital base is going to fall over time, and 10% on a lower capital base is a lower income number.
So, we think the first thing is, you know that you sort of you need to rely on the income naturally generated by high quality companies. For example, by-rates strategies can tend to just turn capital into income or high turnover strategies. You don't know whether you're relying on the natural dividends of the company. But when you do own quality stocks that are increasing their dividend per share over time, you can naturally grow the income stream. And that's really about the best way to protect longevity - is being in growth assets.
Naturally, income portfolios are going to be biased to higher levels of income and have lower growth than growth stocks, for example. But you know, an income portfolio can still generate income growth of four or 5% per annum, maybe a bit less than a growth portfolio that might be generating six or 7% per annum. But you're skewing your mix of return towards that income at the expense of some growth naturally. But obviously, the important thing for a retiree is when you consider the natural growth rate of a total portfolio, a balanced portfolio, defensive assets might have zero growth and you need know probably in excess of 50% in growth assets generating around that 5% per annum growth in order to get the overall portfolio to generate sufficient income and growth to offset inflation, which might be around two and a half per cent per annum over time.
So, I guess what are the implications for portfolio construction for retirees versus accumulators and how important really are these franking credits?
So, we think the, you know, I've talked about that level of income. So, you know, for a 600,000-dollar portfolio, we want to generate $30,000 a year of income and we want that income to grow over time and we want to reduce the risk to that income stream. So, the first thing is really about ignoring the index because the index is really concentrated. Seven stocks in the ASX 200 generate over half of the entire dividend income of the index, and the bank sector has traditionally generated in excess of 40% of the income of the index.
To us, that's just too much concentration risk in a narrow set of stocks or in one economic sector that can be impacted at the same time. This is a perfect example going on right now, where you're seeing some concentrated income ETFs, typically where the iron ore stocks are a very large part of their portfolio - and with the iron ore price falling, they're suffering materially from that high concentration risk where they might have like 30% of the portfolio just in the iron ore related stocks. So, we think you should have a limit on individual stock risk and a limit on sector risk so that you can really diversify the sources of your income. And we also think you should fully value franking credits for retirees on that zero-tax rate. Because if you can, you know, obviously if you take a 4% dividend, yielding portfolio can get an extra 2% from franking credits and get a 6% yield for annum that the market doesn't fully value in the capital value. That's one of the few free lunches that exist in finance for retirees.
So, our industry's focus on volatility is a key measurement of risk that always struck me as odd, I guess, given that I think the investors key risk is really not meeting their needs or objectives for retirees. Clearly, a certain level of income is a key need. So, can you elaborate on your views that portfolio income stability is a key risk? And how should this be managed?
Yeah, I totally agree that the real risk, you know, is not if you retire today and how much is your capital value going up and down on a monthly basis over the next five years? That's not the real risks for a retiree. The real risk is that you, you invest $100 today, you're expecting $5 of income and in five years’ time you turn around and discover you're only getting $2.50 a year of income, that that's what we would call an income shock. It's sort of those, it's a material change to the ongoing income generation of a portfolio. And it's what many investors have suffered in recent years from - by example - from the yield structure falling in markets.
So, we think, you know, you do need to focus on diversification, and you need to look at the level of income variability. So how much does the dividend per unit on your fund or your shares vary over time compared to the expectations of drawdown that an investor has?
So, the phenomenal returns from many growth stocks over the last ten years plus has resulted in a wide variance of returns from different equity strategies. So, are investors really giving up on total returns when they buy a single portfolio to equity income strategies? So, I guess income needs can potentially be met by a combination of both income and a bit of drawdown of capital, and particularly if you're enjoying strong capital growth on your portfolio.
Yeah, it's certainly true. I think, you know, partly it's about the behavioural finance risk so that drawing down on capital is much easier in strong markets than it is in other markets. Clearly, investment styles go through time periods where they in and out of favor and especially the last three and five years has just been, as have been a very strong growth market.
I do think one of the things that's very important when you're building the income portfolio is that you have a good investment return, total return, alpha process. So, you know, our approach to picking the right stocks for an income portfolio is very much based on a traditional alpha strategy.
So, whereas I mentioned before, we really don't believe in turning capital into income, we're trying to pick the right stocks, they might be a little bit lower growth than the rest of the market, but they're reliable and they're going to have good total returns over time.
Certainly, in recent time periods, growth stocks have moved from a capital valuation sense to such extremes that the risk is, you know, is more heightened in those growth stocks today than at any time we've seen almost in the last 50 years.
Yeah. Well, there's not a lot of room for error in the management of a lot of those growth stocks. I would agree, Reece. They are quite eye watering, some of the valuations. You do wonder about what the future looks like in the returns for those types of securities.
So, the growth of ESG products over the last three years has really been extraordinary and I guess the acceptance and take up of the investor, um, it's very much resonated. And bit I sort of found when I dig into it and I start to look at a screen, any level of detail, it's a pretty complex analysis that you start to uncover. But I guess just at a general level, can there be ESG equity income strategies and are they a viable option for investors? And how may they differ from a, you know, a normal equity income strategy?
Yeah. Well, we think ESG is a really critical topic, and in many, in many cases, it's misunderstood. I think the way we would describe it is that these ESG integrated investment processes, then there's the ethical screening or socially responsible type products. And then the newer generation is what you might call sustainability products where they're trying to find sustainability winners. For Martin Currie Australia, integrated ESG we have across all of our products, and we think that's critical in terms of assessing the sustainability risks of each company, best governance practices, actively engaging for companies for improvement, to improve their practices, which will help their share rating, including that in our assessment of each company, including in our engagement practices with board and management over time. So that ESG integration is a critical part of every portfolio we have. For those investors who are more sensitive to particular areas of harm, we have an ethical income strategy which excludes specific characteristics like tobacco, alcohol, that can meet investor needs in that regard. And what we tend to do is build a similar risk and return characteristic while looking for substitute companies that avoid that.
There are also - we have a sustainability product that is less focused on income, but really about looking for those companies that have got great sustainability practices and a much best in class over time. And we think that's a spectrum of sort of ESG products that exists at the moment, and ethical income is certainly a viable means for investors focused on those issues in a sensitive manner.
Interesting, your opening comments, there, Reece, because I have long believed that to a good quality, a genuine ESG strategy must be integrated into the investment process.
It must be both a combination of a positive and the negative screen and including engagement with each company. I have often at times wondered how these proliferation of investment strategies that just purely have a negative screen where their blind spots are to weigh ESG risks that I guess they're not quite aware of.
So it is, I guess it's positive from my perspective to hear your description of the way you guys have integrated it into your investment process. We're well aware of the impact of COVID, the COVID induced economic slowdown and the impact on bond yields and cash, but how have equity income strategies been impacted over the last 18 months? I guess ultimately, you know, we've just gone through the recent reporting season, so have there been any real surprises, some that may even lead you to believe they could be an increase in that volatility of dividends payable across the ASX 200?
Yeah, the pulse, for sure. 2020 with COVID was the biggest challenge to dividends that we've had since the GFC, or even more so than the GFC. You know, the global financial crisis was pretty much a capital markets event more than it was a real-world event.
And in many ways, the real advantage of dividend income is that it is paid by the real world. You know, it's paid by the profits of companies and the revenues from companies. You know, when you go to the supermarket, and you buy food that determines the profit that determines the dividend for a particular company. But with social distancing, COVID had a much bigger impact on that, the real-world earnings than before. And so, for the ASX 200, we saw the level of dividend income or yield fell about 35% in 2020 versus 2019.
That has broadly recovered now because as we as companies have adapted and come through lockdown, it really highlights to us the importance of what we're trying to achieve in that sufficient income for life across our strategies.
So, our equity income portfolio, by being more diversified from the market, not having the concentration risk, for example, in banks, we had a tough year. You know, the dividend income fell about 20%, but the yield premium to the market was about a 40% premium to the market.
And that dividend income stream has recovered strongly. So, it has been there was a temporary impact as the broadly the portfolios recovered, and we really think it showed the strength of our equity income approach in protecting that income stream compared to the broader market.
And as to the reporting season, though, the strength of cash flows for companies was remarkable, balance sheets are in very strong positions. Companies’ payout ratios have been lowered from pre-COVID levels, which puts them in a strong position to actually grow their dividends close to double digits over the next couple of years until they get back to prior levels. And at the same time, companies are reinvesting more in their business as they're seeing many opportunities for improvement.
Maybe just to finish, Reece, a bit of an ongoing debate across the whole of the investment industry.
You know, we're probably going into the twelfth or the thirteenth year where growth-style investing has outperformed value-styled investing. So, what sort of factors do you believe will result in a turnaround? And when you know, we'll go through a prolonged period again, when value will outperform growth? And I'll caveat there - being, I remember, a young guy joining the industry, you know, I think value would outperform growth till about 60 of the previous 100 years, and it had about the ten-year run of outperformance.
So, I think that it's a question on everyone's minds at the moment. And then obviously the impact it will have on portfolios and allocations to various active equity managers.
I think this is one of the biggest risks in markets right now.
So, I mean, clearly, we you know, the broader equity market is not necessarily cheap. You know, the price to earnings ratio on the market is not that cheap, but it's not when you compare equities to, for example, bonds, the mispricing the equities doesn't, you know, they look very cheap in that regard.
So, when you look at the dispersion of the valuation put on growth stocks... For example, the PE on the growth indices at 35 or 40 times versus PE on a value index at sub 18 times or 15 times.
That dispersion and valuation is the largest we've seen basically at the moment, so similar to tech bubble levels, similar to the GFC in terms of that dispersion. So that's one measure, that just tells you how out of line the valuation is on markets at the moment.
But when you look at the correlations of what drives shorter term value growth performance to help you think about the timing of that, it's got a lot to do with the level and change of the PMI as a lead indicator on growth, as well as movements in bond yields and inflation.
And so, PMI is quite strong and that would suggest that they should be doing quite well. The bond yields staying low has probably been the biggest negative impact on value strategies versus growth. But clearly, we're seeing a lot more inflation in the system.
There's a big debate about whether it's transitory or permanent. We think this is a lot more transitory inflation that obviously than there is permanent. But the structural increasing costs around, for example, energy transition to net zero means that inflation going forward is going to be much higher than the past.
And then central bank and government policies of stimulus is really creating a structure where rates will rise and that would be very supportive of value strategies, in our view.
Yeah, I think I tend to agree with you on that. I think there's a combination of issues that have been at play for the long term now with the last decade and ultimately around the extraordinary monetary policy that the central banks have implemented. And potentially there's also something going on in productivity. And I guess what I mean by that productivity not being maybe accurately measured by the technology revolution that we've been going through.
But I certainly appreciate your comments around the valuation differences between growth and value stocks. It's quite extraordinary there, so there will come a day, I have no doubt, and I suspect it sooner than later when value will turn around.
So, Reece, I just wanted to thank you very much for joining us today on the Net Wealth Investment Podcast. It's been a really interesting discussion with you, and I think some of the comments you have made around equity, income, income in portfolios, the challenges for retirees, I think, will be certainly well received by the listener base of the podcast series. And I think we've also got a bit of work to do in the back of my mind about advancing modern portfolio theory to include an income or drawdown component and how that would look going forward. But thank you again, Reece. We have really appreciated your time and your input to the podcast.
Thanks for all the great discussion. Thank you. And to the listeners, thank you for joining us again on the podcast series.
I hope you're all keeping well and managing to charge towards Christmas and we'll have a bit of a break over that period to recharge the batteries. So thanks for joining us. All the best and I look forward to joining you on the next instalment of the Net Wealth Investment Podcast series.
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